An Introduction to Accumulated Profits and Losses
The money that is left over after businesses pay their shareholders dividends is referred to as accumulated profit, also known as retained profits. The amount is included in a company's balance sheet; more precisely, it is included in the shareholder equity section. Losses that have been carried over from prior years and the sum reflected in the company's audited balance sheet are referred to as "accumulated losses."
Effect on Accumulated Profits and Losses at the Time of Reconstitution
At the time of reconstitution of the firm, any reserves which exist at the date of admission of the partner are transferred to the old partners in either the capital account or the current account, as the case may be in their old profit sharing ratio in order to give benefit to the old partners of their contribution towards the firm.
The accounting treatment of reserves, accumulated profits or losses is classified into two parts:
When reserves and accumulated profits/losses are transferred to capital accounts.
When reserves and accumulated profits/ losses are not to be transferred to capital accounts.
Accounting Treatment When Reserves and Accumulated Profits/Losses Are transferred to Capital Accounts
The following entries shall be passed when reserves and accumulated profits/losses are transferred to capital accounts:
1. For transfer of reserves and accumulated profits
2. For transfer of reserves and accumulated losses
Accounting Treatment When Reserves and Accumulated Profits/Losses Are Not to Be Transferred to Capital Accounts
Steps involved in passing a journal entry when reserves and accumulated profits/ losses are not to be transferred to the capital accounts:
Step 1: Compute the net effect of the reserves and accumulated profit or losses.
Step 2: Calculate sacrificing/gaining share.
Sacrificing/Gaining share= Old share - New share
Step 3: Compute the share of gain and loss in the net effect (computed in step 1) for each partner.
For gaining partner = Net Effect X Share Gained
For Sacrificing partner= Net Effect X Share Sacrificed
Step 4: Adjustment entry
Specific Line Item of Reserves and Accumulated Profits/Losses
Free reserves such as Reserve Fund, General Reserve, Capital Reserve, Retained Earnings, Undistributed Profits, Profit and Loss Account Credit Balance and contingency reserves will always be credited to the capital accounts of old partners in the old ratio.
Workmen compensation reserves are made in accordance with the provisions of the Workmen compensation act. Its treatment is dependent on the claim of workmen's compensation.
Investment fluctuation reserves are created out of profits in order to meet the fluctuation in the value of an investment in the markets. Its treatment varies as per the market value of the investment.
Profit and loss account debit balance, advertisement suspense account, preliminary expenses account, miscellaneous expenditure account, and deferred revenue expenditure account will always be debited to the capital account of old partners in the old ratio.
Few reserves, such as employees provident fund, taxation fund, employees saving fund, and machinery replacement fund, should never be distributed as they are neither profits nor free reserves.
Solved Questions
Q1. X, Y and Z are partners sharing the profits in the ratio of 4:3:2. From 1st April 2022, they decided to share the profits equally. On that date, their book showed a credit balance of Rs. 18000 in the profit and loss account and a balance of Rs 4500 in the general reserve. Record the necessary journal entries for the distribution of profit and general reserves.
Solution: Journal Entries
Q2. X, Y and Z are partners sharing the profits in the ratio of 4:3:2 .From 1st April 2022, they decided to share the profits in the ratio of 2:3:4. On that date balance sheet is as follows:
Balance sheet (An extract)
As at 31st March 2021
Show the accounting treatment if there is no other information.
Solution: Journal Entries
Journal Entries
Conclusion
At the time of reconstitution of the partnership firm, it becomes necessary to evaluate the assets and liabilities of the firm in order to have an equitable distribution of profit or loss among the partners of the firm. There must also be the treatment of reserves, accumulated profits or losses existing at the time of reconstitution of the partnership. The accounting treatment of reserves, accumulated profits or losses is classified into two parts: when reserves and accumulated profits/losses are transferred to capital accounts and when reserves and accumulated profits/ losses are not to be transferred to capital accounts.
FAQs on Treatment of Reserves and Accumulated Profits in Accounting
1. What is the basic accounting treatment for reserves and accumulated profits when a partnership firm is reconstituted?
During the reconstitution of a partnership firm (due to admission, retirement, death, or change in profit-sharing ratio), existing reserves and accumulated profits or losses are distributed among the old partners in their old profit-sharing ratio. This is done to ensure that these past earnings, which belong to the old partners, are credited to their capital accounts before the new partnership terms take effect. The journal entry typically involves debiting the respective reserve or profit accounts and crediting the old partners' capital accounts.
