Retirement of a Partner

In the previous chapter, we looked at what happens when a new partner joins the firm. We saw how the existing partners had to sacrifice a piece of their profit share to make room for the newcomer.

Now, we are going to look at the exact opposite scenario: what happens when a partner decides to leave?

People retire from partnerships for all sorts of reasons. It could be old age, failing health, a desire to start a different business, or simply a disagreement with the other partners. Whatever the reason, when a partner walks out the door, the partnership as it previously existed comes to an end. The firm itself might continue doing business, but it does so under a newly reconstituted agreement among the remaining partners.

When a partner retires, we have two main jobs as accountants:

1. 1Re-slice the pie: Figure out how the remaining partners will share profits from now on.
2. 2Settle the bill: Calculate exactly every single rupee the retiring partner is owed up to their last day, and figure out how to pay them.

This chapter will walk you through this entire process, step by step, from first principles. We will cover how to calculate the new profit-sharing ratios, how to handle the firm's goodwill, how to revalue assets, and finally, how to close out the retiring partner's account.

1. The Profit-Sharing Ratios: Who Gets the Extra Slice?

When a partner retires, they leave their share of the future profits behind on the table. The remaining partners will scoop up this abandoned share. Because the remaining partners are now getting a bigger piece of the pie than they used to, we say they have "gained."

To handle this mathematically, we need to understand two terms: the New Profit-Sharing Ratio and the Gaining Ratio.

Calculating the New Ratio and Gaining Ratio

How we calculate these ratios depends entirely on the agreement between the remaining partners. Let's look at the two most common scenarios you will face.

Scenario A: The agreement is silent (The "Strike-Out" Method) If the problem tells you that a partner is retiring, but gives you absolutely no information about how the remaining partners will share profits in the future, you assume they will continue sharing in their existing relative proportions.

This is the easiest calculation in accounting. You simply take the old ratio and strike out the retiring partner's share.

Example: Amar, Akbar, and Anthony are partners sharing profits in the ratio of 3:2:1. Akbar decides to retire. What is the new ratio?

• Old Ratio = 3 : 2 : 1
• Strike out Akbar's share (the middle number, 2).
• New Ratio for Amar and Anthony = 3 : 1.
• In this case, their Gaining Ratio is also exactly 3:1. They gained Akbar's share in the exact same proportion as their old relationship.

Scenario B: The remaining partners purchase the share in a specific ratio Sometimes, the remaining partners decide to split the retiring partner's share in a specific, agreed-upon way.

Example: Sita, Gita, and Mita are partners sharing profits in the ratio of 5:3:2. Mita retires. Her share (2/10) is taken up by Sita and Gita equally.

• Mita's share = 2/10.
• Sita gains half of Mita's share: 1/2 of 2/10 = 1/10.
• Gita gains half of Mita's share: 1/2 of 2/10 = 1/10.
• Now, add this gain to their old shares to find the New Ratio:
• Sita's New Share = Old Share (5/10) + Gain (1/10) = 6/10.
• Gita's New Share = Old Share (3/10) + Gain (1/10) = 4/10.
• The New Ratio is 6:4, which simplifies to 3:2.
• The Gaining Ratio is 1:1 (because they split Mita's share equally).

The Master Formula

If you are ever given the Old Ratio and the New Ratio, and you need to find the Gaining Ratio, use this simple formula:

Gaining Ratio = New Ratio - Old Ratio

If the result is positive, the partner has gained. (If the result is negative, it actually means that partner sacrificed some of their share, which is rare in retirement but mathematically possible if the new ratio is drastically altered).

Gaining Ratio vs. Sacrificing Ratio

Examiners love to test if you understand the conceptual difference between what happens during admission and what happens during retirement. Let's put them side-by-side so you never confuse them.

