Chapter 3: Reconstitution of Partnership Firm - Admission

(MODES OF RECONSTITUTION)

A partnership firm may go for reconstitution for various reasons such as;

• Change in the profit-sharing ratio among the Existing Partners.
• Admission of a Partner.
• The Retirement of an Existing Partner.
• Death or Insolvency of a Partner.

ADMISSION OF A PARTNER

• Admission of a partner is one of the modes of reconstitution of partnership firm because when a new partner is admitted, the existing agreement among the partners comes to an end & a new agreement comes into existence which results in change in profit sharing ratio, goodwill valuation & reassessment of assets & liabilities.
• The capital contribution of the new partner, his liabilities, and share of profits is decided upon.
• As per Section 31 of the Indian Partnership Act, the new partner shall not be admitted to the firm without the consent of all existing partners.
• After admission, the new partner gets the following two rights :

• Right to share future profits of the firm
• Right to share in the assets of the firm
• He/she  also becomes liable for any liability of the business incurred after admission & any loss incurred by the firm

• The new/incoming partner receives share in future profits that is equal to the sacrifice of profit by an existing partner/partners of the firm & the same new partner has to compensate the partner/partners who are sacrificing their share in profits in his/her favor.
• Such amount paid by the incoming partner is known as Goodwill or Premium for Goodwill.
• Besides Goodwill/Premium for Goodwill, the new partner also contributes in Capital to get the rights in the assets of the firm.

Effects of Admission of Partner

1. Old partnership agreement comes to an end & a new agreement is formed.
2. New or incoming partner becomes entitled to the future share of profits & losses of the firm.
3. New or incoming partner contributes an agreed amount of capital in the firm.
4. New or incoming partner gets a right to the assets of the firm.
5. Adjustments are made regarding the accumulated profits & losses
6. Assets are revalued & liabilities are reassessed & the net change is adjusted in existing or old partner’s capital accounts in their old profit sharing ratio.
7. Goodwill of the firm is valued in order to pay the sacrificing partner for their sacrificed share by the gaining partners through their capital accounts.

What are the adjustments required on the admission of a partner?

1. Determining new profit sharing ratio
2. Valuation of adjustment of goodwill
3. Adjustment of profit/loss arising from revaluation of assets & reassessment of liabilities.
4. Adjustments of accumulated profits, reserves & losses.
5. Adjustment of capital (if agreed)

 

CHAPTER -3

Reconstitution of a Partnership Firm – Admission of a Partner

 

Partnership 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 for all. Any change in the existing agreement amounts to reconstitution of the partnership firm. This results in an end of the existing agreement and a new agreement comes into being with a changed relationship among the members of the partnership firm and/or their composition. However, the firm continues. The partners often resort to reconstitution of the firm in various ways such as admission of a new partner, change in profit sharing ratio, retirement of a partner, death or insolvence of a partner. In this chapter we shall have a brief idea about all these and in detail about the accounting implications of admission of a new partner or an on change in the profit sharing ratio.

Modes of Reconstitution of a Partnership Firm

Reconstitution of a partnership firm usually takes place in any of the following ways:

Admission of a new partner: A new partner may be admitted when the firm needs additional capital or managerial help. According to the provisions of Partnership Act 1932 unless it is otherwise provided in the partnership deed a new partner can be admitted only when the existing partners unanimously agree for it. For example, Hari and Haqque are partners sharing profits in the ratio of 3:2. On April 1, 2017 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 stands 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 1,2017 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, 2017. 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, 2017. 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.

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 primarily to compensate the sacrificing 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.

Determination of New Profit Sharing Ratio

The new or incoming partner is entitled to the share of future profits & losses of the firm. Therefore, there will be a change in the existing profit sharing ratio of the old partners since the new partner will acquire his/her share from the existing share of old partners. The new or incoming partners may acquire the share from the old partner in the following ways;

1. In their old profit-sharing ratio
2. In a particular ratio or surrendered ratio
3. In a particular fraction from some of the partners

Let us discuss in detail;

1. When a new partner acquires his share from old or existing partners in their old profit sharing ratio;

In this situation, the share of the new partner is given & it is assumed that the new partner has acquired his share from old partners in their old profit sharing ratio. Old partners continue to share the balance profits & losses in their old profit-sharing ratio. Unless otherwise agreed, the profit-sharing ratio of the existing partners remains unchanged & the new profit sharing ratio is determined by deducting new or incoming partner’s share from 1 & then dividing the balance in old profit sharing ratio of the old partners.

