Reconstitution — Change in Profit-Sharing Ratio
When partners reshuffle who gets how much profit, the firm's assets and goodwill must be revalued so no one gains or loses unfairly — this chapter gives you the exact tools to make that happen.
India has millions of partnership firms — from kirana stores to CA practices — and every one of them eventually revisits its profit-sharing arrangement; knowing how to account for that change is a core CA Foundation topic and a guaranteed question in your CBSE Class 12 board exam.
Concept
Lots of students think…
"Revaluation gains are shared among partners in the new profit-sharing ratio because that is the ratio going forward."
Actually…
Revaluation gains belong to the period before the change, so they must be distributed in the old ratio. Using the new ratio here is one of the most penalised mistakes in board exams.
By the end of this chapter you will understand what happens inside a partnership firm's accounts when partners decide to change who gets how much profit — and exactly why those adjustments are fair to everyone.
What is Reconstitution?
A partnership firm is held together by a deed that says how profits are shared. When partners agree to change those shares — without shutting down the firm — that is called reconstitution. The firm keeps running; only the internal agreement is updated.
Rajesh and Deepak run a garment export unit in Tirupur and share profits equally. After three years, Deepak moves abroad and wants a smaller share, so they revise the deed to 3:1. The firm stays open — only the ratio changes.
Sacrificing Ratio vs Gaining Ratio
When the ratio changes, one partner gives up a slice of future profit (they sacrifice) and another receives it (they gain). The sacrificing ratio = old share minus new share. The gaining ratio = new share minus old share. These ratios tell you who owes what to whom.
Aarav's old share is 5/10 and new share is 4/10 — he sacrifices 1/10. Chitra's old share is 2/10 and new share is 3/10 — she gains 1/10. Bhavesh's share stays at 3/10, so he neither sacrifices nor gains.
Goodwill and Why It Flows
Goodwill is the invisible value of a firm — its loyal customers, good name, and trusted relationships. You cannot touch it, but it is worth real money. When someone gains a bigger profit share, they will now enjoy this goodwill too, so they must pay the person who gave up their share for it.
The Mumbai stationery firm's goodwill is valued at ₹2,00,000. Chitra gains 1/10, so she pays ₹2,00,000 × 1/10 = ₹20,000. Aarav sacrifices 1/10, so he receives ₹20,000 credited to his Capital Account.
Revaluation of Assets and Liabilities
Old book values go stale. A building bought five years ago may be worth twice as much today. Before the new ratio kicks in, every asset and liability is reassessed at current market value. Any gain or loss from this reassessment belongs to all partners — but in their old ratio, because they created that value together under the old deal.
Rajesh and Deepak's factory shed was bought for ₹12 lakh but is now worth ₹20 lakh — a gain of ₹8 lakh. Their machinery dropped from ₹4 lakh to ₹2.5 lakh — a loss of ₹1.5 lakh. Net gain: ₹6.5 lakh, split equally (old 1:1 ratio) — ₹3.25 lakh each to their Capital Accounts.
The Revaluation Account
You record the reassessment in a temporary account called the Revaluation Account. Gains (an asset rises in value, or a liability falls) are credited here. Losses (an asset falls in value, or a liability rises) are debited. The net balance is then transferred to all partners' Capital Accounts in the old profit-sharing ratio.
The stationery firm's stock was in the books at ₹80,000 but is worth ₹95,000 — a ₹15,000 gain. This ₹15,000 is credited to the Revaluation Account, then split among Aarav, Bhavesh, and Chitra in their old 5:3:2 ratio — not the new one.
The Right Order Matters
Always do revaluation first, then goodwill. Revaluation uses the old ratio; goodwill uses the sacrificing/gaining ratio. Mixing the two up is the most common mistake in board exams. Think of it this way: settle the past (revaluation in the old ratio) before you adjust for the future (goodwill between the people whose shares changed).
In the Tirupur firm example: first, the ₹6.5 lakh net revaluation gain is split 1:1 (old ratio) between Rajesh and Deepak. Then and only then is goodwill of ₹5 lakh processed — Deepak's Capital is credited ₹1.25 lakh and Rajesh's is debited ₹1.25 lakh.
Common Traps to Avoid
Three mistakes students make: (1) sharing revaluation gains in the new ratio — wrong, always use the old ratio. (2) splitting goodwill among all partners like revaluation — wrong, only the sacrificing and gaining partners are involved. (3) crediting the full goodwill value to the sacrificing partner — wrong, only their proportionate sacrifice fraction applies.
If a partner sacrifices 1/5 of profits and the firm's goodwill is ₹1,00,000, they receive ₹20,000 — not the full ₹1,00,000. The firm's total goodwill is just the base; the sacrificed fraction is the multiplier.
Notes
The full picture
A partnership is built on a deed — a legal agreement under the Indian Partnership Act, 1932 that says, among other things, how profits and losses are divided. But businesses evolve. A partner may want a larger stake as they take on more work, or a senior partner may want to slow down and reduce their share. When partners change this profit-sharing ratio while the firm continues to operate, it is called reconstitution. The firm is not dissolved; it simply updates its internal agreement. The partnership deed is revised to record the new arrangement.
The moment the profit-sharing ratio changes, a critical question arises: what happens to value that already exists in the firm? Suppose the firm bought a building five years ago for ₹15 lakh; today it is worth ₹30 lakh. That ₹15 lakh gain was earned under the old ratio. If you simply switch to the new ratio without acknowledging this, the partner who gains a larger share going forward would also benefit from value they did nothing to create. To prevent this, a Revaluation Account is prepared. All assets and liabilities are reassessed at current market values. Any gain (asset value rises, or liability falls) is credited to the Revaluation Account; any loss is debited. The net balance is then transferred to all partners' Capital Accounts in their old profit-sharing ratio — because the value arose under that old agreement.