• When is it calculated?
• Sacrificing Ratio: Calculated at the time of admission of a new partner.
• Gaining Ratio: Calculated at the time of retirement (or death) of an old partner.
• What does it measure?
• Sacrificing Ratio: The share of profit surrendered by old partners in favour of the new partner.
• Gaining Ratio: The share of profit acquired by remaining partners from the retiring partner.
• The Formula:
• Sacrificing Ratio: Old Ratio - New Ratio
• Gaining Ratio: New Ratio - Old Ratio
• What is it used for?
• Sacrificing Ratio: Used to distribute the Premium for Goodwill brought in by the new partner to the old partners.
• Gaining Ratio: Used to determine how much the remaining partners must pay to compensate the retiring partner for their share of goodwill.

2. Treatment of Goodwill: Paying for the Past

When a partner retires, they are leaving behind a business that they helped build. Over the years, their hard work, customer relationships, and good decisions helped create the firm's "Goodwill" (its good reputation that guarantees future profits).

Because the retiring partner is leaving, they won't get to enjoy those future profits. Therefore, it is only fair that the remaining partners—who will enjoy those future profits—compensate the retiring partner for their share of the goodwill today.

There are two completely different types of goodwill you will encounter in a retirement problem, and you must treat them differently. Mixing these up is the most common mistake students make.

Type 1: Existing Goodwill (The Ghost of the Past)

This is goodwill that is already sitting on the Asset side of the old Balance Sheet.

Accounting standards (specifically AS-26) state that goodwill should only be recorded in the books if money or money's worth has been paid for it. Internally generated goodwill should not sit on the balance sheet. Therefore, whenever the firm is reconstituted (like a retirement), we must clean up the balance sheet and wipe this old goodwill off the books.

The Rule: Write off existing goodwill immediately among ALL partners (including the retiring one) in their OLD profit-sharing ratio.

Journal Entry:

All Partners' Capital A/cs ... (Dr) [In Old Ratio] To Goodwill A/c ... (Cr) (Being existing goodwill written off)

Type 2: Valued Goodwill (The Compensation)

This is the fresh valuation of the firm's goodwill done on the exact date of retirement. It will be given to you in the adjustments outside the balance sheet (e.g., "Goodwill of the firm is valued at ₹60,000").

We do not open a Goodwill Account for this. Instead, we adjust it directly through the partners' capital accounts. The remaining partners (who are gaining the future profits) must pay the retiring partner (who is sacrificing their future profits).

Step 1: Calculate the retiring partner's share of the valued goodwill. (Total Firm Goodwill × Retiring Partner's Old Share)

Step 2: The remaining partners will bear this cost in their Gaining Ratio.

Journal Entry:

Gaining Partners' Capital A/cs ... (Dr) [In Gaining Ratio] To Retiring Partner's Capital A/c ... (Cr) (Being retiring partner's share of goodwill adjusted to gaining partners)

3. Revaluation of Assets and Liabilities

Over the years, the value of the firm's assets (like land, buildings, or machinery) will have changed. Liabilities might have increased or decreased. The values shown on the old Balance Sheet are likely outdated.

Before the retiring partner leaves, we must find the true, current value of the business. If a piece of land bought for ₹1,00,000 ten years ago is now worth ₹5,00,000, that ₹4,00,000 profit belongs to the retiring partner just as much as it belongs to the remaining partners.

To figure this out, we prepare a Revaluation Account (also called a Profit and Loss Adjustment Account).

You already learned how to prepare this account in the chapter on admitting a new partner. The rules of debit and credit are exactly the same:

• Debit side (Losses): Decrease in asset value, increase in liability, unrecorded liabilities.
• Credit side (Gains): Increase in asset value, decrease in liability, unrecorded assets.

The Crucial Difference for Retirement: When a new partner is admitted, the revaluation profit or loss is shared only among the old partners. When a partner retires, the revaluation profit or loss is shared among ALL partners (including the retiring partner) in their OLD profit-sharing ratio.

Why? Because the retiring partner was part of the firm while those assets were gaining or losing value. They deserve their cut of the profit, or they must bear their share of the loss, up to the date they leave.

