Partnership Accounts Changes in partnership firm

<< ESSENTIALS OF PARTNERSHIP

COMPANY ACCOUNTS 1 >>

Advance Financial Accounting (FIN-611)

Lesson # 19

Partnership Accounts

Changes in partnership firm

Subsequent to the formation of a partnership firm, a different accounting treatment is required

when any of the following changes occur in the constitution of the partnership (Partnership

deed) these changes might occur because of the following reasons:

· Admission of a new partner

· Retirement of an existing partner

· Death of a partner

Admission of a new partner

A new partner may be admitted for different reasons such as personal influence, need of more

capital, or special skills.

At the time of admission of a new partner, certain adjustments are necessary in the books of

accounts; among those calculation of good will is very important.

Goodwill

Goodwill may arise from such attributes of a business as good reputation, good customer

relationship, strategic location, skill of its employees, dynamic management, durability of its

products, effective advertisement, patented manufacturing process, outstanding credit rating,

training program of the employees, and good relationship with suppliers and employees, etc.

Goodwill may be described as the aggregate of those intangible attributes of a business that

contribute to the superior earning capacity of the business. Goodwill is the outcome of an

impression created in the mind of each customer and related persons.

Valuation of Goodwill

Methods to be adopted in valuing goodwill will depend upon the circumstances of each

particular case. At the time of valuation of goodwill, the partnership deed should be examined

and valuation should be done in uch a manner as must have been agreed upon by the partners.

Goodwill Calculation methods

1. Average profit method

2. Super profit method

3. Market capitalization method

Average Profit Method

Under this method, at first, average profit is calculated on the basis of the past few years'

profits. At the time of calculating average profit, precaution must be taken in respect of any

abnormal items of profit or loss which may affect future profit. It should be mentioned that

average profit is based on simple average method.

After calculating average profit, it is multiplied by a number (times) 3, or 4, or 5, what ever, as

agreed. The product will be the value of the goodwill.

For example:

Goodwill is three times of the average profit of previous five years.

Let's suppose:

Average profit = 100 / 5 = 20

Goodwill = 20 x 3 = 60

Advance Financial Accounting (FIN-611)

Solved Problem No 1:

Years

Profit

1st year

20,000

2nd year

40,000

3rd year

50,000

4th year

70,000

Total

180,000

Goodwill of the firm is equal to the three years purchase of the last four years average profits:

Average profit = 180,000 / 4 = Rs. 45,0000

Goodwill = 45,000 x 3 = 135,000

Super Profit Method

Super profit is the excess of actual profit (average profit) over the normal profit of an entity. A

common method of valuation of goodwill is the super profit method. A business unit may

possess some advantages which enable it to make extra profits over and above the amount that

would be earned if the capital of the business was invested elsewhere with similar risks. These

extra profits, generally expressed as super profits, can be valued, and goodwill is the value of

the few years' purchase of super profit.

In this method, super profits are taken as the basis for calculating goodwill in place of average

profit.

Certain steps are followed in calculating goodwill under super profit method, these are as

under:

1. Calculate Capital of the firm

2. Calculate normal profit by multiplying firm's capital with normal rate of return

3. Calculate average profit of the firm

4. Calculate super profit by subtracting normal profit from the average profit

5. Multiply the super profit by the number of year's purchase (number of times)

6. The product will be called goodwill.

Let's suppose:

Normal profit = 200,000 x 18% = 36,000

Super profit = Average profit Normal profit

= 45,000 36,000 = 9,000

Goodwill

= 9,000 x 3 = 27,000

Market Capitalization Method

Under this method the value of the firm is first determined based on the market capitalization

rate using the following formula:

Average profit of the firm x 100

% of market rate of return

Advance Financial Accounting (FIN-611)

The above formula will give an estimate of the firm's value in the market. By subtracting the

book value of the net assets (owners' equity/capital) of the firm from the above calculated

value we shall get the amount of goodwill.

Suppose average profit of the firm is Rs. 45,000 and the market rate of return is 18% and the

capital (net assets) of the firm is Rs. 200,000.

