CHAPTER 5

CHANGE IN CAPITAL STRUCTURE BY

WITHDRAWAL, RETIREMENT, DEATH OR
INCAPACITY OF A PARTNER

LEARNING OBJECTIVES

1. Discuss and understand the accounting procedures in recording the retirement or

withdrawal of a partner by sale of interest to a new partner or to the continuing or
remaining partners.

2. Discuss and understand the accounting procedures in recording the retirement or

withdrawal of a partner by sale of interest to the partnership.

3. Discuss and understand the accounting procedures in recording the dissolution of a

partnership due to death or incapacity of a partner.

REVIEW OF THE CHAPTER

CHANGE IN
CAPITAL STRUCTURE

Retirement or Retirement or Death or Incapacity

Withdrawal Withdrawal of a Partner
Sale of Interest to a Sale of Interest to the Equal to capital interest
New Partner or Partnership At less than or more
Continuing Partner Equal to capital interest than capital interest
Equal to capital interest At less than or more  Bonus method
At less than capital than capital interest  Asser
interest  Bonus method Revaluation
At more than capital  Asser Method
interest Revaluation
Method
CHANGE IN CAPITAL STRUCTURE BY WITHDRAWAL OR RETIREMENT OF A
PARTNER

The partnership may allow any of its partners to withdraw or retire from the firm. The business
may continue after such withdrawals; on the other hand, the interest of the retiring or
withdrawing partners may be:
1. Sold to a new partner (outsider)
2. Sold to the continuing (remaining) partners
3. Sold to the partnership

SALE OF INTEREST TO A NEW PARTNER

With the consent of the remaining partners, the retiring partner may sell his interest to an
outsider. The sale is recorded in the same manner as in the admission of a new partner by
purchase. The partnership recognizes only the transfed of capital interest from the retiring partner
to the new partner. Any gain or loss form the sale is a personal gain or loss of the retiring partner.

SALE OF INTEREST TO CONTINUING PARTNERS

The interest of the retiring partner ay be acquired by any of the continuing partners. The
transaction is recorded in the same manner as the sale of interest to a new partner. The
partnership recognizes only the transfer of capital interest from the retiring partner to the
acquiring partner or partners.

SALE OF INTEREST TO THE PARTNERSHIP

A retiring partner may sell his capital interest to the continuing partners through the partnership.
The partnership has the obligation to make payment to the retiring partner either by:
1. payment in cash;
2. transfer of noncash assets: or
3. recognition of a liability for the full or the balance of the unpaid interest of the retiring
partner.
The purchase price or amount of settlement by the partnership to the retiring partner may be:
1. equal to the interest of the retiring partner (at book value)
2. less than the interest of the retiring partner (at less than book value)
3. more than the interest of the retiring partner (at more than book value)
When the payment to the retiring partner is less than or more than his capital interest, the
difference between the purchase price and the capital interest may be accounted for using:
1. bonus method
2. asset revaluation method

ACCOUNTING PROBLEMS INVOLVED IN THE

RETIREMENT OF A PARTNER

The interest in the partnership of a retiring partner must be established upon his retirement. A
partner’s interest in the partnership is affected by his investments, withdrawals, share on
partnership profit or losses, loans to the partnership and loan from the partnership. Following are
the accounting problems involved in determining the capital interest of a retiring partner:

1. Determination if the profit or loss from the beginning of the accounting period to the date of
withdrawal or retirement and the distribution of such profit or loss.

2. Closing of the partnership books.

3. Correction of accounting errors in prior periods like overstatement or understatement of

inventories, excessive depreciation charges and failure to provide adequately for doubtful
accounts.

4. Revaluation of partnership assets to current values.

5. Recording of bonus brought about by the retirement of a partner.

6. Settlement of the interest of the retiring partner.

CALCULATION OF RETIRING PARTNER’S INTEREST

The interest of a retiring partner must be established upon retirement, as mentiones earlier. The
following are considered in the determination of such interest: investments, withdrawals, share in
profit and losses to the date of retirement, loan, advances and the revaluation of partnership
assets to current values.
The following schedule will be helpful in determining the interest of a retiring partner:

Investments
- Withdrawals
+ Share in partnership profit to date of retirement or
- Share in partnership losses to date of retirement
+ Loans and advances to the partnership or
- Loans and advances from the partnership
+ Revaluation of assets increasing their recorded values or
- Revaluation of assets decreasing their recorded values

Interest upon retirement

Illustrative Problem A: The statements of financial position of the partnership of Dy, David
and Diaz on December 31, 2014 follows:

Assets Liabilities & Capital

Cash P 110,000 Liabilities P 20,000
Other Assets 30,000 Dy, Capital 20,000
David, Capital 40,000
Diaz, Capital 60,000
P 140,000 Total Liabilities and Capital P 140,000

The partners share profits and losses in the ratio of 4:2:4. On July 1, 2015, Diaz asked to be
allowed to withdraw from the partnership. The partners decided to close the books as of this date
so as to determine tha capital interest of Diaz. Profit for the six months ended amounted P60,000
while drawings of Dy, David and Diaz amount to P4,000, P6,000 and P2,000, respectively.
Profits and losses are to be shared equally after the retirement of Diaz.

The following entries will be prepared prior to the retirement of Diaz from the partnership:

1. Income Summary 60,000

Dy, Capital 24,000
David, Capital 12,000
Diaz, Capital 24,000
Net income from Jan.1 to June 30
divided in the ratio of 4:2:4

2. Dy, Capital 4,000

David, Capital 6,000
 Diaz, Capital 2,000
Dy, Drawing 4,000
David, Drawing 6,000
Diaz, Drawing 2,000

After considering the preceding entries, the capital interest of the partners as of July 1, 2015 may
now be computed as follows:

Capital balance, Dec. 31, 2014 P60,000 P20,000 P40,000

Share in profit from Jan 1, - June 30 24,000 24,000 12,000
Withdrawals ( 2,000) ( 4,000) ( 6,000)
Capital balance, July 1, 2015 P82,000 P40,000 P46,000

The entries to record the retirement of Diaz using several assumptions are illustrated below and
on the succeeding pages.

Assumption 1 – Sale of interest to a new partner. Diaz sold his interest to Duque for
P100,000.

Diaz, Capital 82,000

Duque, Capital 82,000

The gain of P18,000 (P100,000 – P82,000) is a personal gain of Diaz since the sale of the interest
to an outsider is a personal transaction between the buying partner and Diaz.

Assumption 2 – Sale of interest to the continuing partners. Diaz sold his interest to Dy and
David for P75,000; the interest being divided equally by the remaining partners. Profits and
losses after the retirement of Diaz will be divided equally.

Diaz, Capital 82,000

Dy, Capital 41,000
David, Capital 41,000

The loss of P7,000 (P75,000 – P82,000) is a personal loss of Diaz since the sale of the interest to
Dy and David is a personal transaction among the partners.

Assumption 3- Sale of interest to the partnership. Diaz sold his interest to the partnership. The
partners agreed to make immediate cash settlement to the retiring partner. Profits and losses after
the retirement of Diaz will be divided equally.

Case A – Settlement to retiring partner is equal to his capital interest. The partnership
paid Diaz P82,000.

Diaz, Capital 82,000

 Cash 82,000

This settlement involves no bonus nor asset revaluation.

Case B – Settlement is less than the capital interest of the retiring partner (at less than
book value). The partnership paid Diaz P76,000 which is P6,000 less than his capital
interest of P82,000.