Journal Entry for Revaluation Profit:

Revaluation A/c ... (Dr) To All Partners' Capital A/cs ... (Cr) [In Old Ratio]

4. Distributing Accumulated Profits and Reserves

Look at the Liabilities side of the firm's old Balance Sheet. Do you see a "General Reserve", a "Reserve Fund", or a "Profit & Loss A/c" balance?

These are accumulated profits. They are savings that the firm set aside from past earnings instead of distributing them to the partners. Because these savings were built up while the retiring partner was working at the firm, the retiring partner is entitled to their share before they leave.

Just like existing goodwill, we must clear these out of the balance sheet and give them to the partners.

The Rule: Distribute all accumulated profits and reserves to ALL partners in their OLD profit-sharing ratio.

Journal Entry for distributing a Reserve:

General Reserve A/c ... (Dr) Profit & Loss A/c (Profit balance) ... (Dr) To All Partners' Capital A/cs ... (Cr) [In Old Ratio]

Note: If there is an accumulated loss (a P&L debit balance sitting on the Asset side of the balance sheet), you do the exact reverse. Debit all partners' capital accounts in the old ratio to make them bear the loss.

5. Calculating the Retiring Partner's Final Balance

We have now gathered all the pieces. It is time to calculate exactly how much money the firm owes the retiring partner. We do this by preparing the Retiring Partner's Capital Account.

Think of the Capital Account as a bucket. We pour in everything the partner is owed (Credits), and we scoop out everything the partner owes the firm (Debits). The water left in the bucket is their final settlement amount.

6. Settling the Account: Cash or Loan?

Once we know the final balancing figure, the firm has to pay the retiring partner. There are three ways this can happen, and the exam question will explicitly tell you which one to use.

Method 1: Paid in full immediately in cash/bank. If the firm has enough liquidity, they just write a cheque and the partner walks away.

Retiring Partner's Capital A/c ... (Dr) To Bank/Cash A/c ... (Cr)

Method 2: Paid partly in cash, and the rest transferred to a Loan Account. The firm might pay a lump sum today, and promise to pay the rest later.

Retiring Partner's Capital A/c ... (Dr) [Total amount owed] To Bank A/c ... (Cr) [Amount paid today] To Retiring Partner's Loan A/c ... (Cr) [The remaining balance]

Method 3: The entire amount is transferred to a Loan Account. If the firm has no spare cash, or the agreement dictates it, the entire final balance is converted into a loan. The retiring partner is no longer an owner; they are now a creditor (a lender) to the firm.

Retiring Partner's Capital A/c ... (Dr) To Retiring Partner's Loan A/c ... (Cr)

The Trap: Section 37 of the Indian Partnership Act, 1932

What happens if the firm transfers the money to a Loan Account, but the partnership deed doesn't say anything about what interest rate to pay on that loan?

The firm is now using the retiring partner's money to continue doing business and making profits. The law does not let the firm do this for free.

Under Section 37 of the Indian Partnership Act, 1932, if the dues of a retiring partner are not settled immediately, and there is no specific agreement on interest, the retiring partner has a powerful choice. They are entitled to choose whichever of the following two options gives them more money:

1. 1Interest at the rate of 6% per annum on the unpaid balance.
2. 2That share of the firm's profits which has been earned by using their unpaid money.

7. Comprehensive Worked Example

Let’s put everything together into a single, complete problem. Read through this carefully, as it mirrors the exact sequence of steps you must take in an exam.

The Scenario: Rahul, Sachin, and Virat are partners sharing profits in the ratio of 3:2:1. Their Balance Sheet on 31st March shows:

• General Reserve: ₹60,000
• Existing Goodwill (on Asset side): ₹30,000
• Capital Balances: Rahul (₹2,00,000), Sachin (₹1,50,000), Virat (₹1,00,000).

On 1st April, Sachin decides to retire. The partners agree to the following terms:

1. 1Rahul and Virat will share future profits in the ratio of 3:1.
2. 2The Goodwill of the firm is valued at ₹90,000.
3. 3Assets are revalued, resulting in a net Revaluation Profit of ₹24,000.
4. 4Sachin is to be paid ₹20,000 in cash immediately, and the balance is to be transferred to his Loan Account.

