1. Meaning & characteristics of NPO

NON-PROFIT ORGANISATION

MEANING & CHARACTERISTICS

Organizations are of two types: - profit-making & non-profit making. Profit-making organizations operate with the main objective of earning profit. But there are organizations whose objective is not to earn profit but to render services. These organizations are called non-profit making organizations. The services are rendered to its own members or to the society at large. The main objective of such organizations may be social, educational, religious, or charitable. The surplus arising from rendering services is not distributed among its members by way of dividends or share of profit but utilized for the furtherance of the objective of the organization—examples of non-profit making organizations are clubs, societies, schools, colleges, hospitals, charitable trusts etc.

Features of non-profit making ORGANISATIONS:

The features of non-profit making organizations are as follows:

1.         Service motive – Unlike profit-making organizations, the non-profit making organization operates with the motive to serve the people of the society.

2.         Separate identity – The non-profit making organizations have separate legal entities.

3.         Form of organization – Such organizations function in the form of schools, colleges, hospitals, clubs, societies, charitable trusts etc.

4.         Utilisation of surplus – The excess revenue earned over the cost incurred in the process of rendering services is not distributed among its members. Rather it is utilized for achieving the objective of serving society.

5.         Financing – Non-profit making organizations cannot financially operate only by receiving revenue from rendering services. Therefore, it receives donations either from members or outsiders to finance the cost of rendering services.

6.         Budget – Each non-profit organization prepares an annual budget. The budget gives information about the anticipated receipt and expenditure for the ensuing year.

7.         Management – Such organizations are managed by elected representatives of the members.

8.         Accounting – Non-profit making organizations are required to prepare their annual accounts and these accounts are submitted to the members of the government departments. The accounts are prepared on an accrual basis.

1. Meaning & characteristics of NPO

CHAPTER – 1

ACCOUNTING FOR NOT-FOR-PROFIT ORGANISATION

Meaning & characteristics of NPO
There are certain organisations which are set up for providing service to its members and the public in general. Such organisations include clubs, charitable institutions,  schools,  religious organisations, trade unions, welfare societies and societies for the promotion of art and culture. These organisations have service as the main objective and not the profit as is the case of organisations in business. Normally, these organisations do not undertake any business activity, and are managed by trustees who are fully accountable to their members and the society for the utilization of the funds raised for meeting the objectives of the organisation. Hence, they also have to maintain proper accounts and prepare the financial statement which take the form of Receipt and Payment Account; Income and Expenditure Account; and Balance Sheet. at the end of for every accounting period (normally a financial year).
This is also a legal requirement and helps them to keep track of their income and expenditure, the nature of which is different from those of the business organisations. In this chapter we shall learn about the accounting aspects relating to not-for-profit organisation.

Meaning and Characteristics of Not-for- Profit Organisation
Not-for -Profit Organisations refer to the organisations that are for used for the welfare of the society and are set up as charitable institutions which function without any profit motive. Their main aim is to provide service to a specific group or the public at large. Normally, they do not manufacture, purchase or sell goods and may not have credit transactions. Hence they need not maintain many books of account (as the trading concerns do) and Trading and Profit and Loss Account. The funds raised by such organisations are credited to capital fund or general fund. The major sources of their income usually are subscriptions from their members donations, grants-in-aid, income from investments, etc. The main objective of keeping records in such organisations is to meet the statutory requirement and help them in exercising control over utilisation of their funds. They also have to prepare the financial statements at the end of each accounting period (usually a financial year) and ascertain their income and expenditure and the financial position, and submit them to the statutory authority called Registrar of Societies.

The main characteristics of such organisations are:

1. Such organisations are formed for providing service to a specific group or public at large such as education, health care, recreation, sports and so on without any consideration of caste, creed and colour. Its sole aim is to provide service either free of cost or at nominal cost, and not to earn profit.

2. These are organised as charitable trusts/societies and subscribers to such organisation are called members.

3. Their affairs are usually managed by a managing/executive committee elected by its members.

4. The main sources of income of such organisations are: (i) subscriptions from members, (ii) donations (general). (iii) legacies(general). (iv) grant- in-aid, (v) income from investments, etc.

5. The funds raised by such organisations through various sources are credited to capital fund or general fund.

6. The surplus generated in the form of excess of income over expenditure is not distributed amongst the members. It is simply added in the capital fund.

7. The Not-for-Profit Organisations earn their reputation on the basis of their contributions to the welfare of the society rather than on the customers’ or owners’ satisfaction.

8. The accounting information provided by such organisations is meant for the present and potential contributors and to meet the statutory requirement.

1. Nature of partnership, Partnership Deed, Maintenance of Partnership accounts,

Chapter - 2

Accounting for Partnership  : Basic Concepts

You have learnt about the preparation of financial statements for a sole proprietary concern. As the business expands, one needs more capital and larger number of people to manage the business and share its risks. In such a situation, people usually adopt the partnership form of organisation. Accounting for partnership firms has it’s own peculiarities, as the partnership firm comes into existence when two or more persons come together to establish business and share its profits. On many issues affecting distribution of profits, there may not be any specific agreement between the partners. In such a situation the provisions of the Indian Partnership Act 1932 apply. Similarly, calculation of interest on capital, interest on drawings and maintenance of partners capital accounts have their own peculiarities. Not only that a variety of adjustments are required on the death of a partner or when a new partner is admitted and so on. These peculiar situations need specific treatment in accounting that need to be clarified.

The present chapter discusses some basic aspects of partnership such as distribution of profit, maintenance of capital accounts, etc. The treatment of situations like admission of partner, retirement, death and dissolution have been taken up in the subsequent chapters.

Nature of Partnership

When two or more persons join hands to set up a business and share its profits and losses, they are said to be in partnership. Section 4 of the Indian Partnership Act 1932 defines partnership as the‘relation between persons who have agreed to share the profits of a business carried on by all or any of them acting for all’.

Persons who have entered into partnership with one another are individually called ‘partners’ and collectively called ‘firm’. The name under which the business is carried is called the ‘firm’s name’. A partnership firm has no separate legal entity, apart from the partners constituting it. Thus, the essential features of partnership are:

  1. Two or More Persons: In order to form partnership, there should be at least two persons coming together for a common goal. In other words, the minimum number of partners in a firm can be two. There is however, a limit on their maximum number. By virtue of Section 464 of the Companies Act 2013, the Central Government is empowered to prescribe maximum number of partners in a firm but the number of partners can not be more than 100. The Central government has prescribed the maximum number of partness in a firm to be 50.
  1. Agreement: Partnership is the result of an agreement between two or more persons to do business and share its profits and losses. The agreement becomes the basis of relationship between the partners. It is not necessary that such agreement is in written form. An oral agreement is equally valid. But in order to avoid disputes, it is preferred that the partners have a written agreement.
  1. Business: The agreement should be to carry on some business. Mere co- ownership of a property does not amount to partnership. For example, if Rohit and Sachin jointly purchase a plot of land, they become the joint owners of the property and not the partners. But if they are in the business of purchase and sale of land for the purpose of making profit, they will be called partners.
  1. Mutual Agency: The business of a partnership concern may be carried on by all the partners or any of them acting for all. This statement has two important implications. First, every partner is entitled to participate in the conduct of the affairs of its business. Second, that there exists a relationship of mutual agency between all the partners. Each partner carrying on the business is the principal as well as the agent for all the other partners. He can bind other partners by his acts and also is bound by the acts of other partners with regard to business of the firm. Relationship of mutual agency is so important that one can say that there would be no partnership, if the element of mutual agency is absent.
  1. Sharing of Profit: Another important element of partnership is that, the agreement between partners must be to share profits and losses of a business. Though the definition contained in the Partnership Act describes partnership as relation between people who agree to share the profits of a business, the sharing of loss is implied. Thus, sharing of profits and losses is important. If some persons join hands for the purpose of some charitable activity, it will not be termed as partnership.
  1. Liability of Partners: Each partner is liable jointly with all the other partners and also severally to the third party for all the acts of the firm done while he is a partner. Not only that the liability of a partner for acts of the firm is also unlimited. This implies that his private assets can also be used for paying off the firm’s debts. 

Partnership Deed

Partnership comes into existence as a result of agreement among the partners. The agreement can be either oral or written. The Partnership Act does not require that the agreement must be in writing. But wherever it is in writing, the document, which contains terms of the agreement is called ‘Partnership Deed’. It generally contains the details about all the aspects affecting the relationship between the partners including the objective of business, contribution of capital by each partner, ratio in which the profits and the losses will be shared by the partners and entitlement of partners to interest on capital, interest on loan, etc.

The clauses of partnership deed can be altered with the consent of all the partners. The deed should be properly drafted and prepared as per the provisions of the ‘Stamp Actand preferably registered with the Registrar of Firms.

Contents of the Partnership Deed

The Partnership Deed usually contains the following details:
•    Names and Addresses of the firm and its main business;
•    Names and Addresses of all partners;
•    Amount of capital to be contributed by each partner;
•    The accounting period of the firm;
•    The date of commencement of partnership;
•    Rules regarding operation of Bank Accounts;
•    Profit and loss sharing ratio;
•    Rate of interest on capital, loan, drawings, etc;
•    Mode of auditor’s appointment, if any;
•    Salaries, commission, etc, if payable to any partner;
•    The rights, duties and liabilities of each partner;
•    Treatment of loss arising out of insolvency of one or more partners
•    Settlement of accounts on dissolution of the firm;
•    Method of settlement of disputes among the partners;
•    Rules to be followed in case of admission, retirement, death of a partner
•    Any other matter relating to the conduct of business.
Normally, the partnership deed covers all matters affecting relationship of partners amongst themselves. However, if there is no express agreement on certain matters, the provisions of the Indian Partnership Act, 1932 shall apply.

Provisions of Partnership Act Relevant for Accounting

The important provisions affecting partnership accounts are as follows:

(a) Profit Sharing Ratio: If the partnership deed is silent about the profit sharing ratio, the profits and losses of the firm are to be shared equally by partners, irrespective of their capital contribution in the firm.

(b) Interest on Capital: No partner is entitled to claim any interest on the amount of capital contributed by him in the firm as a matter of right. However, interest can be allowed when it is expressly agreed to by the partners. Thus, no interest on capital is payable if the partnership deed is silent on the issue.

(c) Interest on Drawings: No interest is to be charged on the drawings made by the partners, if there is no mention in the Deed.

(d) Interest on Loan: If any partner has advanced loan to the firm for the purpose of business, he/she shall be entitled to get an interest on the loan amount at the rate of 6 per cent per annum.

(e) Remuneration for Firm’s Work: No partner is entitled to get salary or other remuneration for taking part in the conduct of the business of the firm unless there is a provision for the same in the Partnership Deed.

Apart from the above, the Indian Partnership Act specifies that subject to contract between the partners:

(i) If a partner derives any profit for him/her self from any transaction of the firm or from the use of the property or business connection of the firm or the firm name, he/she shall account for the profit and pay it to the firm.

(ii) If a partner carries on any business of the same nature as and competing with that of the firm, he/she shall account for and pay to the firm, all profit made by him/her in that business.

Special  Aspects  of Partnership  Accounts

Accounting treatment for partnership firm is similar to that of a sole proprietorship business with the exception of the following aspects:

•   Maintenance of Partners’ Capital Accounts;

•   Distribution of Profit and Loss among the partners;

•   Adjustments for Wrong Appropriation of Profits in the Past;

•   Reconstitution of the Partnership Firm; and

•   Dissolution of Partnership Firm.

The first three aspects mentioned above have been taken up in the following sections of this chapter. The remaining aspects have been covered in the subsequent chapters.

1. Nature of partnership, Partnership Deed, Maintenance of Partnership accounts,

Meaning

 Partnership business is an association between two or more persons who agree to do business & share profits & losses. The partners act as both agents & principals of the firm.

“Partnership is the relation between persons who have agreed to share the profits of a business carried on by all or any of them acting for all.” Section 4 of Indian Partnership Act, 1932.

Nature & Essential features of Partnership

Partnership is a separate business entity from the accounting viewpoint. However, from the legal viewpoint, a partnership firm is not separate from its partners. In case the business assets are not enough to meet the liabilities, the partner’s personal assets would also be liable to meet the debts.

Features

  1. Two or more persons – In a partnership business, the minimum number of partners is two & the maximum number of partners allowed is 50.
  2. Agreement – The relationship between partners is based on an agreement & that agreement is known as Partnership Deed.
  3. Profit-sharing – A partnership business is formed to do lawful business.
  4. Business of partnership can be carried on by all or any of them acting for all.

Partnership Deed

Partnership comes into existence by an oral or written agreement between the partners which contains all the terms & conditions of partnership. This agreement defines the relationship between partners. It is a legal document which is signed by all the partners. This document helps in avoiding any kind of dispute in future among the partners. This document is known as Partnership Deed.

A partnership deed, we can say, is the most important document in partnership business & it consists of the following clauses;

  1. Description of partners – Name, description & address of partners.
  2. Description of the firm – Name & address of the firm.
  3. Principal place of business – Address of the principal place of business
  4. Nature of business – What type of business is it - Trading or manufacturing? The nature of business is mentioned here.
  5. Commencement of Business – Date of commencement of partnership is mentioned here.
  6. Capital Contribution – The amount of capital to be contributed by each partner & whether the capital accounts are fixed or fluctuating.
  7. Interest on Capital – Rate of interest, if allowed, on capital
  8. Interest on Drawings – Rate of interest, if to be charged, on drawings
  9. Profit-Sharing Ratio – Ratio in which profits & losses are to be shared by partners.
  10. Interest on Loan – Rate of interest on loan given by a partner to a firm.
  11. Salary – Amount of salary, and commission to be paid to the partners
  12. Settlement of accounts – The manner in which the accounts of the partners are to be settled in case of his retirement, death or dissolution of partnership.
  13. Accounting period – The date on which accounts shall be closed every year.
  14. Rights & duties of partners – The rights & duties of partners are defined here.
  15. Duration of partnership – The period of partnership for which it has been started.
  16. Bank account operation – How shall the bank accounts be operated? Whether it shall be operated by any partner or jointly.
  17. Valuation of Assets – The manner in which the assets & liabilities of the firm are to be valued.
  18. Death of a partner – Whether the firm will continue or dissolve after the death of a partner.
  19. Settlement of Disputes – If there is any dispute among the partners then how it’ll be settled.

SPECIAL ASPECTS OF A PARTNERSHIP ACCOUNT

When the partnership deed is silent or does not have any clause in respect of the following matters or no partnership deed has been prepared by the partners, the following provisions of the Indian Partnership Act, 1932, shall apply:-

  1. Sharing of profit & losses – Profit & losses to be shared equally by all the partners.
  2. Interest on Capital – Interest on capital is not paid to any partner.
  3. Interest on Drawings – Interest on drawings is not charged to any partner.
  4. Interest on loan or advance/ loans by partners – Interest on loans is paid @ 6% pa. Interest is payable even if there is a loss.
  5. Remuneration to partners – Remuneration (salary, commission etc.) is not paid or allowed to any partner.

Some other important points:-

  1. A minor may be admitted for the benefit of partnership.
  2. A partner may retire from partnership with the consent of other partners or as per the agreement.
  3. Registration of firm is optional & not compulsory.
  4. Unless otherwise agreed by the partners, a firm is dissolved on the death of a partner.

Note – These provisions are applicable even if the partnership deed does not have a clause to this effect.

Maintenance of Partnership Accounts

This is how partnership accounts are maintained

After the determination of net profit by preparing Profit & Loss A/c, we have to prepare Profit & Loss Appropriation A/c.  Profit & Loss Appropriation A/c is an extension of Profit & Loss A/c. It is credited with the Net Profit taken from the Profit & Loss A/c & interest on drawings & debited with interest on capital, partner’s salaries & commissions. If the partners decide to transfer a certain part of the profit to Reserves, then it is also shown in the Dr side& the balance profit is distributed among the partners in their profit sharing ratio.

 

2. Accounting records

Accounting Records of Not-for-Profit Organisations

As stated earlier, normally such organisations are not engaged in any trading or business activities. The main sources of their income are subscriptions from members, donations, financial assistance from government and income from investments. Most of their transactions are in cash  or through the bank. These institutions are required by law to keep proper accounting records and keep proper control over the utilization of their funds. This is why they usually keep a cash book in which all receipts and payments are duly recorded. They also maintain a ledger containing the accounts of all incomes, expenses, assets and liabilities which facilitates the preparation of financial statements at the end of the accounting period. In addition, they are required to maintain a stock register to keep complete record of all fixed assets and the consumables.

They do not maintain any capital account. Instead they maintain capital fund which is also called general fund that goes on accumulating due to surpluses generated, life membership fee, etc., received from year to year. In fact, a proper system of accounting is desirable to avoid or minimise the chances of misappropriations or embezzlement of the funds contributed by the members and other donors.

Final Accounts or Financial Statements

The Not-for-Profit Organisations are also required to prepare financial statements at the end of the each accounting period. Although these organisations are non-profit making entities and they are not required to make Trading and Profit & Loss Account but it is necessary to know whether the income during the year was sufficient to meet the expenses or not. Not only that they have to provide the necessary financial information to members, donors, and contributors and also to the Registrar of Societies. For this purpose, they have to prepare their final accounts at the end of the accounting period and the general principles of accounting are fully applicable in their preparation as stated earlier, the final accounts of a ‘not-for-profit organization’ consist of the following:

a. Receipt and Payment Account

b. Income and Expenditure Account

c. Balance Sheet.

The Receipt and Payment Account is the summary of cash and bank transactions which helps in the preparation of Income and Expenditure Account and the Balance Sheet. Besides, it is a legal requirement as the Receipts and Payments Account has also to be submitted to the Registrar of Societies along with the Income and Expenditure Account, and the Balance Sheet.

Income and Expenditure Account is akin to Profit and Loss Account. The Not-for-Profit Organisations usually prepare the Income and Expenditure Account and a Balance Sheet with the help of Receipt and Payment Account. However, this does not imply that they do not make a trial balance. In order to check the accuracy of the ledger accounts, they also prepare a trial balance which facilitates the preparation of accurate Receipt and Payment Account as well as the Income and Expenditure Account and the Balance Sheet.

In fact, if an organisation has followed the double entry system they must prepare a trial balance for checking the accuracy of the ledger accounts and it will also facilitate the preparation of Receipt and Payment account. Income and Expenditure Account and the Balance Sheet.

Receipt and Payment Account

It is prepared at the end of the accounting year on the basis of cash receipts and cash payments recorded in the cash book. It is a summary of cash and bank transactions under various heads. For example, subscriptions received from the members on different dates which appear on the debit side of the cash book, shall be shown on the receipts side of the Receipt and Payment Account as one item with its total amount. Similarly, salary, rent, electricity charges paid from time to time as recorded on the credit side of the cash book but the total salary paid, total rent paid, total electricity charges paid during the year appear on the payment side of the Receipt and Payment Account. Thus, Receipt and Payment Account gives  summarized  picture of various receipts  and payments, irrespective of whether they pertain to the current period, previous period or succeeding period or whether they are of capital or revenue nature. It may be noted that this account does not show any non cash item like depreciation. The opening balance in Receipt and Payment Account represents cash in hand/cash at bank which is shown on its receipts side and the closing balance of this account represents cash in hand and bank balance as at the end of the year, which appear on the credit side of the Receipt and Payment Account. However, if it is bank overdraft at the end it shall be shown on its debit side as the last item. Let us look at the cash book of Golden Cricket Club given in the example to show how the total amount of each item of receipt and payment has been worked out.

Example 1

Golden Cricket Club Cash Book (Columnar)

Part A

Item wise Aggregation of various Receipts :

Subscriptions (2014–2015)

   Subscriptions (2013–14)

   Subscription (2015–16)

Entrance Fees

Locker Rent

Life Membership fee

Donation for Buildings

Interest on Government securities

    Part B

Item wise Aggregation of various Payments

Insurance Premium

Printing and Stationery

Lighting

Telephone Expenses

Rates and Taxes

Government Securities

Wages and Salaries

Postage and Courier Service

The above data can also be shown in the form of the respective accounts in the ledger. A detailed illustrative list of items of receipts and payments is given in figure 1.

Figure 1

Receipt and Payment Account is given below:

Receipt and Payment Account for the year ending ————

Fig. 1.1: Format of Receipt and Payment Account

There will be either of the two amounts i.e., each at bank or bank overdraft, not both.

It may be noted that the receipts side of the Receipt and Payment Account gives a list of revenue receipts (for past, current and future periods) as well as capital receipts. Similarly, the payments side of the Receipts and Payments Account lists the Revenue Payments (for past, current and future periods) as well as Capital Payments.

Features

    1. It is a summary of the cash book. Its form is identical with that of simple cash book (without discount and bank columns) with debit and credit sides. Receipts are recorded on the debit side while payments are entered on the credit side.
    2. It shows the total amounts of all receipts and payments irrespective of the period to which they  pertain . For example, in the Receipt and Payment account for the year ending on March 31, 2016, we record the total subscriptions received during 2015–16 including the amounts related to the years 2014–2015 and 2016-2017. Similarly, taxes paid during 2015–16 even if they relate to the years 2014–15 and 2016–2017.
    3. It includes all receipts and payments whether they are of capital nature or of revenue nature.
    4. No distinction is made in receipts/payments made in cash or through bank. With the exception of the opening and closing balances, the total amount of each receipt and payment is shown in this account.
    5. No non-cash items such as depreciation outstanding expenses accrued income, etc. are shown in this account.
    6. It begins with opening balance of cash in hand and cash at bank (or bank overdraft) and closes with the year end balance of cash in hand/ cash at bank or bank overdraft. In fact, the closing balance in this account (difference between the total amount of receipts and payments) which is usually a debit balance reflects cash in hand and cash at bank unless there is a bank overdraft.

Steps in the Preparation of Receipt and Payment Account

  1. Take the opening balances of cash in hand and cash at bank and enter them on the debit side. In case there is bank overdraft at the begining of the year, enter the same on the credit side of this account.
  2. Show the total amounts of all receipts on its debit side irrespective of their nature (whether capital or revenue) and whether they pertain to past, current and future periods.
  3. Show the total amounts of all payments on its credit side irrespective of their nature (whether capital or revenue) and whether they pertain to past, current and future periods.
  4. None of the receivable income and payable expense is to be entered in this account as they do not involve inflow or outflow of cash.
  5. Find out the difference between the total of debit side and the total of credit side of the account and enter the same on the credit side as the closing balance of cash/bank. In case, however, the total of the credit side is more than that of the total of the debit side, show the difference on the debit as bank overdraft and close the account.

From the following information based on the data assimilated from the cash book given in example 1, at page 4, the Receipt and Payment Account of Golden Cricket Club for the year ended on March 31, 2015 will be prepared as follows:

Summary of Cash Book

 

   Receipt and Payment Account for the year ending March 31, 2015

Revision 1

From the following particulars relating to Silver Point, prepare a Receipt and Payment account for the year ending March 31, 2017.

Solution

Books of Silver Point Receipt and Payment Account for the year ending March 31, 2017

2. Accounting records

financial statements of non-profit making organizations

Like trading organizations, non-profit making organizations also prepare their financial statements at the end of each accounting period. Their financial statements comprise the following:

             1.         Receipts and Payments Account (Cash Book)

             2.         Income and Expenditure Account (Profit & Loss A/c)

             3.         Balance Sheet.

1. Receipts and Payments ACCOUNT:

 The following points are noteworthy relating to Receipts and Payments A/C:

a. Receipts and Payments Account is a summary of cash transactions.

b. It shows the opening and closing balance of cash and bank, receipts and payments (both cash and cheque) and the closing cash and bank balance at the end of the accounting period.

c. The left-hand side records all receipts and the right-hand side all payments (whether revenue or capital or relating to current years past or future accounting years).

d. It shows a classified summary of cash transactions during a given period.

For example, fees may be received from the members of a club on different dates and appear on different pages of the Cash Book as it is a chronological record. But the total fees received during the accounting period is shown in the Receipts and Payments Account.

Keypoints OF RECEIPTS and Payments Account

1.         It is similar to a Cash Book of a trading concern.

2.         It is a real account. Receipts are recorded on the receipt side and payments are recorded on the payment side.

3.         It starts with the opening cash and bank balance and closes with the closing cash and bank balance.

4.         Both cash and bank transactions are merged in the same column.

5.         All types of receipts are recorded on its receipts side irrespective of the nature of receipts (i.e. both capital and revenue receipts and receipts relating to past, present and future years).

6.        All types of payments are recorded on the credit side irrespective of the nature of payments (i.e. both capital and revenue payments and payments relating to past, present and future years).

Format of Receipts and Payments Account:

Name of the Non-Profit Making Organisation:-

Receipts and Payments Account for the year ended **********

Income and Expenditure Account

Important Facts about Income & Expenditure A/C:

  • Income and Expenditure Account is similar to Profit and Loss Account of a trading concern
  • Since non-profit making organizations do not operate on profit objectives, income and Expenditure Account is prepared instead of preparing Profit and Loss Account.
  • On the debit side, it shows all revenue expenses relating to the current year whether paid or not. 
  • On the credit side, it shows all revenue incomes and gains relating to the current year whether received or not.
  • It is a nominal account and its preparation procedure is the same as that of a Profit and Loss Account of a trading concern.
  • The balancing figure of this account is called surplus/excess of income over expenditure or deficit/excess of expenditure over income.

Key points of Income and Expenditure Account

1.         It is similar to the Profit and Loss Account of a trading concern.

2.         It is a nominal account. Expenses and losses are recorded on the debit side and incomes and gains are recorded on the credit side. The expenses are matched with revenues of the concerned period.

3.         All revenue incomes relating to the current year whether received or due are recorded on the credit side.

4.         All revenue expenses relating to the current year whether paid or outstanding are recorded on the debit side.

5.         Capital expenditures and capital receipts are not recorded in this account.

6.         It records both cash and non-cash items such as depreciation.

Format of Income and Expenditure Account

 (Name of the Non-Profit Making Organisation)

Income and Expenditure Account

For the year ended on *********

The distinction between Receipts and Payments Account and Income and Expenditure A/c

3. Balance Sheet

           The balance sheet of a non-profit making organization is prepared on the same line as that of a trading concern. Assets including accrued income and prepaid expenses are shown on the assets side and the liabilities side shows all liabilities including outstanding expenses. Capital Fund (same as Capital Account in case of trading concerns) appears on the liabilities side. The surplus during the period is added to the Capital Fund and the deficit is subtracted.

             Note: When no information regarding Capital Fund is available, it can be ascertained by preparing the Balance Sheet at the beginning of the year i.e. Opening Balance Sheet.

3. Preparation of opening & closing Balance Sheet, Some peculiar items, Incidental Trading Activity

  Income and Expenditure Account

It is the summary of income and expenditure for the accounting year. It is just like a profit and loss account prepared on accrual basis in case of the business organisations. It includes only revenue items and the balance at the end represents surplus or deficit. The Income and Expenditure Account serves the same purpose as the profit and loss account of a business organisation does. All the revenue items relating to the current period are shown in this account, the expenses and losses on the expenditure side and incomes and gains on the income side of the account. It shows the net operating result in the form of surplus (i.e. excess of income over expenditure) or deficit (i.e. excess of expenditure over income), which is transferred to the capital fund shown in the balance sheet.

The Income and Expenditure Account is prepared on accrual basis with the help of Receipts and Payments Account along with additional information regarding outstanding and prepaid expenses and depreciation etc. Hence, many items appearing in the Receipts and Payments need to be adjusted. For example, as shown in Example 1, (Page No. 10) subscription amount of Rs.2, 65,000 received during the year 2014-15 appearing on the receipts side of the Receipt and Payment Account includes receipts for the periods other than the current period. But the subscription amount of Rs. 2,25,000 pertaining to the current year only will be shown as income in Income and Expenditure Account for the year 2014-15.

Steps in the Preparation of Income and Expenditure Account

Following steps may be helpful in preparing an Income and Expenditure Account from a given Receipt and Payment Account:

1.  Persue the Receipt and Payment Account thoroughly.

2. Exclude the opening and closing balances of cash and bank as they are not an income.

3. Exclude the capital receipts and capital payments as these are to be shown in the Balance Sheet.

4. Consider only the revenue receipts to be shown on the income side of Income and Expenditure Account. Some of these need to be adjusted by excluding the amounts relating to the preceding and the succeeding periods and including the amounts relating to the current year not yet received.

