FUNDAMENTALS OF ACCOUNTING - CHAPTER 8

CHAPTER ----- 8 PARTNERSHIP ACCOUNTS Unit 1 Introduction to Partnership Accounts Copyright -The Institute of Chartered Accountants of India INTRODUCTON TO PARTNERSHIP ACCOUNTS Learning objectives After studying this unit, you will be able to : (cid:2) Understand the features of a partnership firm and the need for a Partnership Deed. (cid:2) Understand the points to be covered in a Partnership Deed regarding accounts. (cid:2) Learn the technique of maintaining Profit and Loss Appropriation Account. (cid:2) Familiarize with the two methods of maintaining Partners’ Capital Accounts, namely Fixed Capital Method and Fluctuating Capital Method. (cid:2) Note that Capital Account balance as per Fluctuating Capital method is just equal to the sum of the balances of Capital Account and Current Account as per Fixed Capital Method. (cid:2) Learn how to arrive at the corrected net profit figure which is to be taken to be Profit and Loss Appropriation Account after rectification of errors. Rectification of errors may be necessary to arrive at the net profit of the partnership and preparing Profit and loss Appropriation Account. (cid:2) Learn that interest on capital and drawings, salaries/commissions are to be shown in the Profit and Loss Appropriation Account and not in the Profit and Loss Account. Also learn that drawings by partners will not appear in the Appropriation Account. 1. INTRODUCTION An individual i.e., a sole proprietor may not be in a position to cope with the financial and managerial demands of the present day business world. As a result, two or more individuals may decide to pool their financial and non-financial resources to carry on a business. The preparation of final accounts of sole proprietors have already been discussed in chapter 6. The final accounts of partnership firms including basic concepts of accounting for admission of a partner, retirement and death of a partner have been discussed in succeeding units of this chapter. 2. DEFINITION AND FEATURES OF PARTNERSHIP The Indian Partnership Act defines partnership as “the relationship between persons who have agreed to share the profit of a business carried on by all or any of them acting for all.” The essential features of partnership are : 1. An association of two or more persons; 2. An agreement entered into by all persons concerned; 3. Existence of a business; 4. The carrying on of such business by all or any one of them acting for all; and 5. Sharing of profits of the business (including losses). 6. Unlimited liability of all partners. 8.2 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India The persons who enter into such an agreement are called partners and the business is called a firm. 3. LIMITED LIABILITY PARTNERSHIP The Indian Partnership Act of 1932 provides for a general form of partnership which is the most prevalent form in India, but, over time the general form of partnership has lost its charm because of the inherent disadvantages in it, the most important shortcoming is the unlimited liability of all partners for business debts and legal consequences, regardless of their holding, as the firm is not a legal entity. General partners are also jointly and severally liable for tortuous acts of co-partners. Each partner has the exposure of their personal assets being appropriated and liquidated to meet partnership dues. With the growth of the Indian economy, the role played by its entrepreneurs as well as its technical and professional manpower has been acknowledged internationally. Entrepreneurship, knowledge, risk and capital may be combined to provide a further impetus to India’s economic growth. In this background, a need has been felt for a new corporate form that would provide an alternative to the traditional partnership, with unlimited personal liability on the one hand, and, the statute-based governance structure of the limited liability company on the other, in order to enable professional expertise and entrepreneurial initiative to combine, organize and operate in flexible, innovative and efficient manner. The Government felt that with Indian professionals increasingly transacting with or representing multi-nationals in international transactions, the extent of the liability they could potentially be exposed to, is extremely high. Hence, in order to encourage Indian professionals to participate in the international business community without apprehension of being subject to excessive liability, the need for having a legal structure like the LLP is encouraged The Limited Liability Partnership (LLP) is viewed as an alternative corporate business proposal that provides the benefits of limited liability but allows its members, the flexibility of organizing their internal structure as a partnership based on a mutually arrived agreement. The LLP will be a separate legal entity, liable to the full extent of its assets, with the liability of the partners being limited to their agreed contribution in the LLP which may be of tangible or intangible nature or both tangible and intangible in nature. No partner would be liable on account of the independent or un-authorized actions of other partners or their misconduct. The liabilities of the LLP and partners who are found to have acted with intent to defraud creditors or for any fraudulent purpose shall be unlimited for all or any of the debts or other liabilities of the LLP. The main benefit in an LLP is that it is taxed as a partnership, but has the benefits of being a corporate, or more significantly, a juristic entity with limited liability. An LLP has the special characteristic of being a separate legal personality distinct from its partners. The LLP is a body corporate in nature and only Partnership accounts as per The Indian Partnership Act, 1932 has been discussed in this chapter. FUNDAMENTALS OF ACCOUNTING 8.3 Copyright -The Institute of Chartered Accountants of India INTRODUCTON TO PARTNERSHIP ACCOUNTS 4. MAIN CLAUSES IN A PARTNERSHIP DEED From the accounting point of view, the main thing is that relations among the partners will be governed by mutual agreement. The agreement is known as Partnership Deed which is to be properly stamped. It should be comprehensive to avoid disputes later on. It is usual therefore, to find the following clauses in a Partnership Deed which may or may not be registered. 1. Name of the firm and the partners; 2. Commencement and duration of business; 3. Amount of capital to be contributed by each partner; 4. Amount to be allowed to each partner as drawings and the timings of such drawings; 5. Rate of interest to be allowed to each partner on his capital and on his loan to the firm, and to be charged on his drawings; 6. The ratio in which profits or losses are to be shared; 7. Whether a partner will be allowed to draw any salary; 8. Any variations in the mutual rights and duties of partners; 9. Method of valuing goodwill on the occassions of changes in the constitution of the firm ; 10. Procedure by which a partner may retire and the method of payment of his dues; 11. Basis of the determination of the executors of a deceased partner and the method of payment; 12. Treatment of losses arising out of the insolvency of a partner; 13. Procedure to be allowed for settlement of disputes among partners; 14. Preparation of accounts and their audit. Registration of the firm is not compulsory, but non-registration restricts the partners or the firm from taking any legal action. Often there is no written Partnership Deed or, if there is one, it may be silent on a particular point. In that case the relevant sections of the Partnership Act will apply. If on any point the Partnership Deed contains a clause, it will hold good; otherwise the provisions of the Act relating to the questions will apply. 5. POWERS OF PARTNERS The Partners are supposed to have the power to act in certain matters and not to have such powers in others. In other words, unless a public notice has been given to the contrary, certain contracts entered into by a partner on behalf of the partnership, even without consulting other partners are binding and the provisions of the Act relating to the question will apply. In case of a trading firm, the implied powers of partners are the following. (a) Buying and selling of goods : (b) Receiving payments on behalf of the firm and giving valid recepit; (c) Drawing cheques and drawing, accepting and endorsing bills of exchange and promissory notes in the name of the firm; (d) Borrowing money on behalf of the firm with or without pledging the stock-in-trade; (e) Engaging servants for the business of the firm. 8.4 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India In certain cases an individual partner has no power to bind the firm. This is to say that third parties cannot bind the firm unless all the partners have agreed. These cases are : (a) Submitting a dispute relating to the firm arbitration; (b) Opening a bank account on behalf of the firm in the name of a partner; (c) Compromise or relinquishment of any claim or portion of claim by the firm; (d) Withdrawal of a suit or proceeding filed on behalf of the firm; (e) Admission of any liability in a suit or proceedings against the firm; (f) Acquisition of immovable property belonging to the firm; (g) Entering into partnership on behalf of the firm. The rights, duties and power of partners can be changed by mutual consent. Students should remember that in the absence of any agreement to the contrary; 1. no partner has the right to a salary, 2. no interest is to be allowed on capital, 3. no interest is to be charged on the drawings, 4. interest at the rate of 6% is to be allowed on a partner’s loan to the firm, and 5. profits and losses are to be shared equally. Note : In the absence of an agreement, the interest and salary payable to a partner will be paid only if there is profit. 6. ACCOUNTS There is not much difference between the accounts of a partnership firm and that of sole proprietorship (provided there is no change in the firm itself). The only difference to be noted is that instead of one Capital Account there will be as many Capital Accounts as there are partners. If, for instance, there are three partners A, B, and C there will be a Capital Account for each one of the partners, A’s Capital Account will be credited by the amount contributed by him as capital and similarly B’s and C’s Capital Accounts will be credited with the amounts brought in by them respectively as capital. When a partner takes money out of the firms for his domestic purpose, either his Capital Account can be debited or a separate account, named as Drawings Account, can be opened in his name and the account may be debited. In a Trial Balance of a partnership firm, therefore, one may find Capital Accounts of partners as well as Drawings Accounts. Finally the Drawings Account of a Partner may be transferred to his Capital Account so that a net figure is available. But, often the Drawings Account or Current Account (as it is usually called) remains separate. 