Adjustment of Accumulated Profits and Losses

Concept First

When a partner retires or dies, the firm's books may contain accumulated profits (like General Reserve, Reserve Fund, or a credit balance in the Profit & Loss Account) or accumulated losses (a debit balance in the Profit & Loss Account). These belong to all partners in their old profit-sharing ratio, because they were earned or incurred during the period when all partners were together. The retiring or deceased partner is entitled to their share of these accumulated profits and is also liable for their share of accumulated losses.

The key idea is that these reserves or losses must be distributed to all partners' capital accounts in the old ratio before the retiring partner's final claim is calculated. This ensures the retiring partner gets exactly what is due to them from past earnings.

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Accounting Treatment for Accumulated Profits and Losses

The adjustment is done through two journal entries:

1. For Transfer of Accumulated Profits (Reserves)

When there is a General Reserve, Reserve Fund, or any accumulated profit (credit balance in P&L Account), the entry is:

Why? The Reserve is a liability (or accumulated profit) that belongs to the partners. By debiting it, we reduce that liability. By crediting each partner's capital account, we increase their claim on the firm by their share of the reserve.

2. For Transfer of Accumulated Losses

When there is an accumulated loss (debit balance in Profit & Loss Account), the entry is:

Why? The accumulated loss reduces the partners' claims. By debiting each partner's capital account, we reduce their capital by their share of the loss. By crediting the Profit & Loss A/c, we close that loss balance.

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Worked Example from the Textbook

Situation: Inder, Gajender, and Harinder are partners sharing profits in the ratio of 3:2:1. Inder retires. The Balance Sheet shows a General Reserve of ₹90,000.

Old Ratio: Inder : Gajender : Harinder = 3 : 2 : 1

Distribution of General Reserve:

• Inder's share = ₹90,000 × 3/6 = ₹45,000
• Gajender's share = ₹90,000 × 2/6 = ₹30,000
• Harinder's share = ₹90,000 × 1/6 = ₹15,000

Journal Entry:

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When a Partner Retires in the Middle of the Year

If retirement happens between two accounting periods, the retiring partner is entitled to a share of profit (or loss) for the intervening period — from the date of the last Balance Sheet to the date of retirement. This also includes any interest on capital, interest on drawings, etc., as per the partnership deed.

The main challenge is calculating the profit for this intervening period. The textbook shows three methods:

Method 1: Based on Last Year's Profit

Use the profit of the immediately preceding year as a base, then adjust for the time period.

Example: Maira, Shabnam, and Vipul share profits 5:4:1. Profit for year ending March 31, 2019 was ₹1,00,000. Vipul retires on June 30, 2019.

Calculation:

• Vipul's share of profit = Last year's profit × (Time period/12) × Vipul's share
• = ₹1,00,000 × (3/12) × (1/10)
• = ₹1,00,000 × 3/12 × 1/10 = ₹10,000

Journal Entry:

Method 2: Based on Average Profits of Last Few Years

If the partnership deed specifies, use the average profit of the last 3 years (or any agreed number of years).

Example: Same firm. Profits for last 3 years: ₹1,36,000 (2016-17), ₹1,54,000 (2017-18), ₹1,00,000 (2018-19). Vipul retires on June 30, 2019.

Calculation:

• Average profit = (₹1,36,000 + ₹1,54,000 + ₹1,00,000) / 3 = ₹3,90,000 / 3 = ₹1,30,000
• Vipul's share = ₹1,30,000 × (3/12) × (1/10) = ₹13,000

Journal Entry:

Method 3: Based on Sales

If the partnership deed provides, profit for the intervening period can be calculated based on the ratio of sales during that period to total sales of the year.

Example: Sales for 2018-19 were ₹8,00,000. Profit for that year was ₹1,00,000. Sales from April 1 to June 30, 2019 were ₹1,50,000.

Calculation:

• Profit rate = ₹1,00,000 / ₹8,00,000 = 0.125 (or 12.5%)
• Profit for intervening period = ₹1,50,000 × 0.125 = ₹18,750
• Vipul's share (1/10) = ₹18,750 × 1/10 = ₹7,500

Journal Entry:

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Closing the Profit & Loss Suspense Account

After the retiring partner's share of profit is credited to their capital account, the Profit & Loss Suspense A/c has a debit balance. This balance must be closed by transferring it to the gaining partners' capital accounts in their gaining ratio.

Journal Entry: