Reconstitution of a Partnership Firm · Existing Partners and Goodwill- Nature and Methods of its...

Reconstitution of a

Partnership Firm:Change in Profit Sharing Ratio among the

Existing Partners and Goodwill- Nature

and Methods of its Valuation

Reconstitution of a

Partnership Firm:Learning Objectives:• Reconstitution of Partnership

• Sacrificing Ratio

• Gaining Ratio

• Goodwill

• Methods of valuation of Goodwill

• Reserves and Accumulated profits

• Revaluation of Assets and Liabilities

• Adjustment of Capitals.

Reconstitution of a Partnership

FirmsA change in the nature of relationship among

the members, effected through a fresh

agreement under which the existing business

continues is called reconstitution.

Modes of Reconstitution

Change in profit sharing ratio

Admission of a partner

Retirement of a partner

Death of a partner

Amalgamation of two partnership firms

Goodwill

GoodwillGoodwill is the value of reputation of a firm

It is in respect of the profits expected in future

over and above the normal profits

GoodwillOver a period of time a well established

business develops an advantage of good

name, reputation and wide business

connections which help the business to earn

more profits

In accounting, the monetary value of

such advantage is known as goodwill

Features of Goodwill

It is an intangible asset

It is a valuable asset

It is helpful in earning excess profits

It is difficult to place an exact value on

goodwill

It is valuable only when entire business is

sold

Factors Affecting Goodwill

Location of Business:

If it is centrally located in a place having more

customer traffic, the goodwill tends to be high.

Factors Affecting GoodwillNature of Business:

The firm which produces the products having a

stable demand is able to earn more profits and

therefore has more goodwill.

Factors Affecting GoodwillEfficiency of Management:

Based on the efficiency of management, the

productivity and the profitability of an

organization be higher and it determines the value of

goodwill


Time Factor:

A business concern running profitably for a

longer period will have more goodwill since it

is better known to the customers.


Market Situation:

The monopoly or limited competition enables

the business to earn more profit, which leads

to higher goodwill.


Special Advantages:

Import licenses, well known foreign collaboration,

patents, trademarks etc. will help to earn more profit

which leads to higher goodwill for the firm


Future Competition:

The likelihood or possibility of increased

competition in future would definitely

reduce the value of Goodwill.

Classification of Goodwill

Purchased Goodwill:

Purchased goodwill is the goodwill which is

acquired by making a payment.

Example:

When a business is purchased, the excess of

purchase consideration over its net assets

(Assets – Liabilities) is referred to as

purchased goodwill.

Classification of Goodwill

Self-Generated Goodwill or Inherent Goodwill:

It is internally generated goodwill which arises

from a number of characteristics which an on

going business possesses.

Need for Valuation

of

Goodwill

Need for Valuation of Goodwill

Change in profit sharing ratio among the

existing partners.

2:11:1


Admission of a partner


Retirement of a partner


Death of a partner


Dissolution of a firm or sale of partnership

business


Amalgamation of firms

Methods of

Valuation of

Goodwill

Average Profit

Method

Methods of Valuation of Goodwill

Average Profit Method

Here the goodwill is valued at an agreed

number of ‘years’ purchase of the average

profits of the past a few years

20+30+40

-------------- =30

3



20+30+40

-------------- =30

3

This method 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



Eg: Net profit of a business for the last 3 years

was Rs. 10000, 20000 and 30000, the partners

decided to calculate the goodwill based on 2

years purchase of average profit

:. Average Profit =

(10000 + 20000 + 30000) / 3 = 20000

Goodwill = 20000 x 2 = 40000

Weighted

Average Profit

Method


Weighted Average Profit Method

Year Profit Weight

2017 20,000 1

2018 30,000 2

2019 50,000 3

Here weights are assigned for each year’s profit



Total 10 1,50,000

Weighted Average Profit = 1,50,000 / 10 = 15,000

Goodwill = 15,000 x 3 = 15,000

(Based on 3 years purchase of weighted average profit)