5. Take the revenue expenses to the expenditure side of the Income and Expenditure Account with due adjustments as per the additional information provided relating to the amounts received in advance and those not yet received.

6. Consider the following items not appearing in the Receipt and Payment Account that need to be taken into account for determining the surplus/ deficit for the current year :

    a. Depreciation of fixed assets.

    b. Provision for doubtful debts, if required.

    c. Profit or loss on sale of fixed assets.

Now you will observe how the income and expenditure account is prepared from the receipts and payments account given in example 1, on page 10.

Income and Expenditure Account for the year ending on March 31, 2015

Note that-

  1.    Opening and closing cash/bank balances have been excluded.
  2.    Payment for purchase of Government securities being capital expenditure has been excluded.
  3.    Amount of subscriptions received for the year 2013-14 and 2015-16 have been excluded.
  4.    Life membership fee is an item of capital receipt and so excluded.
  5.    Donation for building is a receipt for a specific purpose and so excluded.

   Revision 2

   From the Receipt and Payment Account given below, prepare the Income and Expenditure Account of Clean Delhi Club for the year ended March 31, 2017.

   Receipt and Payment Account for the year ending March 31, 2017

Solution

Books of Clean Delhi Club

Income and Expenditure Account for the year ending March 31, 2017

Revision3

From the following Receipt and Payment Account for the year ending March 31, 2015 of Negi's Club, prepare Income and Expenditure Account for the same period:

Receipt and Payment Account for the year ending March 31, 2015

The following additional information is available:

  1. Salaries outstanding – Rs. 1,500;
  2. Entertainment expenses outstanding – Rs. 500;
  3. Bank interest receivable – Rs. 150;
  4. Subscriptions accrued – Rs. 400;
  5. 50 per cent of entrance fees is to be capitalised;
  6. Furniture is to be depreciated at 10 per cent per annum.

Solution

  Books of Negi's Club

Income and Expenditure Account for the year ending 31.3.2015

Distinction between Income and Expenditure Account and Receipt and Payment Account

Based upon discussion made in regard to the Receipts and Payments Account and the Income and Expenditure Account we make the distinction between Income and Expenditure Account and Receipts and Payments Account in the tabular form:

 Balance Sheet

‘Not-for-Profit’ Organisations prepare Balance Sheet for ascertaining the financial position of the organisation. The preparation of their Balance Sheet is on the same pattern as that of the business entities. It shows assets and liabilities as at the end of the year. Assets are shown on the right hand side and the liabilities on the left hand side. However, there will be a Capital Fund or General Fund in place of the Capital and the surplus or deficit as per Income and Expenditure Account which is either added to/deducted from the capital fund, as the case may be. It is also a common practice to add some of the capitalised items like legacies, entrance fees and life membership fees directly in the capital fund.

Besides the Capital or General Fund, there may be other funds created for specific purposes or to meet the requirements of the contributors/donors such as building fund, sports fund, etc. Such funds are shown separately in the liabilities side of the balance sheet.

Some times it becomes necessary to prepare Balance Sheet as at the beginning of the year in order to find out the opening balance of the capital/general fund.

Preparation of Balance Sheet

The following procedure is adopted to prepare the Balance Sheet:

1. Take the Capital/General Fund as per the opening balance sheet and add surplus from the Income and Expenditure Account. Further, add entrance fees, legacies, life membership fees, etc. received during the year.

2. Take all the fixed assets (not sold/discarded/or destroyed during the year) with additions (from the Receipts and Payments account) after charging depreciation (as per Income and Expenditure account) and show them on the assets side.

3. Compare items on the receipts side of the Receipts and Payments Account with income side of the Income and Expenditure Account. This is to ascertain the amounts of: (a) subscriptions due but not yet received: (b) incomes received in advance; (c) sale of fixed assets made during the year; (d) items to be capitalised (i.e. taken directly to the Balance Sheet) e.g. legacies, interest on specific fund investment and so on.

4. Similarly compare, items on the payments side of the Receipt and Payment Account with expenditure side of the Income and Expenditure Account. This is to ascertain the amounts if: (a) outstanding expenses; (b) prepaid expenses; (c) purchase of a fixed asset during the year; (d) depreciation on fixed assets; (e) stock of consumable items like stationery in hand; (f) Closing balance of cash in hand and cash at bank as, and so on.

A proforma Balance Sheet is given for the proper understanding of preparing the balance sheet.

Balance Sheet of as on ...............

Fig. 1.2: Proforma Balance Sheet

Revision4

From the following Receipt and Payment Account and additional information relating to Excellent Cricket Club, prepare Income and Expenditure Account for the year ended March 31, 2015 and Balance Sheet as on date.

 

  Donations and Surplus on account of tournament are to be kept in Reserve for a permanent pavilion. Subscriptions due on March 31, 2015 were Rs. 42,000. Write-off fifty per cent of sports materials and thirty per cent of printing and stationery.

  Solution

  Books of Excellent Cricket Club Income and Expenditure Account for the year ending on March 31, 2015

   Note:  Since the opening balance of the capital fund is not given, the same has been ascertained by preparing opening balance sheet.

     Balance Sheet of Excellent Cricket Club as on March 31, 2015

   

Balance Sheet of Excellent Cricket Club as on March 31, 2014

   Some Peculiar Items

  Final accounts of the Not-for-Profit organisations are prepared on the similar pattern as that of a business orgnisation. However, a few items of income and expenses of such orgnisations are somewhat different in nature and need special attention in their treatment in final accounts. They        are peculiar to these orgnisations. Some of the common peculiar items are explained as under:

  Subscriptions:

 Subscription is a membership fee paid by the member on annual basis. This is the main source of income of such orgnisations. Subscription paid by the members is shown as receipt in the Receipt and Payment Account and as income in the Income and Expenditure Account. It may be noted   that Receipt and Payment Account shows the total amount of subscription actually received during the year while the amount shown in Income and Expenditure Account is confined to the figure related to the current period only irrespective of the fact whether it has been received or not.   For example, a club received Rs. 20,000 as subscriptions during the year 2016-17 of which Rs.3,000 relate to year 2015-16 and Rs.2,000 to 2017-18, and at the end of the year 2016-17 Rs.6,000 are still receivable. In this case, the Receipt and Payment Account will show Rs.20,000 as   receipt from subscriptions. But the Income and Expenditure Account will show Rs. 21,000 as income from subscriptions for the year 2016-17, the calculation of which is given as below:    

The above amount of subscriptions to be shown as income can also be ascertained by preparing the subscription account as follows:

Subscription Account

Revision 5

As per Receipt and Payment Account for the year ended on March 31, 2017, the subscriptions received were Rs. 2,50,000. Additional Information given is as follows:

  1.  Subscriptions Outstanding on 1.4.2016 Rs. 50,000
  2. Subscriptions Outstanding on 31.3.2017 Rs.35,000
  3. Subscriptions Received in Advance as on 1.4.2016 Rs.25,000
  4. Subscriptions Received in Advance as on 31.3.2017 Rs.30,000

Ascertain the amount of income from subscriptions for the year 2016–17 and show how relevant items of subscriptions appear in opening and closing balance sheets.

Solution

Alternately, income received from subscriptions can be calculated by preparing a Subscriptions account as under.

Subscription Account

Relevant items of subscription can be shown in the opening and closing balance sheet as under:

Balance Sheet as on March 31, 2014

Relevant data only

Balance Sheet as on March 31, 2015

Relevant data only

 

Revision 6

Extracts of Receipt and Payment Account for the year ended March 31, 2017 are given below:

Receipt                                                                          Subscriptions (Rs.)

2015-16                                                                                 2,500

2016-17                                                                                 26,750

2017-18                                                                                 1,000

       30,250

Additional Information:

Total number of members: 230. Annual membership fee: Rs. 125.

Subscriptions outstandings on April 1, 2016: Rs. 2,750.

Prepare a statement showing all relevant items of subscriptions viz., income, advance, outstandings, etc.

Solution

Amount of subscription due for the year 2016-17 irrespective of cash Rs. 28,750 (i.e. Rs. 125 × Rs. 230).

Note:  The amount of subscriptions outstanding as on 01-04-2017 has been ascertained as follows:

Revision 7

From the following extract of Receipt and Payment Account and the additional information, compute the amount of income from subscriptions and show as how they would appear in the Income and Expenditure Account for the year ending March 31, 2015 and the Balance Sheet.

Receipt and Payment  Account  for the year ending  March 31, 2015

Additional Information:

 

Solution

Income and expenditure account for the year ending on march 31, 2015

Note:  Total amount of subscriptions outstanding as on 31-3-2015 are Rs. 18,500. This, includes Rs. 1,500 (Rs. 8,500 - Rs. 7,000) for subscriptions still outstanding for 2013-14.  Hence, the subscriptions outstanding for 2014-15 are Rs. 17,000 (Rs. 18,500 - Rs. 1,500)

Balance Sheet (Relevant Data) as on  March 31, 2015

 Relevant data only

Donations:

It is a sort of gift in cash or property received from some person or organisation. It appears on the receipts side of the Receipts and Payments Account. Donation can be for specific purposes or for general purposes.

(i) Specific Donations: If donation received is to be utilised to achieve specified

purpose, it is called Specific Donation. The specific purpose can be an extension of the existing building, construction of new computer laboratory, creation of a book bank, etc. Such donation is to be capitalised and shown on the liabilities side of the Balance Sheet irrespective of the fact whether the amount is big or small. The intention is to utilise the amount for the specified purpose only.

(ii) General Donations: Such donations are to be utilised to promote the general purpose of the organisation. These are treated as revenue receipts as it is a regular source of income hence, it is taken to the income side of the Income and Expenditure Account of the current year.

Legacies:

 It is the amount received as per the will of a deceased person who may or may not specify the use of the amount. Legacies, use of which is specified are specific legacy and is shown in the balance sheet as liability. If the use is not specified it is considered as revenue nature and credited to income and expenditure account.

Life Membership Fees:

Some members prefer to pay lump sum amount as life membership fee instead of paying periodic subscription. Such amount is treated as capital receipt and credited directly to the capital/general fund.

Entrance Fees: 

Entrance fee also known as admission fee is paid only once by the member at the time of becoming a member. In case of organisations like clubs and some charitable institutions, is limited and the amount of entrance fees is quite high. Hence, it is treated as non-recurring item and credited directly to capital/general fund.

Sale of old asset:

 Receipts from the sale of an old asset appear in the Receipts and Payments Account of the year in which it is sold. But any gain or loss on the sale of asset is taken to the Income and Expenditure Account of the year. For example, if an item furniture with a book value of Rs. 800 is sold for Rs. 700, this amount of Rs. 700 will be shown as receipt in Receipts and Payments Account and Rs. 100 on the expenditure side of the Income and Expenditure Account as a loss on sale of old asset and while showing furniture in the balance sheet Rs. 800 will be deducted from its total book value.

Sale of Periodicals:

It is an item of recurring nature and shown as the income side of the Income and Expenditure Account.

Sale of Sports Materials:

 Sale of sports materials (used materials like old balls, bats, nets, etc) is the regular feature with any Sports Club. It is usually shown as an income in the Income and Expenditure Account.

Payments of Honorarium:

It is the amount paid to the person who is not the regular employee of the institution. Payment to an artist for giving performance at the club is an example of honorarium. This payment of honorarium is shown on the expenditure side of the Income and Expenditure Account.

Endowment Fund:

It is a fund arising from a bequest or gift, the income of which is devoted for a specific purpose. Hence, it is a capital receipt and shown on the Liabilities side of the Balance Sheet as an item of a specific purpose fund.

Government Grant:

Schools, colleges, public hospitals, etc. depend upon government grant for their activities. The recurring grants in the form of maintenance grant is treated as revenue receipt (i.e. income of the current year) and credited to Income and Expenditure account. However, grants such as building grant are treated as capital receipt and transferred to the building fund account. It may be noted that some Not-for-Profit organisations receive cash subsidy from the government or government agencies. This subsidy is also treated as revenue income for the year in which it is received.

Special Funds

The Not-for-Profit Organisations office create special funds for certain purposes/activities such as 'prize funds', 'match fund' and 'sports fund', etc. Such funds are invested in securities and the income earned on such investments is added to the respective fund, not credited to Income and Expenditure Account. Similarly, the expenses incurred on such specific purposes are also deducted from the special fund. For example, a club may maintain a special fund for sports activities. In such a situation, the interest income on sports fund investments is added to the sports fund and all expenses on sports deducted there from. The special funds are shown in balance sheet. However, if, after adjustment of income and expenses the balance in specific or special fund is negative, it is transferred to the debit side of the Income and Expenditure Account or adjusted as per prescribed directions. (see Illustrations 8 and 9.)

Revision 8

Show how you would deal with the following items in the financial statements of a Club:

Solution

Revision 9

(a) Show the following information in financial statements of a ' Not-for-Profit' Organisation:

(b) What will be the effect, if match expenses go up by Rs. 6,000 other things remaining the same?

Solution

(a)  Balance Sheet as on………..*

Only relevant data.

(b) If match expenses go up by Rs. 6,000, the net balance of the match fund becomes negative i.e. Debit exceeds the Credit, and the resultant debit balance of Rs. 2,000 shall be charged to the Income and Expenditure Account of that year.

Revision 10

Extract of a Receipt and Payment Account for the year ended on March 31, 2015:

Payments:  Stationery Rs. 23,000

Additional Information:

Solution

Stationery:

Normally expenses incurred on stationary, a consumable items are charged to Income and Expenditure Account. But in case stock of stationery (opening and/or closing) is given, the approach would be make necessary adjustments in purchases of stationery and work out cost of stationery consumed and show that amount in Income and Expenditure Account and its stock in the balance sheet. For example, the Receipt and Payment Account shows a payment for stationery amounting to Rs. 40,000 and there is an opening and closing stationery amounting to Rs. 12,000 and Rs. 15,000. The amount of expense on stationery will be worked out as follows:

In case stationery is also purchased on credit, the amount of its consumption will be worked out as given in Revision12.

Revision 11

Following is the Receipt and Payment Account of an Entertainment Club for the period April 1, 2016 to March 31, 2017.

Receipt and Payment  Account for the year ending March 31, 2017

Additional Information

  1. The club had 225 members, each paying an annual subscription of Rs. 500. Subscription outstanding as on 31 March 2016 Rs. 15,000.
  2. Telephone bill outstanding for the year 2016-2017 is Rs. 2,000.
  3. Locker Rent Rs. 3,050 outstanding for the year 2015-16 and Rs. 1,500 for 2016-17.
  4. Salary outstanding for the year 2016-17 Rs. 4,000.
  5. Opening Stock of Printing and stationery Rs. 2,000 and closing stock of printing and stationery is Rs. 3,000 for the year 2016-17.
  6. On 1st April 2016 other balances were as under:
  7. Depreciation Furniture and Building @ 12.5% and 5% respectively assuming that it is on reducing balance for the year ending March 31,2017

Prepare  Income  and  Expenditure  account  and  Balance  Sheet as  on that date.

Book of entertainment club

Income and expenditure account for the year ending on march 31, 2017

Solution

Balance Sheet of Entertainment Club as on March 31, 2016

 

Balance Sheet of Entertainment Club as on March 31, 2017

Revision 12

 

Prepare Income and Expenditure Account and Balance Sheet for the year ended

March 31, 2015 from the following information.

Receipt and Payment  Account for the year ending March 31, 2015

The following additional information is provided to you:

1. There are 1800 members each paying an annual subscription of

Rs. 200, Rs. 8,000 were in arrears for 2013-14 as on April 1, 2014.

2. On March 31, 2015 the rates were prepaid to June 2015; the charge paid every year being Rs. 24,000.

3. There was an outstanding telephone bill for Rs. 1,400 on March 31, 2015.

4. Outstanding sundry expenses as on March 31, 2014 totaled Rs. 2,800.

5. Stock of stationery as on March 31, 2014 was Rs. 2000; on March 31, 2015, it was Rs. 3,600.

6. On March 31, 2014 Building stood at Rs. 4,00,000 and it was subject to depreciation @ 2.5% p. a.

7. Investment on March 31, 2014 stood at Rs. 8,00,000.

8. On March 31, 2015, income accrued on investments purchased during the year amounted to Rs. 1,500.

 

Solution

Income  and Expenditure  Account for the year ending on March 31, 2015

Balance Sheet as on March 31, 2015

Balance Sheet as on March 31, 2014

 Working Note :

Subscription Account 

Revision 13

Following is the Receipt and Payment Account of Friendship Club in respect of the Year on 31.3.2016

Receipt and Payment  Account for the year ending March 31, 2016.

Additional Information :

1.  There are 500 members, each paying an annual subscription of Rs. 50, Rs. 17,500 being in arrears for 2014-15 at the beginning of 2015-16. During 2014-15, subscriptions were paid in advance by 40 members for 2015-16.

2.  Stock of stationery on March 31, 2015, was Rs. 1,500 and on March 31, 2016, Rs. 2,000.

3.  On March 31, 2016, the rates and taxes were prepaid to the following January 31, the annual charge being Rs. 1,500.

4.  Telephone bill unpaid as on March 31, 2015 Rs. 3,000 and on March 31, 2016 Rs. 1,500.

5.  Sundry expenses accruing at 31.3.2015 were Rs. 250 and at March 31, 2016 Rs. 300.

6.  On March 31, 2015 Building stood in the books at Rs. 2,00,000 and it is required to write off depreciation @ 10% p.a.

7.  Value of 8% Government Securities on March 31, 2015 was Rs. 75,000 which were purchased at that date at Par. Additional Government Securities worth Rs. 25,000 are purchased on March 31, 2016.

 You are required to prepare:

(a)  An Income and Expenditure Account for the year ended on 31.3.2016 (b)  A Balance Sheet on that date.

Solution

Books of Friendship Club 

Balance sheet as on march 31, 2015

 

Income  and Expenditure  Account for the year ending on March 31, 2015

Verification: 500 x 50 = 25000.

Balance Sheet of Friendship Club as on March 31, 2016

Income and Expenditure  Account based on Trial Balance

In case of not-for-profit organisations, normally the Income and Expenditure Account and Balance Sheet is prepared based on the Receipts and Payments Account and the additional information given. But, sometimes, the trial balance along with some additional information is given for this purpose. See Revision 14.

Revision 14

From the trial balance and other information given below for a school, prepare Income and Expenditure Account for the year ended on 31.3.2017 and a Balance Sheet as on that date:

Additional Information:

(i)  Tution fee yet to be received for the year are Rs. 25,000.
(ii)  Salaries yet to be paid amount to Rs.30,000.

(iii)  Furniture costing Rs. 40000 was purchased on October 1, 2016 was sold for Rs. 20,000.
(iv)  The book value of the furniture sold was Rs. 50,000 on April 1, 2016 was sold for 
Rs. 20,000.
(v)  Depreciation is to be charged @ 10% p.a. on furniture, 15% p.a. on Library books, and 5% p.a. on building.

Solution

Income  and Expenditure  Account for the year ending on March 31, 2017

 Working Notes: 

1.  As admission fee is a regular income of a school, so it has been taken as a revenue income of the school.

2.  Depreciation on furniture has been computed as following on the assumption that furniture was sold on April 1, 2016.

Balance Sheet as on March 31, 2017

Revision 15

Prepare Income and Expenditure Account of Entertainment Club for the year ending March 31, 2017 and Balance Sheet as on that date from the following information:

Receipt and Payment Account For the year ending on March 31, 2017

Additional Information:

Solution

Books of Entertainment Club Income and Expenditure  Account for the year ending March 31, 2017

Balance Sheet of Entertainment Club as on March 31, 2016

Balance Sheet of Entertainment as on March 31, 2017

Note:  Interest on Prize Fund Investments @ 5% amounts to Rs. 3,000 whereas only Rs. 1,500 have been received; so the balance is treated as Accrued interest.

It is preferable to prepare separate accounts of various items involving many transactions. In this case Account for Subscription, Miscellaneous Expenses, and Sports Materials may be made as a Classroom activity.

Revision 16

Shiv-e-Narain Education Trust provides the information in regard to Receipt and Payment Account and Income and Expenditure Account for the year ended March 31st 2017:

Receipt and Payment  Account for the year ending March 31, 2017

On March 31, 2016 the following balances appeared:

Investments Rs.1, 60,000; Furniture Rs.40, 000; and Books Rs.20, 000.

Income  and Expenditure  Account for the year ending on March 31, 2017

Prepare opening and closing balance sheet

Solution

Shiv-e-Narain Education Trust Balance Sheet as on March 31, 2016

Balance Sheet of Shiv-e-Narain Education Trust as on March 31, 2017

Note:

1Income and Expenditure Account for the current year shows interest on investment income Rs.6,800 while Receipts and Payments Account shows the receipts of   Rs.6,000 the difference of Rs.800 means interest on investment has become due but not yet receivable  during the year.

2.  Income and Expenditure Account shows Rs.90,000 as income from Tuition fees. However, the Receipts and Payments Account shows Rs.10,000 as tuition fees received for the year 2017-18 and Rs.80,000 for 2015-16. It implies that Rs.10,000 on account of tuition fees for the year 2016-17 are still receivable (i.e. Tuition fees are outstanding).

3Receipt and Payment Account shows a payment of Rs.85,000 on account of staff salaries, but the Income and Expenditure Account shows expenditure of Rs.84,000 on account of staff salaries. It means the excess of Rs.1,000 shown in the Receipt and Payment Account may either belong to the pervious year or the next year. Their  is no evidence that staff salaries of Rs.1,000 was outstanding at the end of the  previous year  2013-14. This is why this payment of Rs.1,000 has been considered  as an advance salaries to the staff.

Summary

  1. Difference between Profit Seeking Entities and Not-for-Profit Entities: Profit- seeking entities undertake activities such as manufacturing trading, banking and insurance to bring financial gain to the owners. Not-for-Profit entities exist to provide services to the member or to the society at large. Such entities might sometimes carry on trading activities but the profits arising therefrom are used for further the service objectives.
  2. Appreciation of the need for separate Accounting Treatment for Not-for-Profit Organisations: Since not-for-profit entities are guided primarily by a service motive, the decisions made by their managers are different from those made by their counterparts in profit-seeking entities. Differences in the nature of decisions implies that the financial information on which they are based, must also be different in content and presentation.
  3. Explanation of the nature of the Principal Financial Statements prepare by Not-for- Profit enterprises: Not-for-Profit Organisations that maintain accounts based on the double-entry system of accounting, generally prepare three principal statements to fulfil their information needs. These include Receipts and Payments Account, Income and Expenditure Account, and a Balance Sheet. The Receipts and Payments Account is summarised under relevant heads, cash book which records all cash Receipts and cash Payments without distinguishing between capital and revenue items, and between items relating to the current year and those relating to previous or future years. The Income and Expenditure Account is an income statement which is prepared to ascertain the excess of revenue income over revenue expenditure or vice versa, for a particular accounting year, as a result of the entity's overall activities. Although it is considered to be a substitute for the Trading and Profit and Loss Account of a profit-seeking entity, there are certain conceptual differences between the two statements. The Balance Sheet is prepared at the end of the entity's accounting year to depict the financial position on that date. It includes the Capital Fund or Accumulated Fund, special purpose funds, and current liabilities on the left hand or liabilities side, and fixed assets and current assets on the right hand or assets side.
  4. Difference between the Receipt and Payment Account and the Income and Expenditure Account: Many differences exist between the Receipt and Payment Account and the Income and Expenditure Account which is evident from the nature and purpose of two statements. While the former records both capital and revenue receipts and payments relating to any accounting year, the latter records only revenue items relating to the current accounting year. Non-cash expenses such as depreciation on fixed assets and outstanding incomes and expenses are shown in the latter but omitted in the former. The Receipt and Payment Account has an opening balance while the Income and Expenditure Account does not. The closing balance of the former account represents cash and bank balances on the closing date while in the latter account it indicates surplus or deficit from the activities of the enterprise.
  5. Conversion of a Receipt and Payment Account into an Income and Expenditure Account: This essentially involves five steps namely, (i) adjusting the revenue receipts on the debit side to include accrued incomes and incomes relating to the current year received earlier and to exclude amounts received in arrears or in advance; (ii) adjusting revenue payments on the credit side; (iii) identifying and showing non-cash expenses and losses on the debit side of the Income and Expenditure Account; (iv) computing and showing profits/losses from trading and/or social activities on the credit/debit side of the Income and Expenditure Account; and (v) ascertaining the surplus or deficit as the closing balance of the Income and Expenditure Account.

3. Preparation of opening & closing Balance Sheet, Some peculiar items, Incidental Trading Activity

How to Prepare Opening & Closing Balance Sheet?

Step 1 – Take into account the closing balances of assets & liabilities of the previous year & the opening balances of the Receipts & Payments A/c will be the cash in hand & cash at the bank as of that date. The Balancing Figure will be Capital Fund

Step 2 – After the preparation of the opening Balance Sheet, we shall proceed towards the preparation of the Closing Balance Sheet& for this purpose, the assets will be then adjusted for any sale or purchase during the year. Any gain or loss on the sale of assets will be taken to Income & Expenditure A/c. Any depreciation will also be taken to Income & Expenditure A/c. Only the net assets will appear on the Balance Sheet& the payments made for the purchase of new assets in the Receipts & Payments A/c shall appear as the new asset or added to the old assets.

Step 3 – From the Receipts side, any capital receipts like contributions to Building Fund & specific funds like specific donations will be recorded on the liabilities side.

Step 4 – Adjustments for prepaid & outstanding expenses will be made to the relevant expenses. Outstanding expenses & advance subscriptions will appear on the liabilities side whereas prepaid expenses & outstanding subscriptions will appear on the asset side.

Step 5 – The liabilities appearing in the previous year’s Balance Sheet should be checked with the payments made during the year. If some liabilities have been paid, then these liabilities will not appear in the new Balance Sheet to the extent they are paid. Only the net unpaid amount if any will appear on the Balance Sheet.

Step 6 – Finally, the Capital Fund balance from Opening Balance Sheet shall be adjusted with surplus or deficit from the Income & Expenditure A/c & also any specific fund which is not required anymore will be added to the Capital fund.

AN EXAMPLE OF CLOSING A BALANCE SHEET

Meaning and Treatment of Special Items

             The meaning and treatment of the special items in the financial statements of non-profit making organizations are as follows:

1.         Capital Fund

             Non-profit organizations follow FUND BASED ACCOUNTING method. In this method, the fund is of two types i.e. General Fund or Capital Fund & Specific Fund.  The capital introduced is known as the General Fund or Capital Fund. It is an unrestricted fund that can be used to achieve the objectives of society. All the recurring expenses like salary and rent are charged to General Fund through Income & Expenditure A/c similarly all the revenues are added to the General Fund through Income & Expenditure A/c. If the fund money is invested somewhere then the interest earned will be directly added to the General Fund/Capital Fund.

             On the other hand, Specific Fund is a restricted fund set up for a specific purpose. The money can be used only for the achievement & realization of that particular purpose. The restriction on the use of this fund is either put by the donor or by the management. If the fund money is invested somewhere then the interest earned will be directly added to the specific Fund. It is again classified into two types;

  1. Specific Asset Building – Funds used for building some fixed assets like Building or Pavilion.
  2. Revenue Funds – Funds used for maintaining certain recurring expenses such as Tournament fund, Scholarship Fund, Sports Fund etc.

2.         Subscriptions

             Subscriptions are collected by non-profit making organizations from their members regularly. It is revenue in nature. It is the main source of income for any non-profit making organization. Subscriptions related to the current year shall be recorded in Income & Expenditure A/c whether received or not. Subscriptions due for the current year shall also be shown in the asset side of the Balance Sheet. Subscriptions received in advance for next year shall not appear in the Income & Expenditure A/c as it is not a current year item but the amount received in advance shall be recorded as a liability in the Balance sheet as it is a prepaid income.

Explanation:-

Income& Expenditure A/c is nothing but P/L A/c with a different name. Since the purpose of preparing P/L A/c is to find out the current year's profit or loss, therefore, only current items of revenue nature is recorded in P/L A/c. In the same way, Income & Expenditure A/c also records only the current year items & items of the previous year & next year are excluded.

  • Outstanding at the end shall be added as it is a current year item.
  • Outstanding at the beginning shall be deducted as it is a previous year's item (last year’s closing outstanding is this year’s opening outstanding)
  • Advance at the End is not a current year item. It is the membership fees received for next year in advance so it’ll be deducted from the total subscriptions received.
  • Advance at the beginning is this year’s income because it represents last year’s closing advance i.e. membership fees for the current year received in advance during the previous year.