6.1 Profit and Loss Appropriation : During the course of business, a partnership firm will prepare Trading Account and a Profit and Loss Account at the end of every year. This is done exactly on the lines already given in the chapter 6. This is to say that final accounts of a sole proprietorship concern will not differ from the accounts of a partnership firm. The Profit and Loss Account will show the profit earned by the firm or loss suffered by it. This profit or loss has to be transferred to the Capital Accounts of partners according to the terms of the Partnership FUNDAMENTALS OF ACCOUNTING 8.5 Copyright -The Institute of Chartered Accountants of India INTRODUCTON TO PARTNERSHIP ACCOUNTS Deed or according to the provisions of the Indian Partnership Act (if there is no Partnership Deed or if the Deed is silent on a particular point). Suppose the Profit and Loss Account reveals a profit of Rs. 90,000. There are two partners, A and B. A devotes all his time to the firm; B does not. A’s capital is Rs. 50,000 and B’s is Rs. 20,000. There is no Partnership Deed. In such a case the profit will be distributed among A and B equally. This is irrespective of the fact that B does not work as much as A does and B’s capital is much less than that of A. But if the Partnership Deed lays down that A is to get a salary and interest is to be allowed on the capital, then first of all, from the profit earned, A’s salary must be deducted and interest on the Capital Accounts of both partners will be deducted. The remaining profit will be divided equally between A and B. Further if the Partnership Deed says that profits are to be divided in the ratio of, say, three- fourth to A and one-fourth to B, then this will be the ratio to be adopted. The student can see for himself that if a salary is to be allowed to a partner, the Profit and Loss Account will be debited and the Partner’s Capital Account will be credited. Similarly, if interest is to be allowed on capital, the Profit and Loss Account will be debited and the respective Capital Accounts will be credited. Let us take an illustration to understand how to divide profits among partners. Illustration 1 A and B start business on 1st January, 2009, with capitals of Rs. 30,000 and Rs. 20,000. According to the Partnership Deed, B is entitled to a salary of Rs. 500 per month and interest is to be allowed on capitals at 6% per annum. The remaining profits are to be distributed amongst the partners in the ratio of 5:3. During 2009 the firm earned a profit, before charging salary to B and interest on capital amounting to Rs. 25,000. During the year A withdrew Rs. 8,000 and B withdrew Rs. 10,000 for domestic purposes. Give journal entries relating to division of profit. Solution Journal Entries 2009 Dr. Cr. Rs. Rs. Dec. 31 Profit and Loss Account Dr. 6,000 To B’s Capital Account 6,000 (Salary due to B @ Rs. 500 per month) Profit and Loss Account Dr. 3,000 To A’s Capital Account 1,800 To B’s Capital Account 1,200 (Interest due on Capital @ 6% per month) Profit and Loss Account Dr. 16,000 To A’s Capital Account 10,000 To B’s Capital Account 6,000 (Remaining profit of Rs. 16,000 divided) between A and B in the ratio of 5:3) 8.6 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India Now, let us learn the preparation of profit and loss appropriation account with the help of same illustration of partnership firm consisting of partners A and B. Illustration 2 Ram, Rahim and Karim are partners in a firm. They have no agreement in respect of profit- sharing ratio, interest on capital, interest on loan advanced by partners and remuneration payable to partners. In the matter of distribution of profits they have put forward the following claims : (i) Ram, who has contributed maximum capital demands interest on capital at 10% p.a. and share of profit in the capital ratio. But Rahim and Karim do not agree. (ii) Rahim has devoted full time for running the business and demands salary at the rate of Rs. 500 p.m. But Ram and Karim do not agree. (iii) Karim demands interest on loan of Rs. 2,000 advanced by him at the market rate of interest which is 12% p.a. How shall you settle the dispute and prepare Profit and Loss Appropriation Account after transferring 10% of the divisible profit to Reserve. Net profit before taking into account any of the above claims amounted to Rs. 45,000 at the end of the first year of their business. Solution There is no partnership deed. Therefore, the following provisions of The Indian Partnership Act are to be applied for settling the dispute. (i) No interest on capital is payable to any partner. Therefore, Ram is not entitled to interest on capital. (ii) No remuneration is payable to any partner. Therefore, Rahim is not entitled to any salary. (iii) Interest on loan is payable @ 6% p.a. Therefore, Karim is to get interest @ 6% p.a. on Rs. 2,000 instead of 12%. (iv) The profits should be distributed equally. Profit and Loss Appropriation Account for the year ended… Dr. Cr. Particulars Rs. Particulars Rs. To Interest on Karim Loan A/c By Profit and Loss A/c (Rs. 2,000 x 6/100) 120 (Net profit) 45,000 To Reserve A/c – 10% of Rs. (45,000-120) 4,488 To Share of Profit A/c : Ram: Rs. 13,464; Rahim: Rs. 13,464; Karim: Rs. 13,464 40,392 45,000 45,000 FUNDAMENTALS OF ACCOUNTING 8.7 Copyright -The Institute of Chartered Accountants of India INTRODUCTON TO PARTNERSHIP ACCOUNTS Illustration 3 A and B start business on 1st January, 2009, with capitals of Rs. 30,000 and Rs. 20,000. According to the Partnership Deed, B is entitled to a salary of Rs. 500 per month and interest is to be allowed on capitals at 6% per annum. The remaining profits are to be distributed amongst the partners in the ratio of 5:3. During 2009 the firm earned a profit, before charging salary to B and interest on capital amounting to Rs. 25,000. During the year A withdrew Rs. 8,000 and B withdrew Rs. 10,000 for domestic purposes. Prepare Profit and Loss Appropriation Account. Solution Profit and Loss Appropriation Account Rs. Rs. To B’s Capital Account-Salary 6,000 By Net Profit 25,000 To A’s Capital Account-interest 1,800 To B’s Capital Account-interest 1,200 To Profit transfer to : A’s Capital Account (5/8) 10,000 B’s Capital Account (3/8) 6,000 25,000 25,000 Let us also learn the preparation of capital accounts of partners with the help of same illustration of partnership firm consisting of partners A and B. Illustration 4 A and B start business on 1st January, 2009, with capitals of Rs. 30,000 and Rs. 20,000. According to the Partnership Deed, B is entitled to a salary of Rs. 500 per month and interest is to be allowed on capitals at 6% per annum. The remaining profits are to be distributed amongst the partners in the ratio of 5:3. During 2009 the firm earned a profit, before charging salary to B and interest on capital amounting to Rs. 25,000. During the year A withdrew Rs. 8,000 and B withdrew Rs. 10,000 for domestic purposes. Prepare Capital Accounts of Partners A and B. 8.8 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India Solution A’s Capital Account Dr. Cr. 2009 Rs. 2009 Rs. Dec. 31 To Cash - (Drawings) 8,000 Jan. 1 By Cash 30,000 To Balance c/d 33,800 Dec. 31 By Profit and Loss A/c - Interest 1,800 By Profit and Loss A/c - (5/8 Profit) 10,000 41,800 41,800 2010 Jan. 1 By Balance b/d 33,800 B’s Capital Account Dr. Cr. 2009 Rs. 2009 Rs. To Cash - (Drawings) 10,000 Jan. 1 By Cash 20,000 To Balance c/d 23,200 Dec. 31 By Profit and Loss A/c - Salary 6,000 - Interest 1,200 By Profit and Loss A/c 6,000 - (3/8 Profit) 33,200 33,200 2010 Jan. 1 By Balance b/d 23,200 6.2 Fixed and Fluctuating Capital : You have seen in the above example that the Capital Account of A has changed from Rs. 30,000 at the beginning to Rs. 33,800 and B’s Capital A/c from Rs. 20,000 to Rs. 23,200. This is because we have made entries in respect of interest, salary, profit earned during the year and money taken out by the partners in the Capital Account itself. If the Capital Accounts are prepared on this basis, capitals are said to be fluctuating. Some firms, however prefer to continue to show the Capital Accounts of the partners at the same old figure. This means that no entry is to be made in the Capital Account in respect of interest, salary, profit and drawings etc. A separate account is to be opened for this purpose. This account is known as the Current Account or even as Drawings Account. Under this system interest on capital if allowed, should be calculated only on the amount of the fixed capital. 6.2.1 Interest on Capital : Interest is generally allowed on capitals of the partners. Interest on capital of partners is calculated for the relevant period for which the amount of capital has been used in the business. Normally, it is charged for full year on the balance of capital at the FUNDAMENTALS OF ACCOUNTING 8.9 Copyright -The Institute of Chartered Accountants of India INTRODUCTON TO PARTNERSHIP ACCOUNTS beginning of the year unless some fresh capital is introduced during the year. On the additional capital introduced, interest for the relevant period of utilisation is calculated. For example, A has Rs. 30,000 capital in the beginning of the year and introduces Rs. 10,000 during the year. If rate of interest on capial is 20 % p.a., interest on A’s capital is calculated as follows: ⎡ 20 ⎤ ⎡ 20 6 ⎤ ⎢30,000× ⎥ + ⎢10,000× × ⎥ = Rs. 6,000 + Rs. 1,000 = Rs. 7,000 ⎣ 100⎦ ⎣ 100 12⎦ In case of fixed capital accounts, interest is calculated on the balance of capital accounts only and no interest is payable / chargeable on the balance of current accounts. Net loss and Interest on Capital : Subject to contract between the partners, interest on capitals is to be provided out of profits only. Thus in case of loss, no interest is provided. But in case of insufficient profits (i.e., net profit less than the amount of interest on capital), the amount of profit is distributed in the ratio of capital as partners get profit by way of interest on capital only. 6.2.2 Interest on Drawings : Sometimes interest is not only allowed on the capitals, but is also charged on drawings. In such a case, interest will be charged according to the time that elapses between the taking out of the money and the end of the year. Suppose X, a partner, has drawn the following sum of money – Rs. On 29th February, 2009 500 On 31st March, 2009 400 On 30th June, 2009 600 On 31st October, 2009 800 Accounts are closed on 31st December every year. Interest is chargeable on drawings at 6% per annum. The interest on X’s drawings will be calculated as shown below : 1. On Rs. 500 for 10 months, i.e. Rs. 25 2. On Rs. 400 for 9 months, i.e. 18 3. On Rs. 600 for 6 months, i.e. 18 4. On Rs. 800 for 2 months, i.e. 8 Total 69 Alternatively, it can be calculated as follows : Amount Number of months Product 500 10 5,000 400 9 3,600 600 6 3,600 800 2 1,600 2,300 13,800 Interest on Rs. 13,800 for one month at 6% per annum is Rs. 69. 