Year Profit Weight Product

2016 5,000 1 5,000

2017 10,000 2 20,000

2018 15,000 3 45,000

2019 20,000 4 80,000



Steps:

1. Assign the weights for each year - 1, 2, 3 etc.

2. Find the Product - Weight X Profit

3. Find the Total of Products

4. Divide the Total of Products by Total Weights

5. Multiply the Weighted Average Profit X No. of

Years Purchase

Super Profit

Method


Super Profit Method

Super Profit means the excess of the actual

profits earned by a business unit over and

above the normal return expected on

investment in similar class of business

A

10%B

10%

C

15% D

10%

E

10%


Super Profit Method

Under this method:

Super Profit = Actual Profit – Normal Profit

Normal Profit = Capital Employed x NRR / 100

Goodwill = Super Profit X No. of years

Actual Profit may be the Average Profit

NRR = Normal Rate of Return

Methods of Valuation of GoodwillSuper Profit MethodExample:

Average Profit - 20,000, Capital Employed – 200,000

and NRR = 8% Goodwill based on 2 years purchase.

Super Profit = Actual Profit – Normal Profit

Normal Profit = Capital Employed x NRR / 100

= 200,000 X 8/100 = 16,000

Super Profit = 20,000 – 16,000 = 4,000

Goodwill = Super Profit X No. of years

= 4,000 x 2 Yrs = 8,000

Capitalization

Method

Capitalization of

Average Profit

Capitalization of

Super Profit


Capitalization of Average Profit

Here the goodwill is ascertained by deducting

actual capital employed (net assets) from the

capitalized value of average profits

Goodwill = Capitalized value of average profit –

Actual capital employed



Capitalized value of Avg. Profit =

Average Profit x 100 / Normal Rate of Return

Capital Employed =

Total Assets (Excluding Goodwill) – Outside

Liabilities



Example:

Average Profit – 50,000, NRR – 10%,

Total Assets – 400,000 and Liabilities – 50,000

Capitalized value of average profit =

50,000 x 100/10 = 500,000

Capital Employed (net assets) =

400,000 – 50,000 = 350,000

Goodwill = 500,000 – 350,000 = 150,000


Capitalization of Super Profit

Goodwill is ascertained by capitalizing

super profit

Goodwill =

Super Profit x 100 / Normal Rate of Return


Capitalization of Super Profit

Example:

Super Profit = 20000 and NRR = 10%

Goodwill =

Super Profit x 100 / Normal Rate of Return

Goodwill = 20000 x 100/10 = 200,000

Meaning of Sacrificing Ratio

The ratio in which the partner or partners have agreed to

sacrifice their shares in profit in favour of other partner or

partners, is known as sacrificing ratio.

Sacrificing Ratio = Old Ratio – New Ratio

Meaning of Gaining Ratio

Gaining ratio arises when one partner gain some

share of profit from change in profit sharing ratio.

Gaining Ratio = New Ratio – Old Ratio

Calculation of Sacrificing Ratio

and Gaining Ratio

Example:

A and B were partners in a firm sharing profit and losses in the ratio of 2:1.

With effect from 1st July, 2019 they agreed to share profits and losses

equally. Calculate the individual partners gain or sacrifice due to change in

ratio.

Old Ratio = 2:1 and New Ratio = 1:1

Sacrificing Ratio = Old Ratio – New Ratio

Sacrificing Ratio = 2/3 – ½ = 1/6 (Sacrifice)

Gaining Ratio = New Ratio – Old Ratio

Gaining Ratio = 1/2 – 1/3 = 1/6 (Gain)

Treatment

of

Goodwill

Change in Profit Sharing Ratio

In certain cases the partners in a firm may

change their existing profit sharing ratio.

1:1

2:1


By this, some partners will gain in

future profits while others will lose.


In such a case the gaining partner should

compensate the sacrificing partner.