2. When share of the New partner is given & new ratio of Old Partners is also given;

In this case, the new partner’s share is deducted from 1 & the balance is divided among old partners in their new ratio. Hence, there is a new profit-sharing ratio for all the partners.

3. When New or Incoming Partner acquires his share from old or existing partners in a particular ratio;

In such a case, the new or incoming partner acquires a part of share of profits from one partner & a part of share of profits from another partner. The existing partner’s share will change to the extent of share sacrificed on admission of new partner.

4. When new or incoming partner acquires his shares by surrender of particular fraction of their shares by the old or existing partners;

In such a case, the shares surrendered by the old partners in favor of the new partners are added & it becomes the share of the new partner. The shares surrendered by the old partners is deducted from their respective share to determine old partner’s share in the reconstituted firm. 

The Concept of Sacrificing Ratio

Sacrificing ratio can be explained as the ratio in which existing or old partners sacrifice their share of profits in favor of the new or incoming partner. It can also be defined as the ratio in which the new partner is given a share by the existing partners. This share can be given by all the partners equally or by some of the partners in agreed share. Sacrificing ratio determines the compensation that new partner should pay to the old partners for the share of profits sacrificed by them. The following can be the situations under which sacrificing ratio is determined;

1. When the share of new or incoming partner is given without giving the details of the sacrifice made by the old or existing partners

In this situation, there is no change in the profit sharing ratio of old partners because it is assumed that the partners make sacrifices in their old profit sharing ratio & for that reason sacrificing ratio is always in the old profit sharing ratio.

2. When the old ratio of old or existing partners & new ratio of all the partners are given

In this case, the sacrificing ratio is the difference between the old ratio & the new ratio.

3. When new or incoming partner acquires the share by surrendering a particular fraction of shares by old partners

In such a case, the shares surrendered by the old partner in favor of the new partner are added & it becomes the share of the incoming or new partner. The shares so surrendered by the old partner is deducted from his old share to find out his share in the reconstituted firm.

Revision  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

Jyoti’s share = 3/10

Anshu’s new share =  3/5 – 2/10 = 4/10

Nitu’s new share = old share – share surrendered

= 2/5 – 1/ 10 = 3/10

The new profit sharing ratio between Anshu, Nitu and Jyoti will be  4 : 3 : 3

Revision 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 sacrificed 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.

Solution

Ram’s old share = 3/5

Share sacrificed by Ram = ¼ of 3/5 = 3/20

Ram’s new share = 3/5 – 3/20 = 9/20

Shyam’s old share = 2/5

Share sacrificed by shyam = 1/3 of 2/5 = 2/15

Shyam’s new share = 2/5 – 2/15 = 4/15

Ghanshyam’s new share =   Ram’s sacrifice + Shyam’s Sacrifice

= 3/20 + 2/15 = 17/60

New profit sharing ratio among Ram, Shyam and Ghanshyam will be 27:16:17

Revision 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

Pal’s share = 1/4

Das’s new share = old share – share surrendered = 4/5 – ¼ = 11/20

Sinha’s new share = 1/5

The new profit sharing ratio among Das, Sinha and Pal will be 11:4:5.

Mary’s share  = 1/4

Remaining share = 1 – ¼ = 3/4

 

This 3/4 share is to be shared by Amar and Bahadur in the ratio  of 2:1.

Therefore,

Amar’s new share  = 2/3 of ¾  = 6/12 or 2/4

Bahadur’s new share = 1/3 of ¾ = 3/12 or 1/4

New profit sharing ratio of Amar, Bahadur and Mary will be 2:1:1.

Amar’s sacrifice = 3/5 – 2/4 = 2/20

Bahadur’s sacrifice  = 2/5 – ¼ = 3/20

 

Sacrificing ratio among Amar and Bahadur will be 2:3.

