Partnership Reconstitution PDF

Reconstitution of a Partnership Firm – Admission of a Partner 3 LEARNING OBJECTIVES After studying this chapter P artnership is an agreement between two or more...

Reconstitution of a Partnership Firm – Admission of a Partner 3 LEARNING OBJECTIVES After studying this chapter P artnership is an agreement between two or more persons (called partners) for sharing the profits of a business carried on by all or any of them acting you will be able to: Explain the concept and the for all. Any change in the existing agreement ways of reconstitution of a amounts to reconstitution of the partnership firm. partnership firm; This results in an end of the existing agreement and Identify the matters that need adjustments in the books of a new agreement comes into being with a changed firm when a new partner is relationship among the members of the partnership admitted; firm and/or their composition. However, the firm Determine the new profit continues. The partners often resort to reconstitution sharing ratio and calculate the sacrificing ratio; of the firm in various ways such as admission of a Define goodwill and new partner, change in profit sharing ratio, enumerate the factors that retirement of a partner, death or insolvence of a affect it; partner. In this chapter we shall have a brief idea Explain the methods of about all these and in detail about the accounting valuation of goodwill; implications of admission of a new partner or an on Describe how goodwill will be treated under different change in the profit sharing ratio. situations when a new partner is admitted; 3.1 Modes of Reconstitution of a Partnership Make necessary adjustments Firm for revaluation of assets and reassessment of liabilities; Reconstitution of a partnership firm usually takes Make necessary adjustments place in any of the following ways: for accumulated profits and losses; Admission of a new partner: A new partner may be Determine the capital of each admitted when the firm needs additional capital or partner, if required according to the new profit sharing ratio managerial help. According to the provisions of and make necessary Partnership Act 1932 unless it is otherwise provided adjustments; in the partnership deed a new partner can be Make necessary adjustments admitted only when the existing partners on change in the profit sharing ratio among the unanimously agree for it. For example, Hari and existing partners. Haqque are partners sharing profits in the ratio of 2015-16 116 Accountancy – Not-for-Profit Organisation and Partnership Accounts 3:2. On April 1, 2015 they admitted John as a new partner with 1/6 share in profits of the firm. With this change now there are three partners of the firm and it stand reconstituted. Change in the profit sharing ratio among the existing partners: Sometimes the partners of a firm may decide to change their existing profit sharing ratio. This may happen an account of a change in the existing partners’ role in the firm. For example, Ram, Mohan and Sohan are partners in a firm sharing profits in the ratio of 3:2:1. With effect from April 1,2015 they decided to share profits equally as Sohan brings in additional capital. This results in a change in the existing agreement leading to reconstitution of the firm. Retirement of an existing partner: It means withdrawal by a partner from the business of the firm which may be due to his bad health, old age or change in business interests. In fact a partner can retire any time if the partnership is at will. For example, Roy, Ravi and Rao are partners in the firm sharing profits in the ratio of 2:2:1. On account of illness, Ravi retired from the firm on March 31, 2015. This results in reconstitution of the firm now having only two partners. Death of a partner: Partnership may also stand reconstituted on death of a partner, if the remaining partners decide to continue the business of the firm as usual. For example, X,Y and Z are partners in a firm sharing profits in the ratio 3:2:1. X died on March 31, 2015. Y and Z decide to carry on the business sharing future profits equally. The continuity of business by Y and Z sharing future profits equally leads to reconstitution of the firm. 3.2 Admission of a New Partner When firm requires additional capital or managerial help or both for the expansion of its business a new partner may be admitted to supplement its existing resources. According to the Partnership Act 1932, a new partner can be admitted into the firm only with the consent of all the existing partners unless otherwise agreed upon. With the admission of a new partner, the partnership firm is reconstituted and a new agreement is entered into to carry on the business of the firm. A newly admitted partner acquires two main rights in the firm– 1. Right to share the assets of the partnership firm; and 2. Right to share the profits of the partnership firm. For the right to acquire share in the assets and profits of the partnership firm, the partner brings an agreed amount of capital either in cash or in kind. Moreover, in the case of an established firm which may be earning more profits than the normal rate of return on its capital the new partner is required to contribute some additional amount known as premium or goodwill. This is done 2015-16 Admission of a Partner 117 primarily to compensate the existing partners for loss of their share in super profits of the firm. Following are the other important points which require attention at the time of admission of a new partner: 1. New profit sharing ratio; 2. Sacrificing ratio; 3. Valuation and adjustment of goodwill; 4. Revaluation of assets and Reassessment of liabilities; 5. Distribution of accumulated profits (reserves); and 6. Adjustment of partners’ capitals. 3.3 New Profit Sharing Ratio When new partner is admitted he acquires his share in profits from the old partners. In other words, on the admission of a new partner, the old partners sacrifice a share of their profit in favour of the new partner. But, what will be the share of new partner and how he will acquire it from the existing partners is decided mutually among the old partners and the new partner. However, if nothing is specified as to how does the new partner acquire his share from the old partners; it may be assumed that he gets it from them in their profit sharing ratio. In any case, on admission of a new partner, the profit sharing ratio among the old partners will change keeping in view their respective contribution to the profit sharing ratio of the incoming partner. Hence, there is a need to ascertain the new profit sharing ratio among all the partners. This depends upon how does the new partner acquires his share from the old partners for which there are many possibilities. Let us understand it with the help of the following illustrations. Illustration 1 Anil and Vishal are partners sharing profits in the ratio of 3:2. They admitted Sumit as a new partner for 1/5 share in the future profits of the firm. Calculate new profit sharing ratio of Anil, Vishal and Sumit. Solution 1 Sumit’s share = 5 1 4 Remaining share = 1− = 5 5 3 4 12 Anil’s new share = of = 5 5 25 2 4 8 Vishal’s new share = of = 5 5 25 New profit sharing ratio of Anil, Vishal and Sumit will be 12:8:5. Note: It has been assumed that the new partner acquired his share from old partners in old ratio. 2015-16 118 Accountancy – Not-for-Profit Organisation and Partnership Accounts Illustration 2 Akshay and Bharati are partners sharing profits in the ratio of 3:2. They admit Dinesh as a new partner for 1/5th share in the future profits of the firm which he gets equally from Akshay and Bharati. Calculate new profit sharing ratio of Akshay, Bharati and Dinesh. Solution 1 2 Dinesh’s share = or 5 10 3 1 5 Akshay’s share = − = 5 10 10 2 1 3 Bharati’s share = − = 5 10 10 New profit sharing ratio between, Akshay, Bharati and Dinesh will be 5:3:2. Illustration 3 Anshu and Nitu are partners sharing profits in the ratio of 3:2. They admitted Jyoti as a new partner for 3/10 share which she acquired 2/10 from Anshu and 1/10 from Nitu. Calculate the new profit sharing ratio of Anshu, Nitu and Jyoti. Solution 3 Jyoti’s share = 10 3 2 4 Ashu’s new share = − = 5 10 10 Nitu’s new share = Old share – Share Surrendered 2 1 3 = − = 5 10 10 The new profit sharing ratio between Anshu, Nitu and Jyoti will be 4 : 3 : 3. Illustration 4 Ram and Shyam are partners in a firm sharing profits in the ratio of 3:2. They admit Ghanshyam as a new partner. Ram surrenders 1/4 of his share and Shyam 1/3 of his share in favour of Ghanshyam. Calculate new profit sharing ratio of Ram, Shyam and Ghanshyam. 2015-16 Admission of a Partner 119 Solution 3 Ram’s old share = 5 1 3 3 Share surrendered by Ram = of = 4 5 20 3 3 9 Ram’s new share = − = 5 20 20 2 Shyam’s old share = 5 1 2 2 Share surrendered by Shyam = of = 3 5 15 2 2 4 Shyam’s new share = − = 5 15 15 Ghanshyam’s new share = Ram’s sacrifice + Shyam’s Sacrifice 3 2 17 = + = 20 15 60 New profit sharing ratio among Ram, Shyam and Ghanshyam will be 27:16:17 Illustration 5 Das and Sinha are partners in a firm sharing profits in 4:1 ratio. They admitted Pal as a new partner for 1/4 share in the profits, which he acquired wholly from Das. Determine the new profit sharing ratio of the partners. Solution 1 Pal’s share = 4 Das’s new share = Old Share – Share Surrendered 4 1 11 = − = 5 4 20 1 Sinha’s new share = 5 The new profit sharing ratio among Das, Sinha and Pal will be 11:4:5. 3.4 Sacrificing Ratio The ratio in which the old partners agree to sacrifice their share of profit in favour of the incoming partner is called sacrificing ratio. The sacrifice by a partner is equal to : Old Share of Profit – New Share of Profit 2015-16 120 Accountancy – Not-for-Profit Organisation and Partnership Accounts As stated earlier, the new partner is required to compensate the old partner’s for their loss of share in the super profits of the firm for which he brings in an additional amount known as premium or goodwill. This amount is shared by the existing partners in the ratio in which they forego their shares in favour of the new partner which is called sacrificing ratio. The ratio is normally clearly given as agreed among the partners which could be the old ratio, equal sacrifice, or a specified ratio. The difficulty arises where the ratio in which the new partner acquires his share from the old partners is not specified. Instead, the new profit sharing ratio is given. In such a situation, the sacrificing ratio is to be worked out by deducting each partner’s new share from his old share. Look at the illustrations 6 to 8 and see how sacrificing ratio is calculated in such a situation. Illustration 6 Rohit and Mohit are partners in a firm sharing profits in the ratio of 5:3. They admit Bijoy as a new partner for 1/7 share in the profit. The new profit sharing ratio will be 4:2:1. Calculate the sacrificing ratio of Rohit and Mohit. Solution 5 Rohit’s old share = 8 4 Rohit’s new share = 7 5 4 3 Rohit’s sacrifice = − = 8 7 56 3 Mohit’s old share = 8 2 Mohit’s new share = 7 3 2 5 Mohit’s sacrifice = − = 8 7 56 Sacrificing ratio among Rohit and Mohit will be 3:5. Illustration 7 Amar and Bahadur are partners in a firm sharing profits in the ratio of 3:2. They admitted Mary as a new partner for 1/4 share. The new profit sharing ratio between Amar and Bahadur will be 2:1. Calculate their sacrificing ratio. 2015-16 Admission of a Partner 121 Solution 1 Marry’s share = 4 1 3 Remaining share = 1− = 4 4 This 3/4 share is to be shared by Amar and Bahadur in the ratio of 2:1. Therefore, 2 3 6 2 Amar’s new share = of = or 3 4 12 4 1 3 3 1 Bahadur’s new share = of = or 3 4 12 4 New profit sharing ratio of Amar, Bahadur and Mary will be 2:1:1. 3 2 2 Amar’s sacrifice = − = 5 4 20 2 1 3 Bahadur’s sacrifice = − = 5 4 20 Sacrificing ratio among Amar and Bahadur will be 2:3. Illustration 8 Ramesh and Suresh are partners in a firm sharing profits in the ratio of 4:3. They admitted Mohan as a new partner. The profit sharing ratio of Ramesh, Suresh and Mohan will be 2:3:1. Calculate the gain or sacrifice of old partner. Solution 4 Ramesh’s old share = 7 2 Ramesh’s new share = 6 4 2 10 Ramesh’s sacrifice = − = 7 6 42 3 Suresh’s new share = 6 3 Suresh’s old share = 7 3 3 3 Suresh’s gain = − = 6 7 42 1 7 Mohan’s share = or 6 42 2015-16 122 Accountancy – Not-for-Profit Organisation and Partnership Accounts Ramesh’s sacrifice = Suresh’s gain+Mohan’s gain 3 7 10 = + = 42 42 42 In this case, the whole sacrifice is by Ramesh. Test your Understanding - I 1. A and B are partners sharing profits in the ratio of 3:1. They admit C for 1/4 share in the future profits. The new profit sharing ratio will be: 9 3 4 (a) A , B , C 16 16 16 8 4 4 (b) A , B , C 16 16 16 10 2 4 (c) A , B , C 16 16 16 8 9 10 (d) A , B , C 16 16 16 2. X and Y share profits in the ratio of 3:2. Z was admitted as a partner who sets 1/5 share. New profit sharing ratio, if Z acquires 3/20 from X and 1/20 from Y would be: (a) 9 : 7 : 4 (b) 8 : 8 : 4 (c) 6 : 10 : 4 (d) 10 : 6 : 4 3. A and B share profits and losses in the ratio of 3 : 1, C is admitted into partnership for 1/4 share. The sacrificing ratio of A and B is: (a) equal (b) 3 : 1 (c) 2 : 1 (d) 3 : 2. 3.5 Goodwill Goodwill is also one of the special aspects of partnership accounts which requires adjustment (also valuation if not specified) at the time of reconstitution of a firm viz., a change in the profit sharing ratio, the admission of a partner or the retirement or death of a partner. 3.5.1 Meaning of Goodwill Over a period of time, a well-established business develops an advantage of good name, reputation and wide business connections. This helps the business to earn more profits as compared to a newly set up business. In accounting, the monetary value of such advantage is known as “goodwill”. It is regarded as an intangible asset. In other words, goodwill is the value of the reputation of a firm in respect of the profits expected in future over and above the normal profits. It is generally observed that when a person pays for goodwill, 2015-16 Admission of a Partner 123 he/she pays for something, which places him in the position of being able to earn super profits as compared to the profit earned by other firms in the same industry. In simple words, goodwill can be defined as “the present value of a firm’s anticipated excess earnings” or as “the capitalised value attached to the differential profit capacity of a business”. Thus, goodwill exists only when the firm earns super profits. Any firm that earns normal profits or is incurring losses has no goodwill. 3.5.2 Factors Affecting the Value of Goodwill The main factors affecting the value of goodwill are as follows: 1. Nature of business: A firm that produces high value added products or having a stable demand is able to earn more profits and therefore has more goodwill. 2. Location: If the business is centrally located or is at a place having heavy customer traffic, the goodwill tends to be high. 3. Efficiency of management: A well-managed concern usually enjoys the advantage of high productivity and cost efficiency. This leads to higher profits and so the value of goodwill will also be high. 4. Market situation: The monopoly condition or limited competition enables the concern to earn high profits which leads to higher value of goodwill. 5. Special advantages: The firm that enjoys special advantages like import licences, low rate and assured supply of electricity, long-term contracts for supply of materials, well-known collaborators, patents, trademarks, etc. enjoy higher value of goodwill. 3.5.3 Need for Valuation of Goodwill Normally, the need for valuation of goodwill arises at the time of sale of a business. But, in the context of a partnership firm it may also arise in the following circumstances: 1. Change in the profit sharing ratio amongst the existing partners; 2. Admission of new partner; 3. Retirement of a partner; 4. Death of a partner; and 5. Dissolution of a firm involving sale of business as a going concern. 6. Amalgamation of partnership firms. 