The Indian Partnership Act, 1932 provides legal guidelines for reconstituting a partnership firm in cases of admission of a new partner, retirement of a partner, expulsion of a partner, or insolvency of a partner.
Sections 31 to 35 of the Act outline the legal consequences of such changes in the partnership.
I am Supriya Gill, a lawyer and in this article, we will deal with a detailed explanation of the procedure for the admission or retirement of a partner. Let’s delve into these provisions for a better understanding.
Admitting or retiring a partner in a firm requires procedures for a smooth transition. For admission, existing partners must agree on terms, including profit and loss share. The new partner contributes capital, signs a partnership agreement, and follows rights and responsibilities. Retiring partners give notice and agree on buyout terms. The partnership agreement gets amended to reflect changes. Legal guidance ensures fairness for all involved.
To know the detailed procedure, read the full article.
Definition of partnership
A partnership is an association of persons with the object of jointly doing something to make a profit. In other words, when two or more persons, with the object of making a profit, agree to do business jointly, it is deemed that a partnership has come into existence.
As per Section 4 of the Indian partnership Act, a partnership is a relation between persons who have agreed to share the profits of a business carried on by all, or any of them acting for all.
Statutory characteristics of Partnership
- More than one person
- Existence of business
- Contractual relationship
- Profit motive and sharing of profit
- Principal-Agent relationship
Admission of a Partner
Admission of a partner means the entry of a new partner with the consent of other partners.
The incoming partner will bring cash as capital for business. He also brings money as goodwill to compensate the old partners who sacrifice.
As per Section 31(1) of The Indian Partnership Act, 1932 no new partner can enter into a partnership until the old partners give their assent. A new partner after admission will be responsible for all the acts of the firm but he will not be responsible for the acts committed before his admission.
When a new partner is added, technically there is a change in the constitution of the firm. Thus, the firm is reconstituted under a fresh agreement.
Effect of admission of a partner
- The old partnership comes to an end and a new partnership comes into exist
- The number of partners increases in the firm.
- The new partner acquires the right of sharing in the future profits of the firm. To acquire this right, he is generally required to bring his shares of goodwill. The amount of goodwill is to be shared by the old partners in their sacrificing ratio.
- The new partner acquires the right of sharing the assets of the firm. To acquire this right, he usually brings in an agreed amount of capital in cash or in kind or both.
- Assets and Liabilities are revalued to share any increase or decrease in value among old partners in the old ratio.
- The goodwill of the firm is valued to compensate the sacrificing partners by bringing the share of goodwill by the new partner.
Adjustments on the admission of a new partner
- Calculation of the new profit-sharing ratio
Upon admission of a replacement partner in a partnership firm, he acquires his share in profits from the old partners.
This means that the old partners will sacrifice a share of their profit in favour of the new partner. However, the share and the way the new partner acquires it from the existing partners are mutually agreed upon by the old partners and the new partner.
If no specific agreement is made, it will be assumed that the new partner will acquire his share from the old partners in their profit-sharing ratio.
In any case, the admission of a new partner will result in a change in the profit-sharing ratio among the old partners, depending on their respective contribution to the profit-sharing ratio of the incoming partner.
Thus, it is necessary to determine the new share ratio among all the partners, which will depend on how the new partner acquires his share from the old partners, with various possibilities.
- Calculation of sacrificing ratio
The ratio at which the old partners agree to sacrifice their share of profit in favour of the incoming partner is known as the sacrificing ratio.
As mentioned earlier, the new partner is required to compensate the old partners for their loss of share in the super-profits of the firm that he brings in, by paying an additional amount known as premium or goodwill.
This amount is shared by the existing partners in the ratio in which they forego their shares in favour of the new partner, which is the sacrificing ratio.
The ratio is generally clearly stated and agreed upon among the partners, which could be the old ratio, equal sacrifice, or a specified ratio.
However, difficulties arise when the ratio at which the new partner acquires his share from the old partners is not specified, and only the new profit-sharing ratio is given.
In such a situation, the sacrificing ratio is to be determined by subtracting each partner’s new share from his old share.