Revision 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

Ramesh’s old share             = 4/7

Ramesh’s new share            = 2/6

Ramesh’s sacrifice               = 4/7 – 2/6 = 10/42

Suresh’s new share             = 3/6

Suresh’s old share               = 3/7

Suresh’s gain                       = 3/6 – 3/7 = 3/42

Mohan’s share                     = 1/6 0r 7/ 42

Ramesh’s sacrifice               =   Suresh’s gain+Mohan’s gain

= 3/42 + 7/42 = 10/ 42

In this case, the whole sacrifice is by Ramesh alone.

Goodwill:
Goodwill is the value of the reputation of a firm. In other words, a well-established business develops the advantage of a good name, reputation and wide business connections. This helps the business to earn more profits as compared to newly set-up businesses. This advantage in monetary terms is called ‘Goodwill’ & it arises only if a firm is able to earn higher profits than normal.

 “Goodwill may be said to be that element arising from the reputation, connections or other advantages possessed by a business which enable it to earn greater profits than the return normally to be expected on the capital represented by the net tangible assets employed in the business.” – Spicer and Pegler

Characteristics of Goodwill:

1. Goodwill is an intangible asset
2. It is a valuable asset. It helps in earning higher profits than normal.
3. It is very difficult to place an exact value on goodwill. It is fluctuating from time to time due to changing circumstances of the business.
4. Goodwill is an attractive force that brings in customers.
5. Goodwill comes into existence due to various factors.

Factors Affecting the Value of Goodwill

1. Nature of business: Company produces high value-added products or has stable demand in the market. Such a company will have more goodwill and is able to earn more profits.

2. Location: If a business is located in a favorable place, it will attract more customers and therefore will have more goodwill.

3. Efficient Management: Efficient Management brings high productivity and costs efficiency to the business which enables it to earn higher profits and thus more goodwill.

4. Market Situation: A firm under monopoly or limited competition enjoys high profits which leads to a higher value of goodwill.

5. Special Advantages: A firm enjoys a higher value of goodwill if it has special advantages like import licenses, low rate and assured supply of power, long-term contracts for sale and for purchase, patents, trademarks etc.

6. Quality of Products: If the quality of products of the firm is good and regular, then it has more goodwill.

 Valuation of Goodwill: Why is it needed?

1. At the time of sale of a business;
2. Change in the profit-sharing ratio amongst the existing partners;
3. Admission of a new partner.
4. Retirement of a partner;
5. Death of a partner;
6. Dissolution of a firm;
7. The amalgamation of the partnership firm

Methods of Valuation of Goodwill: There are various methods for the valuation of goodwill in the partnership business. The value of goodwill may differ in different methods. Goodwill is an intangible asset, so it is very difficult to calculate its exact value. As per the money measurement concept of Accounting, anything that cannot be measured in terms of money should not be recorded in books of accounts. Therefore, it is important to convert Goodwill into monetary terms to record it in the books of accounts. The methods followed for valuing goodwill are:

1. Average Profit Method
2. Super Profit Method
3. Capitalisation Method.

1. Average Profit Method: In this method, Goodwill is calculated on the basis of the number of past years profits. In this method, the goodwill is valued at an agreed number of years purchase of the average profits of the past few years.  A number of years purchase means the period for which the business would be able to earn profit only on the basis of the Goodwill of the business.

There are two different methods of calculating average profit which are:

1. Simple average

2. Weighted average

Simple Average: In the simple average method, the goodwill is calculated by multiplying the average profit with the agreed number of years of purchase.

Step 1 – Find out normal profit by deducting abnormal gains & non-business incomes & adding abnormal losses & non-business expenses.

Step 2 – Average Profit = Total Profits/Number of years of profit & loss given

Step 3 - Goodwill = Average Profit x No. of years of purchase

Example of Simple Average Profit Method

The following illustration will help in understanding the concept of Average Profit method more clearly.

ABC & Co. has these profits in the following years

2010 – ₹5000

2011- ₹4000

2012- ₹5000

2013- ₹3000

2014- ₹5000

Calculate the goodwill at 4 years of purchase.

Solution

Average Profit = Total Profit / No.of years

= 5000+4000+5000+3000+5000

= 22000/5

= 4400

Goodwill = Average Profit x No. of years of purchase

= 4400 x 4

= 19600

Weighted Average: In the weighted average method, weights are assigned to the profits of each year with more weightage for the recent years. The goodwill is calculated by multiplying the weighted average profit with the number of years of purchase.