3.5.4 Methods of Valuation of Goodwill Since goodwill is an intangible asset it is very difficult to accurately calculate its value. Various methods have been advocated for the valuation of goodwill of a partnership firm. Goodwill calculated by one method may differ from the goodwill 2015-16 124 Accountancy – Not-for-Profit Organisation and Partnership Accounts calculated by another method. Hence, the method by which goodwill is to be calculated, may be specifically decided between the existing partners and the incoming partner. The important methods of valuation of goodwill are as follows: 1. Average Profits Method 2. Super Profits Method 3. Capitalisation Method 3.5.4.1 Average Profits Method Under this method, the goodwill is valued at agreed number of ‘years’ purchase of the average profits of the past few years. It is based on the assumption that a new business will not be able to earn any profits during the first few years of its operations. Hence, the person who purchases a running business must pay in the form of goodwill a sum which is equal to the profits he is likely to receive for the first few years. The goodwill, therefore, should be calculated by multiplying the past average profits by the number of years during which the anticipated profits are expected to accrue. For example, if the past average profits of a business works out at Rs. 20,000 and it is expected that such profits are likely to continue for another three years, the value of goodwill will be Rs. 60,000 (Rs. 20,000 × 3), Illustration 9 The profit for the five years of a firm are as follows – year 2010 Rs. 4,00,000; year 2011 Rs. 3,98,000; year 2012 Rs. 4,50,000; year 2013 Rs. 4,45,000 and year 2014 Rs. 5,00,000. Calculate goodwill of the firm on the basis of 4 years purchase of 5 years average profits. Solution Year Profit (Rs.) 2010 4,00,000 2011 3,98,000 2012 4,50,000 2013 4,45,000 2014 5,00,000 Total 21,93,000 Total Profit of Last 5 Years 21,93,000 Average Profit = = Rs. = Rs. 4,38,600 No. of years 5 Goodwill = Average Profits × No. of years purchased = Rs. 4,38,600 × 4 = Rs. 17,54,400 2015-16 Admission of a Partner 125 The above calculation of goodwill is based on the assumption that no change in the overall situation of profits is expected in the future. The above illustration is based on simple average. Sometimes, if there exists an increasing on decreasing trend, it is considered to be better to give a higher weightage to the profits to the recent years than those of the earlier years. Hence, it is a advisable to work out weighted average based on specified weights like 1, 2, 3, 4 for respective year’s profit. However, weighted average should be used only if specified. (See illustrations 10 and 11). Illustration 10 The Profits of firm for the five years are as follows: Year Profit (Rs.) 2011–12 20,000 2012–13 24,000 2013–14 30,000 2014–15 25,000 2015–16 18,000 Calculate the value of goodwill on the basis of three years’ purchase of weighted average profits based on weights 1,2,3,4 and 5 respectively. Solution Year Ended 31 st Mar ch Profit Weight Product (Rs.) 2011–12 20,000 1 20,000 2012–13 24,000 2 48,000 2013–14 30,000 3 90,000 2014–15 25,000 4 1,00,000 2015–16 18,000 5 90,000 15 3,48,000 3,48,000 Weighted Average Profit = Rs. = Rs. 23,200 15 Goodwill = Rs. 23,200 × 3 = Rs. 69,600 2015-16 126 Accountancy – Not-for-Profit Organisation and Partnership Accounts Illustration 11 Calculate goodwill of a firm on the basis of three year’ purchase of the weighted average profits of the last four years. The profit of the last four years were: 2012 Rs. 20,200; 2013 Rs. 24,800; 2014 Rs. 20,000 and 2015 Rs. 30,000. The weights assigned to each year are : 2012 – 1; 2013 – 2; 2014 – 3 and 2015 – 4. You are supplied the following information: 1. On September 1, 2014 a major plant repair was undertaken for Rs. 6,000, which was charged to revenue. The said sum is to be capitalised for goodwill calculation subject to adjustment of depreciation of 10% p.a. on reducing balance method. 2. The Closing Stock for the year 2013 was overvalued by Rs. 2,400. 3. To cover management cost an annual charge of Rs. 4,800 should be made for purpose of goodwill valuation. Solution Calculation of Adjusted Profit 2012 2013 2014 2015 Rs. Rs. Rs. Rs. Given Profits 20,200 24,800 20,000 30,000 Less: Management Cost 4,800 4,800 4,800 4,800 Add: Capital Expenditure 15,400 20,000 15,200 25,200 Charged to Revenue - - 6,000 - 15,400 20,000 21,200 25,200 Less: Unprovided Depreciation - - 200 580 15,400 20,000 21,000 24,620 Less: over valuation of Closing Stock - 2,400 - - 15,400 17,600 21,000 24,620 Add: over value of opening stock - - 2,400 - Adjusted Profits 15,400 17,600 23,400 24,620 Calculation of weighted average profits: (Rs.) Year Profit Weight Product 2012 15,400 1 15,400 2013 17,600 2 35,200 2014 23,400 3 70,200 2015 24,620 4 98,480 Total 10 2,19,280 2015-16 Admission of a Partner 127 2,19,280 Weight Average Profit = Rs. = Rs. 21,928 10 Goodwill = Rs. 21,928 × 3 = Rs. 65,784 Notes to Solution (i) Depreciation of 2005 = 10% of Rs. 6000 for 4 months = Rs. 6000 × 10/100 × 4/12 = Rs. 200 (ii) Depreciation of 2006 = 10% of Rs. 6000 – Rs. 200 for one year = Rs. 5800 × 10/100 + Rs. 580 (iii) Closing Stock of 2004 will become opening stock for the year 2005. 3.5.4.2 Super Profits Method The basic assumption in the average profits (simple or weighted) method of calculating goodwill is that if a new business is set up, it will not be able to earn any profits during the first few years of its operations. Hence, the person who purchases an existing business has to pay in the form of goodwill a sum equal to the total profits he is likely to receive for the first ‘few years’. But it is contended that the buyer’s real benefit does not lie in total profits; it is limited to such amounts of profits which are in excess of the normal return on capital employed in similar business. Therefore, it is desirable to value, goodwill on the basis of the excess profits and not the actual profits. The excess of actual profits over the normal profits is termed as super profits. Capital Employed × Normal Rate of Return Normal Profit = 100 Suppose an existing firm earns Rs. 18,000 on the capital of Rs. 1,50,000 and the normal rate of return is 10%. The Normal profits will work out at Rs. 15,000 (1,50,000 × 10/100). The super profits in this case will be Rs. 3,000 (Rs. 18,000 – 15,000). The goodwill under the super profit method is ascertained by multiplying the super profits by certain number of years’ purchase. If, in the above example, it is expected that the benefit of super profits is likely to be available for 5 years in future, the goodwill will be valued at Rs. 15,000 (3,000 × 5). Thus, the steps involved under the method are: 1. Calculate the average profit, 2. Calculate the normal profit on the capital employed on the basis of the normal rate of return, 3. Calculate the super profits by deducting normal profit from the average profits, and 4. Calculate goodwill by multiplying the super profits by the given number of years’ purchase. 2015-16 128 Accountancy – Not-for-Profit Organisation and Partnership Accounts Illustration 12 The books of a business showed that the capital employed on December 31, 2014, Rs. 5,00,000 and the profits for the last five years were: 2010– Rs. 40,000: 2011-Rs. 50,000; 2012-Rs. 55,000; 2013-Rs.70,000 and 2014-Rs. 85,000. You are required to find out the value of goodwill based on 3 years purchase of the super profits of the business, given that the normal rate of return is 10%. Solution Cap ital E mp loyed × Normal Rate of Return Normal Profits = 1 00 5, 00,000 × 10 = Rs. = Rs. 50,000 100 Average Profits: Year Profit (Rs.) 2010 40,000 2011 50,000 2012 55,000 2013 70,000 2014 85,000 Total 3,00,000 Average Profits = Rs. 3,00,000/5 = Rs. 60,000 Super Profit = Rs. 60,000 – Rs. 50,000 = Rs. 10,000 Goodwill = Rs. 10,000 × 3 = Rs. 30,000 Illustration 13 The capital of the firm of Anu and Benu is Rs. 1,00,000 and the market rate of interest is 15%. Annual salary to partners is Rs. 6,000 each. The profits for the last 3 years were Rs. 30,000; Rs. 36,000 and Rs. 42,000. Goodwill is to be valued at 2 years purchase of the last 3 years’ average super profits. Calculate the goodwill of the firm. Solution 15 Interest on capital = 1,00,000 × = Rs. 15,000…………(i) 100 Add: partner’s salary = Rs. 6,000 × 2 = Rs. 12,000…………(ii) 2015-16 Admission of a Partner 129 Normal Profit(i+ii) = Rs. 27,000 1,08, 000 Average Profit = Rs. 30,000+Rs.36,000+Rs.42,000 = Rs. 3 = Rs. 36,000 Super Profit = Average Profit–Normal Profit = Rs. 