8.10 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India If the dates on which amounts are drawn are not given, the student will do well to charge interest for six months on the whole of the amount on the assumption that the money was drawn evenly through out the year. In the above example, the total drawings come to Rs. 2,300; and at 6% for 6 months, the interest comes to Rs. 69. The entry to record interest on drawings is- debit the Capital Account of the partner concerned (or his Current Account if the capital is fixed) and credit the Profit and Loss Appropriation Account. If withdrawals are made evenly in the beginning of each month, interest can be calculated easily for the whole of the amount of 6-1/2 months; if withdrawals are made at the end of each month, interest should be calculated for 5-1/2 months. 6.2.3 Guarantee of Minimum Profit : Sometimes, one partner can enjoy the right to have minimum amount of profit in a year as per the terms of the partnership agreement. In such case, allocation of profit is done in a normal way if the share of partner, who has been guaranteed minimum profit, is more than the amount of guaranteed profit. However, if share of the partner is less than the guaranteed amount, he takes minimum profit and the excess of guaranteed share of profit over the actual share is borne by the remaining partners as per the agreement. There are three possibilities as far as share of deficiency by other partners is concerned. These are as follows : Excess is payable by one of the remaining partners. Excess is payable by atleast two or all the partners in an agreed ratio. Excess is payable by remaining partners in their mutual profit sharing ratio. If the question is silent about the nature of guarantee , the burden of guarantee is borne by the remaining partners in their mutual profit sharing ratio. Illustration 5 A and B are partners sharing profits and losses in the ratio of their effective capital. They had Rs.1,00,000 and Rs. 60,000 respectively in their Capital Accounts as on 1st January, 2009. A introduced a further capital of Rs.10,000 on 1st April, 2009 and another Rs. 5,000 on 1st July, 2009. On 30th September, 2009 A withdrew Rs. 40,000. On 1st July, 2009, B introduced further capital of Rs.30,000. The partners drew the following amounts in anticipation of profit. A drew Rs. 1,000 per month at the end of each month beginning from January, 2009. B drew Rs.1,000 on 30th June, and Rs. 5,000 on 30th September, 2009. 12% p.a. interest on capital is allowable and 10% p.a. interest on drawings is chargeable. Date of closing 31.12.2009. Calculate: (a) Profit-sharing ratio; (b) Interest on capital; and (c) Interest on drawings. FUNDAMENTALS OF ACCOUNTING 8.11 Copyright -The Institute of Chartered Accountants of India INTRODUCTON TO PARTNERSHIP ACCOUNTS Solution (a) Calculation of Effective Capital A B Rs. 1,00,000 invested for 3 months i.e., Rs. 60,000 invested for 6 months i.e., Rs. 3,00,000 invested for 1 month 3,00,000 Rs. 3,60,000 invested for 1 month 3,60,000 Rs. 1,10,000 invested for 3 months i.e., Rs. 90,000 invested for 6 months, i.e., Rs. 3,30,000 invested for 1 month. 3,30,000 Rs. 5,40,000 invested for 1 month 5,40,000 9,00,000 Rs. 1,15,000 invested for 3 months i.e, Rs. 3,45,000 invested for 1 month. 3,45,000 Rs. 75,000 invested for 3 months, i.e., Rs. 2,25,000 invested for 1 month. 2,25,000 12,00,000 (b) Calculation of Interest on Capital A = Rs. 12,00,000 x 12/100 x 1/12 = Rs. 12,000 B = Rs. 9,00,000 x 12/100 x 1/12 = Rs. 9,000 (c) Calculation of Interest on Drawings A = Rs. 12,000 x 10/100 x 5.5/12 = Rs. 550 B = Rs. 1,000 x 10/100 x 6/12 = Rs. 50 Rs. 5,000 x 10/100 x 3/12 = Rs. 125 Illustration 6 Ram and Rahim start business with capital of Rs. 50,000 and Rs. 30,000 on 1st January, 2009. Rahim is entitled to a salary of Rs. 400 per month. Interest is allowed on capitals and is charged on drawings at 6% per annum. Profits are to be distributed equally after the above noted adjustments. During the year, Ram withdrew Rs. 8,000 and Rahim withdrew Rs. 10,000. The profit for the year before allowing for the terms of the Partnership Deed came to Rs. 30,000. Assuming the capitals to be fixed, prepare the Profit and Loss Appropriation Account and the Capital and Current Accounts relating to the partners. 8.12 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India Solution Profit & Loss (Appropriation) Account Dr. Cr. 2009 Rs. 2009 Rs. Dec. 31 To Rahim’s Current A/c Dec. 31 By Net Profit 30,000 Salary 4,800 By Sundries-Interest on To Sundries-Interest on Drawings : Capitals : Ram’s Current A/c Ram’s Current A/c 3,000 (6% on Rs. 8,000 for Rahim’s Current A/c 1,800 6 months) 240 To Profit transferred to Rahim’s Current A/c Ram’s Current A/c (1/2) 10,470 (6% on Rs. 10,000 for Rahim’s Current A/c (1/2) 10,470 6 months) 300 30,540 30,540 Illustration 7 With the help of same information given in illustration 6, let us prepare the Capital and Current Accounts of Ram and Rahim. Solution Ram’s Capital Account 2009 Rs. 2009 Rs. Dec. 31 To Balance c/d 50,000 Jan. 1 By Cash 50,000 2010 Jan. 1 By Balance b/d 50,000 Rahim’s Capital Account 2009 Rs. 2009 Rs. Dec. 31 To Balance c/d 30,000 Jan. 1 By Cash 30,000 2010 Jan. 1 By Balance b/d 30,000 Ram’s Current Account 2009 Rs. 2009 Rs. Dec. 31 To Cash (Drawings) 8,000 Dec. 31 By Profit and Loss A/c - To Profit and Loss A/c - Interest 3,000 Interest on Drawings 240 By Profit and Loss A/c - To Balance c/d 5,230 1/2 profit 10,470 13,470 13,470 2010 Jan. 1 By Balance b/d 5,230 FUNDAMENTALS OF ACCOUNTING 8.13 Copyright -The Institute of Chartered Accountants of India INTRODUCTON TO PARTNERSHIP ACCOUNTS Rahim’s Current Account 2009 Rs. 2009 Rs. ? To Cash (Drawings) 10,000 Dec. 31 By Profit and Loss A/c Dec. 31 To Profit and Loss A/c Salary 4,800 Interest on Drawings 300 Interest 1,800 To Balance c/d 6,770 By Profit and Loss A/c Profit 10,470 17,070 17,070 2010 Jan. 1 By Balance b/d 6,770 Illustration 8 Weak, Able and Lazy are in partnership sharing profits and losses in the ratio of 2:1:1. It is agreed that interest on capital will be allowed @ 10% per annum and interest on drawings will be charged @ 8 percent per annum. (No interest will be charged/allowed on Current Accounts). The following are the particulars of the Capital and Drawings Accounts of the partners: Weak Able Lazy Rs. Rs. Rs. Capital (1.1.2009) 75,000 40,000 30,000 Current Account (1.1.2009) 10,000 5,000 (Dr.) 5,000 Drawings 15,000 10,000 10,000 The draft accounts for 2009 showed a net profit of Rs. 60,000 before taking into account interest on capitals and drawings and subject to following rectification of errors : (a) Life Insurance premium of Weak amounting to Rs. 750 paid by the firm on 30th June, 2009 has been charged to Miscellaneous Expenditure A/c. (b) Repairs of Machinery amounting to Rs. 10,000 has been debited to Plant Account and depreciation thereon charged @ 20%. (c) Travelling expenses of Rs. 3,000 of Able for a pleasure trip to U.K. paid by the firm on 30th June, 2009 has been debited to Travelling Expenses Account. You are required to prepare the Profit and Loss Appropriation Account for the year ended 31st December, 2009. 8.14 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India Solution WEAK, ABLE & LAZY Profit and Loss Appropriation Account for the year ended 31st December, 2009 Rs. Rs. Rs. Rs. To Interest on Capital : By Net Profit (Adjusted) 55,750 Weak 7,500 By Interest on Drawings : Able 4,000 Weak 630 Lazy 3,000 14,500 Able 520 Lazy 400 1,550 To Partner’s Current A/cs : Share of profit : Weak 21,400 Able 10,700 Lazy 10,700 42,800 57,300 57,300 Working Notes : 1. Adjusted Profit Rs. Net Profit as per Profit & Loss A/c 60,000 Add : Drawings by Weak : Life Insurance Premium of Weak charged to Miscellaneous Expenditure A/c of the Firm. 750 Drawing by Able : Travelling expenses of Able in connection with pleasure trip to U.K. charged to travelling expenses A/c of the firm. 3,000 63,750 Less : Repairs to Machinery wrongly capitalised 10,000 Less : Depreciation charged @ 20% 2,000 8,000 55,750 2. Interest on Drawings : Weak Able Lazy Rs. Rs. Rs. Drawings 15,000 10,000 10,000 Add : Rectificatory adjustments 750 3,000 – 15,750 13,000 10,000 Interest @ 8% p.a. for 6 months 630 520 400 FUNDAMENTALS OF ACCOUNTING 8.15 Copyright -The Institute of Chartered Accountants of India INTRODUCTON TO PARTNERSHIP ACCOUNTS Illustration 9 After preparation of Profit and Loss Appropriation Account for the year ended 31st December, 2009 let us prepare Current Accounts of partners Weak, Able and Lazy for the year ended 31st December, 2009. Solution Partners’ Current Accounts Weak Able Lazy Weak Able Lazy Rs. Rs. Rs. Rs. Rs. Rs. To Balance b/d – – 5,000 By Balance b/d 10,000 5,000 – To Drawings 15,000 10,000 10,000 By Profit & Loss App. A/c 7,500 4,000 3,000 To Life Insurance (Int. on capital) Premium 750 – – By Profit & Loss App. A/c 21,400 10,700 10,700 To Travelling Exps. – 3,000 – (Share of profit) To Profit & Loss App. By Balance c/d A/c (Int. on drawings) 630 520 400 – – 1,700 To Balance c/d 22,520 6,180 38,900 19,700 15,400 38,900 19,700 15,400 Illustration 10 Ram and Rahim are in partnership sharing profits and losses in the ratio of 3:2. As Ram, on account of his advancing years, feels he cannot work as hard as before, the chief clerk of the firm, Ratan, is admitted as a partner with effect from 1st January, 2009, and becomes entitled to 1/10th of the net profits and nothing else, the mutual ratio between Ram and Rahim remaining unaltered. Before becoming a partner, Ratan was getting a salary of Rs. 500 p.m. together with a commission of 4% on the net profits after deducting his salary and commission. It is provided in the partnership deed that the share of Ratan’s profits as a partner in excess of the amount to which he would have been entitled if he had continued as the chief clerk, should be taken out of Ram’s share of profits. The net profit for the year ended December 31, 2009 is Rs. 1,10,000. Show the distribution of net profit amongst the partners. 8.16 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India Solution Amount due to Ratan as a Chief Clerk Rs. Salary 6,000 Commission 4/104 (Rs. 1,10,000 - Rs. 6,000) 4,000 10,000 Share of Profit as a partner (1/10th of 1,10,000) 11,000 Excess chargeable to Ram 1,000 Profit and Loss Appropriation Account for the year ended 31.12.2009 Dr. Cr. Particulars Rs. Particulars Rs. To Share of Profit A/c By Profit and Loss A/c (Net profit) 1,10,000 Ram 3/5 (Rs. 1,10,000 – Rs. 10,000) less Rs. 1,000 59,000 Rahim 2/5 (Rs. 1,10,000 – Rs. 10,000) 40,000 Ratan 1/10 (Rs. 1,10,000) 11,000 1,10,000 1,10,000 SELF EXAMINATION QUESTIONS Pick up the correct answer from the given choices: 1. Following are the essential elements of a partnership firm except: (a) Atleast two persons. (b) There is an agreement between all partners. (c) Equal share of profits and losses. (d) Partnership agreement is for some business. 