Weighted Average Profit = Sum of Weighted profits / Sum of weights

Goodwill = Weighted Average Profit x No. of years of purchase

If the profits remain constant over a period of a few years then there should be equal weightage given for all the years which is the simple average method.

If the profit is fluctuating every year then the preference shifts to the weighted average method with necessary weightage given to profits obtained from recent years.

Super Profit Method: In this method, goodwill is valued on the basis of excess profits earned by a firm in comparison to average profits earned by other firms. When a similar type of business earns a return as a certain percentage of the capital employed, it is called ‘normal return’. The excess of actual profit over the normal profit is called ‘Super Profits’.

For Ex – The other firms are earning profits within @ 15% return whereas a particular firm is earning profits @ 20%. This 5% of extra return is known as Super Profit.

Steps:

1. Calculate Actual Average Profit i.e. [ Total Profit  No. of Years ]
2. Calculate Normal Profit i.e.
   =  Capital Employed × Normal Rate of Return 100
   [Capital Employed = Total Assets – Outside Liabilities]
3. Find Out Super Profits
   Super Profits = Actual Average Profit – Normal Profit

4. Calculate the Value of Goodwill
= Super profit × No. of years purchased

3. Capitalisation Methods: There are two ways of finding out the value of Goodwill through this method;

(a) By capitalizing the average profits
(b) By capitalizing the super-profits.

(a) Capitalisation of Actual Average Profit Method:

1. Calculate actual average profit: [ Total Profit  No. of Years ]
2. Capitalize the average profit on the basis of the normal rate of return:
   The capitalized value of the actual average profit
   = Actual Average Profit × 100 Normal Rate of Return 
3. Find out the actual capital employed:
   Actual Capital Employed = Total Assets at their current value other than [Goodwill, Fictitious assets and non-trade investments] – Outside Liabilities.
4. Compute the value of Goodwill:
   Goodwill = Capitalised value of actual average profit – Actual Capital Employed.

(b) Capitalisation of Super Profit Method:

1. Calculate Actual Capital Employed [same as above].

2. Calculate Super Profit [same as under Super Profit Method].

3. Multiply the Super Profit by the required rate of return multiplier:
    Goodwill = Super Profit × 100 Normal Rate of Return 

Treatment of Goodwill:
To compensate old partners for the loss (sacrifice) of their share in profits, the incoming partner, who acquires his share of profit from the old partners brings in some additional amount termed as a share of goodwill.
Goodwill, at the time of admission, can be treated in two ways:

1. Premium Method
2. Revaluation Method.

1. Premium Method:
The premium method is followed when the incoming partner pays his share of goodwill in cash. From the accounting point of view, the following are the different situations related to the treatment of goodwill:

(a) Goodwill (Premium) paid privately (directly to old partners)
[No entry is required]

(b) Goodwill (Premium) brought in cash through the firm
1. Cash A/c or Bank A/c Dr.
To Goodwill A/c
(For the amount of Goodwill brought by new partner)

2. Goodwill A/c Dr.
To Old Partner’s Capital A/c
(For the amount of Goodwill distributed among the old partners in their sacrificing ratio)

Alternatively:
1. Cash A/c or Bank A/c Dr.
To New Partner’s Capital A/c (For the amount of Goodwill brought b> a new partner)

2. New Partner’s Capital A/c Dr.
To Old Partner’s Capital A/c’s (For the amount of Goodwill distributed among the old partners in their sacrificing ratio)

3. If old partners withdrew goodwill (in full or in part) (if any)
Old Partner’s Capital A/c’s Dr.
To Cash A/c or Bank A/c
(For the amount of goodwill withdrawn by the old partners)

When goodwill already exists in books:
If the goodwill already exists in the books of firms and the incoming partner brings his share of goodwill in cash, then the goodwill appearing in the books will have to be written off.