36,000–Rs. 27,000 = Rs. 9,000 Goodwill = Super Profit × No of years’ purchase = Rs. 9,000 × 2 = Rs. 18,000 3.5.4.3 Capitalisation Methods Under this method the goodwill can be calculated in two ways: (a) by capitalizing the average profits, or (b) by capitalizing the super profits. (a) Capitalisation of Average Profits: Under this method, the value of goodwill is ascertained by deducting the actual capital employed (net assets) in the business from the capitalized value of the average profits on the basis of normal rate of return. This involves the following steps: (i) Ascertain the average profits based on the past few years’ performance. (ii) Capitalize the average profits on the basis of the normal rate of return to ascertain the capitalised value of average profits as follows: Average Profits × 100/Normal Rate of Return (iii) Ascertain the actual capital employed (net assets) by deducting outside liabilities from the total assets (excluding goodwill). Capital Employed = Total Assets (excluding goodwill) – Outside Liabilities (iv) Compute the value of goodwill by deducting net assets from the capitalised value of average profits, i.e. (ii) – (iii). Illustration 14 A business has earned average profits of Rs. 1,00,000 during the last few years and the normal rate of return in a similar business is 10%. Ascertain the value of goodwill by capitalisation average profits method, given that the value of net assets of the business is Rs. 8,20,000. Solution Capitalised Value of Average Profits 1,00, 000 × 100 Rs. = Rs. 10,00,000 10 2015-16 130 Accountancy – Not-for-Profit Organisation and Partnership Accounts Goodwill = Capitalised value – Net Assets = Rs. 10,00,000 – Rs. 8,20,000 = Rs.1,80,000 (b) Capitalisation of Super Profits: Goodwill can also be ascertained by capitalising the super profit directly. Under this method there is no need to work out the capitalised value of average profits. It involves the following steps. (i) Calculate capital employed of the firm, which is equal to total assets minus outside liabilities. (ii) Calculate normal profits on capital employed. (iii) Calculate average profit for past years, as specified. (ii) Calculate super profits by deducting normal profits from average profits. (iii) Multiply the super profits by the required rate of return multiplier, that is, Goodwill = Super Profits × 100 Normal Rate of Return In other words, goodwill is the capitalised value of super profits. The amount of goodwill worked out by this method will be exactly the same as calculated by capitalising the average profits. For example, using the data given in illustration 14 where the average profits are Rs. 1,00,000 and the normal profits are Rs. 82,000 (10% of Rs. 8,20,000), the super profits worked out as Rs. 18,000 (Rs. 1,00,000 – Rs. 82,000), the goodwill will be Rs. 18,000 × 100 = Rs. 1,80,000. 10 Illustration 15 1. The goodwill of a firm is to be worked out at three years’ purchase of the average profits of the last five years which are as follows: Years Profits (Loss) (Rs.) 2012 10,000 2013 15,000 2014 4,000 2015 (5,000) 2016 6,000 2. The capital employed of the firm is Rs. 1,00,000 and normal rate of return is 8%, the average profits for last 5 years are Rs. 12,000 and goodwill is to be worked out at 3 years’ purchase of super profits, 3. Rama Brothers earn an average profit of Rs. 30,000 with a capital of Rs. 2,00,000. The normal rate of return in the business is 10%. Using capitalisation of super profits method work out the value the goodwill of the firm. 2015-16 Admission of a Partner 131 Solution 1. Total Profits = Rs. 10,000 + Rs. 15,000 + Rs. 4,000 + Rs. 6,000 – Rs. 5,000 = Rs. 30,000 Average Profits = Rs. 30,000/5 = Rs. 6,000 Goodwill = Average Profits × 3 = Rs. 6,000 × 3 = Rs.18,000 2. Average Profit = Rs. 12,000 8 Normal Profit = Rs.1,00,000 × = Rs. 8,000 100 Super Profit=Average Profit – Normal profit = Rs. 12,000 – Rs. 8,000 = Rs. 4,000 Goodwill=Super Profit × 3 = Rs. 4,000 × 3 = Rs. 12,000 3. Normal Profit= Rs. 2,00,000 × 10/100 = Rs. 20,000 Super Profit = Average Profit – Normal Profit = Rs. 30,000 – Rs. 20,000 = Rs. 10,000 Goodwill=Super Profit × 100/Normal Rate of Return = 10,000 × 100/10 = Rs. 1,00,000. 3.5.5 Treatment of Goodwill As stated earlier, the incoming partner who acquires his share in the profits of the firm from the existing partners brings in some additional amount to compensate them for loss of their share in super profits. It is termed as his share of goodwill (also called premium). Alternatively he may agree that goodwill account be raised in the books of the firm by giving the necessary credit to the old partners. Thus, when a new partner is admitted, goodwill can be treated in two ways: (1) By Premium Method, and (2) By Revaluation Method. 3.5.5.1 Premium Method This method is followed when the new partner pays his share of goodwill in cash. The amount of premium brought in by the new partner is shared by the existing partners in their ratio of sacrifice. If this amount is paid to the old partners directly (privately) by the new partner, no entry is made in the books of the firm. But, when the amount is paid through the firm, which is generally the case, the following journal entries are passed: (i) Cash A/c Dr. To Goodwill A/c (Amount brought by new partner as premium) (ii) Goodwill A/c Dr. To Existing Partners Capital A/c (Individually) (Goodwill distributed among the existing partners in their sacrificing ratio) 2015-16 132 Accountancy – Not-for-Profit Organisation and Partnership Accounts Alternatively, it is credited to the new partner’s capital account and then adjusted in favour of the existing partners in their sacrificing ratio. In that case the journal entries will be as follows: (i) Cash A/c Dr. To New Partner’s Capital A/c (Amount brought by new partner for his share of goodwill) (ii) New Partner’s Capital A/c Dr. To Existing Partner’s Capital A/cs (Individually) (Goodwill brought by new partners distributed among the existing partners in their sacrificing ratio) If the partners decide that the amount of premium credited to their capital accounts should be retained in business, there is no need to pass any additional entry. If, however, they decide to withdraw their amounts, (in full or in part) the following additional entry will be passed: Existing Partner’s Capital A/c (Individually) Dr. To Cash A/c (The amount of goodwill withdrawn by the existing partners) Illustration 16 Sunil and Dalip are partners in a firm sharing profits and losses in the ratio of 5:3. Sachin is admitted in the firm for 1/5 share of profits. He is to bring in Rs. 20,000 as capital and Rs. 4,000 as his share of goodwill. Give the necessary journal entries, (a) When the amount of goodwill is retained in the business. (b) When the amount of goodwill is fully withdrawn. (c) When 50% of the amount of goodwill is fully withdrawn. Solution (a) When the amount of goodwill credited to existing partners is retained in business 2015-16 Admission of a Partner 133 Books of Sunil and Dalip Journal Date Particulars L.F. Debit Credit (Rs.) (Rs.) (i) Cash A/c Dr. 24,000 To Sachin’s Capital A/c 20,000 To Goodwill A/c 4,000 (The amount brought in by Sachin as Capital and Goodwill) (ii) Goodwill A/c Dr. 4,000 To Sunil’s Capital A/c 2,500 To Dalip’s Capital A/c 1,500 (Goodwill transferred to Sunil and Dalip in the ratio of 5:3) Alternatively, if the goodwill account is not be the brought into the books of accounts the following entries will be recorded: (i) Cash A/C Dr. 24,000 To Sachin’s Capital A/c 24,000 (ii) Sachin’s Capital A/c Dr 4,000 To Sunil’s Capital A/c 2,500 To Dalip’s Capital A/c 1,500 Note: It assumed that the sacrificing ratio is the same as old profit sharing ratio. (b) When the amount of goodwill credited to existing partners is fully withdrawn. Journal Date Particulars L.F. Debit Credit (Rs.) (Rs.) 1. Same as in (a) above 2. Same as in (a) above, 3. Sunil’s Capital A/c Dr. 2,500 Dalip’s Capital A/c Dr. 1,500 To Cash A/c 4,000 (Cash withdrawn by Sunil and Dalip equal to their share of goodwill) (c) When 50% of the amount of goodwill credited to existing partners is withdrawn. Journal Date Particulars L.F. Debit Credit (Rs.) (Rs.) 1. Same as in (a) above, 2. Same as in (a) above 3. Sunil’s Capital A/c Dr. 1,250 Dalip’s Capital A/c Dr. 750 To Cash A/c 2,000 (Cash withdrawn for 50% of their share of goodwill) 2015-16 134 Accountancy – Not-for-Profit Organisation and Partnership Accounts Illustration 17 Vijay and Sanjay are partners in a firm sharing profits and losses in the ratio of 3:2. They decide to admit Ajay into partnership with 1/4 share in profits. Ajay brings in Rs. 30,000 for capital and the requisite amount of premium in cash. The goodwill of the firm is valued at Rs. 20,000. The new profit sharing ratio is 2:1:1. Vijay and Sanjay withdraw their share of goodwill. Give necessary journal entries. Solution (a) Ajay will bring Rs. 5,000 (1/4 of Rs. 20,000) as his share of goodwill (premium) (b) Sacrificing Ratio is 2:3 as calculated below: For Vijay, old ratio is 3/5 and the new ratio is 2/4, hence, his sacrificing ratio is 3 2 12 - 10 2 = − = = 5 4 20 20 For Sanjay, old ratio is 2/5 and the new ratio is 1/4, hence, his sacrificing 2 1 3 ratio is = − = 8−5 = 5 4 20 20 Books of Vijay and Sanjay Journal Date Particulars L.F. Debit Credit (Rs.) (Rs.) 1. Cash A/c Dr. 35,000 To Ajay’s Capital A/c 30,000 To Goodwill A/c 5,000 (The amount of capital and goodwill brought by Ajay) 2. Goodwill A/c Dr. 5,000 To Vijay’s Capital A/c 2,000 To Sanjay’s Capital A/c 3,000 (the amount of goodwill brought by Ajay shared by Vijay and Sanjay in their sacrificing ratio) 3. Vijay’s Capital A/c Dr. 2,000 Sanjay’s Capital A/c Dr. 3,000 To Cash A/c 5,000 (Cash withdrawn by Vijay and Sanjay for their share of goodwill) Note: Alternatively, journal entries (1) and (2) could be as follows: 2015-16 Admission of a Partner 135 Books of Vijay and Sanjay Journal Date Particulars L.F. Debit Credit (Rs.) (Rs.) 1. Cash A/c Dr. 35,000 To Ajay’s Capital A/c 35,000 (Ajay brought in Rs. 30,000 for capital and Rs. 5,000 as goodwill) 2. Ajay’s Capital A/c Dr. 5,000 To Vijay’s Capital A/c 2.000 To Sanjay’s Capital A/c 3,000 (Amount of goodwill brought in by Ajay shared by Vijay and Sanjay in their sacrificing in the ratio of 2:3) When goodwill already exists in books: The above treatment of goodwill was based on the assumption that there was no goodwill account in the books of the firm. However, It is quite possible that when a new partner brings in his share of goodwill in cash, some amount of goodwill already exists in books. In that case, after crediting the old partners by the amount of goodwill brought in by the new partner, the existing goodwill must be written off by debiting the old partners in their old profit sharing ratio. But, if it is decided that the goodwill may continue to appear in the books at its old value, the amount to be brought in by new partner will have to be proportionately reduced i.e., He will be required to bring cash only for this share of the excess of the agreed value of goodwill over the amount of goodwill already appearing in books. For example, In illustration 17, the goodwill of the firm is valued at Rs. 20,000 and Ajay who is admitted to 1/4 share in its profits, brings in Rs. 5,000 as his share of goodwill. Suppose, goodwill already appeared in books at Rs. 10,000 and there is no decision to retain it. In that case, after crediting Vijay and Sanjay for the amount of goodwill brought in by Ajay, the following additional journal entry shall be recorded for writing off the existing amount of goodwill. Date Particulars L.F. Debit Credit (Rs.) (Rs.) Vijay’s Capital A/c Dr. 6,000 Sanjay’s Capital A/c Dr. 4,000 To Goodwill A/c 10,000 (Goodwill written-off in old ratio) In case, however, the partners decide to maintain the Goodwill Account as it is, the new partner is required to bring in as his share of goodwill only in respect of the difference between its total value and the book value. In other words, Ajay will be required to bring in Rs. 2,500 only [1/4 of Rs. 10,000 (Rs 20,000 – Rs. 10,000)]. Which will be credited to old partners in their sacrificing ratio, and no entry will be recorded for writing off the existing amount of goodwill. 2015-16 136 Accountancy – Not-for-Profit Organisation and Partnership Accounts Illustration 18 Srikant and Raman are partners in a firm sharing profits and losses in the ratio of 3:2. They decide to admit Venkat into partnership with 1/3 share in the profits. Venkat brings in Rs 30,000 as his capital. He also promises to bring in the necessary amount for his share of goodwill. On the date of admission, the goodwill has been valued at Rs 24,000 and the goodwill account already appears in the books at Rs 12,000. Venkat brings in the necessary amount for his share of goodwill and agrees that the existing goodwill account be written off. Record the necessary journal entries in the books of the firm. Solution Books of Srikant and Raman Journal Date Particulars L.F. Debit Credit (Rs.) (Rs.) 1. Cash A/c Dr. 38,000 To Venkat’s Capital A/c 30,000 To Goodwill A/c 8,000 (Amount brought in by Venkat as his capital and his share of goodwill) 2. Goodwill A/c Dr. 8,000 To Srikant’s Capital A/c 4,800 To Raman’s Capital A/c 3,200 (Goodwill brought in by Venkat shared by old partners in their ratio of sacrifice) 3. Srikant’s Capital A/c Dr. 7,200 Raman’s Capital A/c Dr. 4,800 To Goodwill A/c 12,000 (Goodwill already appearing in books written-off in the old ratio) Note: Since nothing is given about the ratio in which the new partner acquires his share of profit from Srikant and Raman, it is implied that they sacrifice their share of profit in favour of Venkat in the old ratio i.e., 3:2. 3.5.5.2 Revaluation Method This method is followed when the new partner does not bring in his share of goodwill in cash. In such a situation, the goodwill account is raised in the books of account by crediting the old partners in the old profit sharing ratio. When goodwill account is to be raised in the books of account there are two possibilities, (a) No goodwill appears in books at the time of admission, and (b) Goodwill already exists in books at the time of admission. 2015-16 Admission of a Partner 137 (a) When no goodwill exists in the books: When no goodwill exists in the books at the time of the admission of a new partner, the goodwill account must be raised at its full value. This can be done by debiting goodwill account with its full value and crediting the old partners’ capital accounts in their profit sharing ratio. The journal entry will be: Goodwill A/c Dr. To Old Partners’ Capitals A/c (individually) (Goodwill raised at full value in the old ratio) The goodwill thus raised shall appear in the balance sheet of the firm at its full value. Illustration 19 Ahuja and Barua are partners in a firm sharing profits and losses in the ratio of 3:2. They decide to admit Chaudhary into partnership for 1/5 share of profits, which he acquires equally from Ahuja and Barua. Goodwill is valued at Rs. 30,000. Chaudhary brings in Rs. 16,000 as his capital but is not in a position to bring any amount for goodwill. No goodwill account exists in books of the firm. Goodwill account is to be raised at full value. Record the necessary journal entries. Solution Book of Ahuja and Barua Journal Date Particulars L.F. Debit Credit (Rs.) (Rs.) 1. Cash A/c Dr. 16,000 To Chaudhary’s Capital A/c 16,000 (Amount brought for capital) 2. Goodwill A/c Dr. 30,000 To Ahuja’s Capital A/c 18,000 To Barua’s Capital A/c 12,000 (Goodwill raised at full value in old ratio) Note: Goodwill shall appear in the balance sheet at Rs. 30,000 Sometimes, a partner may bring in a part of his share of goodwill. In such a situation, after distributing the amount brought in for goodwill among the old partners in their sacrificing ratio, the goodwill account is raised in the books based on the portion of premium not brought by the new partner. For example, Pooja and Sandeep are partners sharing profits in ratio of 3:3. They admit Tushar as a new partner for 1 3 share in profits. Tushar is to bring in Rs. 30,000 as his 2015-16 138 Accountancy – Not-for-Profit Organisation and Partnership Accounts share of goodwill as the total value of goodwill is estimated at Rs. 90,000. But he brings Rs. 15,000 only (half of what is due) on this account. In this case, after due credit for Rs. 15,000 to Pooja’s and Sandeep’s capital accounts