3.         Donations

             A non-profit making organization may receive donations from time to time. Donations received for a particular purpose like the development of a pavilion, construction of a building, awarding prizes etc. are called specific donations. A donation received not for a specific purpose is called a general donation.

             Accounting Treatment: All specific donations are to be capitalized i.e. put in the liabilities side of the Balance Sheet.

             If the general donation is a big amount it is to be capitalized i.e. added to the Capital Fund in the liabilities side of the Balance sheet.

             In case the general donation is a small amount it is treated as income and put in the credit side of the Income and Expenditure Account.

             Note: Whether the amount of general donation is big or small, it is judged by considering the nature of the activities of the non-profit making organizations.

4.         Entrance Fees

             This is the fee collected from the new entrants on admission to the clubs or societies etc. It is also known as admission fees.

             Accounting Treatment: The entrance fees may be treated as revenue or capital depending upon the rule and by-laws of the organizations.

5.         Legacies

             It is a kind of gift received by a non-profit making organisation as per the will of a deceased person.

             Accounting Treatment: If legacy is a small amount, it is treated as an income and is to be taken in the credit side of Income and Expenditure Account.

             In case of a big amount, it should be capitalised i.e. added to Capital Fund in the liabilities side of Balance Sheet.

             Note:Whether the amount of legacy is big or small, it is judged by considering the nature of activities of non-profit making organisation.

6.         Life Membership Fees

             Membership fees for the whole life collected from members is known as life membership fees. In this case the member is to pay a lump-sum amount instead of periodic payments and enjoys the benefits of the organisation till the end of his life.

             Accounting Treatment: Life membership fees is treated as capital item and hence added to the Capital fund.

             Note: However, there is another way of treatment.

             It is credited to a separate fund (Life Membership Fees Account) and an amount equal to the annual membership fee (subscription) is transferred to the Income and Expenditure Account. The balance in the separate fund is shown in the liabilities side of the Balance Sheet. If a life member dies, then the balance lying in the special fund is transferred to the Capital Fund of the organization.

7.         Special Fund

            Sometimes a non-profit making organisation may create funds for some special purposes. For example, a sports club may create Tournament Fund for meeting tournaments expenses or a building fund for the construction of building etc.

             Accounting Treatment: The fund may be invested in banks or in Govt. securities.

  • Any income relating to such special fund is added to this fund.
  • Any expenditure on account of this fund is subtracted from such fund.
  • Such special fund appears in the liabilities side of Balance Sheet.
  • If there is deficit (the expenditure on account of fund is more than the amount of fund) it is recorded in the expenditure side of Income and Expenditure Account.

8.       Calculation of Cost of Consumable Goods – Consumable goods are the items that are used or consumed during the year such as sports material, stationery, books, medicines, and food items. In the Income & Expenditure A/c, only the amount of such items consumed will during the year be shown. Therefore, it is necessary to find out the cost of consumption of such goods.

STEPS TO PREPARE INCOME & EXPENDITURE A/C FROM RECEIPTS & PAYMENTS A/C

  1. Prepare the Opening Balance Sheet to find out the opening balance of Capital Fund (if it is not given).
  2. Identify the revenue receipts from the receipts side of Receipts & Payment A/c & show them in the Income side of the Income & Expenditure A/c. Capital receipts will be shown in the Balance sheet.
  3. Identify the Capital expenditure from the payment side of Receipts & Payment A/c & show it in the Balance sheet. Capital items won’t appear in Income & Expenditure A/c.
  4. Certain items do not appear in Receipts & Payment A/c but shall be recorded in Income & Expenditure A/c such as depreciation of fixed assets, loss on sale of fixed assets, and profit on the sale of fixed assets. Depreciation & loss shall be shown in the Expenditure side whereas profit on the sale of fixed assets shall be shown in the Income side.
  5. Finally, find out the surplus or deficit i.e. if the income side is higher it is surplus & if the expenditure side is higher then it is a deficit.
  6. Prepare Closing Balance Sheet by taking into consideration the opening balance of assets & liabilities, surplus/deficit, purchase & sale of assets during the year & depreciation on fixed assets. The surplus shall be added to the Capital whereas the Deficit shall be deducted from the Capital.

INCIDENTAL TRADING ACTIVITY

This Incidental Trading activity is also known as incidentals, these are the gratuities and the fees or costs which are incurred in addition to the main item, service or event paid for during the trading pursuits.

Trading pursuits like a hospital or a chemist shop or even a beauty parlor or canteen, all these places can also in use to furnish certain provisions to the members or public. In this scenario, the trading A/c has to be drawn to determine the outcome of this incidental pursuit. The profit from these trading pursuits is solicited to accomplish the primary objectives which satisfy the cause for which the establishment was set up, then it is transferred to the Income and Expenditure A/c. 

In Relation to the Above, the following are the Details:

  • The trading A/c has to be outlined to ascertain either profit or loss due to incidental commercial pursuit. All these costs and revenues in a straight way and principally are associated with such pursuits, are documented in the trading A/c. After this, the Balance of the trading A/c is being transferred to the Income and Expenditure A/c
  • Income and Expenditure A/c documents, also the trading profit (or loss), and all other incomes and expenses are not documented in the Trading A/c. Surfeit or deficit is disclosed by the Income and Expenditure A/c as is being transferred to the capital or general fund.

2. Maintenance of capital accounts, Distribution of profit among the partners

Maintenance  of Capital Accounts of Partners

All transactions relating to partners of the firm are recorded in the books of the firm through their capital accounts. This includes the amount of money brought in as capital, withdrawal of capital, share of profit, interest on capital, interest on drawings, partner’s salary, commission to partners, etc.
There are two methods by which the capital accounts of partners can be maintained. These are: (i) fixed capital method, and (ii) fluctuating capital method. The difference between the two lies in whether or not the transactions other than addition/withdrawal of capital are recorded in the capital accounts of the partners.

Fixed Capital Method: Under the fixed capital method, the capitals of the partners shall remain fixed unless additional capital is introduced or a part of the capital is withdrawn as per the agreement among the partners. All items like share of profit or loss, interest on capital, drawings, interest on drawings, etc. are recorded in a separate accounts, called Partner’s Current Account. The partners’ capital accounts will always show a credit balance, which shall remain the same (fixed) year after year unless there is any addition or withdrawal of capital. The partners’ current account on the other hand, may show a debit or a credit balance. Thus under this method, two accounts are maintained for each partner viz., capital account and current account, While the partners’ capital accounts shall always appear on the liabilities side in the balance sheet, the partners’ current account’s balance shall be shown on the liabilities side, if they have credit balance and on the assets side, if they have debit balance. The partner’s capital account and the current account under the fixed capital method would appear as shown below:

Partner’s  Capital  Account

Partner’s  Current  Account

                                                                                                                                           Fig. 2.1: Proforma of Partner’s Capital and Current Account under Fixed Capital Method.

Fluctuating Capital Method: Under the fluctuating capital method, only one account, i.e. capital account is maintained for each partner. All the adjustments such as share of profit and loss, interest on capital, drawings, interest on drawings, salary or commission to partners, etc are recorded directly in the capital accounts of the partners. This makes the balance in the capital account to fluctuate from time to time. That’s the reason why this method is called fluctuating capital method. In the absence of any instruction, the capital account should be prepared by this method. The proforma of capital accounts prepared under the fluctuating capital method is given below:

Partner’s  Capital  Account

                                                                                                                                                          Fig. 2.2: Proforma of Partner’s Capital Account under Fluctuating capital Method.

Distinction between Fixed and Fluctuating Capital Accounts

The main points of differences between the fixed and fluctuating capital methods can be summed up as follows:

Distribution of Profit among Partners

 The profits and losses of the firm are distributed among the partners in an agreed ratio. However, if the partnership deed is silent, the firm’s profits and losses are to be shared equally by all the partners.

You know that in the case of sole partnership the profit or loss, as ascertained by the profit and loss account is transferred to the capital account of the proprietor. In case of partnership, however, certain adjustments such as interest on drawings, interest on capital, salary to partners, and commission to partners are required to be made. For this purpose, it is customary to prepare a Profit and Loss Appropriation Account of the firm and ascertain the final figure of profit and loss to be distributed among the partners, in their profit sharing ratio.

Profit and Loss Appropriation Account

Profit and Loss Appropriation Account is merely an extension of the Profit and Loss Account of the firm. It shows how the profits are appropriated or distributed among the partners. All adjustments in respect of partner’s salary, partner’s commission, interest on capital, interest on drawings, etc. are made through this account. It starts with the net profit/net loss as per Profit and Loss Account. The journal entries for preparation of Profit and Loss Appropriation Account and making various adjustments through it are given as follows:

Journal Entries

1. Transfer of the balance of Profit and Loss Account to Profit and Loss Appropriation Account:

(a)     If Profit and Loss Account shows a credit balance (net profit): Profit and Loss A/c                                           Dr.

To Profit and Loss Appropriation A/c

(b)     If Profit and Loss Account shows a debit balance (net loss) Profit and Loss Appropriation A/c                        Dr.

To Profit and Loss A/c

2.  Interest on Capital:

(a)    For Allowing interest on capital:

Interest on Capital A/c                            Dr.

To Partner’s Capital/Current A/cs (individually)

(b)     For transferring interest on capital to Profit and Loss Appropriation Account: Profit and Loss Appropriation A/c                 Dr.

To Interest on Capital A/c

3.  Interest on Drawings:

(a)     For charging interest on drawings to partnerscapital accounts: Partners Capital/Current A/c’s (individually)                      Dr.

To Interest on Drawings A/c

(b)     For transferring interest on drawings to Profit and Loss Appropriation Account: Interest on Drawings A/c                          Dr.

To Profit and Loss Appropriation A/c

4.  Partner’s Salary:

(a)     For Allowing partner’s salary to partner’s capital account: Salary to Partner A/c                                      Dr.

To Partner’s Capital/Current A/c’s (individually)

(b)     For transferring partner’s salary to Profit and Loss Appropriation Account: Profit and Loss Appropriation A/c                Dr.

To Salary to Partner’s A/c

5.  Partner’s Commission:

(a)     For crediting commission allowed to a partner, to partner’s capital account: Commission to Partner A/c                             Dr.

To Partner’s Capital/Current A/c’s (individually)

(b)     For transferring commission allowed to partners to Profit and Loss Appropriation Account.

Profit and Loss Appropriation A/c                           Dr.

To Commission to Partners Capital/Current A/c

              6.  Share of Profit or Loss after appropriations:

      (a   If Profit:

Profit and Loss Appropriation A/c                       Dr.
To Partner’s Capital/Current A/c’s (individually)

(b  If Loss:

Partner’s Capital/Current A/c (individually) To Profit and Loss Appropriation A/c

Note: In case firm suffers a loss, no interest on capital, salary, remuneration is to be allowed to partners. The Proforma of Profit and Loss Appropriation Account is given as follows:

Profit  and Loss Appropriation Account

                                                                                                                                                    Fig. 2.3: Proforma of Profit and Loss Appropriation Account

Revision 1

Sameer and Yasmin are partners with capitals of Rs.15,00,000 and Rs. 10,00,000 respectively. They agreed to share profits in the ratio of 3:2. Show how the following transactions will be recorded in the capital accounts of the partners in case: (i) the capitals are fixed, and (ii) the capitals are fluctuating. The books are closed on March 31, every year.

Solution

Fixed Capital Method
Partner’s  Capital  Accounts

Partner’s  Current  Accounts

Fluctuating Capital Method

Partner’s  Capital Accounts

Revision 2

Amit, Babu and Charu set up a partnership firm on April 1, 2019. They contributed Rs. 50,000, Rs. 40,000 and Rs. 30,000, respectively as their capitals and agreed to share profits and losses in the ratio of 3 : 2 :1. Amit is to be paid a salary of Rs. 1,000 per month and Babu, a Commission of Rs. 5,000. It is also provided that interest to be allowed on capital at 6% p.a. The drawings for the year were Amit Rs. 6,000, Babu Rs. 4,000 and Charu Rs. 2,000. Interest on drawings of Rs. 270 was charged on Amit’s drawings, Rs. 180 on Babu’s drawings and Rs. 90, on Charu’s drawings. The net profit as per Profit and Loss Account for the year ending March 31, 2020 was Rs. 35,660. Prepare the Profit and Loss Appropriation Account to show the distribution of profit among the partners.

Solution

Profit  and Loss Appropriation Account

Revision 3

Yadu, Madhu and Vidu are partners sharing profits and losses in the ratio of 2:2:1. There fixed capitals on April 01, 2019 were; Yadu Rs. 5,00,000, Madhu Rs. 4,00,000 and Vidhu Rs. 3,50,000. As per the partnership deed, partners are entitled to interest on capital @ 5% p.a., and Yadu has to be paid a salary of Rs. 2,000 per month while Vidu would be receiving a commission of Rs. 18,000. Net loss of the firm as per profit and loss account for the year ending March 31, 2019 amounted to Rs. 75,000 on the basis of above information prepare profit and loss appropriation account. Prepare profit and loss appropriation account for the year ending March 31, 2019.

Solution

Books of Yadu, Madhu and Vidu Profit and Loss

Appropriation Account for the year ending March 31, 2019

Revision  4

Amitabh and Babul are partners sharing profits in the ratio of 3:2, with capitals of Rs. 50,000 and Rs. 30,000 respectively. Interest on capital is agreed @ 6% p.a. Babul is to be allowed an annual salary of Rs. 2,500. Manager is to be allowed commission Rs. 5,000. Amitabh has also given a Loan on April 01, 2019 of Rs. 50,000 to the firm without any agreement. During the year 2019-20, the profits earned is Rs. 22,250. Prepare Profit and Loss Appropriation account showing the distribution of profit and the partners’ capital accounts for the year ending March 31, 2020.

Solution

Profit  and Loss Appropriation Account

Amitabh’s  Capital Account

Babul’s Capital Account

Working Notes:

Profit  and Loss Account

Interest on Capital

No interest is allowed on partners’ capitals unless it is expressly agreed among the partners. When the Deed specifically provides for it, interest on capital is credited to the partners at the agreed rate with reference to the time period for which the capital remained in business during a financial year. Interest on capital is generally provided for in two situations: (i) when the partners contribute unequal amounts of capitals but share profits equally, and (ii) where the capital contribution is same but profit sharing is unequal. Interest on capital is calculated with due allowance for any addition or withdrawal of capital during the accounting period. For example, Mohini, Rashmi and Navin entered into partnership, bringing in Rs. 3,00,000, Rs. 2,00,000 and Rs. 1,00,000 respectively into the business. They decided to share profits and losses equally and agreed that interest on capital will be provided to the partners @10 per cent per annum. There was no addition or withdrawal of capital by any partner during the year. The interest on capital works out to Rs. 30,000 (10% on 30,000) for Mohini, Rs. 20,000 (10% on 2,00,000) for Rashmi, and Rs.10,000 (10% on 1,00,000) for Navin.

Take another case of Mansoor and Reshma who are partners in a firm and their capital accounts showed the balance of Rs. 2,00,000 and Rs. 1,50,000 respectively on April 1, 2019. Mansoor introduced additional capital of Rs. 1,00,000 on August 1, 2019 and Reshma brought in further capital of Rs. 1,50,000 on October 1, 2019. Interest is to be allowed @ 6% p.a. on the capitals. It shall be worked as follows:

Rs. 2,00,000 ×   6/100   +   Rs. 1,00,000 ×   6/100   ×  8 

For Mansoor

= Rs. 12,000 + Rs. 4,000 = Rs. 16,000

For Reshma

= Rs. 1,50,000  ×  6/100   +  Rs. 1,50,000 ×   6/100 ×  6/12

= Rs. 9,000+Rs. 4,500= Rs. 13,500

When there are both addition and withdrawal of capital by the partners during a financial year, the interest on capital is calculated as follows:

(i)  On the opening balance of the capital accounts of partners, interest is calculated for the whole year;

(ii)  On the additional capital brought in by any partner during the year, interest is

calculated from the date of introduction of additional capital to the last day of the financial year.

(iii)  In case of withdrawal of capital, interest on capital will be calculated as:

On opening capital from the beginning of the year till date of capital withdrawn and then on the reduced capital for the remaining time period. Alternatively, it can be calculated with respect of amount remained in business for the relevant period.

Revision 5

Saloni and Srishti are partners in a firm. Their capital accounts as on April 01. 2019 showed a balance of Rs. 2,00,000 and Rs. 3,00,000 respectively. On July 01, 2019, Saloni introduced additional capital of Rs. 50,000 and Srishti, Rs. 60,000. On October 01 Saloni withdrew Rs.

30,000, and on January 01, 2020 Srishti withdraw, Rs. 15,000 from their capitals. Interest is allowed @ 8% p.a. Calculate interest payable on capital to both the partners during the financial year 2019–2020.

Solution

Statement Showing Calculation of Interest on Capital :

 For Saloni

                                                                                                                           (Rs.)

Interest on Rs. 2,00,000 for 3 months = Rs.2, 00, 000 × 8 × 3/100 × 12             = 4,000

Add : Interest on Rs. 2,50,000 for 3 months = Rs.2, 50, 000 × 8 × 3/100 × 12  = 5, 000

Add : Interest on Rs. 2,20,000 for 6 months = Rs.2, 20, 000 ×  6/12  ×  8/100   = 8,800

 

      Total - 17,800

 For Srishti

                                                                                                                (Rs.)

Interest on Rs. 3,00,000 for 3 months = Rs.3, 00, 000 ×  3/12  ×   8/100               = 6,000

Add : Interest on Rs. 3,60,000 for 6 months  = Rs.3, 60, 000 ×  8/100  ×  6/12  = 14, 400

Add : Interest on Rs. 2,20,000 for 3 months = Rs.3, 45, 000 × 8/100  ×  3/12          = 300 

Sometimes opening capitals of partners may not be given. In such a situation before calculation of interest on capital the opening capitals will have to be worked out with the help of partners’ closing capitals by marking necessary adjustments for the additions and withdrawal of capital, drawings, share of profit or loss, if already shown in the capital accounts the partners.

Revision 6

Josh and Krish are partners sharing profits and losses in the ratio of 3:1. Their capitals at the end of the financial year 2015-2016 were Rs. 1,50,000 and Rs. 75,000. During the year 2015-2016, Josh’s drawings were Rs. 20,000 and the drawings of Krish were Rs. 5,000, which had been duly debited to partner’s capital accounts. Profit before charging interest on capital for the year was Rs. 16,000. The same had also been debited in their profit sharing ratio. Krish had brought additional capital of Rs. 16,000 on October 1, 2015. Calculate interest on capital @ 12% p.a. for the year 2015-2016.

Solution

Statement Showing  Calculation  of Capital at the Beginning

Interest on capital will be as 18,960 (12% of Rs. 1,58,000) for Josh and Rs. 960 for krish calculated as follows:

(Rs. 60,000 ×  12/ 100) + ( Rs. 16,000 ×  12/100  ×  6/12) = Rs. 7,200 + Rs. 960 = Rs. 8,160.

As clarified earlier, the interest on capital is allowed only when the firm has earned profit during the accounting year. Hence, no interest will be allowed during the year the firm has incurred net loss and if in a year, the profit of the firm is less than the amount due to the partners as interest on capital, the payment of interest will be restricted to the amount of profits. In that case, the profit will be effectively distributed in the ratio of interest on capital of each partner.

Revision 7

Anupam and Abhishek are partners sharing profits and losses in the ratio of 3 : 2. Their capital accounts showed balances of Rs. 1,50,000 and Rs. 2,00,000 respectively on April 01, 2019. Show the calculation of interest on capital for the year ending  December 31, 2020 in each of the following alternatives:

(a) If the partnership deed is silent as to the payment of interest on capital and the profit for the year is Rs. 50,000;

(b) If partnership deed provides for interest on capital @ 8% p.a. and the

firm incurred a loss of Rs. 10,000 during the year;

(c) If partnership deed provides for interest on capital @ 8% p.a. and the firm earned a profit of Rs. 50,000 during the year;

(d) If the partnership deed provides for interest on capital @ 8% p.a. and the firm earned a profit of Rs. 14,000 during the year.

Solution

(a)  In the absence of a specific provision in the Deed, no interest will be paid on the capital to the partners. The whole amount of profit will however be distributed among the partners in their profit sharing ratio.

(b) As the firm has incurred losses during the accounting year, no interest on capital

will be allowed to any partner. The firm’s loss will however be shared by the partners in their profit sharing ratio.

     Rs.

(c)  Interest to Anupam @ 8% on Rs. 1,50,000       =   12,000

Interest to Abhishek @ 8% on Rs. 2,00,000            =   16,000

                                                                       = 28,000

As the profit is sufficient to pay interest at agreed rate, the whole amount of interest on capital shall be allowed and the remaining profit amounting to Rs. 22,000 (Rs. 50,000 – Rs. 28,000) shall be shared by the partners in their profit sharing ratio.

(d) As the profit for the year is Rs. 14,000, which is less than the amount of interest on capital due to partners, i.e. Rs. 28,000 (Rs. 12,000 for Anupam and Rs. 16,000 for Abhishek), interest will be paid to the extent of available profit i.e., Rs. 14,000. Anupam and Abhishek will be credited with Rs. 6,000 and Rs. 8,000, respectively. Effectively this amounts to sharing the firm’s profit in the ratio of interest on capital, i.e., 3:4.

Interest on Drawings

The partnership agreement may also provide for charging of interest on money withdrawn out of the firm by the partners for their personal use. As stated earlier, no interest is charged on the drawings if there is no express agreement among the partners about it. However if the partnership deed so provides for it, the interest is charged at an agreed rate, for the period for which drawings have been made. Remained outstanding from the partners during an accounting year. Charging interest on drawings discourages excessive amounts of drawings by the partners. The calculation of interest on drawings under different situations is shown as here under.

When Fixed Amounts was Withdrawn Every Month

Many a time, a fixed amount of money is withdrawn by the partners, at equal time interval, say each month or each quarter. While calculating the time period, attention must be paid to whether the fixed amount was withdrawn at the beginning (first day) of the month, middle of the month or at the end (last day) of the month. If withdrawn on the first day of every month, interest on total amount will be calculated for 6½ months; if withdrawn at the end at every month, it will be calculated for 5½ months, and if withdrawn during the middle of the month, it will be calculated for 6 months.

Suppose, Aashish withdrew Rs. 10,000 per month from the firm for his personal use during the year ending March 31, 2017. The calculation of average period and the interest on drawings, in different situations would be as follows:

(a) When the amount is withdrawn at the beginning of each month:

(c)  When money is withdrawn in the middle of the month

When money is withdrawn in the middle of the month, nothing is added or deduced from the total period.

When Fixed Amount is withdrawn Quarterly

When fixed amount of money is withdrawn quarterly by partners, in such a situation, for the purpose of calculation of interest, the total period of time is ascertained depending on whether the money was withdrawn at the beginning or at the end of each quarter. If the amount is withdrawn at the beginning of each quarter, the interest is calculated on the total money withdrawn during the year, for a period of seven and half months i.e., 12 + 3/ 2 and if withdrawn at the  and of each quarter it will be calculated for a period of 4½ months, i.e., 9 + 0/2.

Suppose Satish and Tilak are partners in a firm, sharing profits and losses equally. During financial year 2016–2017, Satish withdrew Rs. 30,000 quarterly. If interest is to be charged on drawings @ 8% per annum, the calculation of average period and interest on drawings will be as follows:

(a) If the amount is withdrawn at the beginning of each quarter

Statement Showing Calculation  of Interest  on Drawings

 

Alternatively, the interest can be calculated on the total amount withdrawn during the accounting year, i.e. Rs. 1,20,000 for a period of 7½ months (12+9+6+3)/4. as follows:

Rs. 1,20,000 ×  8/100 × 15/2 × 1/12 = Rs 6, 000

(b)   If the amount is withdrawn at the end of each quarter

Statement Showing Calculation  of Interest  on Drawings

Alternatively, the interest can be calculated on the total amount withdrawn during the accounting year, i.e., Rs. 1,20,000 for a period of 4½ months

(9 + 6 + 3 + 0)/4 months as follows: = Rs. 1,20,000 ×  8/100 × 9/2 × 1/12 = 3, 600.

When Varying Amounts are Withdrawn at Different Intervals

When the partners withdraw different amounts of money at different time intervals, the interest is calculated using the product method. Under the product method, for each withdrawal, the money withdrawn is multiplied by the period (usually expressed in months) for which it remained withdrawn during the financial year. The period is calculated from the date of the withdrawal to the last day of the accounting year. The products so calculated are totalled on the total of the products interest at the specified rate is calculated as under:

Total of products × Rate × 1/12

For example, Shahnaz withdrew the following amounts from her firm, for personal use during the year ending March 31, 2017. Calculate interest on drawings by product method, if the rate of interest to be charged is 7 per cent per annum

Calculation of interest on drawings will be as follows:

Statement Showing Calculation  of Interest  on Drawings

​​​​​​Interest = Sum of Products ×  Rate × 1/12 = 4, 50, 000 × 7/100 × 1/12 = 30100/12 = Rs 2, 508 (approx).

Revision 8

John Ibrahm, a partner in Modern Tours and Travels withdrew money during the year ending March 31, 2020 from his capital account, for his personal use. Calculate interest in drawings in each of the following alternative situations, if rate of interest is 9 per cent per annum.

(a) If he withdrew Rs. 3,000 per month at the beginning of the month.
(b) If an amount of Rs. 3,000 per month was withdrawn by him at the end of each month.
(c) If the amounts withdrawn were : Rs. 12,000 on   June 01, 2019, Rs. 8,000; on August 31, 2019, Rs. 3,000; on September 30, 2019, Rs. 7,000, on November 30, 2019, and Rs. 6,000 on January 31, 2020.

Solution

(aAs a fixed amount of Rs. 3,000 per month is withdrawn at the beginning of the month, interest on drawings will be calculated for an average period of 6 1/2 months. Interest on drawings = Rs. 36, 000 × 9 × 13 × 1/100 × 2 × 12 = Rs 1. 755.

(b) As the fixed amount of Rs. 3,000 per month is withdrawn at the end of each month, interest on drawings will be calculated for an average period of 5 1/2 months.

Rs.36,000 ×9 ×11×1 = Rs. 1,485

      100×2×12

(c) Statements showing Calculation  of Interest  on Drawings

 Revision  9

Manu, Harry and Ali are partners in a firm sharing profits and losses equally. Harry and Ali withdrew the following amounts from the firm, for their personal use during 2019-2020. 

Calculate interest on drawings if the rate of interest to be charged is 10 per cent, and the books are closed on December 31 every year.

Statement Showing  Calculation  of Interest  on Drawings

Amount of Interest
Mannu  = Rs 1,56,000 x 10 x 1/100 x 12 = Rs 1, 300
Ali = Rs 1, 50, 000 x 10 x 1/ 100 x 12 = Rs 1, 250

When Dates of Withdrawal are not specified

When the total amount withdrawn is given but the dates of withdrawals are not specified, it is assumed that the amount was withdrawn evenly throughout the year. For example; Shakila withdrew Rs. 60,000 from partnership firm during the year ending March 31, 2020 and the interest on drawings is to be charged at the rate of 8 per cent per annum. For calculation of interest, the period would be taken as six months, which is the average period assuming, that amount is withdrawn evenly in the middle of the month, throughout the year. The amount of interest on drawings works out to be Rs. 2,400 as follows:

Rs 60, 000 x 8 x 6/100 x 12 = Rs 2, 400

When the total amount withdrawn is given but the dates of withdrawals are not specified, it is assumed that the amount was withdrawn evenly throughout the year. For example; Shakila withdrew Rs. 60,000 from partnership firm during the year ending March 31, 2020 and the interest on drawings is to be charged at the rate of 8 per cent per annum. For calculation of interest, the period would be taken as six months, which is the average period assuming, that amount is withdrawn evenly in the middle of the month, throughout the year. The amount of interest on drawings works out to be Rs. 2,400 as follows:

Rs 60, 000 × 8 × 6/100 × 12 = Rs 2, 400

 

2. Maintenance of capital accounts, Distribution of profit among the partners

MAINTENANCE OF CAPITAL ACCOUNTS& DISTRIBUTION OF PROFITS AMONG THE PARTNERS

To record the changes in Capital A/c of each partner, we prepare individual capital accounts for each partner. The capital accounts of partners can be maintained in two methods :

Fixed Capital Method

Fluctuating Capital Method

 

  1. Fixed Capital Method – In this method, the capital A/c of partners remains unaltered or fixed. When this method is followed, two accounts i.e. Capital A/c & Current A/c for each partner are maintained.
  • Capital A/c – The capital account remains unaltered i.e. fixed unless additional capital is introduced or withdrawal is made from the existing capital. If there is no fresh capital introduced or any withdrawals, the capital account of the partner show the same balance year after year.
  • Current A/c – It is prepared to record transactions other than introduction & withdrawal of capital such as interest on capital, interest on drawings, salary or commission to a partner, and share of profits/losses. The balance of current account always keeps fluctuating because of these adjustments.