Old Partner’s Capital A/c’s Dr.
To Goodwill A/c
(For Goodwill written-off in old ratio)

After the admission of the partner, all partners may decide to maintain the Goodwill Account in the books of accounts.
Goodwill A/c Dr.
To All Partner’s Capital A/c’s (For Goodwill raised in the new firm after admission of a new partner in new profit sharing ratio)

2. Revaluation Method:
If the incoming partner does not bring in his share of goodwill in cash, then this method is followed. In this case, the goodwill account is raised in the books of accounts. When goodwill account is to be raised in the books there are two possibilities:
(a) No goodwill appears in books at the time of admission.
(b) Goodwill already exists in books at the time of admission,

(a) No goodwill appears in the books:
Goodwill A/c Dr.
To Old Partner’s Capital A/c’s (For Goodwill raised at full value in the old ratio)

If the incoming partner brings in a part of his share of goodwill. In that case, after distributing the amount brought in for goodwill among the old partners in their sacrificing ratio, the goodwill account is raised in the books of accounts based on the portion of premium not brought by the incoming partner.
Example: X and Y are partners sharing profits in the ratio of 3: 2. They admit Z as a new partner. 14th share. The sacrificing ratio of X and Y is 2: 1. Z brings Rs. 12,000 as goodwill out of his share of Rs. 18,000. No goodwill account appears in the books of the firm.

Answer:

(b) When Goodwill already exists in the books
1. When the value of goodwill appearing in books is equal to the agreed value:
[No Entry is Required]

2. If the value of goodwill appearing in the books is less than the agreed value:
Goodwill A/c Dr.
To Old Partner’s Capital A/c’s (For Goodwill is raised to its agreed value)

3. If the value of goodwill appearing in the books is more than the agreed value:
Old Partner’s Capital A/c’s Dr.
To Goodwill A/c
(For Goodwill brought down to its agreed value)

 If partners, after raising Goodwill in the books and making necessary adjustments decide that the goodwill should not appear in the firm’s balance sheet, then it has to be written off.
All Partners’ Capital A/c’s Dr.
To Goodwill A/c (For Goodwill written off)

 Sometimes, the partners may decide not to show goodwill accounts anywhere in books.
New Partner’s Capital A/c Dr.
To Old Partner’s Capital A/c (For adjustment for New Partner’s Share of Goodwill)

Hidden or Inferred Goodwill:
1. To find out the total capital of the firm by new partner’s capital and his share of profit.
Example: New partner’s capital for the 14th share is Rs. 80,000, the entire capital of the new firm will be
80,000 × 41 = Rs. 3,20,000

2. To ascertain the existing total capital of the firm: We will have to ascertain the existing total capital of the new firm by adding the capital (of all partners, including new partner’s capital after adjustments, if any excluding goodwill)
If assets and liabilities are given:
Capital = Assets (at revalued figures) – Liabilities (at revalued figures)

3. Goodwill= Capital from (1) – Capital from (2)
Generally, this method is used, when the incoming partner does not bring his share of goodwill in cash. Here, we find out the total goodwill of the firm. After that, we can find out the new partner’s share of goodwill and treat accordingly.

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.

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.

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 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

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).

Revision 9

The profit for the five years of a firm are as follows – year 2013 Rs. 4,00,000; year 2014 Rs. 3,98,000; year 2015 Rs. 4,50,000; year 2016 Rs. 4,45,000 and year 2017 Rs. 5,00,000. Calculate goodwill of the firm on the basis of 4 years purchase of 5 years average profits.

Solution

Average Profit Total Profit of Last 5 Years/ No. of years

= Rs  21, 93, 000/5 = Rs 4,  38, 600

Goodwill = Average Profits x  No. of years purchased

= Rs. 4,38,600 × 4 = Rs. 17,54,400

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 Revision 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 Revisions 10 and 11).

Revision  10

The profits of firm for the five years are as follows:

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

 

Weighted Average Profit =  Rs 3, 48, 000/ 15 = Rs 23, 200

Goodwill                       = Rs. 23,200 × 3 =  Rs. 69,600

Revision  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 weighted average profits:

Weight Average Profit  = Rs 2, 19, 280/ 10 = Rs 21, 928

Goodwill   = Rs. 21,928 × 3 = Rs. 65,784

Notes to Solution

1. Depreciation of 2014 =  10% of Rs. 6000 for 4 months = Rs. 6000 × 10/100 × 4/12 = Rs. 200.
2. Depreciation of 2015 = 10% of Rs. 6000 – Rs. 200 for one year = Rs. 5800 × 10/100 + Rs. 580.
3. Closing Stock of 2014 will become opening stock for the year 2015.

