Contents
- 1 Meaning of an Admission of a Partner
- 2 Admission of a New Partner
- 3 Treatment of Goodwill in Admission of a Partner
- 4 Adjustment for Accumulated Profits and Losses in Admission of a Partner
- 5 Revaluation of Assets and Reassessment of Liabilities in Admission of a Partner
- 6 Adjustment of Capitals in Admission of a Partner
- 7 Change in Profit Sharing Ratio among the existing Partners
Meaning of an Admission of a Partner
Admission of a Partner means that a new partner could also be admitted when the firm needs additional capital or managerial help. According to the provisions of the Partnership Act 1932 unless it’s otherwise provided within the partnership deed a replacement partner is often admitted only if the prevailing partners unanimously comply with it.
For example, Harish and Haqbul are partners sharing profits within the ratio of 3:2. On April 1, 2017, they admitted Johny as a replacement partner with a 1/6 share in the profits of the firm. With this change now there are three partners of the firm and it stands reconstituted.
Change within the share ratio among the prevailing partners
Sometimes the partners of a firm may plan to change their existing share ratio. This may happen on account of a change in the existing partners’ role in the firm. For example, Ram, Mohan, and Soham are partners in a firm sharing profits in the ratio of 3:2:1.
With effect from April 1, 2017, they decided to share profits equally as Soham brings in additional capital. This results in a change in the existing agreement leading to the reconstitution of the firm.
Retirement of an existing partner
It means withdrawal by a partner from the business of the firm which can flow from his bad health, adulthood, or change in business interests. A partner can retire at any time if the partnership is at will. For example, Roy, Ravis, and Rao are partners within the firm sharing profits within the ratio of 2:2:1. On account of illness, Ravis retired from the firm on March 31, 2017. This results in the reconstitution of the firm now having only two partners.
Death of a partner
A partnership can also stand reconstituted on the death of a partner if the remaining partners plan to continue the business of the firm as was common. For example, A, B, and C are partners in a firm sharing profits in the ratio of 3:2:1. A died on March 31, 2017. B and C decide to carry on the business sharing future profits equally. The continuity of business by B and C sharing future profits equally leads to the reconstitution of the firm.
Admission of a New Partner
When a firm requires further capital or managerial help or both for the expansion of its business a new partner may be admitted to supplement its existing resources. According to the Partnership Act 1932, a replacement partner is often admitted into the firm only with the consent of all the prevailing partners unless otherwise prescribed.
With the admission of a replacement partner, the partnership firm is reconstituted and a replacement agreement is entered into to hold on to the business of the firm. A newly admitted partner acquires two main rights within the firm–
1. Right to divide the assets of the partnership firm;
2. Right to divide the profits of the partnership firm.
For the proper to accumulate a share within the assets and profits of the partnership firm, the partner brings an agreed amount of capital either in cash or in a similar way. Moreover, within the case of a longtime firm that will be earning more profits than the traditional rate of return on its capital the new partner is required to contribute some additional amount referred to as premium or goodwill.
This is done primarily to compensate the existing partners for the loss of their share in the super-profits of the firm.
Following are the opposite details that require attention at the time of admission of a replacement partner:
1. New profit sharing ratio;
2. Sacrificing ratio;
3. Valuation and adjustment of goodwill;
4. Revaluation of assets and Reassessment of liabilities;
5. Distribution of accumulated profits (reserves); and
6. Adjustment of partners’ capitals.
1. New profit sharing ratio
When a replacement partner is admitted he acquires his share in profits from the old partners. In other words, on the admission of a replacement partner, the old partners sacrifice a share of their profit in favour of the new partner. But, what is going to be the share of the new partner and therefore the way he will acquire it from the prevailing partners is set mutually among the old partners and the new partner.
However, if nothing is specified on how the new partner acquires his share from the old partners; it’s going to be assumed that he gets it from them in their profit-sharing ratio. In any case, on the admission of a new partner, the profit-sharing ratio among the old partners will change keeping in sight their respective contribution to the profit-sharing ratio of the incoming partner.
Hence, there’s a requirement to determine the new share ratio among all the partners. This depends upon how the new partner acquires his share from the old partners and there are many possibilities.
2. Sacrificing ratio
The ratio during which the old partners comply with sacrificing their share of profit in favour of the incoming partner is named the sacrificing ratio. As stated earlier, the new partner is required to compensate the old partners for his or her loss of share within the super-profits of the firm that he brings in an additional amount known as premium or goodwill.
This amount is shared by the prevailing partners within the ratio during which they forego their shares in favor of the new partner which is named the sacrificing ratio. The ratio is generally clearly given as agreed among the partners which might be the old ratio, equal sacrifice, or a specified ratio.
The difficulty arises when the ratio during which the new partner acquires his share from the old partners isn’t specified. Instead, the new profit-sharing ratio is given. In such a situation, the sacrificing ratio is to be figured out by deducting each partner’s new share from his old share.
3. Valuation and adjustment of goodwill
Goodwill is additionally one of the special aspects of partnership accounts that needs adjustment (also valuation if not specified) at the time of reconstitution of a firm viz., a change in the profit-divide ratio, the admission of a partner, or the retirement or death of a partner.
Meaning of Goodwill
Throughout your time, a well-established business develops a plus of excellent name, reputation, and wide business connections. This helps the business to earn more profits as compared to a newly found out business. In accounting, the monetary value of such an advantage is known as “goodwill”.
It is regarded as an intangible asset. In other words, goodwill is the value of the reputation of a firm concerning the profits expected in the future over and above the traditional profits. It is generally observed that when an individual pays for goodwill, he/she pays for something, which places him within the position of having the ability to earn super profits as compared to the profit earned by other firms within the same industry.
In simple words, goodwill is often defined as “the present value of a firm’s expected excess earnings” or as “the capitalized value attached to the differential profit capacity of a business”. Thus, goodwill exists only when the firm earns super-profits. Any firm that earns normal profits or acquired losses has no goodwill.
Factors Affecting the Value of Goodwill
The main factors that influenced the worth of goodwill are as follows:
1. Nature of business:
A firm that produces high-value-added products or has a stable demand is in a position to earn more profits and thus has more goodwill.
2. Location:
If the business is centrally located or is in a neighbourhood having heavy customer traffic, the goodwill tends to be high.
3. Productivity of management:
A well-managed concern usually enjoys the advantage of high productivity and cost-efficiency. This results in higher profits and the worth of goodwill also will be high.
4. Market situation:
The monopoly condition or limited competition enables the concern to earn high profits which leads to the higher value of goodwill.
5. Special advantages:
The firm that enjoys special advantages like import licenses, low rates and assured supply of electricity, long-term contracts for the supply of materials, well-known collaborators, patents, trademarks, etc. enjoy the higher value of goodwill.
Need for Valuation of Goodwill
Normally, the essential for the valuation of goodwill occurs at the time of the sale of a business. But, within the context of a partnership firm it’s going to also arise within the following circumstances:
1. Convert within 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 the sale of the business as a going concern.
6. Amalgamation of partnership firms.
Methods of Valuation of Goodwill
Since goodwill is intangible it’s very difficult to accurately calculate its value. Various methods are advocated for the valuation of the goodwill of a partnership firm. Goodwill calculated by one method may differ from the goodwill calculated by another method. Hence, the method by which goodwill is to be calculated may be specifically decided between the existing partners and the incoming partner.
The important methods of valuation of goodwill are as follows:
1. Average Profits Method
2. Super Profits Method
3. Capitalisation Method
1. Average Profits Method
Under this method, the goodwill is valued at an agreed number of ‘years’ purchases of the typical profits of the past few years. It supports the idea that a replacement business won’t be ready to earn any profits during the first few years of its operations.
Hence, the one that purchases a running business must pay within the sort of goodwill a sum that is adequate to the profits he’s likely to receive for the first few years. The goodwill, therefore, should be calculated by multiplying the past average profits by the number of years during which the anticipated profits are expected to accrue.
For example, if the past median profits of a business work out at Rs. 20,000 and it’s expected that such profits are likely to continue for an additional three years, the worth of goodwill is going to be Rs. 60,000 (Rs. 20,000 × 3),.
2. Super Profits Method
The basic assumption within the average profits (simple or weighted) method of calculating goodwill is that if a replacement business is about up, it’ll not be ready to earn any profits during the first few years of its operations.
Hence, the one that purchases an existing business has got to pay within the sort of goodwill a sum adequate to the entire profits he’s likely to receive for the first ‘few years. But it’s contended that the buyer’s real benefit doesn’t dwell in total profits; it’s limited to such amounts of profits that are in more than the normal return on capital employed in a similar business.
Therefore, it’s desirable to value, goodwill on the idea of the surplus profits and not the particular profits. The excess of actual profits over the traditional profits is termed super-profits.
Normal Profit = Capital Employed × Normal Rate of Return/100
Suppose an existing firm earns Rs. 18,000 on a capital of Rs. 1,50,000 and so the normal rate of return is 10%. The Normal profits will work out at Rs. 15,000 (1,50,000 × 10/100). The super-profits, during this case, are going to be Rs. 3,000 (Rs. 18,000 – 15,000).
The goodwill under the super profit method is ascertained by multiplying the super-profits by a particular number of years’ purchase. If within the above example, it’s expected that the advantage of super-profits is probably going to be available for five years in the future, the goodwill is going to be valued at Rs. 15,000 (3,000 × 5). Thus, the steps involved in the method are:
1. Calculate the average profit,
2. Calculate the traditional profit on the capital employed on the idea of the traditional rate of return,
3. Calculate the super-profits by deducting normal take advantage of the typical profits, and
4. Calculate goodwill by accumulating the super-profits by the given number of years of purchase.
3. Capitalisation Method
Under this method the goodwill is often calculated in two ways:
(a) by capitalizing on the typical profits, or (b) by capitalizing on the super-profits. (a) Capitalization of Average Profits: Under this method, the worth of goodwill is ascertained by deducting the particular capital employed (net assets) within the business from the capitalized value of the typical profits on the idea of the traditional rate of return.
This involves the subsequent steps:
(i) Ascertain the typical profits supported by the past few years’ performances.
(ii) Capitalize the typical profits on the idea of the traditional rate of return to determine the capitalized value of average profits as follows:
(iv) Compute the worth of goodwill by deducting net assets from the capitalized value of average profits, i.e. (ii) – (iii).
Treatment of Goodwill in Admission of a Partner
As stated earlier, the incoming partner who acquires his share within the profits of the firm from the prevailing partners brings in some additional amount to compensate them for the loss of their share in super-profits. It is termed as his share of goodwill (also called a premium).
Alternatively, he may agree that a goodwill account is raised in the books of the firm by giving the necessary credit to the old partners. Thus, when a replacement partner is admitted, goodwill is often treated in two ways: (1) By Premium Method, and (2) By Revaluation Method.
(1) By Premium Method
This method comes after 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 authentic partners in their ratio of sacrifice.
If this amount is paid to the old partners directly (privately) by the new partner, no entry is formed within the books of the firm. But, when the quantity is paid through the firm, which is usually the case, the subsequent journal entries are passed:
| ( i ) | Cash A/c To Goodwill A/c (Amount brought by the new partner as premium) |
Dr. | ||
| ( ii ) | Goodwill A/c To Existing Partners Capital A/c (Individually) (Goodwill distributed among the existing partners in their sacrificing ratio) |
Dr. |
| ( i ) | Cash A/c To New Partner’s Capital A/c (Amount brought by the new partner for his share of goodwill) |
Dr. | ||
| ( ii ) | New Partner’s Capital A/c To Existing Partner’s Capital A/cs (Individually) (Goodwill brought by new partners distributed among the existing partners in their sacrificing ratio) |
Dr. |
If the partners decide that the quantity of premium credited to their capital accounts should be retained in the business, there’s no got to pass any additional entry. If, however, they plan to withdraw their amounts, (in full or in part) the subsequent additional entry is going to be passed:
Existing Partner’s Capital A/c (Individually) Dr.
To Cash A/c
(The amount of goodwill withdrawn by the existing partners)
(2) By Revaluation Method
This method is followed when the new partner doesn’t usher in his share of goodwill in cash. In such circumstances, the goodwill account is raised within the books of account by crediting the old partners within the old share ratio. When a goodwill account is to be raised within the books of account there are two possibilities,
(a) No goodwill appears in books at the time of acceptance
(b) Goodwill already exists in books at the time of acceptance
(a) No goodwill appears in books at the time of acceptance
When no goodwill exists within the books at the time of the admission of a replacement partner, the goodwill account must be raised at its full value. This can be done by debiting the 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 is high up at full value in the old ratio)
The goodwill thus raised shall appear within the record of the firm at its full value.
(b) Goodwill already exists in books at the time of acceptance
If the books already show some balance within the Goodwill Account, the adjustment for goodwill within the old partner’s capital accounts shall be made just for the difference between the agreed value of goodwill and therefore the amount of goodwill appearing in books.
The amount of goodwill appearing within the books could also be but its agreed value or it’s going to be quite the agreed value. If it is less than the agreed value, the difference between the agreed value of goodwill and the amount of goodwill appearing in the books will be debited to the goodwill account and credited to the old partner’s capital accounts in their old share ratio.
If, however, it’s quite the agreed value, the difference is going to be debited to the old partners’ capital accounts in their old profits-sharing ratio and credited to the goodwill account. Thus, the journal entries will be as follows:
(a) When the worth of goodwill appearing within the books is a smaller amount 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 arrives 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)
Adjustment for Accumulated Profits and Losses in Admission of a Partner
Once in a while, a firm may have accumulated profits not yet transferred to the capital accounts of the partners. These are normally in the form of general reserve, reserve fund, and/or Profit and Loss Account balance. The new partner isn’t entitled to possess any share in such accumulated profits.
These are shared among the partners by transferring them to their capital accounts in the old share ratio. Similarly, if there are some accumulated losses within the sort of a debit balance of profit and loss account appearing within the record of the firm. A remote possibility, an equivalent should even be transferred to the old partners’ capital accounts.
Revaluation of Assets and Reassessment of Liabilities in Admission of a Partner
At the time of admission of a new partner, it is always fascinating to ascertain whether the assets of the firm are shown in books at their current values. In case the assets are amplified or understated, these are revalued. Similarly, a reassessment of the liabilities is additionally done so that these are brought within the books at their correct values. At times there can also be some unrecorded assets and liabilities of the firm. These even have to be brought into the books of the firm.
For this purpose, the firm has to prepare the Revaluation Account. The gain or loss on revaluation of every asset and liability is transferred to the present account and eventually, its balance is transferred to the capital accounts of the old partners in their old profit-sharing ratio.
In other words, the revaluation account is credited with the increase in the value of every asset and reduce in its liabilities because it is again debited with a decrease within the value of assets, and an increase in its liabilities is debited to the revaluation account because it’s a loss.
So unrecorded assets are credited and unrecorded liabilities are debited to the revaluation account. If the revaluation account finally displays a credit balance then it indicates a net gain and if there is a debit balance then it indicates a net loss. That will be transferred to the capital accounts of the old partners in the old ratio.
Adjustment of Capitals in Admission of a Partner
Sometimes, at the time of admission, the partners agree that their capitals should even be adjusted so on to be proportionate to their share ratio. In such a situation, if the capital of the new partner is given, an equivalent is often used as a base for calculating the new capital of the old partners.
The capitals thus ascertained should be compared with their old capitals in any case adjustments concerning goodwill reserves and revaluation of assets and liabilities, etc. have been made; then the partner whose capital falls short will usher in the required amount to hide the shortage and therefore the partner who features a surplus, will withdraw the excess amount of capital.
Change in Profit Sharing Ratio among the existing Partners
Sometimes, the partners of a firm plan to change their existing share ratio with no admission or retirement of a partner. This leads to a gain of additional share in future profits of the firm for a few partners while a loss of a neighbourhood thereof for other partners.
For example, A, B, and C are partners in the firm sharing profits within the ratios of 8:5:3 it’s felt that A will no longer be ready to actively participate in the affairs of the firm. Hence, with effect from April 1, 2007, they determined that in the future they will share the profits in the ratio of 5: 6: 5.
This results in A loss of 3/16(8/16-5/16) share in profit while B and C gain 1/16(6/16-5/16) and 2/16(5/16-3/16). In such a situation, first of all, the loss and gain in the value of goodwill (if any) will have to be adjusted. This is done by increasing goodwill at its full value in the MD profit-sharing ratio and then writing it off in the new ratio.
Alternatively, losing partners are often credited, and gaining partners are debited with appropriate amounts without a goodwill account appearing within the books, as explained earlier within the context of the admission of new partners.
Any change, within the share ratio, like an admission of a partner, can also involve adjustments in respect of the revaluation of assets and liabilities, transfer of accumulated profit and losses to partners’ capital accounts within the old share ratio, and adjustment of partners’ capitals, if specified, so on make them proportionate to the new profit sharing ratio. All this is often wiped out in an equivalent way as just in case of admission of a partner.
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