in their sacricifing ratio, goodwill account will be raised by Rs. 45,000 (half of its total value) by crediting their old profit sharing ratio. (b) When goodwill already exists in the books : If the books already show some balance in the Goodwill Account, the adjustment for goodwill in the old partner’s capital accounts shall be made only for the difference between the agreed value of goodwill and the amount of goodwill appearing in books. The amount of goodwill appearing in the books may be less than its agreed value or it may be more than the agreed value. If it is less than the agreed value, the difference between the agreed value of goodwill and the amount of goodwill appearing in the books will be debited to goodwill account and credited to old partner’s capital accounts in their old profit sharing ratio. If, however, it is more than the agreed value, the difference will be debited to the old partners’ capital accounts in their old profits sharing ratio and credited to the goodwill account. Thus, the journal entries will be as under: (a) When the value of goodwill appearing in the books is less than the agreed value. Goodwill A/c Dr. To Old Partners’ Capital A/c (individually) (Goodwill raised to its agreed value) (b) When the value of goodwill appearing in the books is more than the agreed value. Old Partners’ Capital A/c (individually) Dr. To Goodwill A/c (Goodwill brought down to its agreed value) Illustration 20 Ram and Rahim are partners in a firm sharing profits and losses in the ratio of 3:2. Rahul is admitted into partnership for 1/3 share in profits. He brings in Rs. 10,000 as capital, but is not in a position to bring any amount for his share of goodwill which has been valued at Rs. 30,000. Give necessary journal entries under each of the following situations: (a) When there is no goodwill appearing in the books of the firm; (b) When the goodwill appears at Rs 15,000 in the books of the firm; and (c) When the goodwill appears at Rs. 36,000 in the books of the firm. 2015-16 Admission of a Partner 139 Solution (a) When no goodwill appears in the books Books of Ram and Rahim Journal Date Particulars L.F. Debit Credit (Rs.) (Rs.) Cash A/c Dr. 10,000 To Rahul’s Capital A/c 10,000 (Amount brought by Rahul as Capital) Goodwill A/c Dr. 30,000 To Ram’s Capital A/c 18,000 To Rahim’s Capital A/c 12,000 (Goodwill raised at full value in the old profit sharing ratio) (b) When goodwill appears in the books at Rs 15,000 Journal Date Particulars L.F. Debit Credit (Rs.) (Rs.) Cash A/c Dr. 10,000 To Rahul’s Capital A/c 10,000 (Amount brought by Rahul as capital) Goodwill Dr. 15,000 To Ram’s Capital A/c 9,000 To Rahim’s Capital A/c 6,000 (Goodwill raised to its agree value) (c) When the goodwill appears in the books at Rs 36,000 Journal Date Particulars L.F. Debit Credit (Rs.) (Rs.) Cash A/c Dr. 10,000 To Rahul’s Capital 10,000 (Amount brought by Rahul as capital) Ram’s Capital A/c Dr. 3,600 Rahim’s Capital A/c Dr. 2,400 To Goodwill A/c 6,000 (Goodwill brought down to its agreed vlaue) 2015-16 140 Accountancy – Not-for-Profit Organisation and Partnership Accounts Normally, when goodwill is raised in the books of the firm, it will be shown in the balance sheet at its agreed value. If, however, the partners decide that after necessary adjustments have been made in the old partners’ capital accounts, the goodwill should not appear in the firm’s balance sheet, then it has to be written off. This is done by crediting the goodwill account and debiting the capital accounts of all the partners (including the new partner) in the new profit sharing ratio. The net effect of such treatment will be that the new partner’s capital account stands debited to the extent of his share of goodwill and the old partners capital accounts credited in the ratio of their sacrifice, and the goodwill shows nil balance. Illustration 21 A and B are partners sharing profits and losses equally. They admit C into partnership and the new ratio is fixed as 4:3:2. C is unable to bring anything for goodwill but brings Rs 25,000 as capital. Goodwill of the firm is valued at Rs 18,000. Give the necessary journal entries assuming that the partners do not want goodwill to appear in the Balance Sheet. Solution Books of A and B Journal Date Particulars L.F. Debit Credit (Rs.) (Rs.) Cash A/c Dr. 25,000 To C’s Capital A/c 25,000 (Cash brought in by C as Capital) Goodwill 18,000 To A’s Capital A/c 9,000 To B’s Capital A/c 9,000 (Goodwill raised at its full value) A’s Capital A/c Dr. 8,000 B’s Capital A/c Dr. 6,000 C’s Capital A/c Dr. 4,000 To Goodwill A/c 18,000 (Goodwill written-off) The net effect of the entries (2) and (3) above is that C’s Capital account has been debited by Rs. 4,000 and A’s Capital account and B’s Capital account credited in their sacrificing ratio by Rs 1,000 (credit Rs 9,000 – debit Rs 8,000 ) and Rs 3,000 (credit Rs 9,000 – debit Rs 6,000 ) respectively, and goodwill will show nil balance. 2015-16 Admission of a Partner 141 Sometimes, the partners may decide not to show goodwill account anywhere in books (not even in the journal and ledger). In that case, for adjustment of goodwill, just one entry can be passed by debiting the new partner’s capital account with his share of goodwill and crediting the old partners’ capital accounts in their ratio of sacrifice. If in Illustration 21 we were to treat goodwill in this manner, the entry for goodwill would have been as follows: Date Particulars L.F. Debit Credit (Rs.) (Rs.) C’s Capital A/c Dr. 4,000 To A’s Capital A/c 1,000 To B’s Capital A/c 3,000 (Adjustment for C’s share of goodwill) The above entry has the same effect on partners’ capital accounts as journal entries (2) and (3). Box I Accounting standard 10 (AS–10) on “Accounting for Fixed Assets” in its Para 16 states that Goodwill, in general, is recorded in the books only when some consideration in money or money’s worth has been paid for it. Whenever a business is acquired for a price (payable either in cash or in shares or otherwise) which is excess of the net assets taken over, the excess is termed as goodwill’. Goodwill arises from business connections, trade name or reputation of an enterprise or from other intangible benefits enjoyed by an enterprise. As a matter of financial prudence, goodwill is written off over a period. However, many enterprises do not write off goodwill and retain it as an asset. In view of the provision in para 16 of the Accounting Standard 10 (AS-10), some experts feel that in case of admission, retirement or death of a partner or a change in profit sharing ratio among the partners, goodwill cannot be raised in the books of the firm, and all entries relating to goodwill on such occasions should be recorded in books of the firm directly through the partners’ capital accounts only. This is stretching the interpretation of AS–10 too far. What this accounting standard implies is that normally goodwill should not be brought into books unless it is paid for, and whenever it is recorded it should be written- off over a period. Hence, crediting goodwill account with the amount brought in by the incoming partner for his share of goodwill and then transferring it to old partners’ capital accounts by debiting goodwill account is quite in order. Similarly, when the incoming partner is unable to bring in the necessary amount for his share of goodwill, raising goodwill account at its agreed value by crediting the old partners in then old profit sharing ratio and then writing it off immediately by debiting it to all the partners (including the new partner) in the new profit sharing ratio is also acceptable as effectively it is tent amount to purchase of 2015-16 142 Accountancy – Not-for-Profit Organisation and Partnership Accounts goodwill because new partner’s capital account balance stands reduced by his share of goodwill. The same logic equally implies to the adjustments made for raising the goodwill account to its goodwill account when it already appears in the balance sheet. What is important is that in the normal course of raising goodwill as an asset should be avoided of and, if and when it is brought in to books, it should be written off in the shortest possible period. Test your Understanding – II Choose the correct alternative – 1. At the time of admission of a new partner, general reserve appearing in the old balance sheet is transferred to: (a) all partner’s capital account (b) new partner’s capital account (c) old partner’s capital account (d) none of the above. 