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. 

Firms capital includes partners capital and reserves and surplus but excludes fictitious assets and goodwill. 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 firm’s capital on the basis of the normal rate of return.
3. Calculate the super profits by deducting normal profit from the average profits.
4. Calculate goodwill by multiplying the super profits by the given number of years’ purchase.

Revision  12

The books of a business showed that the firm’s capital employed on December 31, 2015, Rs. 5,00,000 and the profits for the last five years were: 2010–Rs. 40,000: 2012-Rs. 50,000; 2013-Rs. 55,000; 2014- Rs.70,000 and 2015-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

Average Profits:

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

Revision 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

Interest on capital  =  1,00,000 × 15/100 = Rs 15, 000     (i)

Add: partner’s salary    =  Rs. 6,000 × 2             = Rs.  12,000…………(ii)

 Normal Profit(i+ii)         = Rs.  27,000

Average Profit                =  Rs. 30,000+Rs.36,000+Rs.42,000 = Rs. 1, 08, 000/3 = 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

Capitalisation Method

Under this method the goodwill can be calculated in two ways: (a) by capitalizing the average profits, or (b) by capitalising the super profits.

(a) Capitalisation of Average Profits: Under this method, the value of goodwill is ascertained by deducting the actual firm’s capital 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 firm’s capital (net assets) by deducting outside liabilities from the total assets (excluding goodwill and ficticious assets).

Firms’ Capital = Total Assets (excluding  goodwill)  – Outside Liabilities

Where outside Liabilities include both long term and short term Liabilities.

(iv    Compute the value of goodwill by deducting net assets from the capitalised value of average profits, i.e. (ii) – (iii).

       Revision 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

Rs 1, 00, 000 × 100/ 10 = Rs 10, 00, 000

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.

1. Calculate capital of the firm, which is equal to total assets (excluding goodwill and ficticious assets) minus outside liabilities.
2. Calculate normal profits on capital employed.
3. Calculate average profit for past years, as specified.
4. Calculate super profits by deducting normal profits from average profits.
5. 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 Revision 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 calculated as follows.

Rs 18, 000 × 100/10 = Rs 1, 80, 000

Revision  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:

2.    The capital 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.

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

Average Profit                             = Rs. 12,000

2. Normal Profit = Rs.1,00,000 × 8 / 10 0  = Rs 8, 000

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.

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 additional amount to compensate them for loss of their share in super profits. It is termed as his share of goodwill (also called premium for goodwill).

When the new Partner brings 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 passed 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:

  

 

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:

 

If the partners decide that the amount of premium for goodwill credited to their capital accounts should be retained in business, an additional entry is not passed. 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 Bank A/c

(The amount of goodwill withdrawn by the existing partners)

Revision 16

Sunil and Dalip are partners in a firm sharing profits and losses in the ratio of

Sachin is admitted in the firm for 1/5th  share of profits. He brings in Rs. 20,000 as capital and Rs. 4,000 as his share of goodwill by cheque. Give the necessary journal entries,

(a) When partners decided to retain goodwill in business.

(b) When the amount of goodwill is fully withdrawn.

(c) When 50% of the amount of goodwill is withdrawn.

Solution

(a) When the amount of goodwill credited to existing partners is retained in business.

        Books  of  Sunil  and  Dalip Journal

Alternatively,

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

(c) When 50% of the amount of goodwill credited to existing partners is withdrawn.

Journal

Revision  17

Vijay and Sanjay are partners in a firm sharing profits and losses in the ratio of 3:2. They admitted 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 = 3/5 – 2/4 = 12 – 10/ 20 = 2/20

For Sanjay, old ratio is 2/5 and the new ratio is 1/4, hence, his sacrificing Ratio is = 2/5 – ¼ = 8 – 5/20 = 3/20

Books of Vijay and Sanjay Journal

Note: Alternatively, journal entries (1) and (2) could be as follows

Books  of  Vijay  and Sanjay Journal

When goodwill already exists in books: Goodwill, if existing in the books of the firm, it is written off at the time of admission of a partner.