2. How is the Workmen's Compensation Reserve (WCR) treated in different scenarios during partnership reconstitution?
The treatment of Workmen's Compensation Reserve depends on whether there is a claim against it. The main scenarios are:
- No Claim: The entire amount of WCR is a free reserve and is credited to the old partners' capital accounts in their old profit-sharing ratio.
- Claim is Less than Reserve: The amount equal to the claim is transferred to a 'Provision for Workmen's Compensation Claim Account'. The remaining surplus is distributed among the old partners.
- Claim Equals Reserve: The entire WCR amount is transferred to the 'Provision for Workmen's Compensation Claim Account'. No amount is distributed to partners.
- Claim is More than Reserve: The entire WCR amount is transferred to the provision account. The excess claim amount is debited to the Revaluation Account as a loss.
3. What is the purpose of an Investment Fluctuation Reserve (IFR) and how is it used?
An Investment Fluctuation Reserve (IFR) is created out of profits to cushion the firm against a fall in the market value of its investments. When the firm is reconstituted, the IFR is used to absorb any loss arising from the revaluation of investments. If the market value of investments falls, the loss is first set off against the IFR. Any surplus reserve is then distributed among the old partners. If the loss exceeds the reserve, the excess is debited to the Revaluation Account.
4. Why are accumulated profits and reserves distributed only to the old partners in their old profit-sharing ratio?
Accumulated profits and reserves represent the undistributed earnings of the firm from the period before its reconstitution. These earnings were generated through the efforts of the old partners under their existing profit-sharing agreement. Therefore, they have the rightful claim to these funds. Distributing them in the old ratio ensures fairness and closes the books on past earnings before a new partner joins or a new profit-sharing ratio is implemented. For more details, you can refer to the Admission of a Partner Class 12 notes.
5. What is the fundamental difference between a 'Reserve' and a 'Provision' in accounting?
The key difference lies in their nature and purpose. A Provision is a charge against profit, created to meet a known liability or a probable future expense where the exact amount is uncertain (e.g., Provision for Doubtful Debts). It is not a distributable profit. A Reserve, on the other hand, is an appropriation of profit, set aside to strengthen the financial position of the business or for a specific future purpose (e.g., General Reserve). Free reserves are part of owners' funds and can be distributed to partners. Explore more about the Difference Between Provision and Reserve for a clearer understanding.
6. How are accumulated losses, such as a debit balance in the Profit & Loss Account, treated upon reconstitution?
Accumulated losses are treated in the opposite manner to accumulated profits. Instead of being credited, they are debited to the old partners' capital accounts in their old profit-sharing ratio. This entry effectively writes off the loss by reducing the partners' capital balances. The journal entry would be: Old Partners' Capital A/c Dr. (in old ratio) To Profit & Loss A/c (Debit Balance) To Deferred Revenue Expenditure A/c.
7. Are all reserves shown on the liability side of a Balance Sheet distributable profits for partners?
No, not all reserves are distributable. It is crucial to distinguish between free reserves and specific reserves that represent liabilities. For example:
- Distributable Reserves: General Reserve, Reserve Fund, and Contingency Reserve are appropriations of profit and belong to the partners.
- Non-Distributable Items: Employees' Provident Fund is a liability towards employees and is never distributed among partners. Similarly, a Taxation Fund is a provision against tax liability.
8. Can you give a simple journal entry example for distributing the General Reserve during a partner's admission?
Certainly. Suppose a firm has two partners, A and B, sharing profits 3:2. They admit C as a new partner. At the time of admission, the Balance Sheet has a General Reserve of ₹50,000. This reserve will be distributed to A and B in their old ratio (3:2) before C's admission.
The journal entry would be:
General Reserve A/c Dr. ₹50,000
To A's Capital A/c ₹30,000 (3/5 of 50,000)
To B's Capital A/c ₹20,000 (2/5 of 50,000)
(Being General Reserve transferred to old partners' capital accounts in their old profit-sharing ratio)