2. Following is the difference between partnership deed and partnership agreement: (a) Partnership deed is in writing and partnership agreement is oral. (b) Partnership deed is signed by all the partners but partnership agreement is signed by majority of the partners. (c) Partnership deed is registered in the court of law whereas partnership agreement is not registered. (d) Partnership deed is not subject to changes unless all partners agrees to it. Partnership agreement can be amended with the consent of more than 50% partners. FUNDAMENTALS OF ACCOUNTING 8.17 Copyright -The Institute of Chartered Accountants of India INTRODUCTON TO PARTNERSHIP ACCOUNTS 3. If a firm prefers Partners’ Capital Accounts to be shown at the amount introduced by the partners as capital in firm then entries for salary, interest, drawings, interest on capital and drawings and profits are made in (a) Trading Account. (b) Profit and Loss Account (c) Balance Sheet (d) Partners’ Current Account. 4. In the absence of any agreement, partners are liable to receive interest on their Loans @: (a) 12% p.a. (b) 10% p.a. (c) 8% p.a. (d) 6% p.a. 5. A partner acts as ……… for a firm. (a) Agent. (b) Third Party. (c) Employee. (d) None of the above. 6. Bill and Monica are partners sharing profits and losses in the ratio of 3:2 having the capital of Rs. 80,000 and Rs. 50,000 respectively. They are entitled to 9% p.a. interest on capital before distributing the profits. During the year firm earned Rs. 7,800 after allowing interest on capital. Profits apportioned among Bill and Monica is: (a) Rs. 4,680 and Rs. 3,120. (b) Rs. 4,800 and Rs. 3,000. (c) Rs. 5,000 and Rs. 2,800. (d) None of the above. 7. Ram and Shyam are partners with the capital of Rs. 25,000 and Rs. 15,000 respectively. Interest payable on capital is 10% p.a. Find the interest on capital for both the partners when the profits earned by the firm is Rs. 2,400. (a) Rs. 2,500 and Rs. 1,500. (b) Rs. 1,500 and Rs. 900. (c) Rs. 1,200 and Rs. 1,200. (d) None of the above. 8. Seeta and Geeta are partners sharing profits and losses in the ratio 4:1. Meeta was manager who received the salary of Rs. 4,000 p.m. in addition to a commission of 5% on net profits after charging such commission. Profits for the year is Rs. 6,78,000 before charging salary. Find the total remuneration of Meeta. (a) Rs. 78,000. (b) Rs. 88,000. (c) Rs. 87,000. (d) Rs. 76,000. 9. The relationship between persons who have agreed to share the profit of a business carried on by all or any of them acting for all is known as ……… (a) Partnership. (b) Joint Venture. (c) Association of Persons. (d) Body of Individuals. 10. Features of a partnership firm are: (a) Two or more persons carrying common business under an agreement. (b) Sharing profits and losses in the fixed ratio. (c) Business carried by all or any of them acting for all. (d) All of the above. 8.18 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India 11. Firm has earned exceptionally high profits from a contract which will not be renewed. In such a case the profit from this contract will not be included in ……… (a) Profit sharing of the partners. (b) Calculation of the goodwill. (c) Both. (d) None. 12. In the absence of an agreement, partners are entitled to (a) Salary. (b) Commission. (c) Interest on Loan and Advances. (d) Profit share in capital ratio. 13. Interest on capital will be paid to the partners if provided for in the agreement but only from ………… (a) Current Profits. (b) Reserves. (c) Accumulated Profits. (d) Goodwill. 14. Partners are suppose to pay interest on drawing only when ……… by the ……… (a) Provided, Agreement. (b) Permitted, Investors. (c) Agreed, Partners. (d) Both (a) & (c) above. 15. When a partner is given Guarantee by the other partner, loss on such guarantee will be borne by (a) Partnership firm. (b) All the other partners. (c) Partner who gave the guarantee. (d) Partner with highest profit sharing ratio. 16. Guarantee given to a partner ‘A’ by the other partners ‘B & C’ means (a) In case of loss ‘A’ will contribute towards that loss. (b) In case of insufficient profits ‘A’ will receive only the share of profit and not minimum guaranteed amount. (c) In case of loss or insufficient profits ‘A’ will withdraw the minimum guaranteed amount. (d) All of the above. 17. What would be the profit sharing ratio if the partnership act is complied with? (a) As per agreement. (b) Equally. (c) In Capital Ratio. (d) None of the above. 18. Would interest on loan be allowed in the absence of any agreement or when partnership deed is silent? (a) No interest allowed. (b) Allowed only if agreed by all the other partners. (c) Will be paid only when there are sufficient profits. (d) Allowed @ 6% p.a. 19. Profit & Loss Appropriation Account is prepared (a) For Proprietorship firm. (b) For partnership firm. (c) Both ‘a’ and ‘b’ (d) None of the above. FUNDAMENTALS OF ACCOUNTING 8.19 Copyright -The Institute of Chartered Accountants of India INTRODUCTON TO PARTNERSHIP ACCOUNTS 20. What time would be taken into consideration if equal monthly amount is drawn as drawings at the beginning of each month? (a) 7 months. (b) 6 months. (c) 5 months. (d) 6.5 months. 21. Where will you record interest on drawings? (a) Debit side of Profit & Loss Appropriation Account. (b) Credit side of Profit & Loss Appropriation Account. (c) Credit side of Profit & Loss Account. (d) Credit side of Capital/Current Account only. 22. What balance does a Partner’s Current Account has? (a) Debit balance. (b) Credit balance. (c) Either ‘a’ or ‘b’. (d) None of the above. 23. Is rent paid to a partner is appropriation of profits? (a) Yes. (b) No. (c) If partner’s contribution as capital is maximum. (d) If partner is a working partner? 24. How would you close the Partner’s Drawings Account? (a) By transfer to Capital or Current Account debit side. (b) By transfer to Capital Account credit side. (c) By transfer to Current Account credit side. (d) Either ‘b’ or ‘c’. 25. A, B and C had capitals of Rs. 50,000; Rs. 40,000 and Rs. 30,000 respectively for carrying on business in partnership. The firm’s reported profit for the year was Rs. 80,000. As per provisions of the Indian Partnership Act, 1932, find out the share of each partner in the above amount after taking into account that no interest has been provided on an advance by A of Rs. 20,000, in addition to his capital contribution. (a) Rs. 26,267 for Partner B and C & Rs. 27,466 for partner A. (b) Rs. 26,667 each partner. (c) Rs. 33,333 for A, Rs. 26,667 for B and Rs. 20,000 for C. (d) Rs. 30,000 each partner. 26. X, Y and Z are partners in a firm. At the time of division of profit for the year there was dispute between the partners. Profits before interest on partner’s capital was Rs. 6,000 and X wanted interest on capital @ 20% as his capital contributions was Rs. 1,00,000 as compared to that of Y and Z which was Rs. 75,000 and Rs. 50,000 respectively. (a) Profits of Rs. 6,000 will be distributed equally with no interest on either Capital. (b) X will get the interest of Rs. 20,000 and the loss of Rs. 14,000 will be shared equally. (c) All the partners will get interest on capital and the loss of Rs. 39,000 will be shared equally. (d) None of the above. 8.20 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India 27. X, Y and Z are partners in a firm. At the time of division of profit for the year there was dispute between the partners. Profits before interest on partner’s capital was Rs. 6,000 and Y determined interest @ 24% p.a. on his loan of Rs. 80,000. There was no agreement on this point. Calculate the amount payable to X, Y and Z respectively. (a) Rs. 2,000 to each partner. (b) Loss of Rs. 4,400 for X and Z & Y will take home Rs. 14,800. (c) Rs. 400 for X, Rs. 5,200 for Y and Rs. 400 for Z. (d) Rs. 2,400 to each partner. 28. X, Y and Z are partners in a firm. At the time of division of profit for the year there was dispute between the partners. Profits before interest on partner’s capital was Rs. 6,000 and Z demanded minimum profit of Rs. 5,000 as his financial position was not good. However, there was no written agreement. Profits to be distributed to X, Y and Z will be (a) Other partners will pay Z the minimum profit and will suffer loss equally. (b) Other partners will pay Z the minimum profit and will suffer loss in capital ratio. (c) X & Y will take Rs. 500 each and Z will take Rs. 5,000. (d) Rs. 2,000 to each of the partners. 29. Following are the differences between Capital Account and Current Account except: (a) Capital Account is prepared under fixed capital method whereas current account is prepared under fluctuating capital method. (b) In capital account only capital introduced and withdrawn is recorded, all other transactions between the firm and partner is recorded in the current account. (c) Interest is sometimes paid on capital account balance but no such interest is payable on current account balances. (d) ‘b’ and ‘c’ above. 30. Following are the differences between Partnership and Joint Venture except: (a) Joint venture is essentially planned for short term mainly for one contract/deal. However, partnerships are normally undertaken as going concerns and are expected to last for a very long period. (b) The persons involved in a joint venture are called co-venturers whereas persons involved in a partnership are called partners. (c) Any specific statute of the Government does not govern joint ventures but the Indian Partnership Act, 1932, governs partnerships. (d) Memorandum of Understanding is mandatory to be drafted to spell the relationship between the co-venturers whereas the basic relationship between the partners is defined by the partnership deed. FUNDAMENTALS OF ACCOUNTING 8.21 Copyright -The Institute of Chartered Accountants of India INTRODUCTON TO PARTNERSHIP ACCOUNTS ANSWERS 1. (c) 2. (c) 3. (d) 4. (d) 5. (a) 6. (a) 7. (b) 8. (a) 9. (a) 10. (d) 11. (b) 12. (c) 13. (a) 14. (d) 15. (c) 16. (c) 17. (b) 18. (d) 19. (b) 20. (d) 21. (b) 22. (c) 23. (b) 24. (a) 25. (a) 26. (a) 27. (c) 28. (d) 29. (a) 30. (d) 8.22 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India CHAPTER ----- 8 PPPPPAAAAARRRRRTTTTTNNNNNEEEEERRRRRSSSSSHHHHHIIIIIPPPPP AAAAACCCCCCCCCCOOOOOUUUUUNNNNNTTTTTSSSSS Unit 2 Treatment of Goodwill in Partnership Accounts Copyright -The Institute of Chartered Accountants of India TREATMENT OF GOODWILL IN PARTNERSHIP ACCOUNTS Learning objectives After studying this unit, you will be able to : (cid:2) Understand when does the need for valuation of goodwill arise. (cid:2) Learn the accounting of goodwill. 