Now consider the partners' profit expectations. A partner who gave up 10% of future profits has permanently reduced their earning potential from the firm. They deserve compensation. This is where goodwill comes in. Goodwill is the value of a firm's reputation, loyal customers, and established relationships — it is not a physical asset you can touch, but it is real economic value. When the profit-sharing ratio changes, partners who sacrifice (reduce) their share must be compensated by those who gain (increase) their share. The sacrificing ratio tells you exactly how much each partner has given up: it equals the partner's old share minus their new share. The gaining ratio tells you how much each partner has received: new share minus old share. These ratios govern how goodwill flows between partners — the gaining partners are debited (they pay), and the sacrificing partners are credited (they receive).
Let us work through this with numbers. Aarav, Bhavesh, and Chitra are partners in a Mumbai stationery wholesale business. They currently share profits 5:3:2. They agree to change the ratio to 4:3:3. Aarav's old share is 5/10, his new share is 4/10, so his sacrifice is 1/10. Bhavesh's old share is 3/10, his new share is 3/10 — no change. Chitra's old share is 2/10, her new share is 3/10, so her gain is 1/10. The firm's goodwill is valued at ₹2,00,000 (using the average profits method, as stated in the deed). Aarav is sacrificing, so his Capital Account is credited ₹2,00,000 × 1/10 = ₹20,000. Chitra is gaining, so her Capital Account is debited ₹20,000. Bhavesh neither sacrifices nor gains, so no goodwill entry touches his account. Separately, a Revaluation Account is opened. The firm's stock, valued at ₹80,000 in the books, is now worth ₹95,000 — a gain of ₹15,000. This ₹15,000 is transferred to all three partners' Capital Accounts in their old ratio (5:3:2), not the new one.
Two practical things to keep in mind when you sit down to solve a problem. First, always deal with revaluation before goodwill: revaluation uses the old ratio, while goodwill uses the sacrificing/gaining ratio. Mixing them up is the most common source of wrong answers in board exams. Second, after all adjustments, check whether the partners need to bring in or withdraw cash to equalise their capitals, if the deed requires equal capitals. The journal entries follow a clear sequence: open the Revaluation Account, transfer its balance to old Capital Accounts, then pass the goodwill entry between the sacrificing and gaining partners' Capital Accounts. That sequence, done carefully, earns you full marks.
An Indian example
Rajesh and his cousin Deepak run a garment export unit in Tirupur, sharing profits equally (1:1). After three years, Deepak moves abroad and wants to reduce his involvement, so they agree to change the ratio to 3:1 in Rajesh's favour. The firm owns a factory shed purchased for ₹12 lakh that a valuer now prices at ₹20 lakh, and old machinery booked at ₹4 lakh is worth only ₹2.5 lakh today. Revaluation shows a net gain of ₹6.5 lakh (₹8 lakh appreciation minus ₹1.5 lakh depreciation), split equally between them in the old 1:1 ratio — ₹3.25 lakh each to their Capital Accounts. Then goodwill: the firm's goodwill is calculated at ₹5 lakh using 2.5 times average profits. Deepak is sacrificing 1/4 (old share 1/2 minus new share 1/4), so his Capital Account is credited ₹1.25 lakh. Rajesh is gaining 1/4, so his Capital Account is debited ₹1.25 lakh. Every rupee is accounted for — Deepak walks away with fair compensation for the share he gave up, and Rajesh pays precisely for the extra profit he will now enjoy.
Key concepts covered
- Sacrificing ratio
- Gaining ratio
- Revaluation of assets & liabilities
- Goodwill treatment
Common misconceptions to watch for
- Many students think revaluation gains are shared in the new profit-sharing ratio. They are not — revaluation gains (and losses) belong to the period before the change, so they must be distributed in the old ratio. Using the new ratio here is one of the most penalised mistakes in board exams.
- Students often believe goodwill is shared among all partners in the old ratio, just like revaluation. Goodwill is not shared among all — it flows only between the partners whose shares actually change. The sacrificing partner's Capital Account is credited and the gaining partner's Capital Account is debited; partners with no change in share are untouched.
- It is common to think the full goodwill value of the firm is credited to the sacrificing partner. Only the proportionate share is credited. If a partner sacrifices 1/5 of the profit and the firm's goodwill is ₹1,00,000, they receive ₹20,000 — not ₹1,00,000. The total goodwill figure is the base; the sacrifice fraction is the multiplier.
Questions
Partners Ravi and Somi share profits 3:2. Somi retires. New ratio is 1:0 (Ravi sole). Assets revalued: goodwill ₹50,000. Calculate sacrificing and gaining ratios.
- 1Write old ratio and new ratio, then find the change for each partner.Old ratio shows initial profit split (3:2). New ratio shows post-retirement split. Each partner's change equals old share minus new share. Sacrificing means giving up; gaining means acquiring. This identifies who pays and who receives goodwill.
Question 1 of 6 · easy
Sacrificing ratio and gaining ratio in partnership reconstitution are always:
Quiz
Test yourself — pick an answer, then hit "Check" to see the explanation and your running score.
Question 1 of 6 · easy
Sacrificing ratio and gaining ratio in partnership reconstitution are always:
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