Current A/c is debited with;

  • Drawings made by partner
  • Interest on drawings
  • Share of loss
  • Transfer of amount to any capital account permanently

Current A/c is credited with;

  • Interest on capital
  • Salary or commission
  • Share of profits
  • Transfer of any amount from capital account permanently

  1. Fluctuating Capital A/c – Under Fluctuating Capital method, only one account namely Capital A/c is maintained for each partner. All the transactions of a partner like salary, commissions, interest on capital are recorded in this account. As a result of this, the capital a/c fluctuates with every transaction. The debit balance of capital account is shown in the liabilities side & the credit balance is shown in the asset side.

INTEREST ON DRAWNGS

  • Drawings refers to the amount withdrawn by the owner in cash or in kind.
  • Interest on drawings is charged only when it is mentioned in the partnership deed.
  • When it is charged, it is debited to Profit & Loss Appropriation A/c.
  • It is either debited to Partner’s Capital A/c or Current A/c depending on whether Fixed Capital or Fluctuating Capital method is being followed

INTEREST ON DRAWINGS : - HOW IT IS CALCULATED?

  • The computation of Interest on Drawings depends upon various factors like when the amount is withdrawn & the time period for which it remains withdrawn etc.
  • So, the situations can be as follows;
  1. Fixed amount is withdrawn at the BEGINNING of every Month

If a partner withdraws fixed amount in the beginning of every month, interest is charged on the whole amount for 6 ½ months

Interest on Drawings = Total Drawings X Rate of Interest X 6 ½                                                                                          100                              12

6 ½ months = Average Period

Average Period Formula = Time left after first drawings + Time left after last drawings                                                              2

  • Average period should be used only when the amount of Drawings is uniform & the time interval between the two consecutive drawings is also uniform.
  1. Fixed amount is withdrawn at the END of every Month.

If a partner withdraws a fixed amount at the end of every month, interest is charged for  5 ½ months.

Interest on Drawings = Total Drawings X Rate of Interest X 5 ½                                                                                               100                              12

  1. Fixed amount is withdrawn in the MIDDLE of every Month

Interest on Drawings = Total Drawings X Rate of Interest X 6                                                                                                      100                        12

  1. Fixed amount is withdrawn at the BEGINNING of every QUARTER

Interest on Drawings = Total Drawings X Rate of Interest X 7 ½                                                                                                        100                       12

  1. Fixed amount is withdrawn in the MIDDLE of every QUARTER

Interest on Drawings = Total Drawings X Rate of Interest X 6                                                                                               100                        12

  1. Fixed amount is withdrawn at the END of every QUARTER

Interest on Drawings = Total Drawings X Rate of Interest X 4 ½                                                                                              100                             12

  1.  Fixed amount is withdrawn during 6 MONTHS
  1. At the BEGINNING OF EACH MONTH

Interest on Drawings = Total Drawings X Rate X 3 ½ 
                                                                                     100      12

  1. In the MIDDLE OF EACH MONTH

Interest on Drawings = Total Drawings X Rate X 3 
                                                                                100      12

  1. At the END OF EACH MONTH

Interest on Drawings = Total Drawings X Rate X 3 ½ 
                                                                                     100      12

  1. If Unequal amount is withdrawn at DIFFERENT DATES, interest on drawings is calculated on the basis of the Simple Method or Product Method

Interest on Drawings = Total of Product X Rate of Interest x 1 or 1                                                                                                                         100                12     365

  1. When the date of withdrawal IS NOT GIVEN, the interest on drawings is calculated for six months on an average basis.
  2. When Rate of Interest is given without the word PER ANNUM, interest is charged without considering the time factor

Journal Entries to Record Interest on Drawings

Salary or Commission to Partners

  • Salary or commission to partners is paid only when it is allowed in Partnership Deed
  • It is an appropriation of profit & not charge against the profit so it should be allowed only when profit is earned
  • Commission may be allowed to the partners either
  • As a percentage of profit before charging such commission

Net Profit (before Commission) x Rate of commission
                                                                           100

or

  • As a percentage of profit after charging such commission

Net profit (before commission) x Rate of Commission
                                                                100+Rate of Commission

Accounting Treatment:-

Partner’s Salaries/ Commission A/c      Dr

        To Partner’s Current A/c                                     (When capitals are fixed)

        To Partner’s Capital A/c                                      (When capitals are fluctuating)

Profit & Loss Appropriation A/c              Dr

         To Partner’s salaries/commission A/c

Interest on Partner’s Loan to the Firm

  • If a partner apart from investing share capital, advances any loan to the firm then he is entitled to receive interest even in the absence of an agreement/deed.
  • In the absence of an agreement/deed, the minimum rate of interest on loan to be paid to the partner is 6% p.a.
  • Interest on loan is a charge against profit & it is transferred to the debit of Profit/Loss A/c & not to the debit of Profit/Loss Appropriation A/c
  • Journal Entries
  • Interest on partner’s loan A/c      Dr

 To Partner’s Loan A/c

  • Profit & Loss A/c                                Dr

To Interest on partner’s loan A/c     

3. Guarantee of profit to a partner, Past adjustments, Final accounts

Guarantee of Profit  to a Partner

Sometimes a partner is admitted into the firm with a guarantee of certain minimum amount by way of his share of profits of the firm. Such assurance may be given by all the old partners  in a certain ratio or by any of the old partners, individually to the new partner. The minimum guaranteed amount shall be paid to such new partner when his share of profit as per the profit sharing ratio is less than the guarnteed amount. For example, Madhulika and Rakshita, who are partners in a firm decide to admit Kanishka into their firm, giving her the guarantee of a minimum of Rs.25,000 as her share in firm’s profits. The firm earned a profit of Rs.1,20,000 during the year and the agreed profit sharing ratio between the partners is decided as 2:3:1. As per this ratio, Madhulika’s share in profit comes to Rs.40,000 (2/6 of Rs. 1,20,000); Rakshita, Rs. 60,000 (3/6 of Rs. 1,20,000) and Kanishka Rs. 20,000 (1/6 of Rs. 1,20,000). The share of Kanishka works out to be Rs.5,000 short of the guaranteed amount. This shall be borne by the guaranteeing partners Madhulika and Rakshita in their profit sharing ratio, which in this case is 2:3, Madhulika’s share in the deficiency comes to Rs.2,000 (2/5 of Rs. 5,000), and that of Rakshita Rs.3,000. The total profit of the firm will be distributed among the partners as follows Madhulika will get Rs.38,000 (her share 40,000 minus share in deficiency Rs.2,000); Rakshita Rs.57,000 (60,000–3,000) and Kanishka Rs. 25,000 (Rs. 20,000 + Rs. 2,000 + Rs. 3,000).

If only one partner gives the guarantee, say in the above case, only Rakshita gives the guarantee, the whole amount of deficiency (Rs.5,000) will be borne by her only. In that case profit distribution will be Madhulika Rs.40,000, Rakshita Rs. 55,000 (60,000–5,000) and Kanishka Rs. 25,000 (Rs. 20,000 + Rs. 5,000).

Revision 10

Mohit and Rohan share profits and losses in the ratio of 2:1. They admit Rahul as partner with 1/4 share in profits with a guarantee that his share of profit shall be at least Rs. 50,000.  The net profit of the firm for the year ending March 31, 2015 was Rs. 1,60,000. Prepare Profit and Loss Appropriation Account.

Solution

Books of Mohit, Rohit and Rahul Profit and Loss Appropriation Account for the year ending .....

Working Notes:

The new profit sharing ratio after admission of Rahul comes to 2:1:1. As per this ratio the share of partners in the profit comes to:

 But, since Rahul has been given a guarantee of minimum of Rs. 50,000 as his share of profit. The deficiency of Rs. 10,000 (Rs. 50,000 – Rs. 40,000) shall be borne by Mohit and Rohan in the ratio in which they share profits and losses between themselves, viz. 2:1 as follows:

Mohit’s share in deficiency comes to 2/3 × Rs. 10,000 = Rs. 6,667

 

Rohan’s share in deficiency comes to 1/3 × Rs. 10,000 = Rs. 3,333

 

Thus Mohit will get Rs. 80,000 – Rs. 6,667 = Rs. 73,333, Rohan will get Rs. 40,000–Rs. 3,333 = Rs. 36,667 and Rahul will get Rs. 40,000 + Rs. 6,667 + Rs. 3,333 = Rs. 50,000 in the profit of the firm.

 

 

Calculation of new profit sharing ratio:

The new partner Rahul’s share is  1/4  The remaining profit is 1 – 1/4  = 3/4, to be shared between Mohit and Rohan in the ratio of 2:1.

Mohit’s new share = 3/4 × 2/3 = 2/4

Rohan’s new share = 3/4 × 1/3 = 1/4

Thus, New profit sharing ratio comes to be  2/4 : 1/4 : 1/4 or 2 : 1: 1

Revision 11

(i) Arun, Varun and Tarun were partners of a law firm sharing profits in the ratio of 5:3:2. Their partnership deed provided the following: (i) Interest on partners' capital @ 5% p.a.

(ii) Arun guaranteed that he would earn a minimum annual fee of Rs.6,00,000 for the firm.

(iii) Tarun was guaranteed a profit of Rs. 2,50,000 (excluding interest on capital) and any deficiency on account of this was to be borne by Arun and Varun in the ratio of 2:3.

During the year ending March 31, 2019, Arun earned a fee of Rs. 3,20,000 and net profits earned by the firm were Rs. 8,60,000. Partner's capital on April 01, 2018 were Arun - Rs. 30,00,000; Varun - Rs. 3,00,000 and Tarun- Rs. 2,00,000.

Prepare Profit and  Loss Appropriation account and show your workings clearly.

Solution

Books of Arun, Varun and Tarun Profit  and   Loss Appropriation Account for the year ending  March 31, 2019 

 Working Notes :- 

Rs. 30,000 to be borne by Arun & Varun in the ratio of 2:3 i.e. Rs. 12,000

and Rs. 18,000 respectively.

Revision 12

John and Mathew share profits and losses in the ratio of 3:2. They admit Mohanty into their firm to 1/6 share in profits. John personally guaranteed that Mohanty’s share of profit, after charging interest on capital @ 10 per cent per annum would not be less than Rs. 30,000 in any year. The capital provided was as follows: John Rs. 2,50,000, Mathew Rs. 2,00,000 and Mohanty Rs. 1,50,000. The profit for the year ending March 31,2015 amounted to Rs. 1,50,000 before providing interest on capital. Show the Profit & Loss Appropriation Account if new profit sharing ratio is 3:2:1.

Solution

Books of John and Mathew

Profit  and Loss Appropriation Account for the year ending....

Working Notes:

Profit after interest on capital is Rs. 90,000, which is to be distributed in the ratio of 3:2:1 as follows: John gets Rs. 45,000 (3/6 × Rs. 90,000), Mathew Rs. 30,000, Mohanty Rs. 15,000. Deficiency of Mohanty from the guaranteed profit of Rs. 15,000 will be borne by John. John will therefore get Rs. 45,000 – Rs. 15,000 = Rs. 30,000, Mathew Rs. 30,000 and Mohanty Rs. 30,000.

Revision 13

Mahesh and Dinesh share profits and losses in the ratio of 2:1. From January 01, 2014 they admit Rakesh into their firm who is to be given a share of 1/10 of the profits with a guaranteed minimum of Rs. 25,000. Mahesh and Dinesh continue to share profits as before but agree to bear any deficiency on account of guarantee to Rakesh in the ratio of 3:2 respectively. The profits of the firm for the year ending December 31, 2015 amounted to Rs. 1,20,000. Prepare Profit and Loss Appropriation Account.

Books of Mahesh and Dinesh Profit  and Loss

Appropriation Account for the year ending .....

Working Notes:

New profit sharing Ratio will be calculated as follows:

Rakesh to share 1/10 of the profit. The remaining profit 9/10 will be shared by Mahesh and Dinesh in the ratio of 2:1.

Mahesh’s share in profit will be  2/3 × 9/10 = 3/10

Dinesh’s share will be 1/3 × 9/10 = 3/10

The New ratio become3/5 : 3/10 : 1/10 or 6:3:1

Mahesh’s share in profit = 1,20,000 ×  6/10 = Rs. 72,000,

Dinesh’s share in profit = Rs. 36,000,

Rakesh’s share in profit = Rs. 12,000.

 

Deficiency of Rakesh (Rs. 13,000) will be shared by Mahesh and Dinesh in the ratio of 3:2.

Mahesh will bear  3/5 of 13,000, i.e. Rs. 7,800 and Rakesh,  2/5 of Rs. 13,000, i.e. Rs. 5,200.

Thus, the profits of the firm will be shared as follows.

Mahesh will get Rs. 72,000 – Rs. 7,800 = Rs. 64,200.

Dinesh will get Rs. 36,000 – Rs. 5,200 = Rs. 30,800

Rakesh will get Rs. 12,000 + Rs. 7,800 + Rs. 5,200 = Rs. 25,000

 

Past Adjustments

Sometimes a few omissions or errors in the recording of transactions or the preparation of summary statements are found after the final accounts have been prepared and the profits distributed among the partners. The omission may be in respect of interest on capitals, interest on drawings, interest on partnersloan, partner’s salary, partner’s commission or outstanding expenses. There may also be some changes in the provisions of partnership deed or system of accounting having impact with retrospective effect. All these acts of omission and commission need adjustments for correction of their impact. Instead of altering old accounts, necessary adjustments can be made either; (a) through ‘Profit and Loss Adjustment Account’, or (b) directly in the capital accounts of the concerned partners. This is explained with the help of following example.

Rameez and Zaheer are equal partners. Their capitals as on April 01, 2015 were Rs. 50,000 and Rs. 1,00,000 respectively. After the accounts for the financial year ending March 31, 2016 have been prepared, it is discovered that interest at the rate of 6 per cent per annum, as provided in the partnership deed has not been credited to the partnerscapital accounts before distribution of profit. In this case, the interest on capital not credited to the partnerscapital accounts works out to be Rs. 3000 (6/100 × Rs. 50,000) for Rameez and Rs. 6,000 (6/100 × Rs. 1,00,000) for Zaheer. Had the interest on capital been duly provided, the firm’s profit would have reduced by Rs. 9,000. By this omission, the whole amount of profit as per Profit and Loss Account (without adjustment of Rs. 9,000) has been distributed among the partners in their profit sharing ratio, and the amounts of interest on capital have not been credited to their capital accounts. This error can be rectified in any of the following ways;

(a) Through Profit and Loss Adjustment Account

(b) Directly in PartnersCapital Accounts

For direct adjustment in partnerscapital accounts first a statement to ascertain the net effect of omission on partnerscapital accounts will be worked out as follows and then the adjustment entries can be recorded.

Statement Showing  Net Effect  of Omitting Interest  on Capital

The statement shows that Rameez has got excess credit of Rs. 1,500 while Zaheer’s account has been credited less by Rs. 1,500. In order to rectify the error Rameez’s capital account should be debited and that of Zaheer, credited with Rs. 1,500 by passing the following journal entry;

journal entry.

Rameez’s Capital A/c                                            Dr.        1,500

To Zaheer’s Capital A/c                                 1,500 (Adjustment for omission of interest on capital)

Revision 14

Nusrat, Sonu and Himesh are partners sharing profits and losses in the ratio of 5 : 3 : 2. The partnership deed provides for charging interest on drawing’s @ 10% p.a. The drawings of Nusrat, Sonu and Himesh during the year ending March 31, 2015 amounted to Rs. 20,000, Rs. 15,000 and Rs. 10,000 respectively. After the final accounts have been prepared, it was discovered that interest on drawings has not been taken into consideration. Give necessary adjusting journal entry.

Statement showing  Net  Effect  of  Omitting Interest  on  Drawings

 

Journal Entry for adjustment of interest on drawings would be:

Summary

1. Definition of partnership and its essential features: Partnership is defined as “Relation between persons who have agreed to share the profits of a business carried on by all or any one of them acting for all”. The essential features of partnership are : (i) To form a partnership, there must be at least two persons; (ii) It is created by an agreement; (iii) The agreement should be for carrying on some legal business; (iv) sharing of profits and losses; and (v) relationship of mutual agency among the partners.

2Meaning and contents of partnership deed: A document which contains the terms of partnership as agreed among the partners is called ‘Partnership Deed’. It usually contains information about all aspects affecting relationship between partners, including objective of business, contribution of capital by each partner, ratio in which profit and losses will be shared by the partners, entitlement of partners to interest on capital, interest on loan and the rules to be followed in case of admission, retirement, death, dissolution, etc.

3. Provisions of Partnership Act 1932 applicable to accounting: If partnership deed is silent in respect of certain aspects, the relevant provisions of the Indian Partnership Act, 1932 become applicable. According to the Partnership Act, the partners share profits equally, no partner is entitled to remuneration, no interest on capital is allowed and no interest on drawings is charged. However, if any partner has given some loan to the firm, he is entitled to interest on such amount @ 6% per annum.

4. Preparation of capital accounts under fixed and fluctuating capital methods: All transactions relating to partners are recorded in their respective capital accounts in the books of the firm. There can be two methods of maintaining Capital Accounts. These are; (i) fluctuating capital method, (ii) fixed capital method. Under fluctuating capital method, all the transactions relating to a partner are directly recorded in the capital account. Under fixed capital method, however the amount of capital remains fixed, the transactions like interest on capital, drawings, interest on drawings, salary, commission, share of profit or loss are recorded in a separate account called ‘Partner’s Current Account’.

5. Distribution of profit and loss: The distribution of profits among the partners is shown through a Profit and Loss Appropriation Account, which is merely an extension of the Profit and Loss Account. It is usually debited with interest on capital and salary/commission allowed to the partners, and credited with net profit as per Profit and Loss Account and the interest on drawings. The balance being profit or loss is distributed among the partners in the profit sharing ratio and transferred to their respective capital accounts.

6. 6. Treatment of guarantee of minimum profit to a partner: Sometimes, a partner may be guaranteed a minimum amount by way of his share in profits. If, in any year, the share of profits as calculated according to his profit sharing ratio is less than the guaranteed amount, the deficiency is made good by the guaranteeing partnersin the agreed ratio which usually is the profit sharing ratio. If, however, such guarantee has been given by any of them, he or they alone shall bear the amount of deficiency.

7. Treatment of past adjustments: If, after the final accounts have been prepared, some omission or commissions are noticed say in respect of the interest on capital, interest on drawings, partner’s salary, commission, etc. necessary adjustments can be made in the partner’s capital accounts through the Profit and Loss Adjustment Account, to rectify the same.

8 Preparation of final accounts of a partnership firm: There is not much difference in the final accounts of a sole proprietary concern and that of a partnership firm except that in case of a partnership firm an additional account called Profit and Loss Appropriation Account is prepared to show distribution of profit and loss among the partners.

3. Guarantee of profit to a partner, Past adjustments, Final accounts

Guarantee of Profit

  • In some cases, a partner may be admitted in the firm on a guarantee in respect of his minimum profit from the business.
  • Such a guarantee may be given to an existing partner as well.
  • Such a guarantee to the incoming partner is given ;
  • All the old partners in agreed ratio
  • Some of the old partners

When all the partners guarantee that one of the partners shall be given a minimum amount of profit, the following amounts have to be calculated separately

  • Share of profit as per profit sharing ratio
  • Minimum Guaranteed Profit
  • The minimum of the above two is given to that partner & the balance of profit (i.e. total profit – profit given to the guaranteed partner) is shared by the remaining partners in the profit-sharing ratio.
  • If the partner’s actual share of profit turns out to be more than the guaranteed profit then in that case the partner will be given the actual amount instead of the guaranteed amount.
  • When one or more than one partner guarantees a minimum profit, the adjustment is made through the partner’s capital accounts. The following steps are followed;
  • Distribute the profit among the partners in their profit sharing ratio
  • If the share of the guaranteed profit of the partner falls short of the minimum amount then the difference is deducted from the original share of profit of the partners who guarantee & it is added with the original share of profit of the guaranteed partner.
  • When two or more partners give guarantee, the shortfall is shared by them in the agreed ratio or in their profit-sharing ration as the case may be.
  • Accounting Treatment of Guarantee of Profit in case of Loss
  • Sometimes it is possible that the firm has incurred losses but the guaranteed profit is to be paid to the partner who has been guaranteed minimum profit. In such a case, the adjustment has to be made through partner’s capital A/c in the following manner;​​​​​​
  1. Distribute the loss among the partners in their profit sharing ratio
  2. Capital A/c of the guaranteed partner is credited with guaranteed minimum profit plus the amount of loss. This amount is debited to remaining partners in their profit sharing ratio or to the debit of the partner who has guaranteed minimum profit.

Past Adjustments

Sometimes, after the final accounts of a firm have been closed, it is found that certain matters have been left out by mistake. In such cases, instead of altering the final accounts which have already been closed, the firm rectifies the error or omission by passing an adjustment entry in the beginning of the financial year. Such adjustments are called past adjustments as they relate to the past.
Steps to pass adjusting journal entry:

Step 1 Calculate the amount already recorded.
Step 2 Calculate the amount which should have been recorded.
Step 3 Calculate the difference between Step 1 and Step 2.
Step 4 Find out the partner who received excess and the partner who received short.
Step 5 Pass the adjusting journal entry by debiting the partner who received excess and by crediting the partner who received short.

PREPARATION OF FINAL ACCOUNTS OF PARTNERSHIP FIRM

Final accounts of a partnership firm are prepared in the usual way in which they are prepared for a sole proprietorship concern except that the profits in the partnership have to be distributed among the various partners according to the terms of the partnership contract and the amount of profit may be arrived at after making adjustments for interest on capital, interest on drawings, salaries to partners, etc. for this another account “Profit & Loss Appropriation Account” is prepared after preparing Profit & Loss Account.

The final accounts prepared by partnership firms are:

a)     Manufacturing account – if manufacturing activity is carried on

b)    Trading and profit and loss account – to ascertain profitability

c)     Profit and loss appropriation account – to show the disposal of profits and surplus

d)    Balance sheet – to ascertain the financial status.

1. Modes of reconstitution of a partnership firm, Admission of a new partner

(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)

 

1. Modes of reconstitution of a partnership firm, Admission of a new partner

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 partnersrole 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.

1. Dissolution of partnership, Dissolution of firm

Dissolution of Partnership & Dissolution of Firm are not the same thing. Whenever there is a change in constitution of the firm, the business of the firm continues. There is a change in constitution in case of admission, retirement & death of a partner. This change leads to dissolution of partnership & not dissolution firm. The relationship between the partners changes but the overall business of the firm continues as usual. However, in the case of dissolution of partnership firm, both the partnership & the business comes to an end. Dissolution of the firm is the end of partnership business. Dissolution of partnership occurs due to the following reasons;

  1. Due to the admission of a new partner
  2. Due to the retirement of a new partner
  3. When a partner is declared insolvent
  4. When the profit-sharing ratio is changed

1. Dissolution of partnership, Dissolution of firm

CHAPTER -5

Dissolution  of Partnership  Firm

You have learnt about the reconstitution of a partnership firm which takes place on account of admission, retirement or death of a partner. In such a situation while the existing partnership is dissolved, the firm may continue under the same name if the partners so decide. In other words, it results in the dissolution of a partnership but not that of the firm. According to Section 39 of the partnership Act 1932, the dissolution of partnership between all the partners of a firm is called the dissolution of the firm.
That means the Act recognises the difference in the breaking of relationship between all the partners of a firm and between some of the partners; and it is the breaking or discontinuance of relationship between all the partners which is termed as the dissolution of partnership firm. This brings an end to the existence of firm, and no business is transacted after dissolution except the activities related to closing of the firm as the affairs of the firm are to be wound up by selling firm's assets and paying its liabilities and discharging the claims of the partners.

Dissolution  of Partnership

As stated earlier dissolution of partnership changes the existing relationship between partners but the firm may continue its business as before. The dissolution of partnership may take place in any of the following ways:

  1. Change in existing profit sharing ratio among partners
  2. Admission of a new partner
  3. Retirement of a partner
  4. Death of a partner
  5. Insolvency of a partner
  6. Completion of the venture, if partnership is formed for that
  7. Expiry of the period of partnership, if partnership is for a specific period of time 

1. Ascertaining the amount due to the retiring or deceased partner, New profit sharing ratio, Gaining ratio,

Reconstitution of the partnership firm can also take place on the retirement of the partner or death of the partner. Here, the existing partnership deed comes to an end a new partnership deed comes into existence where the remaining partners continue to do the business but on different terms and conditions. In both cases, i.e. on retirement or death of a partner, it is required to determine the sum due to the retiring partner or to the legal representatives of the deceased partner.

Retirement of a Partner:
A partner may retire from the partnership firm:

  1. with the consent of all other partners;
    or
  2. in case of retirement at will i.e. (partnership at will);
    or
  3. by giving notice in writing to all other partners by the retiring partner.

On retirement, the old partnership comes to an end arid a new one between the remaining partner1 comes into existence. However the partnership firm as such continues.

Ascertaining the Amount due to Retiring Partner

In order to ascertain the amount due to the retiring partner, we have to calculate the following things

  1. Credit Balance of his Capital Account;
  2. Credit Balance of his Current Account (if any);
  3. His share of goodwill, accumulated profits, reserves etc.;
  4. His share in the profit on revaluation of assets and liabilities;
  5. His share of profit, interest on capital up to the date of retirement;
  6. Any salary/commission due to him.

The following deductions (if any) is made from his share:

  1. Debit balance of the his-current account (if any);
  2. His share of Goodwill to be written off, accumulated losses;
  3. His share of loss on revaluation of assets and liabilities;
  4. His share of loss, drawing and interest on drawings up to the date of retirement.

The various accounting aspects involved in retirement or death are as follows:

  1. New profit sharing ratio
  2. Gaining ratio
  3. Goodwill Treatment
  4. Accumulated profit and losses -Distribution
  5. Profit and Loss till the date of retirement or death
  6. Adjustment of Capital
  7. Settlement of the amount due to retired /deceased partner.

New Profit Sharing Ratio:
The new profit sharing ratio is the ratio in which the remaining partners will share future profits after the retirement or death of any partners. In other words, the new profit sharing ratio of each remaining partner will be the sum total of his old share of profits in the firm and the portion of the retiring partner’s share of the profit acquired.

New Share of Partner = Old share + Acquired share from retiring/deceased partner.

(a) Nothing is mentioned about the new profit sharing ratio at the time of retirement:
If nothing is stated about the future ratio of the remaining partner, then their old ratio is considered as their new ratio. In other words, in the absence of any information regarding the profit-sharing ratio in which the remaining partner acquires the share of the retiring/deceased partner, then it is assumed that they will acquire it in the old profit-sharing ratio and so the share the future profits in their old ratio.

For example, Kapil, Anu and Priti are partners in a firm sharing profits and losses in the ratio of 5: 3: 2. If Anu retires, then the new profit sharing ratio of Kapil and Priti will be 5: 2.

(b) Remaining partners acquire the share of retiring/deceased partner in the specified ratio:
If the remaining partners acquire the share of the retiring/deceased partner in a specified ratio, other than their old ratio, then there is a need to compute a new profit sharing ratio among them. The new profit sharing ratio is equal to the sum total of their old ratio and the share acquired from the retiring/deceased partner.

For example, Kapil, Anu and Priti are partners in a firm sharing profits and losses in the ratio of 5: 3: 2. If Anu retires from the firm and her share was acquired by Kapil and Priti in the ratio of 2: 1. In that case, the new share of profit will be calculated as follows: New share of remaining partner = Old share + Acquired share from the outgoing partner.

(c) Remaining partners may agree on a particular new profit sharing ratio:
If the remaining partners decide on a particular profit sharing ratio to share the future profits of the firm, in such a case the ratio so specified will be the new profit sharing ratio.

Gaining Ratio:

The ratio in which the continuing partners acquire the share of the retiring /deceased partner is called the gaining ratio.
(a) If nothing is mentioned in the agreement: If nothing is mentioned in the agreement about the gaining ratio, then it is assumed that the remaining partners acquire the share of the retiring/deceased partner in their old profit sharing ratio. In that case, the gaining ratio of the remaining partners will be the same as their old profit sharing ratio and there is no need to compute the gaining ratio.

(b) If a new profit sharing ratio is given: If the new profit sharing ratio is given of the remaining partners then we have to compute the gaining ratio. In this case, the gaining ratio is calculated by deducting the old ratio from the new ratio.
Gaining ratio = New ratio – Old ratio

For example X, Y and Z are partners in a firm, sharing profits and losses in ratio of 5:3:2. Y retires from the firm and X and Z decide to share future profits and losses in the ratio of 7: 5

The gaining ratio will be calculated as follows:

 

1. Ascertaining the amount due to the retiring or deceased partner, New profit sharing ratio, Gaining ratio,

CHAPTER-4

Reconstitution of a Partnership Firm – Retirement/Death of a Partner

         Ascertaining the Amount  Due to Retiring/ Deceased  Partner

You have learnt that retirement or death of a partner also leads to reconstitution of a partnership firm. On the retirement or death of a partner, the existing partnership deed comes to an end, and in its place, a new partnership deed needs to be framed whereby, the remaining partners continue to do their business on changed terms and conditions.
There is not much difference in the accounting treatment at the time of retirement or in the event of death. In both the cases, we are required to determine the sum due to the retiring partner (in case of retirement) and to the legal representatives (in case of deceased partner) after making necessary adjustments in respect of goodwill, revaluation of a assets and liabilities and transfer of accumulated profits and losses. In addition, we may also have to compute the new profit sharing’s ratio among the remaining partners and so also their gaining ratio, This covers all these aspects in detail.

The sum due to the retiring partner (in case of retirement) and to the legal representatives/ executors (in case of death) includes:

(i) credit balance of his capital account;

(ii) credit balance of his current account (if any); (iii) his share of goodwill;

(iv) his share of accumulated profits (reserves);

(v) his share in the gain of revaluation of assets and liabilities;

(vi) his share of profits up to the date of retirement/death;

(vii) interest on his capital, if involved, up to the date of retirement/death; and

(viii) salary/commission, if any, due to him up to the date of retirement/death.

The following deductions, if any, may have to be made from his share:

(i) debit balance of his current account (if any);

(ii) his share of goodwill to be written off, if necessary;

(iii) his share of accumulated losses;

(iv) his share of loss on revaluation of assets and liabilities;

(v) his share of loss up to the date of retirement/death;

(vi) his drawings up to the date of retirement/death;

(vii) interest on drawings, if involved, up to the date of retirement/death.

Thus, similar to admission, the various accounting aspects involved on retirement or death of a partner are as follows:

1. Ascertainment of new profit sharing ratio and gaining ratio;

2. Treatment of goodwill;

3. Revaluation of assets and liabilities;

4. Adjustment in respect of unrecorded assets and liabilities;

5. Distribution of accumulated profits and losses;

6. Ascertainment of share of profit or loss up to the date of retirement/death;

7. Adjustment of capital, if required;

8. Settlement of the amounts due to retired/deceased partner;

 

New Profit  Sharing Ratio

New profit sharing ratio is the ratio in which the remaining partners will share future profits after the retirement or death of any partner. The new share of each of the remaining partner will consist of his own share in the firm plus the share acquired from the retiring deceased partner.

Consider the following situations :

(a) normally, the continuing partners acquire the share of retiring or deceased partners in the old profit sharing ratio, and there is no need to compute the new profit sharing ratio among them, as it will be same as the old profit sharing ratio among them. In fact, in the absence of any information regarding profit sharing ratio in which the remaining partners acquire the share of retiring/deceased partner, it is assumed that they will acquire it in the old profit sharing ratio and so share the future profits in their old ratio. For example, Asha, Deepti and Nisha are partners in a firm sharing profits and losses in the ratio of 3:2:1. If Deepti retires, the new profit sharing ratio between Asha and Nisha will be 3:1, unless they decide otherwise.

(b) The continuing partners may acquire the share in the profits of the retiring/deceased partner in a proportion other than their old ratio, In that case, there is need to compute the new profit sharing ratio among them. For example: Naveen, Suresh and Tarun are partners sharing profits and losses in the ratio of 5:3:2. Suresh retires from the firm and his share was required by Naveen and Tarun in the ratio 2:1.

 In such a case, the new share of profit will be calculated as follows:

New share of Continuing Partner = Old Share + Acquired share from the Outgoing Partner

Gaining Ratio 2 : 1

Share acquired by Naveen  

 =2/3 of  3/10

= 2/3  × 3/10 = 1/5 or 2/10

Share acquired by Tarun        

= 1/3  of  3/10

= 1/3 × 3/10 = 3/30 or 1/10

Share of Naveen                    

  = 5/10 + 2/10 = 7/10

Share of Tarun                      

 = 2/10 + 1/10 =  3/10

Thus, the new profit sharing ratio of Naveen and Tarun will be = 7 : 3.

(c) The contributing partners may agree on a specified new profit sharing ratio: In that case the ratio so specified will be the new profit sharing ratio.

Gaining Ratio

The ratio in which the continuing partners have acquired the share from the retiring/deceased partner is called the gaining ratio. Normally, the continuing partners acquire the share of retiring/deceased partner in their old profit sharing ratio, In that case, the gaining ratio of the remaining partners will be the same as their old profit sharing ratio among them and there is no need to compute the gaining ratio, Alternatively, proportion in which they acquire the share of the retiring/deceased partner may be duly spacified. In that case, again, there is no need to calculate the gaining ratio as it will be the ratio in which they have acquired the share of profit from the retiring deceased partner.

The problem of calculating gaining ratio arises primarily when the new profit sharing ratio of the continuing partners is specified. In such a situation, the gaining ratio should be calculated by, deducting the old share of each continuing partners from his new share i.e., new profit share minus old profit share, i.e., new profit share minus old profit share. For example, Amit, Dinesh and Gagan are partners sharing profits in the ratio of 5:3:2. Dinesh retires. Amit and Gagan decide to share the profits of the new firm in

the ratio of 3:2.

The gaining ratio will be calculated as follows :

Amit’s Gaining Share   =   3/5  − 5/10  =  6 – 5/10 =   1/10 

Gagan’s Gaining Share       =   2/5  −  2/10  =  4 – 2/10  =  2/10

Thus, Gaining Ratio of Amit and Gagan = 1:2

This implies Amit gains  1/3 and Gagan gains 2/3 of Dinesh’s share of profit.

Gaining share of Continuing  Partner  = New share – Old share.

Revision  1

Madhu, Neha and Tina are partners sharing profits in the ratio of 5:3:2. Calculate new profit sharing ratio and gaining ratio if

1. Madhu retires

2. Neha retires

3. Tina retires.

Solution

Given old ratio among   Madhu :  Neha : Tina as 5 : 3 : 2

  1. If  Madhu retires, new profit sharing Ratio between Neha and Tina will be Neha : Tina = 3:2 and Gaining Ratio of Neha and Tina =3:2
  2. If  Neha retires new profit sharing Ratio between Madhu and Tina will be Madhu : Tina = 5:2 Gaining Ratio of Madhu and Tina = 5:2
  3. If  Tina retires, new profit sharing ratio between Madhu and Neha will be: Madhu : Neha = 5:3 Gaining ratio of Madhu and Neha = 5:3

Revision  2

Alka, Harpreet and Shreya are partners sharing profits in the ratio of 3:2:1. Alka retires and her share is taken up by Harpreet and Shreya in the ratio of 3:2. Calculate the new profit sharing ratio.

Solution

Gaining Given, Ratio of Harpreet and Shreya  = 3:2 =  3/5 :  2/5

Old Profit Sharing Ratio of between Alka, Harpreet and Shreya 3:2:1

 = 3/6 : 2/6  : 1/6

Share acquired by Harpreet 

 = 3/5 of  3/6  =  9/30

Share acquired by Shreya    

 =   2/5 of  3/6 = 6/30

New Share    =  Old Share + Acquired Share

Harpreet’s New Share            

=   2/6  +  9/30  =  19/30

Shreya’s New Share             

 =   1/6  +  6/30   =  11/30

New Profit Sharing Ratio of Harpreet and Shreya  =  19:11

Revision  3

Murli, Naveen and Omprakash are partners sharing profits in the ratio of 3/8 , 1/2 and  1/8 . Murli retires and surrenders 2/3rd of his share in favour of Naveen and the remaining share in favour of Omprakash. Calculate new profit sharing and the gaining ratio of the remaining partners.

Solution

(i)   Old Share = Naveen   ½ and   Omprakash 1/8

(ii)  Share Acquired by Naveen from Murli

=    2/3 of  3/8 =  2/8

(iii) Share Acquired by Omprakash from Murli

= 1/3 of  3/8 = 1/8

(iv)   New Share  for  Naveen 

= (i) + (ii)  =   ½  +  2/8  = 6/8 or 3/4

(v)   New Share  for  Omprakash

= (i) + (iii)  = 1/8 + 1/8 =  2/8 or 1/4

Thus, the New profit sharing Ratio =  ¾  : ¼  or 3:1

 and the Gaining Ratio =  2/8  : 1/8  or 2 : 1

Revision 4

Kumar, Lakshya, Manoj and Naresh are partners sharing profits in the ratio of 3 : 2 : 1 : 4. Kumar retires and his share is acquired by Lakshya and Manoj in the ratio of 3:2. Calculate new profit sharing ratio and gaining ratio of the remaining partners.

Solution

Thus, the new profit sharing ratio = ¾ : ¼ or 3 : 1 and the Gaining ratio = 2/8 : 1/8 or 2 : 1 {as calculated in (ii)}.

Revision 4

Kumar, Lakshya, Manoj and Naresh are partners sharing profits in the ratio of 3 : 2 : 1 : 4. Kumar retires and his share is acquired by Lakshya and Manoj in the ratio of 3:2. Calculate new profit sharing ratio and gaining ratio of the remaining partners.

Solution

The New Profit Sharing Ratio is 19 : 11 : 20

Gaining ratio is 3 : 2 : 0

Notes : 

1.   Since Lakshya and Manoj are acquiring Kumar’s share of profit in the ratio of  3:2, hence, the gaining ratio will be 3:2 between Lakshya and Manoj.

2.   Naresh has neither sacrificed nor gained.

Revision  5

Ranjana, Sadhna and Kamana are partners sharing profits in the ratio 4:3:2. Ranjana retires; Sadhna and Kamana decided to share profits in future in the ratio of 5:3. Calculate the Gaining Ratio.

Solution

Gaining Share     =    New Share – Old Share

Sadhna’s Gaining Share      =     5/8 – 3/9 = 45 – 24/72 = 21/72

Kamana’s Gaining Share = 3/8 – 2/9 = 27 -16 / 72 = 11/72

Gaining Ratio between Sadhna and Kamana  =  21:11

2. New profit sharing ratio, Sacrificing Ratio

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.

  1. 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.

  1. 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.

  1. 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.

  1. 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.

  1. 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.

2. New profit sharing ratio, Sacrificing Ratio

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 the new partner acquires 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 Revisions.

Revision 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

Sumit’s share = 1/5

Remaining share  =  1 – 1/5 = 4/5

Anil’s new share       = 3/5 × 4/5 =12/25

Vishal’s new share   =   2/5 × 4/5 = 8/25

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

Revision 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

Dinesh’s share = 1/5 or 2/10

Akshay’s share = 3/5 – 1/10 = 5/10

Bharti’s share = 2/5 – 1/10 = 3/10

New profit sharing ratio between Akshay, Bharati and Dinesh will be 5:3:2.

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.

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

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 as premium for goodwill. This amount is shared by the existing partners in the ratio in which they forgo 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 Revisions 6 to 8 and see how sacrificing ratio is calculated in such a situation.

Revision  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

Rohit’s old share  = 5/8

Rohit’s new share = 4/7

Rohit’s sacrifice  = 5/8 – 4/7 = 3/56

Mohit’s old share = 3/8

Mohit’s new share  = 2/7

Mohit’s sacrifice  = 3/8 – 2/7 = 5/56

Sacrificing ratio among Rohit and Mohit will be 3:5.

Revision 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.

Solution

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.

3. Goodwill - Meaning, Nature & Valuation

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.

3. Goodwill - Meaning, Nature & Valuation

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.

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 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,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 earningsor 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.

Factors Affecting the Value of Goodwill

The main factors affecting the value of goodwill are as follows:

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.

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 yearspurchase 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 yearsaverage 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 yearspurchase

=  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).

FirmsCapital = 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 yearspurchase 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

 

 

4. Adjustments of accumulated profits & losses,

Adjustment for Accumulated (Undistributed) Profits and Losses:
1. For Undistributed Profits, Reserves etc.
(For distribution of accumulated profits and reserves to old partners in old profit sharing ratio)
General Reserves A/c Dr.
Reserve fund A/c Dr.
Profit and Loss A/c Dr.
Workmen’s Compensation Fund A/c Dr.
To Old Partner’s Capital A/c’s
(For distribution of accumulated profits and reserves to old partners in old profit sharing ratio)

2. For Undistributed Losses:
Old Partner’s Capital A/c’s Dr.
To Profit and Loss A/c
(For distribution of accumulated losses to old partners in old profit sharing ratio)

Revaluation of Assets and Reassessment of LiabilitiesRevaluation of Assets and Reassessment of Liabilities is done with the help of ‘Revaluation Account’ or ‘Profit and Loss Adjustment Account’.

The journal entries recorded for revaluation of assets and reassessment of liabilities are the following:
1. For increase in the value of an Assets
Assets A/c Dr.
To Revaluation A/c (Gain)

2. For decrease in the value of an Assets
Revaluation A/c Dr.
To Assets A/c (Loss)

3. For appreciation in the amount of Liability
Revaluation A/c Dr.
To Liability A/c (Loss)

4. For reduction in the amount of a Liability
Liability A/c Dr.
To Revaluation A/c (Gain)

5. For recording an unrecorded Assets
Unrecorded Assets A/c Dr.
To Revaluation A/c (Gain)

6. For recording an unrecorded Liability
Revaluation A/c Dr.
To Unrecorded Liability A/c (Loss)

7. For the sale of unrecorded Assets
Cash A/c or Bank A/c Dr.
To Revaluation A/c (Gain)

8. For payment of unrecorded Liability
Revaluation A/c Dr.
To Cash A/c or Bank A/c (Loss)

9. For transfer of gain on Revaluation if the credit balance
Revaluation A/c Dr.
To Old Partner’s Capital A/c’s (Old Ratio)

10. For transfer of loss on Revaluation if debit balance
Old Partner’s Capital A/c’s Dr.
To Revaluation A/c (Old Ratio)

 

Adjustment of Capitals:
1. When the new partner brings in proportionate capital OR On the basis of the old partner’s capital.
(a) Calculate the adjusted capital of old partners (after all adjustments)

(b) Total capital of the firm
= Combined Adjusted Capital × Reciprocal proportion of the share of old partners

(c) New Partner’s Capital
= Total Capital × Proportion of share of a new partner.

2. On the basis of the new partner’s capital:
(a) Total Capital of the firm = New Partner’s Capital × Reciprocal proportion of his share.
(b) Distribute Total Capital in New Profit Sharing Ratio.
(c) Calculate adjusted capital of old partners.
(d) Calculate the difference between New Capital and Adjusted Capital.

  1. If the debit side of the Capital Account is bigger then it means he has excess capital
    Partner’s ( capital Accounts                           Dr.
    To Cash A /c or Bank A/c or Current A/c
  2. If the credit side is bigger then it means that he has short capital
    Cash A/c or Bank A/c or Current A/c          Dr.
    To Partner’s Capital A/c’s

Change in Profit Sharing Ratio among the Existing Partners:

Sometimes the existing partners of the firm may decide to change their profit-sharing ratio. In such a case, some partners will gain in future profits and some will lose. Here the gaining partners should compensate the losing partners unless otherwise agreed upon. In such a situation, first of all, the loss and gain in the value of goodwill (if any) will have to adjust.
1. Goodwill A/c Dr.
To Partner’s Capital A/c’s (For raising the amount of Goodwill in old ratio)

2. Partner’s Capital A/c’s Dr.
To Goodwill A/c
(For writing off the amount of Goodwill in New Profit sharing ratio)

Alternatively:
Gaining Partner’s Capital A/c’s Dr.
To Losing Partner’s Capital A/c’s (For adjustment due to change in profit sharing ratio)

Accounting Treatment of Goodwill

In case of change in profit sharing ratio, the gaining partner must components the sacrificing partner by paying the proportionate amount of goodwill.

Note :(i) Increase in the value of an Asset and decrease in the value of a liability result in profit.

Assets A/cDr.

To Revaluation

(ii) Decrease in the value of any asset and increase in the value of liability gives loss.

Revaluation A/cDr.

To Assets A/c

(iii) For an increase in the value of liabilities.

Revaluation A/cDr.

To Liabilities A/c

(Increase in value of Liability)

(iv) For a decrease in the value of Liabilities

Liabilities A/cDr.

To Revaluation A/c

(Decrease in the value of Liabilities)

(v) When the Revaluation account shows profit

Revaluation A/cDr.

To Partner’s Capital A/c

(Profit credited to Partner’s Capital A/c in old ratio)

(vi) In case of Revaluation Loss

Partner’s Capital A/c’sDr.

To Revaluation A/c

(Loss debited to Partner’s Capital A/cs in old ratio)

4. Adjustments of accumulated profits & losses,

Adjustment  for Accumulated  Profits  and Losses And Revaluation of Assets  and Reassessment  of Liabilities

Sometimes a firm may have accumulated profits not yet transferred to capital accounts of the partners. These are usually in the form of general reserve, reserve and/or Profit and Loss Account. 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 current 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 and/or deferred revenue expenditure appearing in the balance sheet of the firm. It  should  be  transferred  to  the  old  partners’  capital  accounts  (see Revision 23).

Revision  23

Rajinder and Surinder are partners in a firm sharing profits in the ratio of 4:1. On April 15, 2017 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

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 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

Asset A/c                                                      Dr.

Note:  Entries (i), (ii), (iii) and (iv) are recorded only with the amount increase and decrease in the value of assets and liabilities.

Revision  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

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  

Revaluation Account

Partner’s  Capital  Accounts

            Revision 25

  Given below is the Balance Sheet of A and B, who are carrying on partnership business as on March 31,2017. A and B share profits in the ratio of 2:1.

  Balance Sheet of A and B as at March 31, 2017

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       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, partnerscapital accounts, and the Balance Sheet of the constituted firm after admission of the new partner.

Solution

Books of A and B Revaluation Account

Partners’  Capital  Accounts

 

Balance Sheet of A, B and C as on April 01, 2016

Adjustment  of Capitals

Sometimes, at the time of admission, the partners agree that their capitals should also be adjusted so as to be proportionate to their profit sharing ratio. In such a situation, if the capital of the new partner is given, the same can be used as a base for calculating the new capitals of the old partners. The capitals thus ascertained should be compared with their old capitals after all adjustments relating to goodwill reserves and revaluation of assets and liabilities, etc. have been made; and then the partner whose capital falls short, will bring in the necessary amount to cover the shortage and the partner who has a surplus, will withdraw the excess amount of capital. (See Revision 26)

Revision 26

A and B are partners sharing profits in the ratio of 2:1. C is admitted into the firm for 1/4 share of profits. C brings in Rs. 20,000 in respect of his capital. The capitals of old partners A and B, after all adjustments relating to goodwill, revaluation of assets and liabilities, etc., are Rs. 45,000 and Rs. 15,000 respectively. It is agreed that partners’ capitals should be according to the new profit sharing ratio.

Determine the new capitals of A and B and record the necessary journal entries assuming that the partner whose capital falls short, brings in the amount of deficiency and the partner who has an excess, withdraws the excess amount.

Solution

Calculation of new profit sharing ratio: Assuming the new partner C quires his share from A and B in their old profit sharing ratio, i.e 2:1.

Total Share    = 1

C’s Share  = ¼

Remaining Shares = 1- ¼ - ¾

A’s New Share = ¾ × 2/3 – 6/12

B’s New Share = ¾ × 1/5 – 3/12

C’s New Share = ¼ × 3/5 – 3/12

Thus, new profit sharing ratio between A,B and C is 6:3:3 or 2:1:1.

Required Capital of A and B

C’s capital (who has 1/4 share in profits) is Rs. 20,000. B’s new share in profits

1/4. Hence his capital will also be Rs. 20,000. A’s new share is 2/4 which is double of C’s share.  Hence his capital will be Rs. 40,000.

Alternatively, based on C’s capital, the total capital of the firm works out at Rs. 80,000 (4/1 × Rs.20,000). Hence, based on their share in profits, the capital of A and B will be:

A’s capital = 2/4 of 80, 000 = Rs 40, 000

B’s capital = ¼ of 80, 000 = Rs 20,000

The capital of A and B after all adjustments have been made, are Rs. 45,000 and Rs. 15,000 respectively.  Hence, A will withdraw Rs. 5,000 (Rs. 45,000– Rs.40,000) from the firm whereas B will contribute additional amount of Rs. 5,000 (Rs. 20,000–Rs.15,000). The journal entries will be :

Sometimes, the total capital of the firm may clearly be specified and it is agreed that the capital of each partner should be proportionate to his share in profits. In such a situation each partner’s capital (including the new partner’s capital to be brought by him) is calculated on the basis of his share in profits. By bringing in additional amount or withdrawal of excess amount, the final capital of each partner can be brought up to the required level. It may be noted that subject to agreement among the partners, surplus or deficiency in each old partnerscapital accounts can also be taken care of simply by transfer to their respective current accounts. (See Revision 27)

Revision 27

A, B and C are partners in a firm sharing profits the ratio of 3:2:1. D is admitted into the firm for 1/4 share in profits, which he gets as 1/8 from A and 1/8 from B. The total capital of the firm is agreed upon as Rs. 1,20,000 and D is to bring in cash equivalent to 1/4 of this amount as his capital. The capitals of other partners are also to be adjusted in the ratio of their respective shares in profits. The capitals of A, B and C after all adjustments are Rs. 40,000, Rs. 35,000 and Rs. 30,000 respectively. Calculate the new capitals of A,B and C, and record the necessary journal entries.

Solution

Calculation of new profit sharing ratio:

A = ½ - 1/8 = 3/8

B = 1/3 – 1/8 = 5/24

C will continue to get 1/6 as his share in the profits.

Thus, the new profit sharing ratio between A,B,C and D will be:

3/8 : 5/24 : 1/6  or 9/24 : 5/ 24 : 4/24 : 6/24 or 9 : 5 : 4 : 6

Required capitals of all partners:

A’s Capital      =  Rs. 1,20,000 = 9/24 = Rs 45, 000

B’s Capital     =  Rs. 1,20,000 × 5/24 = Rs 25, 000

C’s Capital      =  Rs. 1,20,000 × 4/24 = Rs 20, 000

D’s Capital      =  Rs. 1,20,000 × 6/24 = Rs 30, 000

Hence, A will bring in Rs. 5,000 (Rs. 45,000 – Rs. 40,000), B will withdraw

Rs. 10,000 (Rs. 35,000 – Rs. 25,000), C will withdraw Rs. 10,000 (Rs. 30,000Rs, 20,000) and D will bring in Rs. 30,000. Alternatively, the current accounts can be opened and the amounts to be brought in or withdrawn by A, B and C will be transferred to their respective current accounts subject to the agreement among the partners. The journal entries in this regard will be recorded as follows:

Books of A, B, C and D Journal

Alternatively, for entries (2) and (3) above shall be

Books of A, B, C and D Journal

Revision  28

A and B are partners in a firm sharing profits in the ratio 2:1. C is admitted into the firm with 1/4 share in profits. He will bring in Rs. 30,000 as capital and capitals of A and B are to be adjusted in the profit sharing ratio. The Balance Sheet of A and B as on March 31, 2017 (before C’s admission) was as under:

Balance Sheeof A and B as at March 31,2017

Other terms of agreement are as under:

1.  C will bring in Rs. 12,000 as his share of goodwill.

2.  Building was valued at Rs. 45,000 and Machinery at Rs. 23,000.

3.  A provision for bad debts is to be created @ 6% on debtors.

4.  The capital accounts of A and B are to be adjusted by opening current accounts.

Record necessary journal entries, show necessary ledger accounts and prepare fund’s Balance Sheet after C’s admission.

Books of A, B and C Journal

 

Revaluation Account

Partners’  Capital  Accounts

Partners’  Current  Accounts

Balance  Sheet  of  A, B and C as on March  31,  2017

Notes

New Profit Sharing Ratio

Since nothing is given as to how C acquired his share from A and B. It is assumed that A

and B, between themselves continue to share the profit in the old ratio of 2:1.

C’s Share of Profits = ¼

Remaining Share = 1 – ¼ = ¾

A’s New Share = 2/3 of ¾ = 6/12 = ½

B’s New Share = 1/3 of ¾ = 3/12 = ¼

Thus, new profit sharing ratio between A, B and C is 2:1:1

New Capitals of A and B

C’s capital is Rs 30,000 and his share of profits is 1/4. Based on C’s capital, the total capital of the firm will work out at Rs 1,20,000 (4/1 × 30,000) and the respective capitals of A and B will be as follows :

A’s Capital = 2/4 of 1, 20, 000 = Rs 60, 000

B’s Capital = ¼ of 1, 20, 000 = Rs 30, 000

Revision  29

The Balance Sheet of W and R who shared profits in the ratio of 3 : 2 was as follows on January. 01, 2015.

Balance Sheet of W and R as on Jan. 01, 2015

On this date B was admitted as a partner on the following conditions:

1. He was to get 4/15 share of profit.

2. He had to bring in Rs 30,000 as his capital.

3. He would pay cash  for goodwill which would be based on 2 ½  years purchase      of the profits of the past four years.

4. W and R would withdraw half the amount of goodwill premium brought by B.

5. The assets would be revalued as: Sundry Debtors at book value less a provision of 5%; Stock at Rs 20,000; Plant and Machinery at Rs 40,000; and Patents at Rs 12,000.

6. Liabilities were valued at Rs   23,000, one bill for goods purchased having been omitted from books.

7. Profit for the past four years were :

2011             15,000          2013             14,000

2012             20,000          2014             17,000

Give necessary journal entries and ledger accounts to record the above, and prepare the Balance Sheet after B’s admission.

Solution

Average Profits = Rs 66, 000/4 = Rs 16, 500

Goodwill at 2 ½ Years purchase = Rs .16,500 × 5/2 = Rs 41, 250

B’s share of goodwill = Rs. 41,250 × 4/15 = Rs 11, 000

Books of W, R and B Journal

 

Cash Account

B’s Capital  Account

W’s Capital  Account

 

R’s Capital  Account

Revaluation Account

Balance Sheet of W, R and B as on January 01, 2015

The new profit sharing ratio will be:

W = (1- 4/15 ) × 3/5 = 11/15 × 3/5 = 33/75

R = ( 1 – 4/15 ) × 2/5 = 11/15 × 2/5 = 22/ 75

B = 4/15 = 20/75

The new ratio is 33 : 22 : 20.

Change in Profit  Sharing  Ratio  among  the  Existing  Partners

Sometimes, the partners of a firm decide to change their existing profit sharing ratio without any admission or retirement of a partner. This results in a gain of additional share in future profits of the firm for some partners while a loss of a part thereof for other partners. For example, A, B and C are partners in a firm

sharing profits in the ratios of 8:5:3 It is felt that A will no more be able to actively participate in the affairs of the firm. Hence, with effect from April 1, 2007, they decided that, in future they will share the profits in the ratio of 5:6:5. This result in A losing 3/16 (8/16 – 5/16) share in profits while B and C gaining 1/16 (6/16 – 5/16) and 2/16 (5/16 – 3/16). In such a situation, the loss and gain in the value of goodwill (if any) will have to be adjusted. This is done by crediting sacrificing partner's and debiting gaining partner's with appropriate amounts, as is explained earlier in the context of the admission of a new partners.

