Back to: Financial Accounting
Good day, class.
This week, we will be studying what happens when a new partner is admitted into a partnership.
Admission of a New Partner in a Partnership Business
Partnerships often decide to bring in new members to contribute more capital, introduce new ideas, or expand operations. While this can benefit the business, it also comes with some necessary financial adjustments.
1. Why Admit a New Partner?
A new partner may be admitted into an existing partnership for various reasons:
To increase the financial strength of the business by bringing in more capital
To introduce new business skills, experience, or contacts
To reduce the workload on existing partners
To expand the scope of the business or move into new areas
However, the admission of a new partner means the old agreement between the existing partners ends. A new partnership agreement is usually created, and this affects profit-sharing ratios and capital arrangements.
2. Important Adjustments to Make on Admission
When a new partner joins the business, the existing partners usually make the following adjustments:
a. Change in Profit-Sharing Ratio
The new partner will be entitled to a share of the profits. As a result, the current partners need to agree on how profits will be shared going forward. This may involve reducing their own shares to accommodate the new partner.
For example, if Partner A and Partner B previously shared profits in the ratio 3:2 and Partner C joins with a 1/5 share of profits, the remaining 4/5 will be shared between A and B based on an agreed ratio.
b. Revaluation of Assets and Liabilities
Before the new partner joins, the existing partners may revalue the business’s assets and liabilities. This ensures that the balance sheet reflects current market values.
Increases in asset values result in gains
Decreases result in losses
These gains or losses are shared only between the old partners, in their old profit-sharing ratio, since the new partner was not part of the business during the previous period.
A Revaluation Account is used to record these changes.
c. Goodwill
Goodwill represents the value of the firm’s reputation and customer loyalty. When a new partner joins, they benefit from goodwill that they did not help to build. For this reason, they are often required to compensate the old partners.
There are two common ways to treat goodwill:
Cash Payment: The new partner brings in an agreed amount of money as goodwill, which is shared among the old partners in their old ratio.
Adjustment in Capital Accounts: If no cash is brought in, the goodwill can be recorded in the books and credited to the old partners, while debiting the new partner.
Note: In some cases, goodwill is not recorded at all, especially if the agreement states that it should not appear in the books.
d. Adjustment of Capital Contributions
The new partner will usually bring in capital to match their agreed share of the business. The existing partners may also adjust their capital accounts to reflect the new profit-sharing arrangement.
Sometimes, after goodwill and revaluation adjustments, the partners may decide to have their capital accounts proportionate to the new profit-sharing ratio. This may involve:
Bringing in or withdrawing cash
Transferring balances between partners’ capital and current accounts
3. Illustrative Example (Simplified)
Let’s say:
Partner A and Partner B share profits in a 3:2 ratio.
They agree to admit Partner C, who is to receive 1/5 of the profits.
C brings in N400,000 as capital and N100,000 as goodwill.
Goodwill is to be shared by A and B in their old profit-sharing ratio.
Steps:
Record C’s capital and goodwill contributions.
Distribute goodwill: A gets N60,000; B gets N40,000.
Adjust capital accounts if necessary.
Revalue assets, if agreed, and share revaluation profits or losses between A and B.
Conclusion
The admission of a new partner is more than just receiving money. It involves careful planning, agreement, and accounting adjustments. It affects how profits are shared, how assets are valued, and how partners’ contributions are recorded.
Every adjustment must be made clearly to avoid future disputes and to present a fair view of the firm’s financial position.