The difference between the amount of payment and capital interest of Diaz may now be
considered as:

1. Bonus to the remaining partners (Bonus Method)

2. Asset Revaluation reducing the capital accounts of all the partners

(Asset Revaluation Method)

The entries to record the retirement of Diaz using the two alternative solutions follow:

Bonus Method

Diaz, Capital 82,000

Cash 76,000
Dy, Capital 4,000
David, Capital 2,000
P6,000 x 4/6 = P4,000
P6,000 x 2/6 = P2,000

The bonus of P6,000 is shared by the remaining partners in accordance with their original profit
and loss ration of 4:2

Asset Revaluation Method

Dy, Capital 6,000

David, Capital 3,000
Diaz, Capital 6,000
Other Assets 15,000

The difference of P6,000 is only a portion of the asset revaluation. The total amount of asset
revaluation is calculated by dividing the difference of P6,000 by the retiring partner’s fraction of
interest or P6,000 ÷ 4/10 = P15,000. Thus, the reduction from the capital balances of the partners
will be computed as follows:

Dy = P15,000 x 4/10 = P6,000

David = P15,000 x 2/10 = P3,000
 Diaz = P15,000 x 4/10 = P6,000

After the preceding entry, the capital balance of Diaz is 76,000 and payment to him will be
recorded as follows:

Diaz, Capital 76,000

Cash 76,000

A compound entry may be made as follows:

Dy, Capital 6,000

David, Capital 3,000
Diaz, Capital 82,000
Cash 76,000
Other Assets 15,000

Case C – Settlement is more than the capital interest of the retiring partner ( at more than
book value). The partnership paid Diaz P85,000 which is P3,000 more than his capital interest of
P82,000.

The difference between the amount of payment and the capital interest of Diaz may now be
considered as:

1. Bonus from the remaining partners ( Bonus Method)

2. Asset Revaluation reducing the capital accounts of all the partners
(Asset Revaluation Method)

The entries to record the retirement of Diaz using the two alternative solutions follow:

Bonus Method

Diaz, Capital 82,000

Dy, Capital 2,000
David, Capital 1,000
Cash 85,000
P3,000 x 4/6 = P2,000
P3,000 x 2/6 = P1,000

The bonus of P3,000 is shared by the remaining partners in accordance with their original profit
and loss ratio of 4:2
Asset Revaluation Method

Other Assets 7,500

Dy, Capital 3,000
David, Capital 1,500
Diaz, Capital 3,000
The difference of P3,000 is only a portion of the asset revaluation of the partnership. The total
amount of asset revaluation is calculated by dividing the difference of P3,000 by the retiring
partner’s fraction of interest or P3,000 ÷ 4/10 = P7,5000. This, the increase in the capital
balances of the partners will be computed as follows:
Dy =P7,500 x 4/10 = P3,000
David =P7,500 x 2/10 = P1,500
Diaz = P7,500 x 4/10 = P3.000

After the entry recording the asset revaluation, the capital balance of Diaz is P85,000 and
payment to him will be recorded as follows:
Diaz, Capital 85,000
Cash 85,000

A compound entry may be made as follows:

Other Assets 7,500
Diaz, Capital 82,000
Cash 85,000
Dy, Capital 3,000
David, Capital 1,500

COMPARISON BETWEEN the BONUS AND ASSET REVALUATION METHOD

The two methods discussed may offer different results as to capital balances of the remaining
partners because of the effect on depreciation of the asset revaluation.

To illustrate the effects of the bonus and asset revaluation method, we will use the information
under Assumption 3 – Case C, i.e., the payment to the retiring partners is more than his capita
interest. The schedule below shows the comparison between the bonus and the asset revaluation
method:

Assets Dy, David

Revaluation Capital Capital
Balances after retirement of Diaz under the
bonus method P38,000 P45,000
Balances after retirement of Diaz under the
asset revaluation method P 7,500 P43,000 P47,500
Depreciation on asset revaluation method (divided equally) (7,500) (3,750) (3,750)
Balances after depreciation P39,250 P43,750
Net advantage (disadvantage) of using the bonus method (P 1,250) P 1,250
Based on the above analysis, David will prefer the bonus while Dy will prefer the asset
revaluation method.
CHANGE IN CAPITAL STRUCTURE BY DEATH OR INCAPACITY OF A PARTNER
The death or incapacity of a partner legally dissolves the old partnership since the partner ceases
to be associated in the carrying on of the business. The remaining partners may continue
operations based on a new contract or Articles of Co-Partnership. The interest of the deceased or
incapacitated partner must be determined by the partnership In order to make necessary
settlement with his legal representatives. In case the business is continued without immediate
settlement, the legal representative of the deceased is considered as an ordinary creditor and is to
receive an amount equal to the interest and profits attributable to this interest.
The following accounting problems are encountered in case of death or incapacity of a partner:
1. Determination of the profit or loss from the beginning of the accounting period to the
date of death or incapacity and the distribution of such profit or loss.

2. Closing of the books of the partnership. Partnership agreement, however, may provid3
that the books need not be closed and net income for the fraction of the accounting period
to the date of death or incapacity be determined.

3. Correction of prior year’s if there is any.

4. Revaluation of partnership assets to arrive at current values.

5. Recording of bonus.

6. Settlement of the interest of the deceased or incapacitated partner.

The above problems are similar to those of withdrawal or retirement of a partner. Thus,
accounting for settlement to the deceased or incapacitated partner is the same as that of
withdrawal or retirement.

REVIEW OF THE LEARNING OBJECTIVES

1. Discuss and understand the accounting procedures in recording the retirement or

withdrawal of a partner by sale of interest to a new partner or to the continuing or
remaining partners. A retiring partner may sell his interest to a new partner or to the
remaining partners. The sale of interestis a personal transaction between or among the
partners and any indicated gain or loss is a personal gain or loss of the retiring partner.
However, before recording the sale, the capital interest of the retiring partner should be
updated. The sale is then recorded by transferring the capital interest of the retiring
partner to the acquiring partner.
2. Discuss and understand the accounting procedure in recording the retirement or
withdrawal of a partner by sale of interest to the partnership. The retiring partner may sell
his capital interest to the partnership, which then pays the former either in cash or in the form of
noncash assets. The capital interest of the retiring partner should be established on the date of his
retirement. The partnership may pay him an amount that is equal to his capital interest, at more
than his capital interest, or at less than his capital interest. When the payment is not equal to his
capital interest, the difference may be accounted under any of the following methods: (1) bonus
method (either to the retiring partner or to the remaining partners); or (2) asset revaluation
accruing to all the partners.
3. Discuss and understand the accounting procedures in recording the dissolution of a
partnership due to death or incapacity of a partner. The dissolution of a partnership due to
death or incapacity of a partner is accounted for in almost the same manner as is the retirement of
a partner. Thus, the capital interest of the partner up to date of his incapacity or death should be
established. Settlement is then made to the heirs of the partner or to the legal representatives at
an amount that may be equal to the partner’s capital interest, at more than the capital interest, or
at less than the capital interest. When the settlement is not equal to the deceased or incapacitated
partner’s capital interest, the difference is accounted for under any of the following methods: (1)
bonus method; or (2) asset revaluation method.

GLOSSARY of ACCOUNTING TERMINOLOGIES

Bonus method - a case in retirement or death of a partner wherein the excess of amount paid
over the capital interest of the retiring or deceased partner is recorded as a decrease in the capital
balance of the remaining partners (bonus to retiring or deceased partner from the remaining
partners); the excess of the retiring or deceased partner’s capital balances of the remaining
partners ( bonus to the remaining partners from the retiring or deceased partner).
Retired or deceased partner’s interest – the capital interest of the partner on date of retirement
or death. It is determined by considering additional investment, withdrawals, share in profits and
losses to date of retirement or death, loans, advances and the revaluation of partnership assets to
current values.
Asset revaluation method - the asset revaluation is recorded prior to recording the settlement
with the retiring or deceased partner. The asset revaluation is determined by dividing the
difference between the retiring or deceased partner’s capital interest and the amount of
settlement by his profit and loss sharing ratio.