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Advance Financial Accounting (FIN-611)
VU
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
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Advance Financial Accounting (FIN-611)
VU
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
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Advance Financial Accounting (FIN-611)
VU
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)
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Advance Financial Accounting (FIN-611)
VU
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
Dr
Goodwill accounts
Cr
(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
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Advance Financial Accounting (FIN-611)
VU
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
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Table of Contents:
  1. ACCOUNTING FOR INCOMPLETE RECORDS
  2. PRACTICING ACCOUNTING FOR INCOMPLETE RECORDS
  3. CONVERSION OF SINGLE ENTRY IN DOUBLE ENTRY ACCOUNTING SYSTEM
  4. SINGLE ENTRY CALCULATION OF MISSING INFORMATION
  5. SINGLE ENTRY CALCULATION OF MARKUP AND MARGIN
  6. ACCOUNTING SYSTEM IN NON-PROFIT ORGANIZATIONS
  7. NON-PROFIT ORGANIZATIONS
  8. PREPARATION OF FINANCIAL STATEMENTS OF NON-PROFIT ORGANIZATIONS FROM INCOMPLETE RECORDS
  9. DEPARTMENTAL ACCOUNTS 1
  10. DEPARTMENTAL ACCOUNTS 2
  11. BRANCH ACCOUNTING SYSTEMS
  12. BRANCH ACCOUNTING
  13. BRANCH ACCOUNTING - STOCK AND DEBTOR SYSTEM
  14. STOCK AND DEBTORS SYSTEM
  15. INDEPENDENT BRANCH
  16. BRANCH ACCOUNTING 1
  17. BRANCH ACCOUNTING 2
  18. ESSENTIALS OF PARTNERSHIP
  19. Partnership Accounts Changes in partnership firm
  20. COMPANY ACCOUNTS 1
  21. COMPANY ACCOUNTS 2
  22. Problems Solving
  23. COMPANY ACCOUNTS
  24. RETURNS ON FINANCIAL SOURCES
  25. IASBíS FRAMEWORK
  26. ELEMENTS OF FINANCIAL STATEMENTS
  27. EVENTS AFTER THE BALANCE SHEET DATE
  28. PROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS
  29. ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES AND ERRORS 1
  30. ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES AND ERRORS 2
  31. BORROWING COST
  32. EXCESS OF THE CARRYING AMOUNT OF THE QUALIFYING ASSET OVER RECOVERABLE AMOUNT
  33. EARNINGS PER SHARE
  34. Earnings per Share
  35. DILUTED EARNINGS PER SHARE
  36. GROUP ACCOUNTS
  37. Pre-acquisition Reserves
  38. GROUP ACCOUNTS: Minority Interest
  39. GROUP ACCOUNTS: Inter Company Trading (P to S)
  40. GROUP ACCOUNTS: Fair Value Adjustments
  41. GROUP ACCOUNTS: Pre-acquistion Profits, Dividends
  42. GROUP ACCOUNTS: Profit & Loss
  43. GROUP ACCOUNTS: Minority Interest, Inter Co.
  44. GROUP ACCOUNTS: Inter Co. Trading (when there is unrealized profit)
  45. Comprehensive Workings in Group Accounts Consolidated Balance Sheet