For example, in Revision 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 the following additional journal entry shall be passed for writing off the existing amount of goodwill.

Revision 18

Srikant and Raman are partners in a firm sharing profits and losses in the ratio of 3:2. They admit Venkat into partnership with 1/3 share in the profits. Venkat brings in Rs. 30,000 as his capital. He also brings in the necessary amount for his share of goodwill. On the date of admission, the goodwill is valued at Rs. 24,000 and the goodwill account 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

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.

When the new partner does not bring goodwill  in cash, partly or fully Goodwill not brought by the new partner will be debited to current account of new partner while sacrificing partners' capital accounts will be credited for their respective shares. When the new partner does not bring the share of goodwill, there exists two possibilities :

(a) Goodwill does not exist in the books.

(b) Goodwill exists in the books.

Goodwill does not exist in the books.

When goodwill does not exist in the books, sacrificing partners are credited with their share of goodwill and new partner is debited by the amount of goodwill not brought by him. The journal entry in this case is :

Incoming (New) Partners Current A/c                                                      Dr.

To Sacrificing Partners Capital A/c (individually) (Account of goodwill not brought in by new partner) Sometimes the new partner brings part of premium for goodwill in cash. In such a situation, new partners current account will be debited by the amount not brought by new partner.

For example, for the share of goodwill of Rs. 50,000 the new partner brings

Rs. 20,000 only. In this situation the journal entry will be :

Revision 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

When goodwill exists in the books

Goodwill appearing in the books will be written-off by debiting old partners' capital accounts in their old profit sharing ratio. Thereafter new value of goodwill will be given effect by crediting sacrificing partners' capital accounts and debiting new partners' current account.

 Revision 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; and

(b) When the goodwill appears at Rs 15,000 in the books of the firm;

Solution

(a)  When no goodwill appears in the books

Books of Ram and Rahim Journal

(b) When goodwill appears in the books at Rs. 15,000

Applicability of Accounting Standard 26: Intangible  Assets

The Standard comes into effect in respect of expenditure incurred on intangible items during the accounting periods commencing on or after April 1, 2003. As per the Standard, Intangible Asset under AS 26 is defined as an identifiable, non monetary, without physical existence and held for use in the production or supply of goods or services for rental to others or for administrative purposes.

Significant requirements of AS 26 w.r.t Intangible Assets:

1. Intangible asset should be recognised by fulfilling the criteria as recognized under AS 26.

2. If an in asset does not satisfy recognition criteria, it should be expensed.

3. Internally generated goodwill should not be recognised as an asset.

4. Internally generated brands, mastheads, and publishing titles and other similar in substance should not be recognised as intangible assets.

5. Internally generated assets other than the goodwill, brands, mastheads, and publishing titles may be recognised provided they satisfy recognition criteria as prescribed by AS 26.

6. Intangible assets should be written off as early as possible but not exceeding its estimated life, which normally should not be beyond 10 years.

Accounting Standard 26 implies that:

(a) Purchased goodwill may be accounted for in the books and shown as an asset, where it is accounted for in the books and shown as assets, it should be written off as early as possible, but where it is to be written- off in more than one accounting year, it should be written off in a period not exceeding 10 years. In line with what is prescribed by the Accounting Standard, goodwill appearing in the balance sheet in written off at the time of firm's reconstitution.

(b) Self - generated goodwill is not accounted for in the books and shown as an asset. Thus if self generated goodwill be debited to goodwill account it should be written - off in the same financial year and should not be shown as an asset in the balance sheet. Alternatively value of goodwill may be adjusted by deducting new partners' current account and crediting in their sacrificing ratio. The effect under both the methods is same.

       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 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. In this, C’s Current account will be debited by Rs. 10,000 (his share of goodwill) and A and B’s Capital accounts credited by Rs. 5,000 each.

Revision 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, 2017 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, if:

(a) Sam brings his share of goodwill

(b) Sam does not bring his share of goodwill

Solution

(a)  Sam brings his share of goodwill

Books of Hem, Nem and Samb Journal

(b)  Sam does not bring his share of goodwill

Books of Hem, Nem and Sam Journal 

       Working Notes :

Value of Firm's goodwill

Sam's Capital           =        Rs. 60,000