Any change, in the profit sharing ratio, like admission of partner, may also involve adjustments in respect of revaluation of assets and liabilities, transfer of accumulated profit and losses to partners' capital accounts in the old profit sharing ratio and adjustment of partners' capitals, if specified, so as to make them proportionate to the new profit sharing ratio. All this is done in the same way as in case of admission of a partner.

Revision 30

Dinesh, Ramesh and Suresh are partners in a firm sharing profits and losses in the ratio of 3:3:2. They decided to share the profits equally w.e.f. April 1, 2015. Their Balance Sheet as on March 31, 2016 was as follows :

It was also decide that :

  1. The fixed assets should be valued at Rs. 3,31,000.
  2. A provisions of 5% on sundry debtors be made doubtful debts.
  3. The goodwill of the firm at this date be valued at   years purchase of the average net profits of last, five years which were Rs. 14,000; Rs. 17,000; Rs. 20,000; Rs. 22,000 and Rs. 27,000 respectively.
  4. The value of stock be reduced to Rs. 1,12,000.
  5. Goodwill was not to appear in the books. Pass the necessary journal entries and prepare the revised Balance sheet of the firm.

Solution

Books of Dinesh, Ramesh  and Suresh Journal

Working Notes:

1.   Gain or sacrifice of partners

2.   Goodwill

Total Profits : Rs. 14,000 + Rs. 17,000 + Rs. 20,000 + Rs. 22,000 + Rs. 27,000

= Rs. 1,00,000

Average Profits                     = Rs. 1,00,000/5   = Rs. 20,000

Goodwill                              = Rs. 20,000 ×    = Rs 90, 000

Suresh in expected to bring in Rs. 7,500

as he gain 2/24 shares in profits.

Dinesh in expected to receive Rs. 3,750

as he sacrifices 1/24 share in profits

Ramesh is expected to receive Rs. 3,750

as he sacrifices 1/24 share in profits

3. capital Accounts

Balance  Sheet  as oApril  01,  2015

​Summary

1 Matters requiring adjustments at the time of admission of a partner: Various matters which need adjustments in the books of firm at the time of admission of a new partner are : goodwill, revaluation of assets and liabilities, reserves and other accumulated profits and losses and the capitals of the old partners’ (if agreed).

      2.Determining the new profit sharing ratio and calculating sacrificing ratio: The new partner acquires his share in profits from the old partners’. This reduces the old partnersshare in profits. Hence, the problem of determining the new profit sharing ratio simply involves the determination of old partnersnew share in the profits of the reconstituted firm. Given the new partners share in profits and the ratio, in which he acquires it from the old partners, the new share of each old partner shall be worked out by deducting his share of sacrifice from his old share in profits. The ratio in which the old partners have agreed to sacrifice their shares in profit in favour of the new partner is called the sacrificing ratio. It is usually same as the old profit sharing ratio. However, based on the agreement it can be different also.

      3Treatment of Goodwill: Goodwill is an intangible asset and belonges to its owner at a point of time. On the admission of a new partner the goodwill of the firm belongs to the old partners. It means that on the admission of a new partner some adjustments must be made into the capital accounts of the old  partners for goodwill so that the new partner will not acquire a share in that profit which the firm earns because of its goodwill earned before admission without making any payment for the same. The amount that the new partner pays for goodwill is called goodwill. From accounting point of view the firm may have to face different situations for the treatment of goodwill at the time of admission of a partner. The amount of premium brought in by the new partner is shared by old partners in the ratio of sacrifice. In case the new partner fails to bring his share of premium for goodwill in cash than the capital account of the new partner is debited for his share of premium of goodwill and the old partners capital accounts are credited in their sacrificing ratio.

      4Adjustments for Revaluation of Assets and Reassessment of Liabilities: If, at the time of admission of a partner, the assets and liabilities are revalued or some asset or liability is found unrecorded, necessary adjustments are made through the Revaluatiion Account. Any gain or loss arising from such exercise shall be distributed among the old partner’s in their old profit sharing ratio.

      5Adjustment for reserves and accumulated profits/losses: If, at the time of admission of a partner, any reserve and accumulated profits or losses exist in books of the firm, these should be transferred to old partner’s capital/current accounts in their old profit sharing ratio.

       6Determining/Adjusting partnerscapital: If agreed, the partner’s capital may be adjusted so as to be proportionate to their new profit sharing ratio. In that case, the new partner’s capital is normally used as a base for  determining the new capitals of the old partners and necessary adjustment made through case or by transfer to partner’s current accounts. Other basis also may be available for determining capitals of the partners after admissioin of the new partner like sharing the total capital to be in the firm immeidately after admission of the new partner.

       7Change in profit sharing ratio: Sometimes the partners of a firm may agree to change their existing profit sharing ratio. With a result, some partners will gain in future profits while others will lose. In such a situation, the partner who gain by change in profit effecting amounts to one partner buying the share of profit from another partner. Apart from the payment for compensation, the change in profit sharing ratio also necessitates adjustment in partnerscapital accounts with respect to undistributed profits and reserves, revaluation of assets and reassessment of liabilities.

2. Dissolution of firm

DISSOLUTION OF FIRM

Dissolution of partnership firm occurs due to the following reasons;

  1. Compulsory dissolution
  • When all the partners or all partners except one become insolvent
  • When the business becomes illegal
  • When all the partners except one decide to retire
  • When all the partners except one die
  • When the partnership agreement comes to an end as per the provisions mentioned in the agreement.
  1. Dissolution by Notice – In case of partnership at will, if any partner serves notice to other partners regarding his intention to dissolve the firm then it’ll amount to dissolution of partnership firm.
  2. Dissolution by Agreement – When all the partners mutually agree to dissolve the firm, it is considered to be dissolution of firm.
  3. Dissolution of the firm by Court – Under Section 44 of the Partnership Act, 1932, the court may order dissolution of the firm under following circumstances;
  • A partner becomes insane
  • Sheer impossibility of the business being carried on except at a loss
  • Any other ground on which the court is satisfied that the business cannot be carried & it would be just & equitable that the business is wound up.

Section 39 of the Indian Partnership Act 1932 states that the dissolution of partnership firm among all the partners of the partnership firm is the Dissolution of the Partnership Firm. The dissolution of partnership firm ceases the existence of the organization.After this, the partnership firm cannot enter into any transaction with anybody. It can only sell the assets to realize the amount, pay the liabilities of the firm and discharge the claims of the partners.

However, the dissolution of a firm may be without or with the intervention of the court. It is noteworthy here that the dissolution of partnership may not necessarily result in the dissolution of the firm.But, dissolution of partnership firm always results in the dissolution of the partnership.

2. Dissolution of firm

Dissolution  of Partnership

Dissolution of a partnership firm may take place without the intervention of court or by the order of a court, in any of the ways specified later in this section. It may be noted that dissolution of the firm necessarily brings in dissolution of the partnership. However, dissolution of partnership would not necessarily involve dissolution of firms.

Dissolution of a firm takes place in any of the following ways:

1.  Dissolution by Agreement: A firm is dissolved :

  1. with the consent of all the partners or
  2. in accordance with a contract between the partners.

2.  Compulsory Dissolution: A firm is dissolved compulsorily in the following cases:

  1. when all the partners or all but one partner, become insolvent, rendering them incompetent to sign a contract
  2. when the business of the firm becomes illegal
  3. when some event has taken place which makes it unlawful for the partners to carry on the business of the firm in partnership, e.g., when a partner who is a citizen of a country becomes an alien enemy because of the declaration of war with his country and India.

3.  On the happening of certain contingencies: Subject to contract between the partners, a firm is dissolved :

    1. if constituted for a fixed term, by the expiry of that term
    2. if constituted to carry out one or more ventures, by the completion thereof
    3. by the death of a partner
    4. by the adjudication of a partner as an insolvent

4.  Dissolution by Notice: In case of partnership at will, the firm may be dissolved if any one of the partners gives a notice in writing to the other partners, signifying his intention of seeking dissolution of the firm.

5.  Dissolution by Court: At the suit of a partner, the court may order a partnership firm to be dissolved on any of the following grounds:

1. when a partner becomes insane
​​​​​​​
2. when a partner becomes permanently incapable of performing his duties as a partner
3. when a partner is guilty of misconduct which is likely to adversely affect the business of the firm
4. when a partner persistently commits breach of partnership agreement
5. when a partner has transferred the whole of his interest in the firm to a third party
6. when the business of the firm cannot be carried on except at a loss
7. when, on any ground, the court regards dissolution to be just and equitable

 

3. Settlement of Accounts

Settlement of Accounts

In a case where the partners do not have an agreement regarding the dissolution of the firm, the following provisions of the Indian Partnership Act 1932 will apply:

  • The firm will pay the losses including the deficiency of capital firstly out of the profits, secondly out of the partner’s capital and lastly by the partners individually in their profit sharing ratio.
  • The firm shall apply its assets including any contribution to make up the deficiency firstly, for paying the third party debts, secondly for paying any loan or advance by any partner and lastly for paying back their capitals. Any surplus left after all the above payments is shared by partners in profit sharing ratio.

3. Settlement of Accounts

Settlement of Accounts

In case of dissolution of a firm, the firm ceases to conduct business and has to settle its accounts. For this purpose, it disposes off all its assets for satisfying all the claims against it. In this context it should be noted that, subject to agreement among the partners, the following rules as provided in Section 48 of the Partnership Act 1932 shall apply.

(a) Treatnent of Losses

Losses, including deficiencies of capital, shall be paid :

  1. a. first out of profits,
  2. b. next out of capital of partners, and
  3. c. lastly, if necessary, by the partners individually in their profit sharing ratio.

(b) Application of Assets

The assets of the firm, including any sum contributed by the partners to make up deficiencies of capital, shall be applied in the following manner and order:

  1. a. In paying the debts of the firm to the third parties
    b. In paying each partner proportionately what is due to him/her from the firm for advances as distinguished from capital (i.e. partner' loan)
    c. In paying to each partner proportionately what is due to him on account of capital
    d. the residue, if any, shall be divided among the partners in their profit sharing ratio

Thus, the amount realised from assets along with contribution from partners, if required, shall be utilised first to pay off the outside liabilities of the firm such as creditors, loans, bank overdraft, bill payables, etc. (it may be noted that secured loans have precedence over the unsecured loans); the balance should be applied to repay loans made by the partners to the firm. (in case the balance amount is not adequate enough to pay off such loans and advances, they are to be paid propartionately). The amount left thereafter is utilised in settlement of capital account balances. Then the surplus if any is divided among partners in their profit sharing ratio.

Private Debts and Firn's Debts: Where both the debts of the firm and private debts of a partner co-exist, the following rules, as stated in Section 49 of the Act, shall apply.

  1. a. The property of the firm shall be applied first in the payment of debts of the firm and then the surplus, if any, shall be divided among the partners as per their claims, which can be utilised for payment of their private liabilities.
    b. The private property of any partner shall be applied first in payment of his private debts and the surplus, if any, may be utilised for payment of the firm's debts, in case the firm's liabilities exceed the firm's assets.

It may be noted that the private property of the partner does not include the personal properties of his wife and children. Thus, if the assets of the firm are not adequate enough to pay off firm's liabilities, the partners have to contribute out of their net private assets (private assets minus private liabilities).

Inability  of a Partner  to Contribute  Towards Deficiency

In the context of settlement of accounts among the partners there is still another important aspect to be noted, i.e., when a partner is unable to contribute towards the deficiency of his capital account (the account finally showing a debit balance), he/she is said to be insolvent, and the sum not recoverable is treated as capital loss for the firm. In the absence of any agreement, to the contrary, such a capital loss is to be borne by the remaining solvent partners in accordance with the principle laid down in Garner vs. Murray case, which states that the solvent partners have to bear such loss in the ratio of their capitals as on the date of dissolution. However, the accounting treatment relating to dissolution of partnership on account of insolvency of partners is not being taken up at this stage.

4. Accounting Treatment

ACCOUNTING TREATMENT -  JOURNAL ENTRIES

1. For transferring the assets

Transfer to the debit of realization account at their gross book values of all accounts of assets excluding cash, bank and fictitious assets.

Realization a/c Dr.
To Assets a/c(individually)

It is to be noted that debit balances such as accumulated losses and deferred expenses are not transferred to the realization account. These are transferred to the partners’ capital account in their profit sharing ratio by recording the following entry :

Partners’ capital a/c Dr.
To Fictitious assets a/c


2. For transferring the liabilities

All external liability accounts including provisions, if any, in respect of assets which have been transferred to the realization account are closed by transferring them to the credit of realization account at their book values.

External liabilities a/c(Individually) Dr.
To Realization a/c

Partners’ capital account and loan account of the partner are prepared separately and are not transferred to realization account.


3. For the sale of assets

Bank a/c(realized price) Dr.
To Realization a/c


4. For an asset taken over by a partner

Partner’s capital a/c Dr.
To Realization a/c(Agreed price)


5. For payment to creditors

Any amount paid in cash to creditors, realization account is debited and cash/bank account is credited.

Realization a/c Dr.
To Bank a/c


6. Settlement with the creditors through the transfer of asset 

When a creditor accepts an asset in part payment no entry is recorded. It is because the liability due to the creditors has already been transferred to the credit of realization account and the asset is taken over by the creditor is appearing on the debit side of the realization account. Thus, the debit of the asset cancels the credit of the corresponding liability in the realization account. Sometimes, a creditor may accept part of his payment in cash and part of his payment by taking over an asset. In this case, the entry will be recorded for cash payment only. 

For example, a creditor to whom Rs. 10,000 was due to accepted office equipment worth Rs. 8,000. He will be paid Rs. 2,000 in cash by recording the following entry :

Realization a/c Dr.Rs. 2,000
To Bank a/c Rs. 2,000

Whenever a creditor takes over an asset, there may be two situations :


(a) When a creditor accepts an asset whose value is more than the amount due to him, he will pay cash. It is recorded as :

Bank a/c Dr.
To Realization a/c

(b) When a creditor accepts an asset as a full and final settlement, no journal entry is recorded.

 

7. Expenses of realization

(a) When realization expenses are paid by the firm

Realization a/c Dr.
To Bank a/c


(b) When firm has agreed to pay partner a fixed amount towards realization expenses irrespective of the actual realization expenses

Realization a/c Dr.
To Partners’ capital a/c


(c) When the actual expenses are paid by the firm on behalf of a partner, the following entry will be recorded :

Partners’ capital a/c Dr.
To Bank a/c


(d) However, if a partner himself pays and agreed not to get them reimbursed, no journal entry is recorded.

(e) When the partner agrees to pay the expenses on behalf of the firm, the entry to be recorded :

Realization a/c Dr.
To Partners’ capital a/c


8. When liabilities are paid off

Realization a/c Dr.
To Bank a/c


9. When partner discharges a liability

The liability account is transferred from realization account to partner’s capital account by recording the following entry :

Realization a/c Dr.
Partners’ capital a/c


10. For realization of any unrecorded assets

Bank a/c Dr.
To Realization a/c


11. Unrecorded asset is taken over by a partner

Partners’ capital a/c Dr.

To Realization a/c


12. For settlement of any unrecorded liability

Realization a/c Dr.
To Bank a/c


13. Unrecorded liability is taken over by a partner

Realization a/c Dr.
To Partners’ Capital a/c


14. When the profit (loss) on realization is transferred to partners’ capital account in their respective profit sharing ratio :

(a) In case of profit on realization

Realization a/c Dr.
To Partners’ Capitals a/c(individually)


(b) In case of loss on realization

Partners’ Capitals a/c (individually) Dr.
To Realization a/c


15. For transferring accumulated profits and reserve

All accumulated profits and reserves are transferred to the partners’ capital account in their respective profit-sharing ratios:

Accumulated profit/reserves Dr.
To Partners’ capitals a/c (Individually)


16. Transfer of fictitious assets

All accumulated losses and fictitious assets are debited to the partners’ capital accounts in their profit sharing ratio :

Partners’ capitals a/c (Individually) Dr.
To Accumulated losses/Fictitious Assets a/c


17. Payment of loans

Any loans due to partners are paid off :

Partner’s loan a/c Dr.

To Bank a/c


18. Settlement of capital accounts

(a) If the partner’s capital account shows a debit balance, he is to bring in the necessary cash :

Bank a/c Dr.
To Partners’ capital a/c


(b) In the case of partners whose accounts show credit balance, the same is paid off :
Partners’ capitals a/c Dr.
To Bank a/c

It may be noted that the aggregate amount finally payable to the partners must equal to the amount available in the bank and cash accounts. Thus, all accounts of a firm are closed in case of dissolution. At times, the Balance Sheet of the firm may not be available on dissolution of partnership firm. In such a situation, first of all, all the relevant ledger balances are worked out and then the Balance Sheet of the firm on the date of its dissolution is prepared. Thereafter, the process of dissolution is undertaken in the same manner as discussed above.

What happens to goodwill on the dissolution of partnership?

We all know goodwill is an Intangible Asset. When the firm is shut down, It is common practice to sell all the assets. Thus goodwill that appeared in the Balance Sheet is transferred to the Debit side of the Realisation Account to be sold.

Journal Entry of Goodwill in Dissolution of the partnership Firm

Following are the accounting treatment with journal entries of goodwill at the time of dissolution of the partnership firm

When goodwill is transferred to Realisation Account.

Realization A/c Dr.
To Goodwill A/c
(Being goodwill transferred to realization a/c)

When goodwill is sold in cash

Bank (Cash) A/c Dr.
To Realisation A/c
(Being goodwill is sold)

When goodwill is taken over by Partner

Partner’s Capital A/c Dr
To Realisation A/c
(Being goodwill is taken over by partner)

Note:- If Nothing is mentioned about the realization amount of goodwill. It is assumed the market value of goodwill is nil and nothing is realized


(i) For Unrecorded Assets

An unrecorded asset is such an asset whose value is written off from books of accounts, but it is in usable form. It is shown as:
1. If sold in cash

Cash A/c Dr.

To Realisation A/c

(Unrecorded asset sold off for cash)

 

2. If taken over by any partner

Partner’s Capital A/c Dr.

To Realisation A/c

(Partner takes over unrecorded asset)

ii) For unrecorded liabilities

Liabilities that are not recorded in the books of a firm are called unrecorded liabilities. It can be shown in records as

1. When unrecorded liability is paid off

Realization A/c Dr.

To Cash A/c

(Paid in cash the price of unrecorded liability)

2. When undertaken by a partner

Realization A/c Dr.

To Partner’s Capital A/c

(Liability that is unrecorded is taken over by partner)

Difference Between Realisation and Revaluation Account

 

4. Accounting Treatment

Accounting Treatment

When the firm is dissolved, its books of account are to be closed and the profit or loss arising on realisation of its assets and discharge of liabilities is to be computed. For this purpose, a Realisation Account is prepared to ascertain the net effect (profit or loss) of realisation of assets and payment of liabilities which may be is transferred to partner's capital accounts in their profit sharing ratio. Hence, all assets (other than cash in hand bank balance and fictitious assets, if any), and all external liabilities are transferred to this account. It also records the sale of assets, and payment of liabilities and realisation expenses. The balance in this account is termed as profit or loss on realisation which is transferred to partners' capital accounts in the profit sharing ratio (see figure 5.1).

Realization Account

Fig. 5.1: Format of Realisation Account

Revision 1

Supriya and Monika are partners, who share profit in the ratio of 3:2. Following is the balance sheet as on March 31, 2020.

Balance Sheet of Supriya and Monika as on March 31, 2020

The firm was dissolved on March 31, 2020. Close the books of the firm with the following information:

    1. Debtors realised at a discount of 5%,
    2. Stock realised at Rs.7,000,
    3. Fixed assets realised at Rs.42,000,
    4. Realisation expenses of Rs.1,500,
    5. Creditors are paid in full.

Record necessary journal entries at the time of dissolution of a firm.

Solution

Books of Supriya  and Monika

Realisation Account

Working Notes:

Books of Supriya  and Monika

Realisation Account

                                                                                                                                                    Dr.                                                                   Cr.

Partners Capital  Accounts

                                                                                                                                                 Dr.                                                                                Cr.

Journal Entries

1.  For trnasfer of assets
All asset accounts excluding cash, bank and the fictitious assets, if any are closed by transfer to the debit of Realisation Account at their book values. It may be noted that sundry debtors are transferred at gross value and the provision for doubtful debts is transferred to the credit side of Realisation Account along with liabilities. The same thing will apply to fixed assets, if provision for depreciation account is maintained.

Realisation A/c                                            Dr. To Assets (Individually) A/c
2.  For transfer of liabilities
All external liability accounts including provisions, if any, are closed by transferring them to the credit of Realisation account.
Liabilities (individually)                                Dr. To Realisation A/c
3.  For sale of assets
Bank A/c                                                      Dr.  (with the same value)
To Realisation A/c                                                (with the same value)
4.  For an asset taken over by a partner
Partner's Capital A/c                                    Dr. (with the amount assets are taken over)
To Realisation A/c                                               (with the amount assets are taken over)
5.  For payment of liabilities
Realisation A/c                                            Dr. (with the amount at which settled)
 To Bank A/c                                                        (with the amount at which settled)
6.  For a liability which a partner takes responsibility to discharge
Ralisation A/c                                              Dr. To Partner's Capital A/c
7.  For settlement with the creditor through transfer of assets when a creditor accepts an asset in full and final settlement of his account, no journal entry needs to be recorded. But, if the creditor accepts an asset only as part payment of his/her dues, the entry will be made for cash payment only. For example, a creditor to whom Rs. 10,000 was due accepts office equipment worth Rs. 8,000 and is paid Rs. 2,000 in cash, the following entry shall be made for the payment of Rs. 2,000 only.
Realisation A/c                                            Dr. To Bank A/c
However, when a creditor accepts an asset whose value is more than the due amount he/she pay cash to the firm for the difference for which the entry will be:
Bank A/c                                                      Dr. To Realisation A/c
8.  For paynent of realisation expenses
(a) When some expenses are incurred and paid by the firm in the process of realisation of assets and payment of liabilities:
Realisation A/c                                            Dr. To Bank A/c
(b) When realisation expenses are paid by a partner on behalf of the firm:
Realisation A/c                                            Dr. To Partner's Capital A/c
(c) When a partner has agreed to bear the realisation expenses:
(i) if payment of realisation expenses is made by the firm
Partner's Capital A/c                                    Dr. To Bank A/c
(ii) if the partner himself pays the realisation expenses, no entry is required
Note: In the absence of information about who is paying the expenses, it is implied that expenses are paid by the partner who has agreed to bear expenses.
9.  For agreed remuneration to such partner who agrees to undertake the dissolution work.
Realisation A/c                                            Dr. To Partner's Capital A/c
10. For realisation of any unrecorded assets including goodwill, if any
Bank A/c                                                      Dr. To Realisation A/c
11. For settlement of any unrecorded liability
Realisation A/c                                            Dr. To Bank A/c
12. For transfer of profit and loss on realisation          (Cr. Blance) (a) In case of profit on realisation
Realisation A/c                                            Dr.
To Partners' Capital A/c (individually) A/c
(b) In case of loss on realisation
Partners' Capital A/c (individually)              Dr.   (Dr. Blance) To Realisation A/c
13. For settlement of loan by a firm to a partner:
Bank A/c                                                      Dr. To loan to partners A/c
14. For transfer of accumulated profits in the form of general reserve to partners' capital accounts in their profit sharing ratio:
General Reserve A/c                                     Dr. To Partners' Capital A/c (individually)
15. For transfer of fictitious assets, if any, to partners' capital accounts in their profit sharing ratio:
Partners' Capital A/c (individually)              Dr. To Fictitious Asset A/c
16. For payment of loans due to partners
Partner's Loan A/c                                       Dr. To Bank A/c
17. For settlement of partners' accounts
If the partner's capital account shows a debit balance after posting of rebount entries firms. He brings in the necessary cash for which the entry will be:
Bank A/c                                                      Dr. To Partner's Capital A/c
The balance is paid to partners whose capital accounts show a credit balance and the following entry is recorded.
Partners' Capitals A/cs (individually)           Dr. To Bank A/c
It may be noted that the aggregate amount finally payable to the partners must equal to the amount available in bank and cash accounts. Thus, all accounts of a firm are closed in case of dissolution.

 Revision  2

Sita, Rita and Meeta are partners sharing profit and losses in the ratio of 2:2:1
Their balance sheet as on March 31, 2017 is as follows:

Balance Sheet  of Sita, Rita and Meeta as on March 31, 2017

They decided to dissolve the business. The following amounts were realised: Plant and Machinery Rs.4,250, Stock Rs.3,500, Debtors Rs.1850, Furniture 750.

Sita agreed to bear all realisation paid by the firm expenses. For the service Sita is paid Rs.60.

Actual expenses on realisation paid by the firm amounted to Rs.450.Creditors paid 2% less. There was an unrecorded assets of Rs.250, which was taken over by Rita at Rs.200.

Prepare the necessary accounts to close the books of the firm.

Solution

Books of Sita, Rita and Meeta

Realisation Account 

                                                                                                                                                                 Dr.                                                      Cr.

Partner's  Capital Accounts

                                                                                                                                          Dr.                                                                                   Cr.

Bank Account 

                                                                                                                                             Dr.                                                                                     Cr.

Revision  3

Record journal entries at the time of dissolution of a partnership firm of Vibha, Shobha and Anubha in the following cases:

  1. Dissolution expenses amounted to Rs. 6,500.
  2. Dissolution expenses Rs. 7,800 were paid by Anubha.
  3. Vibha was appointed to look after the dissolution process for which she was given a remuneration of Rs. 12,000
  4. Shobha was appointed to look after the dissolution work for which she was allowed a remuneration of Rs.15,000. She agreed to bear dissolution expenses. Actual dissolution expenses paid by her amounted to Rs.11,800.
  5. Anubha was to look after the dissolution process for which she was allowed a remuneration of Rs. 12,000 she also agreed to bear dissolution expenses. Actual expenses Rs. 9,500 were paid by the firm.
  6. Anubha looked after the dissolution work for remuneration of Rs. 8,500 and agreed to bear dissolution expenses upto Rs. 6,000. Actual expenses paid by her were Rs. 7,600.
  7. Vibha was appointed to look after the dissolution work for which she was allowed a remuneration of Rs. 14,000. She agreed to take over investment of the book value of Rs. 13,000 towards payment of her remuneration. Investments have already been transferred to realisation Account.

Book of Vibha, Shobha and Anubha

Revision 4

Nayana and Arushi were partners sharing profits equally Their Balance Sheet as on March 31, 2020 was as follows:

Balance  Sheet  of  Nayana  and Arushi  as on  March  31,  2017

The firm was dissolved on the above date:

  1. Nayana took over 50% of the stock at 10% less on its book value, and the remaining stock was sold at a gain of 15%. Furniture and Machinery realised for Rs.30,000 and Rs.50,000 respectively.
  2. There was an unrecorded investment which was sold for Rs. 34,000.
  3.  Debtors realised 90% only and Rs.1,200 were recovered for bad debts written-off last year.
  4. There was an outstanding bill for repairs which had to be paid for Rs.2,000.

Record necessary journal entries and prepare ledger accounts to close the books of the firm.

Solution

Books of Nayana and Arushi

Journal

 

Realisation Account

                                                                                                                                 Dr.                                                                                        Cr.

Partners'  Current   Accounts

                                                                                                                                                Dr.                                                                                Cr.

Partner's  Capital   Accounts

                                                                                                                                                     Dr.                                                                       Cr.

Bank Account

                                                                                                                                                             Dr.                                                                    Cr.

Revision 5

Following is the Balance Sheet of Ashwani and Bharat on March 31, 2017.

Balance Sheet  Ashwani and Bharat as on March 31, 2017

The firm was dissolved on that date. The following was agreed transactions took place.
(i)   Aswhani promised to pay Mrs. Ashwani's loan and took away stock for Rs.8,000.
(ii)  Bharat took away half of the investment at 10% less. Debtors realised for Rs.38,000. Creditor's were paid at less of Rs.380. Buildings realised for Rs.1,30,000, Goodwill Rs.12,000 and the remaining Investment were sold at Rs.9,000. An old typewriter not recorded in the books was taken over by Bharat for Rs. 600. Realisation expenses amounted to Rs. 2,000.
Prepare Realisation Account, Partner's Capital Account and Bank Account.