Step 1: Calculate Ratios

• Old Ratio (Rahul : Sachin : Virat) = 3 : 2 : 1
• New Ratio (Rahul : Virat) = 3 : 1
• Let's find the Gaining Ratio (New - Old):
• Rahul's Gain = (3/4) - (3/6) = (9/12) - (6/12) = 3/12
• Virat's Gain = (1/4) - (1/6) = (3/12) - (2/12) = 1/12
• Gaining Ratio = 3:1

Step 2: Clean up the Balance Sheet (Reserves and Old Goodwill)

• General Reserve (₹60,000): Distribute to all in Old Ratio (3:2:1).
• Rahul gets ₹30,000; Sachin gets ₹20,000; Virat gets ₹10,000.
• Existing Goodwill (₹30,000): Write off among all in Old Ratio (3:2:1).
• Rahul's capital drops by ₹15,000; Sachin's by ₹10,000; Virat's by ₹5,000.

Step 3: Adjust Valued Goodwill

• Firm's Valued Goodwill = ₹90,000.
• Sachin's Share of Goodwill = 2/6 of ₹90,000 = ₹30,000.
• Rahul and Virat must pay this ₹30,000 to Sachin in their Gaining Ratio (3:1).
• Rahul pays: 3/4 of 30,000 = ₹22,500.
• Virat pays: 1/4 of 30,000 = ₹7,500.
• Entry: Rahul Cap Dr (22,500), Virat Cap Dr (7,500) to Sachin Cap Cr (30,000).

Step 4: Distribute Revaluation Profit

• Total Profit = ₹24,000. Distribute to all in Old Ratio (3:2:1).
• Rahul gets ₹12,000; Sachin gets ₹8,000; Virat gets ₹4,000.

Step 5: Calculate Sachin's Final Balance Let's build Sachin's Capital Account bucket:

• Opening Balance (Credit): ₹1,50,000
• Add: Share of General Reserve (Credit): ₹20,000
• Add: Share of Valued Goodwill (Credit): ₹30,000
• Add: Share of Revaluation Profit (Credit): ₹8,000
• Total Credits = ₹2,08,000
• Less: Share of Existing Goodwill written off (Debit): ₹10,000
• Final Balance Owed to Sachin = ₹1,98,000

Step 6: Settlement The problem states Sachin is paid ₹20,000 in cash, and the rest goes to a loan.

• Total owed: ₹1,98,000
• Paid in Bank: ₹20,000
• Transferred to Sachin's Loan A/c: ₹1,78,000

Final Settlement Journal Entry:

Sachin's Capital A/c ... (Dr) ₹1,98,000 To Bank A/c ... (Cr) ₹20,000 To Sachin's Loan A/c ... (Cr) ₹1,78,000

And just like that, Sachin is retired, his accounts are settled, and Rahul and Virat can continue the business.

Quick Revision

• Gaining Ratio: The ratio in which remaining partners acquire the retiring partner's share. Formula: `New Ratio - Old Ratio`.
• Silent Agreement: If no new ratio is given, simply strike out the retiring partner's share from the old ratio to find both the new ratio and the gaining ratio.
• Existing Goodwill: Any goodwill already in the Balance Sheet must be written off immediately. Debit ALL partners in their OLD ratio.
• Valued Goodwill: The retiring partner's share of new goodwill is compensated by the remaining partners. Debit GAINING partners in their GAINING ratio, Credit RETIRING partner.
• Revaluation & Reserves: Profits/losses from revaluation and accumulated reserves belong to the past. Distribute them to ALL partners in their OLD ratio.
• Settlement: The final balance of the retiring partner is either paid in cash/bank or transferred to their Loan Account.
• Section 37: If the retiring partner's dues are not settled immediately, they are entitled to either 6% p.a. interest on the unpaid balance OR a proportionate share of the profits earned using their money, whichever is higher.