2. Asha and Nisha are partner’s sharing profit in the ratio of 2:1. Asha’s son Ashish was admitted for 1/4 share of which 1/8 was gifted by Asha to her son. The remaining was contributed by Nisha. Goodwill of the firm in valued at Rs. 40,000. How much of the goodwill will be credited to the old partner’s capital account. (a) Rs. 2,500 each (b) Rs. 5,000 each (c) Rs. 20,000 each (d) None of the above. 3. A, B and C are partner’s in a firm. If D is admitted as a new partner: (a) old firm is dissolved (b) old firm and old partnership is dissolved (c) old partnership is reconstituted (d) None of the above. 4. On the admission of a new partner increase in the value of assets is debited to: (a) Profit and Loss Adjustment account (b) Assets account (c) Old partner’s capital account (d) None of the above. 5. At the time of admission of a partner, undistributed pr ofits appearing in the balance sheet of the old firm is transferred to the capital account of: (a) old partners in old profit sharing ratio (b) old partners in new profit sharing ratio (c) all the partner in the new profit sharing ratio. 3.5.5.3 Hidden Goodwill Sometimes the value of goodwill is not given at the time of admission of a new partner. In such a situation it has to be inferred from the arrangement of the capital and profit sharing ratio. Suppose, A and B are partners sharing profits equally with capitals of Rs. 45,000 each. They admitted C as a new partner for 2015-16 Admission of a Partner 143 one-third share in the profit. C brings in Rs. 60,000 as his capital. Based on the amount brought in by C and his share in profit, the total capital of the newly constituted firm works out to be Rs.1,80,000 (Rs. 60,000 × 3). But the actual total capital of A, B and C works out as Rs. 1,50,000 (Rs. 45,000 + Rs. 45,000 + Rs. 60,000). Hence, it can be inferred that the difference is on account of goodwill i.e., Rs. 30,000 (Rs. 1,80,000 – Rs. 1,50,000). Which is to be shared equally (old ratio) by A and B. This shall raise their capital accounts to Rs. 60,000 each and total capital of the firm to Rs. 1,80,000. Alternatively, if goodwill account is not to be raised, C’s capital account can be debited by Rs. 10,000 (his share of goodwill) and A and B’s Capital accounts credited by Rs. 5,000 each, and firm’s total capital remains Rs. 50,000. Illustration 22 Hem and Nem are partners in a firm sharing profits in the ratio of 3:2. Their capitals were Rs. 80,000 and Rs. 50,000 respectively. They admitted Sam on Jan. 1, 2007 as a new partner for 1/5 share in the future profits. Sam brought Rs. 60,000 as his capital. Calculate the value of goodwill of the firm and record necessary journal entries on Sam’s admission. Solution Value of Firm’s Goodwill Sam’s capital = Rs. 60,000 1 Sam’s share = 5 Total capital of new firm = 5 × Rs.60,000 = Rs. 3,00,000 Hem’s+Nem’s+Sam’s = Rs.80,000 + Rs. 50,000 + Rs.60,000 = Rs.1,90,000 Goodwill of the firm = Rs.1,10,000 (Rs. 3,00,000 – Rs.1,90,000) 1 Sam’s share = × Rs.1,10,000 = Rs. 22,000 5 Books of Hem, Nem and Sam Journal Date Particulars L.F. Debit Credit 2007 Amount Amount (Rs.) (Rs.) 1. Bank A/c Dr. 60,000 To Sam’s Capital A/c 60,000 (Cash brought by Sam for his capital) 2015-16 144 Accountancy – Not-for-Profit Organisation and Partnership Accounts 2. Goodwill A/c Dr. 1,10,000 To Hem’s Capital A/c 66,000 To Nem’s Capital A/c 44,000 (Credit given for goodwill to Hem and Nem on Sam’s admission) Alternatively, if goodwill account is not to be raised, the second journal entry passed for goodwill shall be as fallows. Sam’s Capital A/c Dr. 22,000 To Hem’s Capital A/c 13,200 To Nem’s Capital A/c 8,800 Do It Yourself 1. A firm’s profits for the last three years are Rs. 5,00,000; Rs. 4,00,000 and Rs. 6,00,000. Calculate value of firm’s goodwill on the basis of four years’ purchase of the average profits for the last three years. (Ans : Rs. 20,00,000) 2. A firm’s profits for the last five years were Rs. 20,000, Rs. 30,000, Rs. 40,000, Rs. 50,000 and Rs. 60,000. Calculate the value of firm’s goodwill on the basis of three years’ purchase of weighted average profits after using weight of 1,2,3,4 and 5 respectively. 3. A firm’s profits during 20 13, 2014 , 2015 and 2016 were Rs. 16,000; Rs. 20,000; Rs. 24,000 and Rs. 32,000 respectively. The firm has capital investment of Rs. 1,00,000. A fair rate of return on investment is 18% p.a. Compute goodwill based on three years’ purchase of the average super profits for the last four years. (Ans : Rs. 15,000) 4. Based on the data given in the above question, calculate goodwill by capitalisation of super profits method. Will the amount of goodwill be different if it is computed by capitalisation of average profits? Confirm your answer by numerical verification. 5. Giri and Shanta are partners in a firm sharing profits equally. They admit Kachroo into partnership who, in addition to capital, brings Rs. 20,000 as goodwill for 1/5th share of profits in the firm. What shall be journal entries if: (a) no goodwill appears in the books of the firm. (b) goodwill appears in the books of the firm at Rs. 40,000. 6. A and B are partners in a firm sharing profits in the ratio of 3:2. They admit C into partnership for 1/5th share of profits in the firm. The goodwill of the firm is valued at Rs. 1,00,000. He is unable to bring in his share of goodwill. What will be the journal entries if: (a) Goodwill is raised at full value and then written off. (b) Goodwill is not raised. 3.6 Adjustment for Accumulated Profits and Losses Sometimes a firm may have accumulated profits not yet transferred to capital accounts of the partners. These are usually in the firm of general reserve, reserve 2015-16 Admission of a Partner 145 fund and/or Profit and Loss Account balance. The new partner is not entitled to have any share in such accumulated profits. These are distributed among the partners by transferring it to their capital accounts in old profit sharing ratio. Similarly, if there are some accumulated losses in the form of a debit balance of profit and loss account appearing in the balance sheet of the firm. A remote possibility, the same should also be transferred to the old partners’ capital accounts (see Illustration 23). Illustration 23 Rajinder and Surinder are partners in a firm sharing profits in the ratio of 4:1. On April 15, 2015 they admit Narender as a new partner. On that date there was a balance of Rs. 20,000 in general reserve and a debit balance of Rs. 10,000 in the profit and loss account of the firm. Pass necessary journal entries regarding adjustment of a accumulate a profit or loss. Solution Books of Rajinder,Surinder and Narender Journal Date Particulars L.F. Debit Credit 2015 Amount Amount (Rs.) (Rs.) Apr.15 General Reserve A/c Dr. 20,000 To Rajinder’s capital A/c 16,000 To Surender’s capital A/c 4,000 (General Reserve balance transferred to the capital account of Rajinder and Surinder on Narender’s admission) Rajinder’s Capital A/c Dr. 8,000 Surender’s Capital A/c Dr. 2,000 To Profit and Loss A/c 10,000 (Debit balance of Profit and Loss A/c transferred to old partners’ capital accounts) 3.7 Revaluation of Assets and Reassessment of Liabilities At the time of admission of a new partner, it is always desirable to ascertain whether the assets of the firm are shown in books at their current values. In case the assets are overstated or understated, these are revalued. Similarly, a reassessment of the liabilities is also done so that these are brought in the books at their correct values. At times there may also be some unrecorded assets and 2015-16 146 Accountancy – Not-for-Profit Organisation and Partnership Accounts liabilities of the firm. These also have to be brought into the books of the firm. For this purpose the firm has to prepare the Revaluation Account. The gain or loss on revaluation of each asset and liability is transferred to this account and finally its balance is transferred to the capital accounts of the old partners in