- Accounting treatment of goodwill
Goodwill is an intangible asset that represents the reputation, customer base, brand name, and other non-monetary assets of a business.
In a partnership firm, goodwill arises when the firm’s profits exceed the normal rate of return in the industry due to the partners’ collective efforts.
Goodwill is an essential element of the firm’s value and is recorded in the books of accounts as an asset.
During a reconstitution of a firm, such as a change in profit-sharing ratio, admission, retirement, or death of a partner, the value of goodwill needs to be adjusted.
The adjustment is necessary to ensure that the new partners are compensated for the goodwill they bring into the partnership and that the retiring or outgoing partner is compensated for the share of goodwill they leave behind.
The adjustment may involve the valuation of goodwill or the distribution of the amount of goodwill among the partners according to their new profit-sharing ratio.
As previously mentioned, when a new partner is admitted to the firm and acquires his share of profits from the existing partners, he brings in an additional amount to compensate them for their loss of share in super-profits, which is known as goodwill or premium.
Alternatively, the incoming partner may agree that a goodwill account is raised in the firm’s books by giving credit to the old partners.
Therefore, when a new partner is admitted, goodwill can be treated in two ways:
(1) through the Premium Method
(2) through the Revaluation Method.
- Revaluation of assets and liabilities
When admitting a new partner, it is important to check whether the firm’s assets are valued correctly in the books.
If there are any discrepancies, the assets are revalued and the liabilities are reassessed to ensure they are recorded accurately.
Any unrecorded assets and liabilities must also be included in the books by creating a Revaluation Account.
The Revaluation Account records the gain or loss on the revaluation of each asset and liability.
The balance of this account is then transferred to the capital accounts of the old partners in their old profit-sharing ratio.
The account is credited with any increase in asset value and decrease in liabilities, while it is debited with any decrease in asset value and increase in liabilities.
Unrecorded assets are credited and unrecorded liabilities are debited to the Revaluation Account.
A credit balance in the account indicates a net gain, while a debit balance indicates a net loss. Any balance is transferred to the capital accounts of the old partners in the old ratio.
- Adjustment of capital
The adjustment of capital for new and old partners involves:
- Adjusting Old Partners’ Capital Based on New Partner’s Capital
The new profit-sharing ratio of all partners is calculated, and the total capital of the firm is determined based on the new partner’s capital and their share of profits.
The total capital is then divided among the partners according to the new profit-sharing ratio. Any excess capital of old partners can be withdrawn in cash, and any deficiency must be brought in cash or recorded as provided in the question.
- Determining the New Partner’s Share of Capital Based on Old Partners’ Capital
It involves determining the share of capital for the new partner based on the adjusted capital of the old partners.
After making all adjustments regarding the revaluation of assets and liabilities, the share of goodwill brought in by the new partner, distributing undistributed profits and losses, etc., the residual share of profit after the new partner’s share is found.
The total capital of the firm is determined based on the combined adjusted capital of the old partners and their share of profits.
The new partner’s capital is then calculated based on the total capital of the firm and its share of profits.
Reasons for admitting a new partner
- When more capital is needed for the expansion of business and existing partners consider themselves incapable to meet the requirements.
- When there is a need for a competent and experienced person for the management and working of the firm.
- When the reputation of the firm is to be enhanced by admitting an influential and reputed person into the firm.
- When it is considered desirable to admit any competent and dedicated employee as a partner of the firm.
Rights of a new partner
When a new partner is admitted into a partnership firm, the firm’s structure undergoes reconstruction, and a new agreement is made to carry on the business.
As a result of admission, the new partner acquires:
- The right to share in the assets
- The profits of the partnership firm
For example, if Mr Y is admitted as a new partner in a partnership firm, he gains the right to his share in the assets and profits of the partnership firm through his admission.
Liabilities of a new partner
If a new partner agrees to be liable for all the obligations incurred by the partnership firm before the date of their admission, then and only then will they be liable for those obligations.
This means that the new partner will be responsible for any debts or liabilities that the partnership had before they became a partner, in addition to any new obligations that may arise after their admission.
However, this liability is subject to any agreement between the partners, which may limit the new partner’s liability or specify the extent to which they will be responsible for the partnership’s prior obligations.