1. GOODWILL Goodwill is the value of reputation of a firm in respect of profits expected in future over and above the normal rate of profits. The implication of the term over and above is that there is always a certain normal rate of profits earned by similar firms in the same locality. The excess profit earned by a firm may be due to its locational advantage, better customer service, possession of a unique patent right, personal reputation of the partner or for similar other reasons. The necessity for valuation of goodwill in a firm arises in the following cases : a) When the profit sharing ratio amongst the partners is changed; b) When a new partner is admitted; c) When a partner retires or dies; and d) When the business is dissolved or sold. 2. METHODS FOR GOODWILL VALUATION There are four methods for valuation of goodwill 1) Average profit basis, 2) Super profit basis, 3) Annuity basis, and 4) Capitalisation basis (1) Average Profit Basis : In this case the profits of the past few years are averaged and adjusted for any expected change in future. For averaging the past profit, either simple average or weighted average may be employed depending upon the circumstances. If there exists clear increasing or decreasing trend of profits, it is better to give more weight to the profits of the recent years than those of earlier years. But, if there is no clear trend of profit, it is better to go by simple average. Let us suppose profits of a partnership firm for the last five years were Rs. 30,000, Rs. 40,000, Rs. 50,000, Rs. 60,000 and Rs. 70,000. In this case, a clear increasing trend is noticed 8.24 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India and therefore, average profit may be arrived at by assigning appropriate weights as shown below : 1 2 3 4 = 2 × 3 Year Profit Weight Weighted Profit Rs. Rs. 1 30,000 1 30,000 2 40,000 2 80,000 3 50,000 3 1,50,000 4 60,000 4 2,40,000 5 70,000 5 3,50,000 15 8,50,000 Rs.8,50,000 So, Weighted Average Profit = = Rs. 56,667 15 If goodwill is valued at three years’ purchase of profit, then in this case the value of goodwill is Rs. 56,667 × 3 = Rs. 1,70,000. However, if any such trend is not visible from the figures of past profits, then one should take simple average profit and calculate goodwill accordingly. Let us suppose, profits of a partnership firm for five years were Rs. 30,000, Rs. 25,000, Rs. 20,000, Rs. 30,000 and Rs. 28,000. In this case, there is no clear increasing or decreasing trend of profit. So average profit comes to Rs. 26,600 (arrived at by taking simple average). If the goodwill is valued by taking three years’ of purchase of profit, then in this case, value of goodwill becomes Rs. 79,800. (2) Super Profit Basis : In case of average profit basis, goodwill is calculated on the basis of average profit multiplied by certain number of years. The implication is that such profit will be maintained for so many number of years and the partner(s) who gains in terms of profit sharing ratio should contribute for such gains in profit to the partners who make the sacrifice. On the other hand, super profit means, excess profit that can be earned by a firm over and above the normal profit usually earned by similar firms under similar circumstances. Under this method, the partner who gains in terms of profit sharing ratio has to contribute only for excess profit because normal profit he can earn by joining any partnership firm. Under super profit method, what excess profit a partnership firm can earn is to be determined first. The steps to be followed are given below : a. Identify the capital employed by the partnership firm; b. Identify the average profit earned by the partnership firm based on past few years’ figures; c. Determine normal rate of return prevailing in the locality of similar firms; d. Apply normal rate of return on capital employed to arrive at normal profit; e. Deduct normal profit from the average profit of the firm. If the average profit of the firm is more than the normal profit, there exists super profit and goodwill. FUNDAMENTALS OF ACCOUNTING 8.25 Copyright -The Institute of Chartered Accountants of India TREATMENT OF GOODWILL IN PARTNERSHIP ACCOUNTS Let us suppose, total capital employed by a partnership firm was Rs. 1,00,000 and its average profit was Rs. 25,000. Normal rate of return is 22% in case of similar firms working under similar conditions. So, normal profit is Rs. 22,000 and average profit is Rs. 25,000. The partnership firm earns Rs. 3,000 super profit. Goodwill is generally valued by multiplying the amount of super profit by certain number of years depending upon the expectation about the maintence of such profit in future. If it is expected that the super profit can be maintained for another five years in future, then value of goodwill may be taken as Rs. 3,000 × 5 = Rs. 15,000. (3) Annuity Method : In the super profit method explained above, time value of money is not considered. Although it was expected that super profit would be earned in five future years, still no devaluation was done on the value of money for the time difference. In fact when money will be received in different points of time, its value should be different depending upon the rate of interest. If 15% rate of interest is considered appropriate, then discounted value of super profit to be earned in different future years will be as follows : Year Super Profit Discount Discounted Rs. Factor @ 15% value of Super Profit 1 3,000 .8696 2,608.80 2 3,000 .7561 2,268.30 3 3,000 .6575 1,972.50 4 3,000 .5718 1,715.40 5 3,000 .4972 1,491.60 3.3522 10,056.60 So, under the annuity method, discounted value of total super profit becomes Rs. 10,056.60 and not Rs. 15,000 as was done under super profit method. The word annuity is used to mean identical annual amount of super profit. So, for discounting it is possible to refer to annuity table. As per the annuity table, present value of Re. 1 to be received at the end of each year for n year @ 15% interest p.a. is 3.3522. So value of goodwill under annuity method is Rs. 3,000 × 3.3522 = Rs. 10,056.60. (4) Capitalisation Basis : Under this basis, value of whole business is determined applying normal rate of return. If such value (arrived at by applying normal rate of return) is higher than the capital employed in the business, then the difference is goodwill. The steps to be followed under this method are given below : a. Determine the normal rate of return. b. Find out the average profit of the partnership firm for which goodwill is to be determined. c. Determine the capital employed by the partnership firm for which goodwill is to be determined. 8.26 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India d. Find out normal value of the business by dividing average profit by normal rate of return. e. Deduct average capital employed from the normal value of the business to arrive at goodwill. Let us suppose capital employed by a partnership firm is Rs. 1,00,000. Its average profit is Rs. 20,000. Normal rate of return is 15% Rs.20,000 Normal Value of business = = Rs. 1,33,333 15% Value of goodwill = Rs. 1,33,333 – Rs. 1,00,000 = Rs. 33,333 Illustration 1 Lee and Lawson are in equal partnership. They agreed to take Hicks as one-fourth partner. For this it was decided to find out the value of goodwill. M/s. Lee and Lawson earned profits during 2006-2009 as follows : Year Profits Rs. 2006 1,20,000 2007 1,25,000 2008 1,30,000 2009 1,50,000 On 31.12.2009 capital employed by M/s. Lee and Lawson was Rs. 5,00,000. Rate of normal profit is 20%. Find out the value of goodwill following various methods. Solution Average Profit : Year Profit Weight Weighted Rs. Profit Rs. 2002 1,20,000 1 1,20,000 2003 1,25,000 2 2,50,000 2004 1,30,000 3 3,90,000 2005 1,50,000 4 6,00,000 10 13,60,000 Rs.13,60,000 Weighted Average Profit = = Rs. 1,36,000 10 Method (1) : Average Profit Basis Assumption : Goodwill is valued at 3 year’s purchase Value of Goodwill : Rs. 1,36,000 × 3 = Rs. 4,08,000 FUNDAMENTALS OF ACCOUNTING 8.27 Copyright -The Institute of Chartered Accountants of India TREATMENT OF GOODWILL IN PARTNERSHIP ACCOUNTS Method (2) : Super Profit Basis Average Profit Rs. 1,36,000 Less : Normal Profit 20% on Rs. 5,00,000 Rs. 1,00,000 Rs. 36,000 Assumption : Goodwill is valued at 3 years’ purchase. Value of Goodwill = Rs 36,000 × 3 = Rs. 1,08,000 Method (3) : Annuity Basis Assumptions : (a) Interest rate is equivalent to normal profit rate i.e. 20% p.a. (b) Goodwill is valued at 3 years’ purchases Valuation of Goodwill : Rs. 36,000 × 2.1065 = Rs. 75,834 Method (4) : Capitalisation Basis Normal Value of business : Rs. 1,36,000 X 100 20 = Rs. 6,80,000 Less: Capital Employed in M/s. Lee and Lawson = Rs. 5,00,000 Goodwill = Rs. 1,80,000 Illustration 2 The following particulars are available in respect of the business carried on by Rathore Rs. (1) Capital Invested 1,50,000 (2) Trading Results : 2006 Profit 40,000 2007 Profit 36,000 2008 Loss 6,000 2009 Profit 50,000 (3) Market Rate of interest on investment 10% (4) Rate of risk return on capital invested in business 2% (5) Remuneration from alternative employment of the proprietor Rs. 6,000 (if not engaged in business). per annum 8.28 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India You are requested to compute the value of goodwill on the basis of 5 years’ purchase of super profit of the business calculated on the average profits of the last four years. Solution Average maintainable profits : Rs. Trading profit during 2006 40,000 2007 36,000 2008 50,000 1,26,000 Less : Loss during 2009 6,000 Total 1,20,000 Average Profits 30,000 Less : Remuneration for the proprietor 6,000 Average maintainable Profit 24,000 Normal Profit (12% on capital employed) 18,000 Super Profit 6,000 Goodwill at 5 year’s purchase of super Profit 30,000 3. NEED FOR VALUATION OF GOODWILL Whenever there is any change in the existing relationship of the partners inter se, some partners have to sacrifice their future profit and some others would gain. Those who are sacrificing future profit should be compensated by the others who are gaining. This adjustment of the partnership rights may arise due to admission of a new partner, change in the profit sharing ratio, retirement or death of a partner and a dissolution of the partnership. The partners, who gain in terms of profit sharing ratio, have to pay for such gain as a proportion to the value of goodwill. The partners, who lose in terms of profit sharing ratio, receive payments for the sacrifice as a proportion to the value of goodwill. Dissolution of partnership firms is not covered in this study material and will be discussed in the Integrated Professional Competence Course Study Material. 