ADMISSION OF A PARTNER

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

Admission of a new partner:

 A new partner may be admitted when the firm needs additional capital or managerial help.

Change in the profit sharing ratio among the existing partners:

Sometimes the partners of a firm may decide to change their existing profit sharing ratio. This may happen an account of a change in the existing partners’ role in the firm.

Retirement of an existing partner:

 It means withdrawal by a partner from the business of the firm which may be due to his bad health, old age or change in business interests. In fact a partner can retire any time if the partnership is at will.

Death of a partner:

 Partnership may also stand reconstituted on death of a partner, if the remaining partners decide to continue the business of the firm as usual.

According to the Partnership Act 1932, a new partner can be admitted into the firm only with the consent of all the existing partners unless otherwise agreed upon. With the admission of a new partner, the partnership firm is reconstituted and a new agreement is entered into to carry on the business of the firm. A newly admitted partner acquires two main rights in the firm–

 1. Right to share the assets of the partnership firm; and

 2. Right to share the profits of the partnership firm.

In the case of an established firm which may be earning more profits than the normal rate of return on its capital the new partner is required to contribute some additional amount known as premium or goodwill.

New Profit Sharing Ratio

 When new partner is admitted he acquires his share in profits from the old partners. In other words, on the admission of a new partner, the old partners sacrifice a share of their profit in favour of the new partner.

In any case, on admission of a new partner, the profit sharing ratio among the old partners will change keeping in view their respective contribution to the profit sharing ratio of the incoming partner. Hence, there is a need to ascertain the new profit sharing ratio among all the partners. This depends upon how does the new partner acquires his share from the old partners for which there are many possibilities.

Illustration 1

 Arushi and Vaishnavi are partners sharing profits in the ratio of 3:2. They admitted Sunita as a new partner for 1/5 share in the future profits of the firm. Calculate new profit sharing ratio of Arushi, Vaishnavi and Sunita.

 Solution

Sunita’s share = 1/ 5

Remaining share = 1 -1/ 5  = 4/ 5

Arushi’s new share = 3/ 5 of 4/ 5 = 12/ 25

Vaishnavi’s new share = 2/ 5 of 4/ 5 = 8 /25

New profit sharing ratio of Arushi, Vaishnavi and Sunita will be 12:8:5.

Note: It has been assumed that the new partner acquired his share from old partners in old ratio.

Sacrificing Ratio

 The ratio in which the old partners agree to sacrifice their share of profit in favour of the incoming partner is called sacrificing ratio. The sacrifice by a partner is equal to :

Old Share of Profit – New Share of Profit

Goodwill

 Goodwill is also one of the special aspects of partnership accounts which requires adjustment (also valuation if not specified) at the time of reconstitution of a firm viz., a change in the profit sharing ratio, the admission of a partner or the retirement or death of a partner. Goodwill is of two types-

As per Accounting Standard 26, goodwill is an intangible asset and is valued as per the accounting standard. Self generated goodwill is not shown in the books of accounts while purchased goodwill is shown.

Goodwill is shown after valuation when-

1. A new person is admitted in the firm
2. At the time of reconstitution of the firm
3. Retirement or death of the partner

Goodwill is also one of the special aspects of partnership accounts which requires adjustment (also valuation if not specified) at the time of reconstitution of a firm viz., a change in the profit sharing ratio, the admission of a partner or the retirement or death of a partner.

Meaning of Goodwill

Over a period of time, a business firm develops a good name and reputation among the customers. This help the business earn some extra profits as compared to a newly set up business. In accounting capitalised value of this extra profit is known as goodwill. For example, your firm earns say Rs 1200 and the normal profit was expected from your firm Rs 700. The rate of return is @ 10%. In this case goodwill is ascertained as under :

Step 1 : Excess profit = Actual profit – Desired normal profit  1200 – 700 = 500

Step 2 : Goodwill = 500 X100/ 10 × = Rs 5000

In other words, goodwill is the value of the reputation of a firm in respect of the profit earned in future over and above the normal profit

Factors Affecting the Value of Goodwill

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

 1. Nature of business: A firm that produces high value added products or having a stable demand is able to earn more profits and therefore has more goodwill.

2. Location: If the business is centrally located or is at a place having heavy customer traffic, the goodwill tends to be high.

 3. Efficiency of management: A well-managed concern usually enjoys the advantage of high productivity and cost efficiency. This leads to higher profits and so the value of goodwill will also be high.

 4. Market situation: The monopoly condition or limited competition enables the concern to earn high profits which leads to higher value of goodwill.

 5. Special advantages: The firm that enjoys special advantages like import licences, low rate and assured supply of electricity, long-term contracts for supply of materials, well-known collaborators, patents, trademarks, etc. enjoy higher value of goodwill.

6. Past performace,quality,advantages of patents,copyrights, contracts, inherent risks of business

Need for Valuation of Goodwill

Normally, the need for valuation of goodwill arises at the time of sale of a business. But, in the context of a partnership firm it may also arise in the following circumstances:

 1. Change in the profit sharing ratio amongst the existing partners;

 2. Admission of new partner;

3. Retirement of a partner;

 4. Death of a partner; and

5. Dissolution of a firm involving sale of business as a going concern.

 6. Amalgamation of partnership firms.

Methods of Valuation of Goodwill

The important methods of valuation of goodwill are as follows:

1. Average Profits Method

Under this method, the goodwill is valued at agreed number of ‘years’ purchase of the average profits of the past few years. It is based on the assumption that a new business will not be able to earn any profits during the first few years of its operations. Hence, the person who purchases a running business must pay in the form of goodwill a sum which is equal to the profits he is likely to receive for the first few years. The goodwill, therefore, should be calculated by multiplying the past average profits by the number of years during which the anticipated profits are expected to accrue.

Calculation of Adjusted profits-

Particular

Amount

Given Profits Add- Abnormal losses Add capital loss on sale of asset Add: over valuation over value of opening stock or undervaluation of closing stock Add- non-recurring expenses Add: Capital Expenditure Charged to Revenue Less: Abnormal Gain Less : over valuation over value of closing stock or undervaluation of opening stock Less- non-recurring income Less: Interest on Non trade investments Less: Unprovided Depreciation Less: Management costs, insurance costs Less: Partners remuneration ( if not charged)

The profit for the five years of a firm are as follows – year 2010 Rs. 4,00,000; year 2011 Rs. 3,98,000; year 2012 Rs. 4,50,000; year 2013 Rs. 4,45,000 and year 2014 Rs. 5,00,000. Calculate goodwill of the firm on the basis of 4 years purchase of 5 years average profits

Year Profit (Rs.)

2010 4,00,000

2011 3,98,000

2012 4,50,000

2013 4,45,000

2014 5,00,000

Total 21,93,000.

Average Profit = Total Profit of Last 5Years

No.of years = Rs. 21,93,000/ 5 = Rs. 4,38,600

Goodwill = Average Profits × No. of years purchased = Rs. 4,38,600 × 4 = Rs. 17,54,400

Weighted average Profit Method-

In this method each year profit is assigned a weight i.e. 1, 2, 3, 4 etc. The goodwill is calculated as follows

Weighted average profit = Total product of profit

                                          Total of weights

Super Profits Method

The basic assumption in the average profits (simple or weighted) method of calculating goodwill is that if a new business is set up, it will not be able to earn any profits during the first few years of its operations. it is limited to such amounts of profits which are in excess of the normal return on capital employed in similar business. Therefore, it is desirable to value, goodwill on the basis of the excess profits and not the actual profits. The excess of actual profits over the normal profits is termed as super profits.

Normal Profit=Capital Employed × Normal Rate of Return

                                      100

the steps involved under the method are:

 1. Calculate the average profit,

2. Calculate the normal profit on the capital employed on the basis of the normal rate of return,

3. Calculate the super profits by deducting normal profit from the average profits, and

4. Calculate goodwill by multiplying the super profits by the given number of years’ purchase.

The books of a business showed that the capital employed on December 31, 2014, Rs. 5,00,000 and the profits for the last five years were:

2010– Rs. 40,000:

2011-Rs. 50,000;

2012-Rs. 55,000;

2013 4,45,000

2014-Rs. 85,000.

You are required to find out the value of goodwill based on 3 years purchase of the super profits of the business, given that the normal rate of return is 10%.

?

Normal Profits=Capital Employed  X Normal Rate of Return

100

??

=  Rs. 5,00,000 X 10
                100 
  =  Rs. 50,000

Average Profits-

Year      Profit (Rs.)
2010        40,000
 2011       50,000 
2012        55,000 
2013        70,000 
2014        85,000

Total        3,00,000

Average  Profits =  Rs. 3,00,000/5  = Rs. 60,000 

Super Profit =Rs. 60,000 – Rs. 50,000=Rs. 10,000

Goodwill =Rs. 10,000× 3 = Rs. 30,000

Super Profit =Rs. 60,000 – Rs. 50,000=Rs. 10,000

Goodwill =Rs. 10,000× 3 = Rs. 30,000

Capitalisation Methods

Under this method the goodwill can be calculated in two ways:

(a) by capitalizing the average profits, or

(b) by capitalizing the super profits.

(a) Capitalisation of Average Profits:

Under this method, the value of goodwill is ascertained by deducting the actual capital employed (net assets) in the business from the capitalized value of the average profits on the basis of normal rate of return.This involves the following steps:

1. Ascertain the average profits based on the past few years’ performance.
2. Capitalize the average profits on the basis of the normal rate of return to ascertain the capitalised value of average profits as follows:

                              Average Profits × 100/Normal Rate of Return

        iii.  Ascertain the actual capital employed (net assets) by deducting outside liabilities from the total assets (excluding goodwill).

                               Capital Employed = Total Assets (excluding goodwill) – Outside Liabilitie

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

          A business has earned average profits of Rs. 2,00,000 during the last few years and the normal rate of return in a similar business is 10%. Ascertain the value of goodwill by capitalisation average profits method, given that          the value of net assets of the business is Rs. 16,20,000.

(b) Capitalisation of Super Profits:

Goodwill can also be ascertained by capitalising the super profit directly. Under this method there is no need to work out the capitalised value of average profits. It involves the following steps.

(i) Calculate capital employed of the firm, which is equal to total assets minus outside liabilities. (ii) Calculate normal profits on capital employed.

(iii) Calculate average profit for past years, as specified.

(iv) Calculate super profits by deducting normal profits from average profits.

(v) Multiply the super profits by the required rate of return multiplier, that is

 

Goodwill = Super Profits × 100/ Normal Rate of Return

In other words, goodwill is the capitalised value of super profits. The amount of goodwill worked out by this method will be exactly the same as calculated by capitalising the average profits.

For example, using the data given in Previous where the average profits are Rs. 2,00,000 and the normal profits are Rs. 162,000 (10% of Rs. 16,20,000), the super profits worked out as Rs. 38,000 (Rs. 2,00,000 – Rs. 1,62,000),

the goodwill will be Rs. 38,000 ×100

10

 = Rs. 3,80,000.

Premium Method

This method is followed when the new partner pays his share of goodwill in cash.  The amount of premium brought in by the new partner is shared by the existing partners in their ratio of sacrifice.  If this amount is paid to the old partners directly (privately) by the new partner, no entry is made in the books of the firm.  But, when the amount is paid through the firm,  which is generally the case, the following journal entries are passed:

1. Cash A/c Dr.

To Goodwill A/c (Amount brought by new partner as premium)

1. Goodwill A/c Dr.

To Existing Partners Capital A/c (Individually)

(Goodwill distributed among the existing partners in their sacrificing ratio)

When goodwill already exists in books:

The above treatment of goodwill was based on the assumption that there was no goodwill account in the books of the firm. However, It is quite possible that when a new partner brings in his share of goodwill in cash, some amount of goodwill already exists in books. In that case, after crediting the old partners by the amount of goodwill brought in by the new partner, the existing goodwill must be written off by debiting the old partners in their old profit sharing ratio.

 

Revaluation Method

This method is followed when the new partner does not bring in his share of goodwill in cash.  In such a situation, the goodwill account is raised in the books of account by crediting the old partners in the old profit sharing ratio. When goodwill account is to be raised in the books of account there are two possibilities,

(a) No goodwill appears in books at the time of admission, and

 (b) Goodwill already exists in books at the time of admission

 

1. When no goodwill exists in the books:

When no goodwill exists in the books at the time of the admission of a new partner, the goodwill account must be raised at its full value.  This can be done by debiting goodwill account with its full value and crediting the old partners’ capital accounts in their profit sharing ratio.  The journal entry will be: Goodwill A/c Dr. To Old Partners’ Capitals A/c (individually) (Goodwill raised at full value in the old ratio) The goodwill thus raised shall appear in the balance sheet of the firm at its full value.

 

         b. When goodwill already exists in the books :

If the books already show some balance in the Goodwill Account, the adjustment for goodwill in the old partner’s capital accounts shall be made only for the difference between the agreed value of goodwill and the amount of goodwill appearing in books.

         The journal entries will be as under:

1. When the value of goodwill appearing in the books is less than the agreed value.

Goodwill A/c Dr.

To Old Partners’ Capital A/c (individually)

(Goodwill raised to its agreed value)

         b. When the value of goodwill appearing in the books is more than the agreed value.

Old Partners’ Capital A/c (individually) Dr.

To Goodwill A/c

(Goodwill brought down to its agreed value)

 

Accounting standard 10 (AS–10) on “Accounting for Fixed Assets” in its Para 16 states that Goodwill, in general, is recorded in the books only when some consideration in money or money’s worth has been paid for it. Whenever a business is acquired for a price (payable either in cash or in shares or otherwise) which is excess of the net assets taken over, the excess is termed as goodwill’. Goodwill arises from business connections, trade name or reputation of an enterprise or from other intangible benefits enjoyed by an enterprise.

 

This is stretching the interpretation of AS–10 too far. What this accounting standard implies is that normally goodwill should not be brought into books unless it is paid for, and whenever it is recorded it should be written- off over a period.

 

Adjustment for Accumulated Profits and Losses

Sometimes a firm may have accumulated profits not yet transferred to capital accounts of the partners. These are usually in the firm of general reserve, reservefund and/or Profit and Loss Account balance. The new  partner is not entitled to have any share in such accumulated profits.  These are distributed among the partners by transferring it to their capital accounts in old profit sharing ratio. Similarly, if there are some accumulated losses in the form of a debit balance of profit and loss account appearing in the balance sheet of the firm.

Revaluation of Assets and Reassessment of Liabilities

It is always desirable to ascertain whether the assets of the firm are shown in books at their current values. In case the assets & liabilities are overstated or understated, these are revalued. For this purpose the firm has to prepare the Revaluation Account.

• The gain or loss on revaluation of each asset and liability is transferred to this account and finally its balance is transferred to the capital accounts of the old partners in their old profit sharing ratio.
• It is a nominal account

 

Revaluation A/C

   DR                                                                                                                                                                Cr

Particular	Amount	Particular	Amount
To decrease in assets By increase in liabilities To unrecorded liability To Profit on revaluation		By increase in assets By decrease in liabilities By unrecorded assets By Loss on revaluation

Financial Statements prepared by a partnership-

• Revaluation account
• Journal Entries for adjustment
• Partner’s Capital Account
• Bank Account
• Balance Sheet

The accumulated profits of the partnership firm are to be distributed among Old partners in old ratio If a person fails to bring his part of goodwill then it is withdrawn from his share of capital if fluctuating capitals are maintained and taken out of current account if fixed capital is maintained. This share of goodwill is then transferred to the old partners in sacrificing ratio.