It is important for the new partner to carefully review and understand any such agreement before agreeing to be liable for the partnership’s prior obligations.
Retirement of a Partner
Retirement of a partner means retiring of the partner from a firm. Due to retirement, there is a decrease in the total number of partners.
So, if there is any change in partnership then the old agreement comes to an end and then there is a need to make a new agreement between the remaining partners but after giving a share of everything to the retiring partner.
The retiring partner is having every right which is given in the old agreement, like, Interest on capital, salary, commissions, etc.
Section 32(1) of the Indian Partnership Act, 1932 states that a partner of a partnership firm may retire:
- With the consent of all the other partners of the partnership firm
- By an expressed agreement among the partners
- In case of partnership at will, by giving written notice to all the other partners of the firm conveying his intention of retiring.
A retired partner is not liable to any third party for any acts of the partnership firm that occur after the date of his retirement unless the third party had actual notice of the retirement or the retired partner continued to be represented as a partner of the firm.
Rights of the retiring partner
Section 36 of the Indian Partnership Act, 1932, enumerates the rights of an outgoing or retiring partner. According to this section:
- An outgoing partner may continue a business competing against that firm and may advertise such business unless there is a contract to the contrary.
- However, he may not use the name of the firm, claim himself as a representative of the firm’s business, or solicit the firm’s customers who were dealing with the firm before his cessation as a partner of that firm.
- A retiring partner may enter into an agreement with the other partners of the firm that he shall not carry on any business similar to that of the firm’s business within such specified time period or specified local limit, notwithstanding anything contained in Section 27 of the Indian Contract Act, 1872, if reasonable restrictions are imposed.
- The restrictions imposed on an outgoing or retiring partner must be reasonable and not excessively harsh. The courts will examine the restrictions on a case-by-case basis to determine if they are reasonable or not.
- Section 37 of the Indian Partnership Act, 1932 specifies that a retiring partner is entitled to reclaim their capital share contributed to the firm during retirement through the settlement of accounts with the continuing partners.
- If such an account settlement does not occur during retirement and the firm continues to use the retired partner’s capital for the business, the retired partner can claim their share even after retirement.
- The claim can either be at a rate of 6% per annum on their share in the firm’s property or a share of the firm’s profits attributable to their capital share in the firm.
The settlement of accounts must be done fairly and under the partnership agreement or the provisions of the Indian Partnership Act, 1932, in the absence of an agreement.
Liabilities of a retiring partner
Section 32(2) of the Indian Partnership Act, 1932 states that a retiring partner can be released from any liability towards any third party or for any act of the firm done before their retirement based on an agreement between the retiring partner, the third party, and the remaining partners of the reconstituted firm.
Such an agreement can be explicit or implicit based on the dealings between the third party and the reconstituted firm, which must acknowledge the partner’s retirement.
Section 32(3) of the Indian Partnership Act, 1932 specifies that until a public notification is made regarding the retirement of a partner, the retired partner and the remaining partners of the firm are jointly and severally liable to third parties for any acts done by the firm, which would have been deemed as acts of the firm if done before the retirement.
In other words, the retired partner’s liability towards third parties continues until public notice of their retirement is made, and they are released from further liability for future acts of the firm after the date of their retirement.
Section 32(4) of the Indian Partnership Act, 1932 states that the public notification regarding the retirement of a partner can be made by the retiring partner or any partner of the reconstituted firm.
The notification should be made in a public notice or in a newspaper circulated in the locality where the firm’s business is carried on.
The purpose of the notification is to inform third parties that the partner has retired and is no longer liable for the firm’s acts after the date of the retirement.
Reasons for retiring a partner
- If there is an agreement to that effect
- If all the partners consent to his retirement
- If the partnership is at will
Conclusion
The mutual agency exists among all partners in a partnership firm, making them mutually bound to all transactions of the firm.
To become a partner of an existing firm, consent from all other partners is necessary. Similarly, a partner can only retire from the firm with the consent of all other partners.
Incoming and outgoing partners are only bound by the rights and liabilities of the firm when they are active partners.
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