4. VALUATION OF GOODWILL IN CASE OF ADMISSION OF A PARTNER When a new partner is admitted into a partnership, certain adjustments in accounts become necessary. Chiefly, this is because the new partner will acquire a share in the profits of the firm and because of this, the old partners will stand to lose. Suppose, A and B are partners sharing profits in the ratio of 3:2. If their profits are Rs. 20,000, A will get Rs. 12,000 and B will get Rs. 8,000. If C is admitted and given one fourth share in profits, then out of Rs. 20,000 he will get Rs. 5,000. The remaining Rs. 15,000 will be divided between A and B; A will get Rs. 9,000 and B will get Rs. 6,000. Thus on C’s admission A loses Rs. 3,000 per year and B loses Rs. 2,000 per year. C will have to compensate A and B for this loss. It is no argument to say that on C’s admission the profits will not remain at Rs. 20,000; extra profits will arise and therefore, A and FUNDAMENTALS OF ACCOUNTING 8.29 Copyright -The Institute of Chartered Accountants of India TREATMENT OF GOODWILL IN PARTNERSHIP ACCOUNTS B will both get more than what they previously got. But it should be noted that the additional profits will be earned by the combined efforts of all the partners A, B and C. Therefore, if A and B get a share of the extra profits they are not particularly obliged to C. Out of the present profits of Rs. 20,000 they have to give up a share in favour of C and, therefore, they are entitled to a compensation. The problem of compensation is the chief problem while dealing with admission of a partner. This is tackled through goodwill. But one point should be made clear here. Goodwill is a compensation to old partners for their sacrifice in connection with admission of a new partner. So it is to be credited to the partners according to their profit sacrificing ratio. Whatever share the new partner is getting, it may be sacrificed by the old partners in proportion to their old profit sharing ratio or in different proportion. For example, Nigam and Dhameja are in partnership sharing profits and losses equally. They agreed to take Ghosh as one-third partner. Now one-third share of Ghosh may come out of sacrifice made by Nigam and Dhameja equally (i.e. at their old profit sharing ratio). See the following profit sharing pattern : Profit Sharing Pattern Partners Old Share New Share Sacrifice Gain Nigam 1 1− 1 = 2 x 1 = 1 1 - 1 = 1 - 2 3 3 2 3 2 3 6 Dhameja 1 1− 1 = 2 x 1 = 1 1 - 1 = 1 - 2 3 3 2 3 2 3 6 1 1 Ghosh - - 3 3 In other words, one-third share of Ghosh was borne by Nigam and Dhameja at their old profit sharing ratio. By this process Nigam sacrificed 1/2–1/3=1/6 in share and Dhameja sacrificed 1/2–1/3=/1/6 in share. So the profit sacrificing ratio becomes : Nigam = Dhameja 1/6 = 1/6 1 : 1 which is the same as old profit sharing ratio. But if the new profit sharing ratio of Nigam, Dhameja and Ghosh becomes 4:2:3, then profit sacrificed by Nigam and Dhameja on Ghosh’s admission is not at the old profit sharing ratio. In this case profit sacrificing ratio is as follows : Nigam = 1/2–4/9 = 1/18 Dhameja = 1/2–2/9 = 5/18 i.e. 1 : 5 If Ghosh pays goodwill of Rs. 24,000, then in the first case, Nigam and Dhameja should share it equally; but in second case Nigam should get Rs. 4,000 and Dhameja should get Rs. 20,000. Take another example : Nigam and Dhameja are equal partners. They agreed to take Ghosh as one-third partner. The new profit sharing ratio is 4:2:3. Nigam and Dhameja agreed Rs. 27,000 as value of goodwill. 8.30 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India Journal Entries : Rs. Rs. Ghosh’s Capial Account Dr. 9,000 To Nigam’s Capital Account 1,500 To Dhameja’s Capital Account 7,500 (Goodwill adjustment in the profit sacrificing ratio – Nigam - Rs. 27,000 × 1/18 Dhameja - Rs. 27,000 × 5/18) As per the Accounting Standard, it is not recommended to raise goodwill account but to show the adjustment of goodwill through partners’ capital accounts. 5. ACCOUNTING TREATMENT OF GOODWILL IN CASE OF ADMISSION OF A NEW PARTNER The goodwill should be recorded in the books only when some consideration in money or money’s worth has been paid for it. Therefore, only purchased goodwill should be recorded in the books of the firm. In case of admission of a partner, goodwill cannot be raised in the books of the firm because no consideration in money or money’s worth is paid for it. If the incoming partner brings any premium over and above his capital contribution at the time of his admission, such premium should be distributed to other existing partners. When a new partner is admitted to a firm, the old partners generally sacrifice in favour of the new partner in terms of lower profit sharing ratio in the future. Therefore, the premium for goodwill brought in by the new partner shall be given to the existing partners on the basis of profit sacrificing ratio. The profit sacrificing ratio is computed by deducting the new profit sharing ratio from the old profit sharing ratio. If the difference is positive, then there is a profit sacrifice and in case the difference is negative, then there is a gain in terms of higher future profit sharing ratio. In case of admission of a partner, only those existing partners are entitled to a share for goodwill who have sacrificed a part of their profits in favour of the new partner. Sometimes, goodwill may be evaluated in case of admission of a partner when incoming partner is unable to bring in cash any premium for goodwill. In that situation also, the value of goodwill should not be raised in the books since it is inherent goodwill. Rather it is preferable that such value of goodwill should be adjusted through partners’ capital accounts. It may also be noted that when the incoming partner pays any premium for goodwill privately to the existing partners, no entry is required in the books of the firm. In that case, the amount to be paid to each partner should be calculated as per the profit sacrificing ratio. Example 1 : A, B & C are in partnership sharing profits and losses in the ratio 2:2:1. They want to admit D into partnership with one-fifth share. D brings in Rs. 30,000 as capital and Rs. 10,000 as premium for goodwill. FUNDAMENTALS OF ACCOUNTING 8.31 Copyright -The Institute of Chartered Accountants of India TREATMENT OF GOODWILL IN PARTNERSHIP ACCOUNTS The necessary journal entry will be: Bank A/c Dr. Rs. 40,000 To A’s Capital A/c Rs. 4,000 To B’s Capital A/c Rs. 4,000 To C’s Capital A/c Rs. 2,000 To D’s Capital A/c Rs. 30,000 (Amount brought in by D as Capital and premium for goodwill which is credited to the old partners’ capital accounts in profit sacrificing ratio) Example 2 : A & B are equal partners. They wanted to take C as a third partner and for this purpose goodwill was valued at Rs. 1,20,000. The journal entry for adjustment of value of goodwill through partners’ capital accounts will be : C’s Capital A/c Dr. Rs. 40,000 To A’s Capital A/c Rs. 20,000 To B’s Capital A/c Rs. 20,000 (Adjustment for goodwill) The net effect in partners’ capital accounts is shown on the basis of profit sacrificing ratio: A = 1/6 × Rs. 1,20,000 = Rs. 20,000 (Cr.) B = 1/6 × Rs. 1,20,000 = Rs. 20,000 (Cr.) C = 1/3 × Rs. 1,20,000 = Rs. 40,000 (Dr.) Example 3 : A & B are equal partners. They wanted to admit C as 1/6th partner who brought Rs. 60,000 as goodwill. The new profit sharing ratio is 3:2:1. Profit sacrificing ratio is to be computed as follows : Old Share - New Share = Share Sacrificed A = 1/2 less 3/6 = 0 B = 1/2 less 2/6 = 1/6 So the entire goodwill should be credited to B’s Capital A/c. Cash A/c Dr. Rs. 60,000 To B’s Capital A/c Rs. 60,000 (Goodwill brought in by C credited to B’s Capital A/c) 8.32 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India Example 4 : A, B & C are equal partners. They decided to take D who brought in Rs. 36,000 as goodwill. The new profit sharing ratio is 3:3:2:2. Old Share - New Share = Share Sacrificed A = 1/3 less 3/10 = 1/30 B = 1/3 less 3/10 = 1/30 C = 1/3 less 2/10= 4/30 So goodwill should be shared in the ratio 1:1:4 Cash A/c Dr. Rs. 36,000 To A’s Capital Account Rs. 6,000 To B’s Capital Account Rs. 6,000 To C’s Capital Account Rs. 24,000 (Goodwill brought in by D credited to old partners’ accounts in their profit sacrificing ratio 1:1:4) Illustration 2 The following is the Balance Sheet of Yellow and Green as at 31st December, 2009 : Liabilities Rs. Assets Rs. Creditors 20,000 Cash at Bank 10,000 Capital : Sundry Assets 55,000 Yellow 25,000 Green 20,000 65,000 65,000 The partners shared profits and losses in the ratio 3:2. On the above date, Black was admitted as partner on the condition that he would pay Rs. 20,000 as Capital. Goodwill was to be valued at 3 years’ purchase of the average of four years’ profits which were : Rs. Rs. 2005 9,000 2007 12,000 2006 14,000 2008 13,000 FUNDAMENTALS OF ACCOUNTING 8.33 Copyright -The Institute of Chartered Accountants of India TREATMENT OF GOODWILL IN PARTNERSHIP ACCOUNTS The new profit sharing ratio is 6:5:5. Give journal entries and Balance Sheet if goodwill is adjusted through partners’ capital accounts. Solution Rs. Rs. (i) Bank Account Dr. 20,000 To Black’s Capital Account 20,000 (Amount brought in by Black as capital) (ii) Black’s Capital Account Dr. 11,250 To Yellow’s Capital Account 8,100 To Green’s Capital Account 3,150 (Black’s share of goodwill adjusted through old partners’ capital accounts in the profit sacrificing ratio 18:7) Balance Sheet as on.................... Liabilities Rs. Assets Rs. Creditors 20,000 Cash at Bank 30,000 Capital : Sundry Assets 55,000 Yellow 33,100 Green 23,150 Black 8,750 65,000 85,000 85,000 Note : Calculation of Profit Sacrificing Ratio Old Share - New Share = Share Sacrificed Yellow 3/5 – 6/16 = 18/80 Green 3/5 – 5/16 = 7/80 Illustration 3 With the information given in illustration 2, let us give journal entries and prepare balance sheet assuming that goodwill is brought in cash. Solution Goodwill brought in cash Bank Account Dr. 31,250 To Black’s Capital Account 20,000 To Yellow’s Capital Account 8,100 To Green’s Capital Account 3,150 (Amount brought in by Black as capital and as goodwill; goodwill credited to Yellow and Green’s Capital accounts in the profit sacrficing ratio) 8.34 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India Balance Sheet as on.................... Liabilities Rs. Assets Rs. Creditors 20,000 Cash at Bank 41,250 Capital : Sundry Assets 55,000 Yellow 33,100 Green 23,150 Black 20,000 76,250 96,250 96,250 Illustration 4 Continuing with the same illustration 2, let us give journal entries and prepare balance sheet assuming that goodwill is brought in cash, but withdrawn. Solution Goodwill brought in cash, but withdrawn In addition to the treatment under Illustration 3 the following additional entry will be made: Yellow’s Capital Account Dr. 8,100 Green’s Capital Account Dr. 3,150 To Bank Account 11,250 (Amount withdrawn by Yellow and Green in respect of goodwill credited to them) Balance Sheet as on.................... Liabilities Rs. Assets Rs. Creditors 20,000 Cash at Bank 30,000 Capital : Sundry Assets 55,000 Yellow 25,000 Green 20,000 Black 20,000 65,000 85,000 85,000 Illustration 5 On the basis of information given in illustration 2, let us give journal entries and prepare balance sheet assuming that goodwill is paid privately. Solution There will be no entry for goodwill but Black will pay Rs. 8,100 to Yellow and Rs. 3,150 to Green. For capital brought in by Black, the entry is : Bank Account Dr. 20,000 To Black’s Capital Account 20,000 (Amount brought in by Black as capital) FUNDAMENTALS OF ACCOUNTING 8.35 Copyright -The Institute of Chartered Accountants of India TREATMENT OF GOODWILL IN PARTNERSHIP ACCOUNTS Balance Sheet as on.................... Liabilities Rs. Assets Rs. Creditors 20,000 Cash at Bank 30,000 Capital : Sundry Assets 55,000 Yellow 25,000 Green 20,000 Black 20,000 65,000 85,000 85,000 6. ACCOUNTING TREATMENT OF GOODWILL IN CASE OF CHANGE IN PROFIT SHARING RATIO In case of change in profit sharing ratio, the value of goodwill should be determined and preferably adjusted through capital accounts of the partners on the basis of profit sacrificing ratio. Illustration 6 A, B & C are equal partners. They wanted to change the profit sharing ratio into 4:3:2. Make the necessary journal entries. Solution Journal Entry Rs. Rs. A’s Capital Dr. 10,000 To C’s Capital A/c 10,000 In this case due to change in profit sharing ratio A’s gain is = 4/9 less 1/3 = 1/9 B’s gain is = 1/3 less 1/3 = 0 C’s loss is = 1/3 less 2/9 = 1/9 So, A should compensate C to the extent of 1/9th of goodwill i.e. Rs. 90,000 × 1/9 = Rs. 