Solution

Books of Ashwani and Bharat

Realisation Account 

                                                                                                                                                           Dr.                                                                               Cr.

Partner's  Capital  Accounts

                                                                                                                                         Dr.                                                                                      Cr.

Bank Account

 

Revision  6

Sonia, Rohit and Udit are partners sharing profits in the ratio of 5:3:2. Their

Balance Sheet as on March 31, 2017 was as follows:

Balance Sheet  of Sonia, Rohit  and Udit as on March 31, 2017

The firm was dissolved on that date. Close the books of the firm with following information:

  1. Buildings realised for Rs.1,90,000, Bills receivable realised for Rs.1,10,000; Stock realised Rs.1,50,000; and Machinery sold for Rs.48,000 and furniture for Rs. 75,000.
  2. Bank loan was settled for Rs.1,30,000. Creditors and Bills payable were settled at 10% discount.
  3. Rohit paid the realisation expenses of Rs.10,000 for which he paid Rs.12,000 for completing the dissolution process. Prepare necessary ledger accounts.

Solution

Books of Sonia, Rohit  and Udit

Realisation Account                                                                                                                                                                                                                             Cr.                                                                         Dr.   

Partner's  Capital  Accounts

                                                                                                                                                  Dr                                                                          Cr

Bank Account

                                                                                                                                                     Dr                                                                          Cr

Note:  No entry has been recorded in firm's books for the actual realisation expenses

incurred by Rohit because he gets Rs. 12,000 as his remuneration which has been duly accounted for. 

 

Revision 7

Romesh and Bhawan were in partnership sharing profit and losses as 3:2.
Their Balance Sheet as on March 31, 2017, was as follows:

Balance Sheet  of Romesh  and Bhawan as on March 31, 2014

They decided to dissolve the firm. The following information is available:

  1. Debtors were recovered 5% less. Stock was realised at books value and building was sold for Rs.51,000.
  2. It is found that investment not recorded in the books amounted to Rs.10,000. The same were accepted by one creditor for this amount and other Creditors were paid at a discount of 10%. Bills payable were paid full.
  3. Romesh took over some of the Investments at Rs.8,100 (book value less 10%). The remaining investment were taken over by Bhawan at 90% of the book value less Rs.900 discount.
  4. Bhawan paid bank loan along with one year interest at 6% p.a, An unrecorded liability of Rs.5,000 was paid.

Close the books of the firm by preparing necessary ledger accounts.

Solution

Books of Romesh  and Bhawan

Realisation Account

                                                                                                                                                                  Dr                                                                           Cr

Partner's    Capital   Accounts

                                                                                                                                                                      Dr.                                                                                Cr.

Bank Account

                                                                                                                                                                  Dr.                                                                                   Cr.

Note:  No entry has been made for acceptance of unrecorded investments by a creditor as part payment of his dues as per rules.

Revision  8

Sonu and Ashu sharing profits as 3:1 and  they agree upon dissolution. The
Balance Sheet as on March 31, 2017 is as under:
Balance Sheet  of Sonu and Ashu as on March 31, 2017

Sonu took over plant and machinery at an agreed value of  Rs.60,000.  Stock and Furniture were sold for Rs.42,000 and Rs.13,900 respectively. Debtors were taken over by Ashu at Rs.69,000.  Creditors were paid subject to discount of Rs.900. Sonu agrees to pay the loans. Realisation expenses were Rs.1,600.

Prepare Realisation Account, Bank Account and Capital Accounts of the Partners.

Solution

Books of Sonu and Ashu

Realisation Account

                                                                                                                                                                    Dr.                                                                 Cr.

Partners  Capital  Accounts

                                                                                                                                                               Dr.                                                                                      Cr.

Bank Account

                                                                                                                                                                   Dr.                                                                                     Cr.

Revision 9

Anju, Manju and Sanju sharing profit in the ratio of 3:1:1 decided to dissolve their firm. On March 31, 2014 their position was as follows:

Balance  Sheet  Anju,  Manju and Sanju as on  March  31,  2017

It is agreed that:

  1. Anju takes over the Furniture at Rs.10,000 and Debtors amounting to Rs.2,00,000 at Rs.1,85,000. Anju also agrees to pay the creditors,
  2. Manju is to take over Stock at book value and Buildings at book value less 10%,
  3. Sanju is to take over remaining Debtors at 80% of book value and responsibility for the discharge of the loan,
  4. The expenses of dissolution amounted to Rs.2,200. Prepare Realisation Account, Bank Account and Capital Accounts of the partners.

Solution

Books of Anju, Manju and Sanju

Realisation Account

                                                                                                                                                       Dr.                                                                                       Cr.

Partner's  Capital Accounts

                                                                                                                                                       Dr.                                                                                                  Cr.

Alternatively, Manju's loan may be first paid through bank account then the amount payable by Manju on account of debit balance in her capital account. Rs. 16,0,120 can be corrected form her.

Bank Account

                                                                                                                                                                        Dr.                                                                              Cr.

Revision 10

Sumit, Amit and Vinit are partners sharing profit in the ratio of 5:3:2.
Their Balance Sheet as on March 31, 2017 was as follows:

Balance Sheet  of Sunit, Amit  and Vinit  as on March 31, 2017

The firm was dissolved on that date. Amit took over his wife's loan.

One of the Creditors for Rs.2,600 was not claim the amount. Assets realised as follows:

  1. Machinery was sold for Rs.70,000,
  2. Investments with book value of Rs.1,00,000 were given to Creditors in full settlement of their account. The remaining Investments were taken over by Vinit at an agreed value of Rs.45,000,
  3. Stock was sold for Rs.11,000 and Debtors for Rs.3,000 proved to be bad,
  4. Realisation expenses were Rs.1,500.

Prepare ledger accounts to close the books of the firm.

Solution

Books of Amit,  Sumit and Vinit

Realisation Account

                                                                                                                                                                       Dr.                                                                     Cr.

Partners  Capital  Accounts

                                                                                                                                                            Dr.                                                                                            Cr.

Bank Account

                                                                                                                                                      Dr.                                                                                                     Cr.

Note:  No entry has been made for the investments taken over by the creditors as per rules.

Revision  11

Meena and Tina are partners in a firm and sharing profit as 3:2. They decided to dissolve their firm on March 31, 2017 when their Balance Sheet was a follows:

Balance Sheet  Meena and Tina as on March 31, 2017

The assets and liabilities were disposed off as follows :

  1. Machinery were given to creditors in full settlement of their account and Stock were given to bills payable in full settlement.
  2. Investment were taken over by Tina at book value. Sundry debtors of book value Rs. 50,000 took over by Meena at 10% less and remaining debtors realised Rs. 51,000.
  3. Realisation expenses amount to Rs. 2,000.

Prepare necessary ledger accounts to close the book of the firm.

Solution

Books of Meena and Tina - Realisation Account

Partner's  Capital  Accounts

                                                                                                                                                           Dr.                                                                                                     Cr.

Bank Account

                                                                                                                                                                 Dr.                                                                           Cr.

Summary

1.   Dissolution of Partnership Firm: The dissolution of a firm implies the discontinuance of partnership business and termination of economic relations between the partners. In the case of a dissolution of a firm, the firm closes its business altogether and realises all its assets and pays all its liabilities. The payment is made to the creditors first out of the assets realised and, if necessary, next out of the contributions made by the partners in their profit sharing ratio. When all accounts are settled and the final payment is made to the partners for the amounts due to them, the books of the firm are closed.

2.   Dissolution of Partnership: A partnership gets terminated in case of admission, retirement death, etc. of a partner. This does not necessarily involve dissolution of the firm.

3.   Realisation Account: The Realisation Account is prepared to record the transactions relating to sale and realisation of assets and settlement of creditors. Any profit or loss arising act of this process is shared by partners' in their profit sharing ratio. Partners' accounts are also settled and the Cash or Bank account is closed.

2. Treatment of Goodwill

Treatment of Goodwill:

The outgoing partner is entitled to his share of goodwill at the time of retirement/death because the goodwill has been earned by the firm with the efforts of all the existing partners. Therefore, goodwill is valued as per the agreement, at the time of retirement/death.

Due to the retirement/death of any partner, the continuing partners make again because the future profit will be shared only between the continuing partners. Therefore, the continuing partners should compensate the retiring/deceased partner for his share of goodwill in the gaining ratio.

The accounting treatment for goodwill depends upon whether the goodwill already appears in the books of the firm or not.

When Goodwill does not Appear in the Books: When Goodwill does not appear in the books of the firm, there are four following ways to compensate the retiring partner:
(a) Goodwill is raised at its full value and retained in the books:
Goodwill A/cDr.
To All Partner’s Capital A/c’s
(including retiring/deceased partner)
(For the goodwill raised at its full value and credited to capital A/c’s of a ’1 partners in their old profit sharing ratio)
The full value of goodwill will appear in the new balance sheet.

(b) Goodwill is raised at its full value and written off immediately:
If it is decided that the goodwill will not appear in the balance sheet of the reconstituted firm, then the following journal entries are required:
1. Goodwill A/c Dr.
To All Partner’s Capital A/c’s (For raising of Goodwill and credited to all partners capital A/c’s in their old profit sharing ratio)

2. Continuing Partner’s Capital A/c’s Dr.
To Goodwill A/c
(For written-off goodwill between continuing partners in their new profit sharing ratio)

(c) Goodwill is raised to the extent of retired/deceased partner’s share and written off immediately:
1. Goodwill A/c Dr.
To Retiring/Deceased Partner’s Capital A/c (For the goodwill raised by share of outgoing partner)

2. Continuing Partner’s Capital A/c’s Dr.
To Goodwill A/c
(For the goodwill written off between the continuing partners in their gaining ratio)

(d) No Goodwill account is raised at all in the firm’s books: If the outgoing partner’s share of goodwill is adjusted in the capital accounts of the continuing partners without opening a goodwill account, the following entry will be required:

Continuing Partner’s Capital A/c’s Dr.
To Outgoing Partner’s Capital A/c (For the share of outgoing partner in the goodwill adjusted through capital accounts in the gaining ratio)

The following example clears the above accounting treatment of Goodwill at the time of retirement/death:
Ram, Shyam and Mohan are partners in firm sharing profits and losses in the ratio of 5: 3: 2. Shyam retires. The goodwill of the firm is valued at Rs. 1,40,000 and the remaining partner’s Ram and Mohan continue to share profits in the ratio of 5:2. The following journal entries passed under various alternatives shall be as follows:

If goodwill is raised at full value and retained in books:

If goodwill is raised at full value and written off immediately:

If goodwill is raised to the extent of the retiring partner’s share and written off immediately:

No goodwill account is raised at all in the firm’s books:

When Goodwill is already appearing in the books:
(a) If the value of goodwill appearing is equal to the current value of goodwill of the firm:
Normally, no adjustment is required if both the amounts are the same. Because goodwill stands credited in the accounts of all the partners including the retiring one.

(b) If the book value of goodwill is lower than its present value:
If the book value is less than the present value, the difference will be debited to the goodwill account and credited to the old partner’s capital accounts in their old profit sharing ratio.
Goodwill A/c Dr.
To All Partner’s Capital A/c’s (individually)
(For goodwill raised to its present value)

(c) If the book value of goodwill is more than the agreed or present value:
If the book value of goodwill is more than the present value, the difference will be debited to All partner’s capital accounts in their old profit sharing ratio and credited to the goodwill account.
All Partner’s Capital A/c’s (individually) Dr.
To Goodwill A/c
(For goodwill brought down to its present value)

Alternatively,
1. First, write off the existing goodwill that appears in the books:
All Partner’s Capital A/c’s (individually) Dr.
To Goodwill A/c
(For write-off goodwill to all partners in old profit sharing ratio)

2. Adjust retiring partner’s share of goodwill through capital A/c’s
Remaining Partner’s Capital A/c’s Dr.
To Retiring/deceased Partner’s Capital A/c
(For goodwill share of retiring/deceased partner adjusted to remaining partner’s Capital A/c’s in their gaining ratio)

Hidden GoodwillIf the firm has agreed to settle the retiring/deceased partner by paying him a lump sum, then the amount paid to him in excess of what is due to him based on the capital accounts balance after making all adjustments like accumulated profits and losses and revaluation profit or loss etc. shall be treated as his share of goodwill known as hidden goodwill.

2. Treatment of Goodwill

Treatment of Goodwill

The retiring or deceased partner is entitled to his share of goodwill at the time of retirement/death because the goodwill has been earned by the firm with the efforts of all the existing partners. Hence, at the time of retirement/death of a partner, goodwill is valued as per agreement among the partners the retiring/ deceased partner compensated for his share of goodwill by the continuing partners (who have gained due to acquisition of share of profit from the retiring/ deceased partner) in their gaining ratio. The accounting treatment for goodwill in such a situation depends upon whether or, not goodwill already appears in the books of the firm.

When goodwill does not appear in the books

When goodwill does not appear in the books of the firm, credit in given to the retiring partner for the share in goodwill by debiting the goodwill account to gaining partners capital accounts (individually) in their gaining ratio. The journal entry is :

Gaining Partners Capital A/c     Dr.   (Individually) To Retiring Partners Capital A/c

(Share in goodwill of retiring partner adjusted)

Let us take an example to understand the treatment of goodwill.

A, B and C are partners in a firm sharing profits in the ratio of 3:2:1 B retired and the value of goodwill of the firm in valued at Rs. 60,000. A and C continue the business sharing profits in the ratio of 3:1. The journal entry for adjustment of goodwill will be :

(B's share of goodwill adjusted to remaining partners' capital accounts in their gaining ratio)
It may also happen that as a result of decision on the new profit sharing ratio among the remaining partners, a continuing partner may also sacrifice a part of his share in future profits. In such a situation his capital account will also be credited along with the retiring/deceased partner’s capital account in proportion to his sacrifice and the other continuing partners’ capital accounts will be debited based on their gain in the future profit ratio.

Revision  6

Keshav, Nirmal and Pankaj are partners sharing profits and losses in the ratio of 4 : 3 : 2. Nirmal retires and the goodwill is valued at Rs. 72,000. Keshav and Pankaj decided to share future profits and losses in the ratio of 5 : 3. Record necessary journal entries.

Solution

Journal

Working Notes

Vimal’s share of goodwill = Rs. 72,000 ×  3/9  = Rs. 24,000
Calculation of Gaining Ratio
Gaining Share     =  New Share – Old Share
Keshav’s Gaining Share = 5/8 – 4/9 = 13/72
Pankaj’s Gaining Share =  3/8  −  2/9  =  11/72
Hence, Gaining Ratio between Keshav and Pankaj is 13:11 i.e. 13/24 : 11/24

Revision  7

Jaya, Kirti, Ekta and Shewata are partners in a firm sharing profits and losses in the ratio of 2 : 1 : 2 : 1. On Jaya’s retirement, the goodwill of the firm is valued at Rs. 36,000. Kirti, Ekta and Shewata decided to share future profits equally. Record the necessary journal entry for the treatment of goodwill without opening ’Goodwill Account’.

Solution

Books of Kirti,  Ekta and Shewata

Journal

Working Notes

1.  Jaya’s Share of Goodwill

= Rs. 36,000 × 2/6  = Rs. 12,000

2.  Calculation of Gaining Ratio

Gaining Share  = New Share – Old Share
Kirti’s Gain    = 1/3 – 1/6 = 2/6  − 1/6 = 1/6
Ekta’s Gain      =   1/3  −  2/6  =  2/6  − 2/6  =  0  (Neither Gain nor Sacrifice)
Shewata’s Gain =  1/3  −  1/6  =  2/6  − 1/6  =  1/6
Hence, Gaining  ratio between Kirti and  Shewata 1/6 : 1/6  = 1:1

Revision  8

Deepa, Neeru and Shilpa were partners in a firm sharing profits in the ratio of 5 : 3 : 2. Neeru retired and the new profit sharing ratio between Deepa and Shilpa was 2 : 3. On Neeru’s retirement, the goodwill of the firm was valued at Rs. 1,20,000. Record necessary journal entry for the treatment of goodwill on Neeru’s retirement.

Solution

Books of Deepa and Shilpa

Journal

Working Notes

1.  Calculation of Gaining Ratio

Gaining Share  =  New Share – Old Share

Deepa’s Gaining Share  = 2/5 – 5/10 =  4/10  − 5/10 =  - 1/10 = (1/10)  i.e., Sacrifice.

Shilpa’s Gaining Share = 3/5  − 2/10 = 6/10  – 2/10 =  4/10  i.e., Gain

2. Hence, Shilpa will compensate both Neeru (retiring partner) and Deepa (continuing partner who has sacrificed) to the extent of their sacrifice worked out as follows:

Deepa’s Sacrifice = Goodwill of the firm × Sacrificing Share

= Rs. 1,20,000 ×  1/10  = Rs. 12,000

Neeru’s (Retiring Partner’s Sacrifice) = Rs. 1,20,000 ×  3/10  =  Rs. 36,000.

Revision  9

Hanny, Pammy and Sunny are partners sharing profits in the ratio of 3 : 2 : 1. Goodwill is appearing in the books at a value of Rs. 60,000. Pammy retires and at the time of Pammy’s retirement, goodwill is valued at Rs. 84,000. Hanny and Sunny decided to share future profits in the ratio of 2:1. Record the necessary journal entries.

Solution

 Books of Hanny and Sunny

Journal

Working Notes

(i)  Pammy’s share of current value of goodwill   1/3 of Rs. 84,000

= 1/3 ×  84,000 = Rs. 28,000

(ii)  Gaining Share   =  New Share – Old Share

Hanny’s Gaining Share =  2/3  − 3/6  = 1/6

Sunny’s Gaining Share = 1/3 – 1/6 = 1/6

This gaining Ratio of Hanny and Sunny is 1/6  : 1/6  = 1:1

Hidden Goodwill

If the firm has agreed to settle the retiring or deceased partner’s account by paying him a lump sum amount, then the amount paid to him in excess of what is due to him, based on the balance in his capital account after making necessary adjustments in respect of accumulated profits and losses and revaluation of assets and liabilities, etc., shall be treated as his share of goodwill (known as hidden goodwill).
For example, P, Q and R are partners in a firm sharing profits in the ratio of 3:2:1. R retires, and the balance in his capital account after making necessary adjustments on account of reserves, revaluation of assets and liabilities workout to be Rs. 60,000, P and Q agreed to pay him Rs. 75,000 in full settlement of his claim. It implies that Rs. 15,000 is R’s share of goodwill of the firm. This will be debits to the capital accounts of P and Q in their gaining ratio (3:2 assuming no change in their own profit sharing ratio) and crediting R’s capital Account as follows:

3. Adjustment of revaluation of assets & liabilities, Adjustments of accumulated profits & losses, Adjustment of capitals

Adjustment of Revaluation of Assets and Liabilities:

The retiring /deceased partner must be given a share of all profits that have arisen till his retirement/death and is made to bear his share of losses that have occurred till that period. This necessitates the revaluation of assets and liabilities. At the time of retirement/death of a partner, there may be some assets and liabilities which may not have been shown at their present values.

Not only that, there may be some unrecorded assets and liabilities which need to be brought into books. For this purpose, a revaluation account is opened, for the revaluation of assets and liabilities on the date of retirement/death of the partner. The journal entries to be passed for this purpose are as follows:

1. For increase in the value of assets:
Asset(s) AIc (individually) Dr.
To Revaluation A/c (For increase in the value of assets)

2. For decrease in the value of assets:
Revaluation A/c Dr.
To Assets A/c’s (individually)
(For decrease in the value of assets)

3. For increase in the number of liabilities:
Revaluation A/c Dr.
To Liabilities A/c’s (individually)
(for an increase in liabilities)

4. For decrease in the number of liabilities:
Liabilities A/c’s (individually) Dr.
To Revaluation A/c (For decrease in the liabilities)

5. For an unrecorded asset:
Assets A/c Dr.
To Revaluation A/c
(For unrecorded assets brought into books)

6. For an unrecorded liability:
Revaluation A/c Dr.
To Liability A/c
(For an unrecorded liability brought into books)

7. For the sale of an unrecorded asset:
Cash A/c Dr.
To Revaluation A/c (For the sale of unrecorded assets)

8. For payment of an unrecorded liability:
Revaluation A/c Dr.
To Cash A/c
(For the payment of an unrecorded*liability)

9. For-profit on revaluation:
Revaluation A/c Dr.
To All Partner’s Capital A/c’s (individually)
(For the distribution of profit on revaluation to all partners in their old profit sharing ratio)
Or

10. For Loss on revaluation:
All Partner’s Capital A/c’s (individually) Dr.
To Revaluation A/c
(For the distribution of losses on revaluation to all partners in their old profit sharing ratio)

Reserves and Accumulated Profits and Losses:

The retiring/deceased partner is also entitled to his/her share in the accumulated profits, general reserve, workmen compensation fund 1 etc. and is also liable to share the accumulated losses.

For this purpose the following journal entries are required:
1. For Transferring accumulated profits, General Reserves etc.
To All Partner’s Capital A/c’s (individually)
(For accumulated profits are transferred to all partner’s Capital A/c’s in their old profit sharing ratio)

2. For transfer of accumulated losses:
All Partner’s Capital A/c’s (individually) Dr.
To Profit and Loss A/c To Any Accumulated Loss A/c (For accumulated losses transferred to all partner’s Capital A/c’s in their old profit sharing ratio)

Settlement of Amount Due to Retiring Partner:

The retiring partner is entitled to the amount due to him. It is settled as per the terms of the partnership deed i.e. in lump sum immediately or in various installments with or without interest as agreed or partly in cash immediately and partly in installments.

In absence of any agreement, Section 37 of the Indian Partnership Act, 1932 is applicable, according to this, the retiring partner has an option to receive either interest of 6% p.a. till the payment of his/her amount due or such share of profits which has been earned with his/her money i.e. based on the capital ratio. The necessary journal entries are as follows:
1. If payment (full) is made in cash:
Retiring Partner’s Capital A/c Dr.
To Cash/Bank A/c
(For the amount paid to retire partner)

2. If the amount due to retiring partner’s treated as a loan:
Retiring Partner’s Capital A/c Dr.
To Retiring Partner’s Loan A/c (For the amount due to retiring partner transferred to his loan account)

3. When the amount due to the retiring partner is partly paid in cash and the remaining amount treated as a loan:
Retiring Partner’s Capital A/c Dr. (Total Amount Due)
To Cash/Bank A/c. (Amount paid)
To Retiring Partner’s Loaij A/c (Amount of loan) (For the amount due to retiring, partner; partly paid in cash and remaining transferred to his loan account)

4. When the loan account is settled by paying in installments including principal and interest:
(a) For interest due on loan:
Interest on Loan A/c Dr.
To Retiring Partner’s Loan A/c
(For the interest due on the loan of the retiring partner)

(b) For payment of installment of the loan with interest:
Retiring Partner’s Loan A/c Dr.
To Cash/Bank A/c
(For the amount paid (Instalment + Interest) to retiring
partner)
These entries i.e. (a) and (b) repeated till the loan is paid off.

Adjustment of Partner’s Capital:
At the time of retirement or death of a partner, the remaining partners may decide to adjust their capital contribution in their new profit sharing ratio. The adjustment of the remaining partner’s capitals may involve any one of the following cases:
1. When the total capital of a new firm is specified.
Steps:
(a) Compute the new capital of the remaining partners by dividing total capital in their new profit-sharing ratio.

(b) Calculate the amount of adjusted old capital of the remaining partners after all adjustments regarding goodwill, accumulated profit and losses, profit or loss on revaluation etc.

(c) Find out the surplus or deficiency, as the case may be, in each
of the remaining partner’s capital accounts by comparing the new capital and the adjusted capital. ‘

(d) Adjust the surplus by paying cash to the concerned partner or by crediting his Current Account as agreed. Adjust the deficiency by asking the concerned partner to pay cash or by debiting his current account.

Journal Entries:
For excess capital withdrawn by the remaining partners:
Partner’s Capital A/c’s (individually) Dr.
To Cash/Bank A/c.

For the amount of capital to be brought in by the partners:
Cash/Bank A/c Dr.
To Partner’s Capital AJc’s (individually)
If the adjustment is made through the current account:

For excess capital:
Partner’s Capital A/c’s (individually) Dr.
To Partner’s Current A/c’s (individually)

For short capital:
Partner’s Current A/c’s /individually) Dr.
To Partner’s Capital A/c’s (individually)

2. When the total capital of the new firm is not specified:
Calculate the total capital of the new firm which will be equal to the aggregate of the adjusted old capitals of the continuing partners after all adjustments like goodwill, accumulated profits and losses, profit and losses on revaluation etc.
After calculating the total capital of the new firm, follow the same steps as discussed in case 1.

3. When the amount payable to the retiring partner will be contributed by continuing partners in such a way that their capitals are adjusted proportionately to their new profit sharing ratio:

Calculate the total capital of the reconstituted firm by adding the adjusted old capitals of remaining partners and the cash to be brought in by continuing partners in order to make payment to the retiring/ deceased partner.
Then follow the same step we discussed in case 1.

3. Adjustment of revaluation of assets & liabilities, Adjustments of accumulated profits & losses, Adjustment of capitals

Adjustment  for Revaluation of Assets and Liabilities

At the time of retirement or death of a partner there may be some assets which may not have been shown at their current values. Similarly, there may be certain liabilities which have been shown at a value different from the obligation to be met by the firm. Not only that, there may be some unrecorded assets and liabilities which need to be brought into books. As learnt in case of admission of a partner, a Revaluation Account is prepared in order to ascertain net gain (loss) on revaluation of assets and/or liabilities and bringing unrecorded items into firm’s books and the same is transferred to the capital account of all partners including retiring/deceased partners in their old profit sharing ratio. the Journal entries to be passed for this purpose are as follows:

1.            For increase in the value of assets
Assets A/c’s (Individually)                            Dr. To Revaluation A/c
(Increase in the value of assets)
2.            For decrease in the value of assets
Revaluation A/c                                           Dr. To Assets A/c’s (Individually)
(Decrease in the value of assets)

3.            For increase in the amount of liabilities
Revaluation A/c                                           Dr. To Liabilities A/c (Individually)
(Increase in the amount of liabilities)
4.            For decrease in the amount of liabilities
Liabilities A/c’s (Individually)                      Dr. To Revaluation A/c
(Decrease in the amount of liabilities)
5.            For an unrecorded asset
Assets A/c                                                    Dr. To Revaluation A/c
(Unrecorded asset brought into book)
6.            For an unrecorded liability
Revaluation A/c                                           Dr. To Liability A/c
(Unrecorded liability brought into books)
7.            For distribution of profit or loss on revaluation
Revaluation A/c                                           Dr. To All Partners’ Capital A/c’s (Individually)
(Profit on revaluation transferred to partner’s capital)
(or)
All Partners’ Capital A/c’s (Individually)                      Dr.
To Revaluation A/c
(Loss on revaluation transferred to partner’s capital accounts)

Revision  10

Mitali, Indu and Geeta are partners sharing profits and losses in the ratio of 5 : 3 : 2 respectively. On March 31, 2017, their Balance Sheet was as under:

Geeta retires on the above date. It was agreed that Machinery be valued at Rs.1,40,000; Patents at Rs. 40,000; and Buildings at Rs. 1,25,000. Record the necessary journal entries for the above adjustmentsand prepare the Revaluation Account.

Solution

Books of Mitali  and Indu

Journal

Revaluation Account

Adjustment  of Accumulated  Profits  and Losses

Sometimes, the Balance Sheet of a firm may show accumulated profits in the form of general reserve and/on accumulated losses in the form of profit and loss account debit balance. The retiring/deceased partner is entitled to his/her share in the accumulated profits and is also liable to share the accumulated losses, if any. These accumulated profits or losses belong to all the partners and should be transferred to the capital accounts of all partners in their old profit sharing ratio. The following journal entries are recorded for the purpose.

(i)  For transfer of accumulated profits (reserves),

Reserves A/c                                                         Dr. To All Partners’ Capital A/c’s (Individually)

(Reserves transferred to all partners’

capital account’s in old profit sharing ratio).