their old profit sharing ratio. In other words, the revaluation account is credited with increase in the value of each asset and decrease in its liabilities because it is a gain and is debited with decrease in the value of assets and increase in its liabilities is debited to revaluation account because it is a loss. Similarly unrecorded assets are credited and unrecorded liabilities are debited to the revaluation account. If the revaluation account finally shows a credit balance then it indicates net gain and if there is a debit balance then it indicates net loss. Which will be transferred to the capital accounts of the old partners in old ratio. The journal entries recorded for revaluation of assets and reassessment of liabilities are as follows: (i) For increase in the value of an asset Asset A/c Dr. To Revaluation A/c (Gain) (ii) For reduction in the value of an asset Revaluation A/c Dr. To Asset A/c (Loss) (iii) For appreciation in the amount of a liability Revaluation A/c Dr. To Liability A/c (Loss) (iv) For reduction in the amount of a liability Liability A/c Dr. To Revaluation A/c (Gain) (v) For an unrecorded asset Cash A/c Dr. To Revaluation A/c (Gain) (vi) For an unrecorded liability Revaluation A/c Dr. To Cash A/c (Loss) (vii) For transfer of gain on Revaluation if credit balance Revaluation A/c Dr. To Old Partners Capital A/cs (Old ratio) (individually) (viii) For transferring loss on revaluation Old partner’s Capital A/cs Dr. (Individually) (Old ratio) To Revaluation A/c Note: Entries (i), (ii), (iii) and (iv) are recorded only with the amount increase and decrease in the value of assets and liabilities. 2015-16 Admission of a Partner 147 Illustration 24 Following in Balance Sheet of A and B who share profits in the ratio of 3:2. Balance Sheet of A and B as on April 1, 2015 Liabilities Amount Assets Amount (Rs.) (Rs.) Sundry creditors 20,000 Cash in hand 3,000 Captials Debtors 12,000 A 30,000 Stock 15,000 B 20,000 50,000 Furniture 10,000 Plant and Machinery 30,000 70,000 70,000 On that date C is admitted into the partnership on the following terms: 1. C is to bring in Rs. 15,000 as capital and Rs. 5,000 as premium for goodwill for 1/6 share. 2. The value of stock is reduced by 10% while plant and machinery is appreciated by 10%. 3. Furniture is revalued at Rs. 9,000. 4. A provision for doubtful debts is to be created on sundry debtors at 5% and Rs. 200 is to be provided for an electricity bill. 5. Investment worth Rs. 1,000 (not mentioned in the balance sheet) is to be taken into account. 6. A creditor of Rs. 100 is not likely to claim his money and is to be written off. Record journal entries and prepare revaluation account and capital account of partners. Solution Books of A, B and C Journal Date Particulars L.F. Debit Credit 2015 Amount Amount (Rs.) (Rs.) April Bank A/c Dr. 20,000 01 To C’s capital account 15,000 To Goodwill A/c 5,000 (Cash brought in by C as capital and goodwill/premium) 2015-16 148 Accountancy – Not-for-Profit Organisation and Partnership Accounts 02 Goodwill A/c Dr. 5,000 To A’s Capital A/c 3,000 To B’s Capital A/c 2,000 (Premium divided between A and B in sacrificing ratio 3:2) 03 Revaluation A/c Dr. 3,100 To Stock A/c 1,500 To Furniture 1,000 To Provision for Doubtful Debt A/c 600 (Revaluation in the value of assets on revaluation) 04 Plant and Machinery A/c Dr. 3,000 Investment A/c 1,000 To Revaluation A/c 4,000 (Increase in the value of assets on revaluation) 05 Revaluation A/c Dr. 200 To Outstanding Electricity A/c 200 (Amount provided for outstanding electricity bill) 06 Sundry Creditors A/c Dr. 100 To Revaluation A/c 100 (Amount not likely to be claimed by the creditors written off) 07 Revaluation A/c Dr. 800 To A’s Capital A/c 480 To B’s Capital A/c 320 (Profit on revaluation of assets and re-assessment of liabilities transferred to A and B in old profit sharing ratio) Revaluation Account Dr. Cr. Particulars Amount Particulars Amount (Rs.) (Rs.) Stock 1,500 Plant and Machinery 3,000 Furniture 1,000 Investments 1,000 Provision for Doubtful 600 Sundry Creditors 100 Outstanding Electricity 200 Profit on Revaluation transferred to: A’s Capital 480 B’s Capital 320 4,100 4,100 2015-16 Admission of a Partner 149 Partner’s Capital Accounts Dr. Cr. Date Particulars A B C Date Particulars A B C 2015 (Rs.) (Rs.) (Rs.) 2015 (Rs.) (Rs.) (Rs.) Apr.01 Balance 33,480 22,320 15,000 Apr.1 Balance b/d 30,000 20,000 c/d Bank 15,000 Goodwill 3,000 2,000 Revaluation 480 320 (Profit) 33,480 22,320 15,000 33,480 22,320 15,000 Illustration 25 Given below is the Balance Sheet of A and B, who are carrying on partnership business as on March 31,2015. A and B share profits in the ratio of 2:1. Balance Sheet of A and B as at March 31, 2015 Liabilities Amount Assets Amount (Rs.) ( Rs.) Bills Payable 10,000 Cash in hand 10,000 Sundry creditors 58,000 Cast at bank 40,000 Outstanding expenses 2,000 Sundry debtors 60,000 Capitals Stock 40,000 A 1,80,000 Plant and machinery 1,00,000 B 1,50,000 3,30,000 Building 1,50,000 4,00,000 4,00,000 C is admitted as a partner on the date of the balance sheet on the following terms: 1. C will bring in Rs 1,00,000 as his capital and Rs 60,000 as his share of goodwill for 1/4 share in profits. 2. Plant is to be appreciated to Rs 1,20,000 and the value of buildings is to be appreciated by 10%. 3. Stock is found overvalued by Rs 4,000. 4. A provision for doubtful debts is to be created at 5% of debtors. 5. Creditors were unrecorded to the extend of Rs 1,000. Record revaluation Account, partners’ capital accounts, and the Balance Sheet of the constituted firm after admission of the new partner. 2015-16 150 Accountancy – Not-for-Profit Organisation and Partnership Accounts Solution Books of A and B Revaluation Account Dr. Cr. Particulars Amount Particulars Amount (Rs.) (Rs.) Stock in hand 4,000 Plant and machinery 20,000 Provision for doubtful debts 3,000 Buildings 15,000 Creditors profit on revaluation 1,000 transferred to: A’s Capital 18,000 B’s Capital 9,000 27,000 35,000 35,000 Partners’ Capital Accounts Dr. Cr. Date Particulars A B C Date Particulars A B C 2015 (Rs.) (Rs.) (Rs.) 2015 (Rs.) (Rs.) (Rs.) March Balance c/d 2,38,000 1,79,000 1,00,000 March Balabce b/d 1,80,000 1,50,000 31 31 Bank 1,00,000 Goodwill 40,000 20,000 Revaluation 18,000 9,000 2,38,000 1,79,000 1,00,000 2,38,000 1,79,000 1,00,000 Balance Sheet of A, B and C as on April 01, 2015 Liabilities Amount Assets Amount (Rs.) (Rs.) Bills Payable 10,000 Cash in hand 10,000 Sundry Creditors 59,000 Cash at bank 2,00,000 Outstanding Expenses 2,000 Sundry Debtors 60,000 Capitals Less: Provision for 3,000 57,000 A 2,38,000 doubtful debts B 1,79,000 Stock 36,000 C 1,00,000 5,17,000 Plant and Machinery 1,20,000 Buildings 1,65,000 5,88,000 5,88,000 2015-16 Admission of a Partner 151 Do It Yourself 1. Aslam, Jackab, Hari are equal partners with capitals of Rs. 1,500, Rs. 1,750 and Rs. 2,000 respectively. They agree to admit Satnam into equal partnership upon payment in cash of Rs. 1,500 for one-fourth share of the goodwill and Rs. 1,800 as his capital, both sums to remain in the business. The liabilities of the old firm amount Rs. 3,000 and the assets, apart from cash, consist of Motors Rs. 1,200, Furniture Rs. 400, Stock Rs. 2,650, Debtors of Rs. 3,780. The Motors and Furniture were revalued at Rs. 950 and Rs. 380 respectively, and the depreciation written-off. Ascertain cash in hand and prepare the balance sheet of the firm after Satnam’s admission. 2. Benu and Sunil are partners sharing profits in the ratio of 3:2 on April 1, 2003. Ina was admitted for 1/4 share who paid Rs. 2,00,000 as capital and Rs. 1,00,000 for premium in cash. At the time of admission, general reserve amounting to Rs. 1,20,000 and profit and loss account amounting to Rs. 60,000 appeared on the asset side of the balance sheet. Required: Record necessary journal entries to record the above transactions. 3. Ashoo and Rahul are partners sharing profits in the ratio of 5:3. Gaurav was admitted for 1/5 share and was asked to contribute proportionate capital and Rs. 4,000 for premium (goodwill). The Capitals of Ashoo and Rahul, after all adjustments relating to revaluation, goodwill etc., worked out to be Rs. 45,000 and Rs. 35,000 respectively.