10,000 8.36 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India Illustration 7 A, B and C are in partnership sharing profits and losses in the ratio of 4:3:3. They decided to change the profit sharing ratio to 7:7:6. Goodwill of the firm is valued at Rs. 20,000. Calculate the sacrifice/gain by the partners and make the necessary journal entry. Solution Partner New Share Old Share Difference 7 4 1 A – = - 20 10 20 7 3 1 B – = 20 10 20 6 3 C – = 0 20 10 1 Thus, B gained 1/20th share while A sacrificed 1/20th share i.e. Rs. 20,000 x = Rs. 1,000. For 20 C there was no loss no gain. Journal Entry Rs. Rs. B’s Capital A/c Dr. 1,000 To A’s Capital A/c 1,000 (Being goodwill adjusted through partners’ capital A/cs at sacrificing / gaining ratio) Illustration 8 A, B, C and D are in partnership sharing profits and losses equally. They mutually agreed to change the profit sharing ratio to 3:3:2:2. Give necessary journal entry. Solution 3 1 1 A gains by − = 10 4 20 3 1 1 B gains by − = 10 4 20 1 2 1 C loses by − = 4 10 20 1 2 1 D loses by − = 4 10 20 So if goodwill is valued at Rs. 20,000, A and B should pay @ Rs. 1,000 each (i.e., Rs. 20,000 × 1/20) as compensation to C and D respectively for their sacrifice. FUNDAMENTALS OF ACCOUNTING 8.37 Copyright -The Institute of Chartered Accountants of India TREATMENT OF GOODWILL IN PARTNERSHIP ACCOUNTS Journal Entry Rs. Rs. A’s Capital Account Dr. 1,000 B’s Capital Account Dr. 1,000 To C’s Capital Account 1,000 To D’s Capital Account 1,000 (Being goodwill adjusted through partners’ capital A/cs at sacrificing / gaining ratio) 7. ACCOUNTING TREATMENT OF GOODWILL IN CASE OF RETIREMENT OR DEATH OF A PARTNER In case of retirement of a partner, the continuing partners will gain in terms of profit sharing ratio. Therefore they have to pay to retiring partner for his share of goodwill in the firm in the gaining ratio. Similarly, in case of death of the partner, the continuing partners should bear the share of goodwill due to the heirs of the deceased partner. For this purpose, the goodwill is valued on the date of the retirement or death and adjusted through the capital accounts of the partners. Example : A, B & C are equal partners. C wanted to retire for which value of goodwill is considered as Rs. 90,000. The necessary journal entry will be : A’s Capital A/c Dr. Rs. 15,000 B’s Capital A/c Dr. Rs. 15,000 To C’s Capital A/c Rs. 30,000 (C’s share of goodwill adjusted to existing partners’ capital accounts in profit gaining ratio) Illustration 9 Wise, Clever and Dull were trading in partnership sharing profits and losses 4:3:3 respectively. The accounts of the firm are made upto 31st December every year. The partnership provided, inter alia, that : On the death of a partner the goodwill was to be valued at three years’ purchase of average profits of the three years upto the date of the death after deducting interest @ 8 per cent on capital employed and a fair remuneration of each partner. The profits are assumed to be earned evenly throughout the year. On 30th June, 2009, Wise died and it was agreed on his death to adjust goodwill in the capital accounts without showing any amount of goodwill in the Balance Sheet. It was agreed for the purpose of valuation of goodwill that the fair remuneration for work done by each partner would be Rs. 15,000 per annum and that the capital employed would be Rs. 1,56,000. Clever and Dull were to continue the partnership, sharing profits and losses equally after the death of Wise. 8.38 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India The following were the amounts of profits of earlier years before charging interest on capital employed. Rs. 2006 67,200 2007 75,600 2008 72,000 2009 62,400 You are requested to compute the value of goodwill and show the adjustment thereof in the books of the firm. Solution Computation of the value of goodwill : (i) Average Profit for three years, ending 30th June; before death: Year ending 30th June, 2007 : Rs. Rs. 1/2 of 2006 profits 33,600 1/2 of 2007 Profits 37,800 71,400 Year ending 30th June, 2008 : 1/2 of 2007 37,800 1/2 of 2008 Profits 36,000 73,800 Year ending 30th June, 2009 : 1/2 of 2008 36,000 1/2 of 2009 Profits 31,200 67,200 Total 2,12,400 Average Profits 70,800 (ii) Average future maintainable profit : Average profits earned 70,800 Less : Partner’s remuneration 45,000 Less : 8% on capital employed 12,480 57,480 13,320 (iii) Goodwill @ three years’ purchase 39,960 Adjustment entry for Goodwill Journal Dr. Cr. Rs. Rs. Clever’s Capital Account Dr. 7,992 Dull’s Capital Account Dr. 7,992 To Wise’s Capital Account 15,984 (Adjusting entry passed for share of goodwill of Wise through remaining partners’ capital accounts in gaining ratio) FUNDAMENTALS OF ACCOUNTING 8.39 Copyright -The Institute of Chartered Accountants of India TREATMENT OF GOODWILL IN PARTNERSHIP ACCOUNTS Working Note: Partner New Share Old Share Difference 4 4 Wise – - = - 10 10 1 3 2 Clever - = 2 10 10 1 3 2 Dull - = 2 10 10 SELF EXAMINATION QUESTIONS I. PICK UP THE CORRECT ANSWER FROM THE GIVEN CHOICES: 1. The profits of last five years are Rs. 85,000; Rs. 90,000; Rs. 70,000; Rs. 1,00,000 and Rs. 80,000. Find the value of goodwill, if it is calculated on average profits of last five years on the basis of 3 years of purchase. (a) Rs. 85,000. (b) Rs. 2,55,000. (c) Rs. 2,75,000. (d) Rs. 2,85,000. 2. The profits of last three years are Rs. 42,000; Rs. 39,000 and Rs. 45,000. Find out the goodwill of two years’ purchase. (a) Rs. 42,000. (b) Rs. 84,000. (c) Rs. 1,26,000. (d) Rs. 36,000. 3. Find the goodwill of the firm using capitalization method from the following information: Total Capital Employed in the firm Rs. 8,00,000 Reasonable Rate of Return 15% Profits for the year Rs. 12,00,000 (a) Rs. 82,00,000. (b) Rs. 12,00,000. (c) Rs. 72,00,000. (d) Rs. 42,00,000 4. The capital of B and D are Rs. 90,000 and Rs. 30,000 respectively with the profit sharing ratio 3:1. The new ratio, admissible after 01.04.2006 is 5:3. The goodwill is valued Rs. 80,000 as on that date. Amount payable by a gaining partner to a scarifying partner is: (a) B will pay to D Rs. 10,000. (b) D will pay to B Rs. 10,000. (c) B will pay to D Rs. 80,000. (d) will pay to B Rs. 80,000. 5. A, B and C are equal partners. D is admitted to the firm for one-fourth share. D brings Rs. 20,000 capital and Rs. 5,000 being half of the premium for goodwill. The value of goodwill of the firm is (a) Rs. 10,000 (b) Rs. 40,000. (c) Rs. 20,000. (d) None of the above. 8.40 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India 6. The profits for 2006-07 are Rs. 2,000; for 2007-2008 is Rs. 26,100 and for 2008-2009 is Rs. 31,200. Closing stock for 2007-2008 and 2008-09 includes the defective items of Rs. 2,200 and Rs. 6,200 respectively which were considered as having market value NIL. Calculate goodwill on average profit method. (a) Rs. 23,700. (b) Rs. 17,700. (c) Rs. 13,700. (d) Rs. 17,300. 7. A and B are partners with capitals of Rs. 10,000 and Rs. 20,000 respectively and sharing profits equally. They admitted C as their third partner with one-fourth profits of the firm on the payment of Rs. 12,000. The amount of hidden goodwill is . (a) 6,000. (b) 10,000. (c) 8,000. (d) None of the above. 8. X and Y share profits and losses in the ratio of 2 : 1. They take Z as a partner and the new profit sharing ratio becomes 3 : 2 : 1. Z brings Rs. 4,500 as premium for goodwill. The full value of goodwill will be (a) Rs. 4,500. (b) Rs. 18,000. (c) Rs. 27,000. (d) Rs. 24,000. 9. Under average profit basis goodwill is calculated by: (a) No. of years purchased multiplied with average profits. (b) No. of years purchased multiplied with super profits. (c) Summation of the discounted value of expected future benefits. (d) Super profit divided with expected rate of return. 10. Under super profit basis goodwill is calculated by: (a) No. of years purchased multiplied with average profits. (b) No. of years purchased multiplied with super profits. (c) Summation of the discounted value of expected future benefits. (d) Super profit divided with expected rate of return. 11. Under annuity basis goodwill is calculated by: (a) No. of years purchased multiplied with average profits. (b) No. of years purchased multiplied with super profits. (c) Summation of the discounted value of expected future benefits. (d) Super profit divided with expected rate of return. 12. Under capitalisation basis goodwill is calculated by: (a) No. of years purchased multiplied with average profits. (b) No. of years purchased multiplied with super profits. (c) Summation of the discounted value of expected future benefits. (d) Super profit divided with expected rate of return. FUNDAMENTALS OF ACCOUNTING 8.41 Copyright -The Institute of Chartered Accountants of India TREATMENT OF GOODWILL IN PARTNERSHIP ACCOUNTS 13. The following particulars are available in respect of the business carried on by a partnership firm: Trading Results: 2001 Loss Rs. 5,000 2002 Loss Rs. 10,000 2003 Profit Rs. 75,000 2004 Profit Rs. 60,000 You are required to compute the value of goodwill on the basis of 5 year’s purchase of average profit of the business. (a) Rs. 1,25,000. (b) Rs.1,50,000. (c) Rs. 10,000. (d) Rs. 1,20,000. 14. The profits and losses for the last years are 2001-02 Losses Rs. 10,000; 2002-03 Losses Rs. 2,500; 2003-04 Profits Rs. 98,000 & 2004-05 Profits Rs. 76,000. The average capital employed in the business is Rs. 2,00,000. The rate of interest expected from capital invested is 12%. The remuneration of partners is estimated to be Rs. 1,000 per month not charged in the above losses/profits. Calculate the value of goodwill on the basis of two years purchase of super profits based on the average of four years. (a) Rs. 9,000. (b) Rs. 8,750. (c) Rs. 8,500. (d) Rs. 8,250. 15. A, B and C are partners sharing profits and loss in the ratio 3:2:1. They decide to change their profit sharing ratio to 2:2:1. To give effect to this new profit sharing ratio they decide to value the goodwill at Rs. 30,000. Pass the necessary journal entry if Goodwill not appearing in the old balance sheet and should not appear in the new balance sheet. (a) B’s Capital Account Dr. Rs. 2,000 C’s Capital Account Dr. Rs. 1,000 To A’s Capital Account Rs. 3,000 (b) Goodwill Account Dr. Rs. 30,000 To A’s Capital Account Rs. 15,000 To B’s Capital Account Rs. 10,000 To C’s Capital Account Rs. 5,000 (c) A’s Capital Account Dr. Rs. 12,000 B’s Capital Account Dr. Rs. 12,000 C’s Capital Account Dr. Rs. 6,000 To Goodwill Account Rs. 30,000 (d) A’s Capital Account Dr. Rs. 3,000 To B’s Capital Account Rs. 2,000 To C’s Capital Account Rs. 1,000 8.42 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India 16. Goodwill brought in by incoming partner in cash for joining in a partnership firm is taken away by the old partners in their ……… ratio. (a) Capital. (b) New Profit Sharing. (c) Sacrificing. (d) Old Profit Sharing. 17. A & B are partners sharing profits and losses in the ratio 5:3. On admission, C brings Rs. 70,000 cash and Rs. 48,000 against goodwill. New profit sharing ratio between A, B and C are 7:5:4. Find the sacrificing ratio as A:B (a) 3:1. (b) 4:7. (c) 5:4. (d) 2:1. 18. Following are the factors affecting goodwill except: (a) Nature of business. (b) Efficiency of management. (c) Technical know how. (d) Location of the customers. 19. Weighted average method of calculating goodwill should be followed when: (a) Profits are uneven. (b) Profits has increasing trend. (c) Profits has decreasing trend. (d) Either ‘b’ or ‘c’. 20. In the absence of any provision in the partnership agreement, profits and losses are shared (a) In the ratio of capitals. (b) Equally. (c) In the ratio of loans given by them to the partnership firm. (d) None of the above. 21. The profits and losses for the last years are 2005-06 Losses Rs. 10,000; 2006-07 Losses Rs. 2,500; 2007-08 Profits Rs. 98,000 & 2008-09 Profits Rs. 76,000. The average capital employed in the business is Rs. 2,00,000. The rate of interest expected from capital invested is 12%. The remuneration of partners is estimated to be Rs. 1,000 per month. Calculate the value of goodwill on the basis of four years purchase of super profits based on the annuity of the four years. Take discounting rate as 10%. (a) Rs. 13,500. (b) Rs. 13,568. (c) Rs. 13,668. (d) Rs. 13,868. ANSWERS 1. (b) 2. (b) 3. (c) 4. (b) 5. (b) 6. (b) 7. (a) 8. (c) 9. (a) 10. (b) 11. (c) 12. (d) 13. (b) 14. (b) 15. (a) 16. (c) 17. (a) 18. (d) 19. (d) 20. (b) 21. (d) FUNDAMENTALS OF ACCOUNTING 8.43 Copyright -The Institute of Chartered Accountants of India CHAPTER ----- 8 PPPPPAAAAARRRRRTTTTTNNNNNEEEEERRRRRSSSSSHHHHHIIIIIPPPPP AAAAACCCCCCCCCCOOOOOUUUUUNNNNNTTTTTSSSSS Unit 3 Admission of a New Partner Copyright -The Institute of Chartered Accountants of India Learning Objectives : After studying this unit, you will be able to : (cid:2) Understand the reasons for which revaluation of assets and recomputation of liabilities is required in case of admission of a new partner. Also understand the logic of revaluation of assets and recomputation of liabilities at the time of admission of a partner. (cid:2) Learn the accounting treatments under two circumstances : (a) When revalued assets and recomputed liabilities are shown in the Balance Sheet, and (b) When revalued assets and recomputed liabilities are not shown in the Balance Sheet (cid:2) Learn the technique of treating reserve balance on admission of a partner. (cid:2) See the technique of arriving at new profit-sharing ratio. (cid:2) Observe the technique of inferring goodwill although figure of goodwill is not mentioned clearly. 1. INTRODUCTION New partners are admitted for the benefit of the partnership firm. New partner is admitted either for increasing the partnership capital or for strengthening the management of the firm. When a new partner joins a firm, it is desirable to bring all appreciation or reduction in the value of assets into accounts as on the date of admission. Similarly, if the books contain any liability which has not been paid or if the books do not contain a liability which has to be paid, suitable entries should be passed. The purpose of such entries is to make an updated Balance Sheet on the date of admission. Also, all profits which have accrued but not yet brought into books and similarly, all losses which have occurred but not recorded, should now be brought into books so that the Capital Accounts of the old partners reflect the proper figure. As a result of passing of such entries, any subsequent profits or losses will be automatically shared by the incoming partner along with old partners. Also the value of goodwill is to be assessed and proper accounting treatment is required to bring the value of goodwill into books of accounts. Treatment for goodwill has already been discussed in unit 2 of this chapter. 2. REVALUATION ACCOUNT OR PROFIT AND LOSS ADJUSTMENT ACCOUNT When a new partner is admitted into the partnership, assets are revalued and liabilities are reassessed. A Revaluation Account (or Profit and Loss Adjustment Account) is opened for the purpose. This account is debited with all reduction in the value of assets and increase in liabilities and credited with increase in the value of assets and decrease in the value of liabilities. The difference in two sides of the account will show profit or loss. This is transferred to the Capital Accounts of old partners in the old profit sharing ratio. The entries to be passed are : FUNDAMENTALS OF ACCOUNTING 8.45 Copyright -The Institute of Chartered Accountants of India ADMISSION OF NEW PARTNER 1. Revaluation Account To Assets Account Dr. with the reduction in the value of the assets (individually which show a decrease) To the Liabilities (Individually which with the increase in the liabilities. have to be increased) 2. Assets Account (Individually) Dr. with the increase in the value of the of assets Liabilities Accounts Dr. with the reduction in the amount liabilities To Revaluation Account 3. Revaluation Account Dr. with the profit in the old profit sharing ratio. To Capital A/cs of the old partners or, (Capital A/cs of the old partners) Dr. with the loss in old profit sharing ratio. To Revaluation Account As a result of the above entries, the capital account balances of the old partners will change and the assets and liabilities will have to be adjusted to their proper values. They will now appear in the Balance Sheet at revised figures. Alternatively, the partners may agree that revalued figures will not be shown in the Balance Sheet and Assets and liabilities would appear in the Balance Sheet at their old values. For this, one additional entry is necessary. Capital A/cs Dr. with the amount of revaluation (of all partners including profit in the new profit sharing ratio. newly admitted partner) To Revaluation A/c or, Revaluation A/c Dr. with the amount of revaluation loss To Capital A/cs in the new profit sharing ratio. (of all partners including newly admitted partners) Alternatively, in case partners desire to disclose assets and liabilities in the balane sheet at old figures then the change (i.e. increase or decrease) in the value of assets and liabilities may be adjusted through Partners’ Capital Accounts directly instead of using Revaluation Account. 8.46 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India Illustration 1 The following is the Balance Sheet of Ram and Mohan (who share profits in the ratio of 3:2) as on 1st January, 2009 : Liabilities Rs. Assets Rs. Sundry Creditors 15,000 Buildings 18,000 Ram’s Capital 20,000 Plant and Machinery 15,000 Mohan’s Capital 25,000 Stock 12,000 Debtors 10,000 Bank 5,000 60,000 60,000 On this date Shyam was admitted on the following : 1. He is to pay Rs. 25,000 as his capital and Rs. 10,000 as his share of goodwill for one fifth share in profits. 2. The new profits sharing ratio will be 5:3:2. 3. The assets are to be revalued as under : Rs. Building 25,000 Plant and Machinery 12,000 Stock 12,000 Debtors (because of doubtful debts) 9,500 4. It was found that there was a liability for Rs. 1,500 for goods received but not recorded in books. Give journal entries to record the above. Solution Journal Entries 2009 Dr. Cr. Jan. 1 Bank Account Dr. 35,000 To Shyam’s Capital Account 35,000 (Being amount brought in by Shyam for capital and goodwill) Shyam’s Capital Account Dr. 10,000 To Ram’s Capital Account 5,000 To Mohan’s Capital Account 5,000 (Being Shyam’s share of goodwill adjusted to existing partners’ capital) FUNDAMENTALS OF ACCOUNTING 8.47 Copyright -The Institute of Chartered Accountants of India ADMISSION OF NEW PARTNER accounts in the profit sacrificing ratio 1:1) Revaluation Account Dr. 5,000 To Plant and Machinery Account 3,000 To Provisions for Doubtful Debts Account 500 To Sundry Creditors Account 1,500 (Being recording of the reduction in the value of assets and the liability which had been previously omitted) Building Account Dr. 7,000 To Revaluation Account 7,000 (Being increase in the value of building brought into account) Revaluation Account Dr. 2,000 To Ram’s Capital Account 1,200 To Mohan’s Capital Account 800 (Being profit on revaluation credited to Ram and Mohan in the old profit sharing ratio) Working Note Profit sacrificing ratio: 3/5 less 1/2 = 1/10 2/5 less 3/10 = 1/10 Illustration 2 Continuing with the same illustration 1, let us also give the Balance Sheet of the partnership firm after Shyam’s admission . Solution Balance Sheet of Ram, Mohan and Shyam as at January 1, 2009 Liabilities Rs. Assets Rs. Sundry Creditors 16,500 Buildings 25,000 Capital Account Plant and Machinery 12,000 Ram 26,200 Stock 12,000 Mohan 30,800 Sundry Debtors 10,000 Shyam 25,000 82,000 Less : Provision for Doubtful Debts 500 9,500 Bank 40,000 98,500 98,500 8.48 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India Illustration 3 A and B are partners in a firm, sharing profits and losses in the ratio of 3:2. The Balance Sheet of A and B as on 1.1.2009 was as follows: Liabilities Amount Assets Amount Rs. Rs. Rs. Sundry creditors 12,900 Building 26,000 Bills payable 4,100 Furniture 5,800 Bank overdraft 9,000 Stock-in-trade 21,400 Capital accounts: Debtors 35,000 A 44,000 Less: Provision 200 34,800 B 36,000 80,000 Investment 2,500 Cash 15,500 1,06,000 1,06,000 ‘C’ was admitted to the firm on the above date on the following terms: (i) He is admitted for 1/6 share in the future profits and to introduce a capital of Rs. 25,000. (ii) The new profit sharing ratio of A, B and C will be 3:2:1 respectively. (iii) ‘C’ is unable to bring in cash for his share of goodwill, they decide to calculate goodwill on the basis of C’s share in the profits and the capital contribution made by him to the firm. (iv) Furniture is to be written down by Rs. 870 and stock to be depreciated by 5%. A provision is required for debtors @ 5% for bad debts. A provision would also be made for outstanding wages for Rs. 1,560. The value of buildings having appreciated be brought upto Rs. 29,200. The value of investments is increased by Rs. 450. (v) It is found that the creditors included a sum of Rs. 1,400, which is not to be paid off. Prepare the following: (i) Revaluation account. (ii) Partners’ capital accounts. FUNDAMENTALS OF ACCOUNTING 8.49 Copyright -The Institute of Chartered Accountants of India ADMISSION OF NEW PARTNER Solution Revaluation Account Dr. Cr. Rs. Rs. To Furniture 870 By Building 3,200 To Stock 1,070 By Sundry creditors 1,400 To Provision for doubtful debts By Investment 450 (Rs. 1,750-Rs. 200) 1,550 To Outstanding wages 1,560 5,050 5,050 Partners’ Capital Accounts Dr. Cr. A B C A B C Rs. Rs. Rs. Rs. Rs. Rs. To A 4,500 By Balance b/d 44,000 36,000 – To B 3,000 By Cash A/c – – 25,000 To Balance c/d 48,500 39,000 17,500 By C (working note) 4,500 3,000 – 48,500 39,000 25,000 48,500 39,000 25,000 Working Notes : 1. Calculation of goodwill: C’s contribution of Rs. 25,000 consists of only 1/6th of capital. Therefore, total capital of firm should be Rs. 25,000 x 6 = Rs. 1,50,000 But combined capital of A, B and C amounts Rs. 44,000 + 36,000 + 25,000 = Rs. 1,05,000 Thus, the hidden goodwill is Rs. 45,000 (Rs. 1,50,000 - Rs. 1,05,000). Goodwill will be shared by A & B in their sacrificing ratio. 8.50 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India