(ii)  For transfer of accumulated losses

All Partners’ Capital A/c’s (Individually)               Dr. To Profit and Loss A/c

(Accumulated loss transferred to all partners’

capital accounts in their old profit-sharing ratio)

For example; Inder, Gajender and Harinder are partners sharing profits in the ratio of 3 : 2 : 1. Inder retires and the Balance Sheet of the firm on that date was as follows: Books of Inder,  Gajinder  and Harinder

Balance Sheet  as on March 31, 2017

The journal entry to record the treatment of general reserve will be as follows :

Books  of  Gajender  and Harinder

Journal

When Partner Retires  in the Middle of the Year

Normally retirement of a partner takes place at the end of accounting period. But there can be a case where a partner decides to retire in the middle of the year. In such a case the claim shall include share of profit or loss, interest on capital, interest on drawings if any, from the date of last balance sheet to the date  of retirement. Here, the main problem relates to the calculation of profit for the intervening period, i.e., the period from the date of last balance sheet and the date of retirement. Let us understand by way of example:
Maira, Shabnam and Vipul were partners in a firm sharing profits in the ratio of 5:4:1 profits for the year ending on March 31, 2019 was Rs. 1,00,000. Vipul decides to retire on June 30, 2019. The new profit sharing ratio of the firms is 1:1. Vipul's share of profit for the period of from April 01 to June 30, 2019 shall be calculated as:

Total profit for the year ending on 31st March, 2017 = Rs. 1,00,000

Vipul's share of profit:

Proceeding Year's × Proportionate Period × Share of Deceased Partner

= Rs. 1,00,000 ×  3/12 × 4/10  = Rs. 10,000

12 10

The journal entry will be recorded as follows:

Profit & Loss Suspense A/c    Dr.       10,000

To Vipul's Capital A/c                        10,000

Vipul's share of profit transferred to his capital account

Alternatively, if  Vipul's share of profit was to be calculated on the basis of average profits of the last three years, to which were Rs. 1,36,000 for 2016-17, Rs. 1,54,000 for 2017-18 and Rs. 1,00,000 for 2018-19, Vipul's share of profit for the period from April 7, 2019 to June 30, 2019 shall be calculated on the basis of average profit based on profits for the last year calculated as follows:
Average Profit = Total Profit/ No. of Years  = ( Rs.1 ,36, 000 + Rs. 1, 54, 000 + Rs 1, 00, 000 ) / 3 =  R s. 3,90,000/ 3  = Rs.1,30,000

Vipul’s share of Profit = Rs.1, 30,000

The Journal entry will be:

 Profit and Loss Suspense A/c  13,000

To Vipul's Capital A/c              13,000

In case, the agreement provides, that share of profit of the retiring partner will be worked out on the basis of sales, and it is specified that the sales during the pear 2018-19 were Rs. 8,00,000 and the sales from April 1, 2017 to June 30, 2019 were Rs. 1,50,000 Vipul's share of profits for the period from April 1, 2019 shall be calculated as follows:

If sale is Rs. 80,00,000, the profit   =   Rs. 1,00,000

If sale is Rs. 1, the profit   = 1, 00,000 / 8,00, 000

If sale is Rs. 1,50,000, the profit  = 1, 00,000 / 8, 00, 000 ×1,50, 000

=  Rs. 18,750

Vipul's share of profit  =  Rs. 7,500

Profit & Loss Suspense A/c                     Dr.               75,00

To Vipul's Capital A/c                                                 75,00

For being retiring partners share of profit for the intervening period to books of account, the following journal entry is recorded.

(i)      Profit & Loss Suspense A/c                     Dr.

To Retiring Partners Capital A/c

(Share of profit for intervening/period)

Later, Profit and Loss suspense account is closed by transferring the amount to the gaining partners capital account in their gaining ratio. The journal entry is:

(ii)        Gaining Partners Capital A/c                 Dr.   (in gaining ratio) To Profit & Loss Suspense A/c

Alternatively, the following journal entry can also be passed in place

of (i) or (ii)

Gaining Partners Capital A/c                 Dr. To Retiring partners Capital A/c

(Share of profit of retiring partner credited)

4. Disposal of amount due to retiring partner, Death of a partner

DISPOSAL OF AMOUNT DUE TO RETIRING PARTNER

The partner who is retiring, his or her account is settled as per the terms and conditions of the partnership deed, i.e., in lump sum instantly or in different installments, either with or without interest as consented or partly in cash directly and partially in installment at the consented intermissions. In the absenteeism of any deed, Section 37 of the Indian Partnership Act, 1932 is pertinent, which states that the partner who is retiring or moving out, has a choice to receive interest @ 6% per annum until the date of payment or such share of gains which has been earned with his or her money (i.e., which is based on the capital ratio).

Therefore, the total amount overdue to the retiring partner which is determined after all the modifications and adjustments have been made is to be compensated instantly to the retiring or an outgoing partner. In case the enterprise is not in a situation to make the payment right away, the amount that is overdue is being transferred to the retiring or outgoing Partner’s Loan A/c. The required journal entries are recorded as follows :

When a retiring partner is paid cash in full :

Retiring Partner’s Capital A/c     Dr.

To Cash/Bank A/c 

When retiring partner’s whole amount is treated as loan:

Retiring Partner’s Capital A/c     Dr.

To Retiring Partner’s Loan A/c 

When a retiring partner is partly paid in cash and the remaining amount treated as loan :

Retiring Partner’s Capital A/c   Dr. (Total amount due)

To Cash/Bank A/c                              (Amount Paid)

To Retiring Partner’s Loan A/c      (Amount of Loan) 

When Loan account is settled by paying in instalments includes principal and interest :

• For interest on loan

Interest A/c        Dr.

To Retiring Partner’s Loan A/c

• For payment of installment

Retiring Partner’s Loan A/c    Dr.

To Cash/Bank A/c 

Death of a Partner:

The accounting treatment in the event of the death of a partner is the same as that in the case of the retirement of a partner. Here, his claim is transferred to his executor’s account and settled in the same manner as that of the retired partner.

The only major difference between the retirement and death of a partner is that retirement normally takes place at the end of the accounting period whereas death may occur on any day. Therefore, in case of death, his claim shall also include his share of profit or loss, interest on capital, and interest on drawings (if any), from the beginning of the year to the date of death.

Calculation of profit for the intervening period: Share of profit of a deceased partner

Share of deceased partner = Profit of the firm till the date of death × Deceased partner share

Accounting Treatment of Outgoing Partner’s Share in Profit:
1. Through Profit and Loss Suspense Account
In case of Profit:
Profit and Loss Suspense A/c Dr.
To Deceased Partner’s Capital A/c (Share of profit for the intervening period)

In case of Loss:
Deceased Partner’s Capital A/c Dr.
To Profit and Loss Suspense A/c (Share of loss for the intervening period)

2. Through Capital Transfer In case of Profit:
Remaining Partner’s Capital A/c’s Dr.
To Deceased Partner’s Capital A/c In case of Loss:
Deceased Partner’s Capital A/c Dr.

To Remaining Partner’s Capital A/c’s The executors of deceased partner are entitled to the following:

  1. The credit balance of deceased partner’s capital account;
  2. His share of goodwill;
  3. His share of profit till the date of death;
  4. His share of profit on revaluation of assets and liabilities;
  5. His share of accumulated profits and reserves;
  6. His interest in capital if partnership deed provides till the date of death;
  7. His share of Joint Life Policy (if any);
  8. His salary and commission due (if any);

The following deduction has to be made from above.

  1. His drawings, interest in drawings till the date of death;
  2. His share of loss till the date of death;
  3. His share of loss on revaluation of assets and liabilities. ,
  4. His share of the reduction in the value of goodwill (if any).

Payment to the executors:
1. When payment is made in full Executor’s A/c Dr.
To Bank A/c.

2. When payment is made in installments The executors are entitled to interest when the payment is made in installment. If the deed is silent about this, then 6% p.a. should be given as per Section 37 of the Indian Partnership Act, 1932.

When interest is due
Interest A/c Dr.
To Executor’s A/c

When installment paid along with interest
Executor’s A/c Dr.
To Cash/Bank A/c

4. Disposal of amount due to retiring partner, Death of a partner

Disposal of Amount  Due to Retiring Partner

The outgoing partner’s account is settled as per the terms of partnership deed i.e., in lumpsum immediately or in various instalments with or without interest as agreed or partly in cash immediately and partly in instalment at the agreed intervals. In the absence of any agreement, Section 37 of the Indian Partnership Act, 1932 is applicable, which states that the outgoing partner has an option to receive either interest @ 6% p.a. till the date of payment or such share of profits which has been earned with his/her money (i.e., based on capital ratio). Hence, the total amount due to the retiring partner which is ascertained after all adjustments have been made is to be paid immediately to the retiring partner. In case the firm is not in a position to make the payment immediately, the amount due is transferred to the retiring Partner’s Loan Account, and as and when the amount is paid it is debited to his account. The necessary journal entries recorded are as follows.

1. When retiring partner is paid cash in full.
Retiring Partners’ Capital A/c                      Dr. To Cash/Bank A/c
2. When retiring partners’ whole amount is treated as loan.
Retiring Partners’ Capital A/c                      Dr.   To Retiring Partners’ Loan A/c

3. When retiring partner is partly paid in cash and the remaining amount treated as loan.
Retiring Partners’ Capital A/c                      Dr.   (Total Amount due) To Cash/Bank A/c                                             (Amount Paid)
To Retiring Partners’ Loan A/c                          (Amount of Loan)
4.  When Loan account is settled by paying in instalment includes principal and interest.

a) For interest on loan

Interest A/c                                             Dr. To Retiring Partner’s Loan A/c

b) For payment of instalment

Retiring Partner’s Loan A/c                     Dr. To Cash/Bank A/c

Note:

4. When Loan account is settled by paying in instalment includes principal and interest.

a) For interest on loan

Interest A/c                                             Dr. To Retiring Partner’s Loan A/c

b) For payment of instalment

Retiring Partner’s Loan A/c                     Dr. To Cash/Bank A/c

1.  The balance of the retiring partner’s loan account is shown on the liabilities side of the Balance Sheet till the last instalment is paid to him/her.

2.  Entry number (a) and (b), above will be repeated till the loan is paid off.

Revision  11

Amrinder, Mahinder and Joginder are partners in a firm. Mahinder retires from the firm. On his date of retirement, Rs. 60,000 becomes due to him. Amrinder and Joginder promised to pay him in instalments every year at the end of the year to which he agreed. Prepare Mahinder’s Loan Account in the following cases:
1. When payment is made four yearly instalments plus interest @ 12% p.a. on the unpaid balance.
2. When when payment is made in three yearly instalments of Rs. 20,000 including interest @ 12% p.a on the outstanding balance during the first three years and the balance including interest in the fourth year.
3. When payment is made in 4 equal yearly instalment’s including interest @ 12% p.a. on the unpaid balance.

Solution

(a)  When payment is made in four yearly instalments plus interest

Books of Amrinder  and Joginder

Mahinder’s  Loan Account

(b)  When payment is made in three yearly instalments of Rs. 20,000 each including interest.

Books of Amrinder,  Mahinder  and Joginder

Mahinder’s  Loan Account

(c)  When payment is made in four equal yearly instalments including interest @12% (Annually).

Books  of  Amrinder  and Joginder

Mahinder’s  Loan  Account

Note:

The annual instalment of payment in 4 years @ 12% interest works out at Rs. 19,754 (Annually of Rs. 0.329234 as per Annually Table x 60,000).
It may noted that the accounting treatment for disposal of amount due to retiring partner and deceased partner is similar with a difference that in case of death of a partner, the amount credited to him/her is transferred to his Executors’ Account and the payment has to be made to him/her. This shall be taken up later in this chapter.

Revision  12
The Balance Sheet of Ashish, Suresh and Lokesh who were sharing profits in the ratio of 5 : 3 : 2, is given below as on March 31, 2017.

Balance Sheet  of Ashish, Suresh and Lokesh As on March 31, 2017

Suresh retires on June 30, 2017 date and the following adjustments are agreed upon his retirement.

1.  Stock was valued at Rs. 1,72,000.
2.  Furniture and fittings were valued at Rs. 80,000
3.  Profit share of Suresh till the date of his retirement is to be calculated on the basis of firm's last year profit which is Rs. 2,00,000.
4.  An amount of Rs. 10,000 due from Mr. Deepak, a debtor, was doubtful and a provision for the same was required.
5.  Goodwill of the firm was valued at Rs. 2,00,000.
6.  Suresh was paid Rs. 40,000 immediately on retirement and the balance was transferred to his loan account.
7.  Ashish and Lokesh were to share future profits in the ratio of 3:2.
Prepare Revaluation Account, Capital Account and Balance Sheet of the reconstituted firm.

Solution

Books of Ashish, Suresh and Lokesh

Revaluation Account

Partners’  Capital  Accounts

Balance  Sheet  of  Ashish  and Lokesh  as on  April  01,  2017

Working Notes

1.  Gaining Share  = New Share – Old Share
Ashish’s Gain   = 3/5 – 5/10 = 6/10 - 5/10 = 1/10
 Lokesh’s Gain   = 2/5 – 2/10 = 4/10 – 2/10 = 2/10
 Gaining Ratio between Ashish and Lokesh = 1 : 2,
2.  Suresh’s Share of Goodwill = 3/10  × Rs. 2,00,000 = Rs. 60,000
3.  Suresh's share of profit = 2,00,000 ×  3/13 × 3/10  = Rs. 15,000

Revision  13

Shyam, Gagan and Ram are partners sharing profit in the ratio of 2 : 2 : 1.

Their Balance Sheet as on March 31, 2017 are as under:

As Gagan got a very good break at an MNC, so he decided to retire on that date and it was decided that Shyam and Ram would share the future profits in the ratio of 5 : 3. Goodwill was valued at Rs. 70,000; Machinery at Rs. 78,000; Buildings at Rs. 1,52,000; stock at Rs. 30,000; and bad debts amounting to Rs. 1,550 were to be written off. Record journal entries in the books of the firm and prepare the Balance Sheet of the new firm.

Solution

Books of Shyam, Ram and Gagan

Journal

Balance Sheet of Shyam and Ram as on March 31, 2017

Working Notes

Share Gained  =  New Share – Old Share
Shyam’s Gain  = 5/8 – 2/5 = 25/40 – 16/40 = 9/40
Ram’s Gain   = 3/8 – 1/5 = 15/40 – 8/40 = 7/40
Therefore, Gaining Ratio of Shyam and Ram = 9 : 7.

Revaluation Account

Partners’  Capital  Accounts

Note: As sufficient balance is not available to pay the due amount to Gagan, the balance in his capital account is transferred to his loan account.

Adjustment  of  Partners’  Capitals

At the time of retirement or death of a partner, the remaining partners may decide to adjust their capital contributions in their profit sharing ratio. In such a situation, the sum of balances in the capitals of continuing partners may be treated as the total capital of the new firm, unless specified otherwise. Then, to ascertain the new capital of the continuing partners, the total capital of the firm is divided amongst the remaining partners as per the new profit sharing ratio, and the excess or deficiency of capital in the individual capital account’s may be worked out. Such excess or shortage shall be adjusted by withdrawal of contribution in cash, as the case may be, for which the following journal entries will be recorded.

(i) For excess capital withdrawn by the partner :

Partners’ Capital A/c                                    Dr. To Cash / Bank A/c
(ii) For amount of capital to be brought in by the partner:
Cash / Bank A/c                                          Dr. To Partners’ Capital A/c

Consider the following situations:

The adjustment of the continuing partner’s capitals may involve any one of the three ways as illustrated as follows :
1. When the capital of the new firm as decided by the partners is specified.

Revision  14

Mohit, Neeraj and Sohan are partners in a firm sharing profits in the ratio of 2 : 1 : 1. Neeraj retires and Mohit and Sohan decided that the capital of the new firm will be fixed at Rs. 1,20,000. The capital accounts of Mohit and Sohan show a credit balance of Rs. 82,000 and Rs. 41,000 respectively after making all the adjustments. Calculate the actual cash to be paid off or to be brought in by the continuing partners and pass the necessary journal entries.

Solution

The New Profit Sharing Ratio between Mohit and Sohan = 2 : 1

Books  of  Mohit  and Sohan

Journal

2.   When the total capital of new firm is not specified.

Revision  15

Asha, Deepa and Lata are partners in a firm sharing profits in the ratio of 3 : 2 : 1. Deepa retires. After making all adjustments relating to revaluation, goodwill and accumulated profit etc., the capital accounts of Asha and Lata showed a credit balance of Rs. 1,60,000 and Rs. 80,000 respectively. It was decided to adjust the capitals of Asha and Lata in their new profit sharing ratio. You are required to calculate the new capitals of the partners and record necessary journal entries for bringing in or withdrawal of the necessary amounts involved.

Solution

Calculation of new capitals of the existinging partners

Balance in Asha’s Capital (after all adjustments)           = 1,60,000
Balance in Lata’s Capital                                                =    80,000
Total Capital of the New Firm                                         = 2,40,000
Based on the new profit sharing ratio of 3:1
Asha’s New Capital = Rs. 2,40,000 × ¾  = 1,80,000
Lata’s New Capital = Rs. 2,40,000 × ¼ = 60,000

Note :The total capital of the new firm is based on the sum of the balance in the capital accounts of the continuing partners.

Calculation of cash to be brought in or withdrawn by the continuing partners :

Cash to be brought in on (paid off)

Books  of  Asha and Lata

Journal

3.  When the amount payable to retiring partner will be contributed by continuing partners in such a way that their capitals are adjusted proportionate to their new profit sharing ratio:

Revision  16

Lalit, Pankaj and Rahul are partners sharing profits in the ratio of 4 : 3 : 3. After all adjustments, on Lalit’s retirement with respect to general reserve, goodwill and revaluation etc., the balances in their capital accounts stood at Rs. 70,000, Rs. 60,000 and Rs. 50,000 respectively. It was decided that the amount payable to Lalit will be brought by Pankaj and Rahul in such a way as to make their capitals proportionate to their profit sharing ratio. Calculate the amount to be brought by Pankaj and Rahul and record necessary journal entries for the same. Also record necessary entry for payment to Lalit.
After Lalit’s retirement, the new profit sharing ratio between Pankaj and Rahul is 3 : 3, i.e. 1 : 1.

Solution

Calculation of total capital of the new firm

Balance in Pankaj’s Capital account (after adjustment)         =          60,000
Balance in Rahul’s Capital account (after adjustment)          =          50,000
Amount payable to Lalit (Retiring partner)    =          70,000
Total capital of new firm (i) + (ii) + (iii)        =          1,80,000

Calculation of new capitals of the continuing partners

Pankaj’s New Capital    = Rs. 1,80,000 × ½ = Rs. 90,000
Rahul’s New Capital     = Rs. 1,80,000 × ½  = Rs. 90,000

Calculation of the amounts to be brought in or withdrawn by the continuing partners

Books of Pankaj and Rahul

Journal

Revision  17

The Balance Sheet of Mohit, Neeraj and Sohan who are partners in a firm sharing profits according to their capitals as on March 31, 2017 was as under:

On that date, Neeraj decided to retire from the firm and was paid for his share in the firm subject to the following:

1.  Buildings to be appreciated by 20%.
2.  Provision for Bad debts to be increased to 15% on Debtors.
3.  Machinery to be depreciated by 20%.
4.  Goodwill of the firm is valued at Rs. 72,000 and the retiring partner’s share is adjusted through the   capital accounts of remaining partners.
5.  The capital of the new firm be fixed at Rs. 1,20,000.
Prepare Revaluation Account, Capital Accounts of the partners, and the Balance Sheet after retirement of B.

Solution

Revaluation Account

Partners’  Capital  Accounts  

Balance Sheet  as on March 31, 2017

Working Notes

Bank Account

It is assumed that bank overdraft is taken to pay the retiring partners.
Cash to be brought in or withdrawn by Mohit and Sohan :

Death of a Partner

As stated earlier, the accounting treatment in the event of death of a partner is similar to that in case of retirement of a partner, and that in case of death of a partner his claim is transferred to his executors and settled in the same manner as that of the retired partner. However, there is one major difference that, while the retirement normally takes place at the end of an accounting period, the death of a partner may occur any time. Hence, in case of a partner, his claim shall also include his share of profit or loss, interest on capital, interest on drawings (if any) from the date of the last Balance Sheet to the date of his death of these, the main problem relates to the calculation of profit for the intervening period (i.e., the period from date of the last balance sheet and the date of the partner’s death. Since, it is considered cumbersome to close the books and prepare final account, for the period, the deceased partner’s share of profit may be calculated on the basis of last year’s profit (or average of past few years) or on the basis of sales.
For example, Bakul, Champak and Darshan were partners in a firm sharing profits in the ratio of 5:4:1. The profit of the firm for the year ending on March 31, 2017 was Rs.1,00,000. Champak died on June 30, 2017. Bakul and Darshan decided to share profits equally. Champak’s share of profit for the period from

April 1 to June 30, 2017, shall be calculated as follows:

Total profit for the year ending on 31st March, 2017 = Rs.1,00,000

Champak’s share of profit :

Proceeding Year’s Profit × Proportionate Period × Share of Deceased Partner

= Rs. 1,00,000  × 3/12 × 4/10 = Rs. 10,000

The journal entry will be recorded as follows :

Profit & Loss Suspense A/c                                Dr.                    10,000

To Champak’s Capital A/c                                                           10,000

 (Champak’s share of profit transferred to his capital account)

Alternatively, if Champak’s share of profit was to be calculated on the basis of average profits of the last three years, which were Rs. 1,36,000 for 2014-15, Rs. 1,54,000 for 2015-16 and Rs. 1,00,000 for 2016-17; Champahs share of profit for the period from April 7, 2017 to June 30, 2017 shall be calculated on the basis of average profit based on profits for the last year calculation as follows:

Average Profit =   Total Profit / No. of years

= Rs. 1,36,000 + Rs. 1,54,000 + Rs. 1,00,000
                                  3

Rs. 3,90,000
            3

= Rs. 1,30,000

 Champak’s share of profit         =  Rs. 1,30,000 ×  3/12 months × 4/10 months

=  Rs. 13,000

The Journal entry will be:

Profit & Loss Suspense A/c                                Dr.                    13,000

To Champak's Capital A/c                                                           13,000

In case, the agreement provides, that share of profit of the deceased partner will be worked out on the basis of sales, and it is specified that the sales during the year 2015-16 were Rs. 8,00,000 and the sales from April 1, 2017 to June 30, 2017 were Rs. 1,50,000 Champak’s share of profits for the period from

April 1, 2017 to June 30, 2017 shall be calculated as follows.

If sale is Rs.8,00,000, the profit           = Rs.1,00,000

If sale is Rs.1, the profit    = 1,00,000
                                              8,00,000

If sale is Rs.1,50,000,  the profit           = 1,00,000  X 1,50,000
                                                                 8,00,000

= Rs. 18,750

Champak’s share of profit                    = Rs. 7,500

The Journal entry will be:

Profit & Loss Suspense A/c                     Dr.        2,500

To Champak's Capital A/c                                    7,500

For being deceased partner’s share of profits for the intervening period to books of account, the following journal entry is recorded.

(i) Profit and Loss (Supense) A/c                               Dr.

To Deceased Partner’s Capital A/c

(Share of profit for the intervening period)

Later Profit and Loss Suspense account is closed by transferring the account to

Gaining Partners' Capital Account in their gaining ratio. The journal entry is:

(ii) Gaining Partners Capital A/c [In gaining ratio] To Profit and Loss Suspense A/c

(P&L Suspense account transferred).

Alternatively the following journal entry can also be passed in Place of (i) & (ii)

(ii) Gaining Partners' Capital A/c                      Dr.

To Deceased Partner Capital A/c

(share of profit of Deceased Partner credited)

Revision  18

Anil, Bhanu and Chandu were partners in a firm sharing profits in the ratio of 5:3:2. On March 31, 2017, their Balance Sheet was as under:

Books of Anil, Bhanu and Chandu

Balance Sheet  as on March 31, 2017

Anil died on October 1, 2017. It was agreed between his executors and the remaining partners that :

(a) Goodwill to be valued at 2 12  year’s purchase of the average profits of the previous four years which were :

Year 2013-14 – Rs.13,000, Year 2014-15 – Rs. 12,000, Year 2015-16 – Rs.20,000, Year 2016-17 – Rs.15,000

(b)  Patents be valued at Rs.8,000; Machinery at Rs.28,000; and Building at Rs.25,000.

(c)  Profit for the year 2017-18 be taken as having accrued at the same rate as that of the previous year.

(d)  Interest on capital be provided at 10% p.a.

(e)  Half of the amount due to Anil be paid immediately.

Prepare Anil’s Capital Account and Anil’s Executor’s Account as on October 1, 2017.

Solution

Books of Anil, Bhanu and Chander

Anil’s  Capital  Account

Anil’s  Executor’s  Account

Working Notes

Revaluation Account

Goodwill = 2½ years’ purchase × Average Profit

Average Profit   = Rs. 13,000 + Rs.12,000 + Rs.20,000 + Rs.15,000
                                                            4

= Rs. 60,000
          4

= Rs. 15,000

Goodwill   =  5/2 × Rs. 15,000

= Rs. 37,500

Anil’s Share of Goodwill = 5/10 × Rs. 37,500

=  Rs. 18,750

3.  Profit from the date of last balance sheet to date of death (April 1, 2017 to October 1, 2017)

 = 6 months

Profit for 6 months = Rs. 15,000 × 6/ 12 = Rs. 7,500

Anil’s share of profit = Rs. 7,500 × 5 / 10 = Rs. 3,750

4.  Interest on Capital

(April 1, 2017 to October 1, 2017)

= Rs. 30,000 ×  10 / 100  × 6 / 12

= Rs.1,500

Revision  19

You are given the Balance Sheet of Mohit, Sohan and Rahul who are partners sharing profits in the ratio of 2 : 2 : 1, as on March 31, 2017.

Books of Mohit,  Sohan and Rahul

Balance Sheet  as on March 31, 2017.

Sohan died on June 15, 2017. According to the Deed, his legal representatives are entitled to:

(a)  Balance in Capital Account;
(b)  Share of goodwill valued on the basis of thrice the average of the past 4 years’ profits.
 (c)  Share in profits up to the date of death on the basis of average profits for the past 4 years.
(d)  Interest on capital account @ 12% p.a.
(e)  New Profit sharing ratio of the firm will be 3:2 among Mohit and Rahul respectively.
Profits for the years ending on March 31 of 2014, 2015, 2016, 2017 respectively were Rs. 15,000, Rs. 17,000, Rs. 19,000 and Rs. 13,000.
Sohan’s legal representatives were to be paid the amount due. Mohit and Rahul continued as partner by taking over Sohan’s share equally. Work out the amount payable to Sohan’s legal representatives.

Solution

Books of Mohit,  Sohan and Rahul

Sohan’s  Capital  Account

Working Notes

1.  Sohan’s Share of Goodwill

=  Goodwill of the Firm × 2 / 5
= Rs. 48,000 × 2 / 5  = Rs. 19,200
Goodwill of the Firm   = 3 × Average Profit
=  3 × Rs. 64,000 / 4 = Rs. 48,000

2.  Profit and Loss                                                                                                   

 (Share of Profit from the date of last Balance Sheet to the date of death)  2  ½  months.
= Rs. 64,000 / 4 × 2 / 5 ×  2.5 / 12
= Rs. 1,333

3.  Interest on Capital 

 = Rs. 25,000 × 12  /100  × 25/ 12 = Rs. 625

Summary

  1. New Profit Sharing Ratio: New profit sharing ratio is the ratio in which the remaining partner will share future profits after the retirement or death of any partner.  New Share = Old Share + Acquired Share from the Outgoing partnerGaining Ratio: Gaining ratio is the ratio in which the continuing partners have acquired the share from the retiring deceased partner.
  2. Treatment of Goodwill: The basic rule is that gaining partner(s) shared compensate the sacrificing partner to the extent of their gain for the respective share of goodwill. If goodwill already appears in the books, it will be written off by debiting all partners’ capital account in their old profit sharing ratio.
  3. Revaluation of Assets and Liabilities: At the time of retirement/death of a partner, there may be some assets which may not have been shown at their current values. Similarly, there may be certain liabilities which have been shown at a value different from the obligation to be met by the firm. Besides this, there may be unrecorded assets and liabilities which have to be recorded.
  4. Accumulated Profits or Losses: The reserves (Accumulated profits) or losses belong to all the partners and should be transferred to capital account of all partners.
  5. Retiring partner/deceased partner may be paid in one lump sum or installments with interest.
  6. At the time of retirement/death of a partner, the remaining partner may decide to keep their capital contributions in their profit sharing ratio.

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