Then the good will of the firm will be calculated as under:

Goodwill

= 45,000 / 18 x 100 = 250,000

= 250,000 -200,000

= 50,000

Accounting treatment of goodwill

Since the goodwill of a partnership firm belongs to the old partners and no one else, it is

apparent that some adjustments must be made to the Capital accounts of the old partners upon

the admission of a new partner so that the incoming partner will not take a share of the

goodwill belonging to old partners without payment. The amount that the incoming partner

pays for goodwill is known as premium for goodwill. This goodwill can be treated in the books

of account in any of the following manner:

Goodwill Raised

Scenario-1

When the incoming partner cannot bring cash as premium for goodwill

Here, the capital accounts of the old partners are artificially inflated towards the right of the

goodwill, without any cash contribution. The idea is that if the business were sold immediately

after the admission of the new partner and the goodwill and other assets realized their book

value, the old partners would automatically receive cash for their share of the goodwill since

the amounts attributable to them in respects of the goodwill are now included in their respective

capital accounts.

In this case, goodwill account is to be raised in the books of account at its full value by debiting

the goodwill account and crediting the old partners' capital accounts in old ratio.

Journal Entry

Goodwill A/c 135,000

A's capital A/c

81,000

B's capital A/c

45,000

Working

A's share = 135,000 x 3/5 = 81,000

B's share = 135,000 x 2/5 = 54,000

Important Note

Following should be taken in to account when doing the above treatment for goodwill:

1. If goodwill already appears in the Balance Sheet which is equal to full value of

goodwill so calculated, then no entry is required to be passed.

2. if goodwill already appears in the Balance Sheet which is less than the full value of

goodwill then goodwill is to be raised for the balance (full value of goodwill calculated

less goodwill already appearing in the Balance sheet)

Advance Financial Accounting (FIN-611)

3. if goodwill already appears in the Balance sheet which is more than the full value of

goodwill, then excess goodwill is to be written off. The journal entry will be as under:

Old partners' capital accounts

Goodwill accounts

(Being the value of the goodwill written down to its calculated value)

Goodwill Raised & Written-Off

Scenario-2

When the incoming partner cannot bring anything as premium for goodwill but no goodwill is

to appear in the books:

Since the value of the goodwill constantly changes and partners may not wish that an account

should remain in the books, goodwill is raised in the books first and, thereafter it is written off.

Journal Entry (Goodwill raised)

Goodwill A/c 135,000

A's capital A/c

81,000

B's capital A/c

45,000

Journal Entry (Goodwill raised & written off )

A's capital A/c

67,500

B's capital A/c

45,000

C's capital A/c

22,500

Goodwill A/c

135,000

A's benefit

Old ratio (Cr) 81,000

New ratio (Dr)67,500

(Cr) 13,500

B's benefit

Old ratio (Cr) 54,000

New ratio (Dr)45,000

(Cr) 9,000

A's benefit + B's benefit

13,500 + 9,000 = 22,500

C's share = 22,500

C's share = 135,000 x 1/6 = 22,500

Goodwill Brought in Cash

Scenario-3

When the required amount of premium for goodwill is brought in by the incoming partner and

the money is retained in the business to increase the cash resources:

In this situation, premium for goodwill is to be shared by the old partners in the sacrificing

ratio. The sacrificing ratio is to be calculated by deducting the new ratio from the old ratio for

each partner. It should be noted that when the profit sharing ratio between the old partners does

not change as between themselves, this old profit sharing ratio is their sacrificing ratio.

Goodwill brought in cash

Advance Financial Accounting (FIN-611)

Bank A/c 22,500

C's premium for goodwill A/c 22,500

Distribution of goodwill (sacrifice ratio)

C's premium for goodwill A/c 22,500

A's capital A/c

13,500

B's capital A/c

9,000

A's share = 22,500 x 3/5 = 13,500

B's share = 22,500 x 2/5 = 9,000

Goodwill Brought in Cash & Withdrawn

Scenario-4

When the required amount of premium for goodwill is brought in by the new partners and this

amount is immediately withdrawn by the old partners:

Goodwill brought in cash

Bank A/c 22,500

C's premium for goodwill A/c 22,500

Distribution of goodwill (sacrifice ratio)

C's premium for goodwill A/c 22,500

A's capital A/c

13,500

B's capital A/c

9,000

Goodwill withdrawn

A's capital A/c 13,500

B's capital A/c 9,000

Bank A/c

22,500

Table of Contents: