by Conversion of a partnership firm into a limited company is a strategic decision taken by partners to achieve growth, financial stability, and limited liability. A partnership firm is characterized by personal liability of partners and limited capital, whereas a limited company enjoys perpetual existence, better access to funding, and the benefit of limited liability for its shareholders. This process involves transferring the assets and liabilities of the partnership firm to a newly formed or existing company in exchange for shares and/or other considerations.
Introduction
A partnership firm is governed by the Indian Partnership Act, 1932, and is suitable for small to medium-scale businesses. However, as businesses expand, they may need more capital, better organizational structure, and reduced risk exposure. Converting a partnership into a limited company helps the business in addressing these needs.
A limited company, formed under the Companies Act, 2013, provides partners (who become shareholders) with limited liability, better access to institutional finance, and improved business credibility. The conversion process ensures continuity of business operations and ownership while adhering to legal compliance.
Objectives of Conversion:
The main objectives behind converting a partnership firm into a limited company include:
- Limited Liability:
In a partnership firm, the partners’ personal assets are at risk in case of business losses. By converting into a limited company, shareholders’ liability is restricted to the unpaid amount on shares held by them.
- Perpetual Succession:
A partnership firm dissolves on the retirement, insolvency, or death of a partner. A limited company, on the other hand, continues to exist irrespective of changes in ownership or management.
- Access to Capital:
A limited company can raise funds by issuing shares to the public, private investors, or financial institutions, thus ensuring better capital availability for expansion and growth.
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Transferability of Shares:
Sares of a limited company can be easily transferred, ensuring flexibility in ownership changes.
- Brand Image and Credibility:
Limited companies are perceived as more credible and stable in the market, making it easier to attract clients, investors, and business partners.
- Tax Benefits:
Under the tax laws in India, companies often have more favorable tax treatment compared to partnership firms. Additionally, tax benefits such as carry forward of losses and depreciation may be availed.
- Better Governance:
A company operates under a well-defined regulatory framework as per the Companies Act, ensuring transparency, accountability, and improved decision-making.
Purchase Consideration:
Purchase consideration refers to the amount that the limited company agrees to pay to the partnership firm in exchange for transferring its assets and liabilities. This is an important aspect of the conversion process, as it determines the value at which the partnership business is taken over by the company.
Methods of Calculating Purchase Consideration
- Net Asset Method:
Under this method, the purchase consideration is determined by calculating the net assets of the partnership firm. The net assets are the difference between total assets and total liabilities.
Formula:
Purchase Consideration = Total Assets − Total Liabilities
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Net Payment Method:
In this method, the purchase consideration is determined based on the total amount payable by the company to the partners of the firm. This includes payment in the form of shares, debentures, or cash.
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Intrinsic Value Method:
This method considers the intrinsic or fair value of the firm’s assets and liabilities rather than their book value. This approach is often used when assets have appreciated in value over time.
Steps in Determining Purchase Consideration
- Valuation of Assets:
The company evaluates the assets of the partnership firm, including fixed assets, current assets, and intangible assets like goodwill.
- Valuation of Liabilities:
All external liabilities such as creditors, loans, and outstanding expenses are considered. Internal liabilities, like partners’ capital and reserves, are excluded.
- Calculation of Net Assets:
The difference between the total value of assets and liabilities gives the net assets, which form the basis for determining the purchase consideration.
- Issuance of Shares:
The company may issue shares to partners in exchange for their respective share of capital in the partnership firm. The shares issued can be in the form of equity or preference shares.
Example of Purchase Consideration
A partnership firm, ABC & Co., has decided to convert into a limited company, ABC Ltd. The firm has the following assets and liabilities:
- Assets:
- Fixed Assets: ₹10,00,000
- Current Assets: ₹5,00,000
- Liabilities:
- Creditors: ₹3,00,000
- Loan: ₹2,00,000
Step 1: Calculate Net Assets
Net Assets = Total Assets − Total Liabilities
Step 2: Determine the Purchase Consideration
Assuming that the company agrees to issue shares worth ₹10,00,000 to the partners in proportion to their capital contributions, the purchase consideration will be ₹10,00,000.
Step 3: Distribution of Shares
If the partners’ capital contributions in the firm were as follows:
- Partner A: ₹6,00,000
- Partner B: ₹4,00,000
The company will issue shares worth ₹6,00,000 to Partner A and ₹4,00,000 to Partner B.
Accounting Treatment in the Books of the Company
The limited company records the purchase consideration and the acquisition of assets and liabilities through journal entries.
| Date | Particulars | Debit (₹) | Credit (₹) |
|---|---|---|---|
| 1 | Fixed Assets A/c Dr. | 10,00,000 | |
| Current Assets A/c Dr. | 5,00,000 | ||
| To Creditors A/c | 3,00,000 | ||
| To Loan A/c | 2,00,000 | ||
| To Purchase Consideration A/c | 10,00,000 | ||
| 2 | Purchase Consideration A/c Dr. | 10,00,000 | |
| To Equity Share Capital A/c | 10,00,000 |