Example:

A and B are partners sharing profits in the ratio of 3:2,

they decide to change the ratio into 1:1.In this case,

A loses 1/10th ie; 3/5 – 1/2 and B gains this

1/10th ie; 1/2 - 2/5.


Example:

Here B has to compensate with A and it will be the

proportionate amount of goodwill.

Suppose the total value of goodwill is Rs.50,000, then B

should pay Rs.5000 ie; 50000 x 1/10 to A as compensation.


Example:

The journal entry :

B's Capital Account Dr. 5000

To A's Capital Account 5000

B

A

ACCOUNTING

TREATMENT OF

RESERVES

AND ACCUMULATED

PROFIT OR LOSS

RESERVES AND ACCUMULATED

PROFIT OR LOSSAt the time of change in profit sharing ratio, some

undistributed profits and reserves may stand in

the books


PROFIT OR LOSSIt should be shared among the partners in their

old profit sharing ratio before reconstitution

takes place.

This is to be done even if the question is silent in

this regard


PROFIT OR LOSS

Journal Entry:

Undistributed profits or Reserves:

Profit and Loss Account Dr.

Reserves Account Dr.

To Old Partners’ Capital Account


PROFIT OR LOSSJournal Entry:

Undistributed Losses:

Old Partners’ Capital Account Dr.

To Profit and Loss Account


PROFIT OR LOSS

Same treatment may be followed for

Workmen's Compensation fund and

Investment Fluctuation Fund


PROFIT OR LOSSExample:

A, B and C are partners sharing profit and losses in the ratio of 2:3:4. Theydecided to share future profits and losses in the ratio of 4:3:2. They alsodecided to record the effect of the following without affecting their bookValues: General Reserve Rs. 20,000 and Profit and Loss A/c Rs. 25,000.

You are required to give the necessary single journal entry.

Old Ratio of A, B and C 2/9:3/9:4/9

New Ratio of A, B and C 4/9:3/9:2/9

Sacrifice or Gain:

A = 2/9-4/9 =2/9 (Gain), B = 3/9-3/9=0 , C = 4/9-2/9= 2/9 (Sacrifice)

Journal Entry;

A’s Capital A/c (2/9 of 45,000) Dr. 10,000

To C’s Capital A/c (2/9 of 45,000) 10,000

Revaluation of

Assets and

Liabilities

Revaluation of Assets and Liabilities

Alternatives:

1. If revised values are to be recorded in

the books

2. If revised values are not to be

recorded in the books.


It is better to ascertain that whether the assets and

liabilities of the firm are shown at their correct

value at the time of change in the profit sharing

ratio of existing partners


If they are overstated or understated, they must be

revalued and any profit or loss should be adjusted

to the old partners in their old ratio


All the adjustments regarding revaluation of assets and

liabilities are affected through revaluation account or

the Profit and Loss Adjustment Account


Revaluation A/c is credited with

1. The increase in the value of asset

2. Decrease in the value of liability

3. Any unrecorded asset


Revaluation A/c is debited with

1. The decrease in the value of assets

2. Increase in the value of liability

3. Unrecorded liabilities


Balance in the revaluation account (gains or loss)

should be transferred to the old partners’ capital

account in their old ratio

Revaluation of Assets and LiabilitiesWhen revised values are to be recorded in books:

Example:

X, Y and Z are partners sharing profits equally. They decided that in future Z will get

1/5th share in profits. On the day of change, following is their Balance Sheet:

On this date, Building have been valued at Rs. 15,000, Stock to be reduced by Rs.1,500and provision for doubtful debts to be reduced by Rs. 1,000.

Pass journal entries in the books of firm regarding the revaluation of assets. Preparenecessary ledger accounts and Balance Sheet.

Liabilities Amount Assets Amount

Creditors 18,400 Cash 6,000

Capital A/cs: Debtors 22,500

X 12,500 Less: Provision for Doubtful Debts 4,000 18,500

Y 12,500 Stock 12,500

Z 9,000 34,000 Machinery 5,400

Buildings 10,000

52,400 52,400


Solution:

Journal

Building a/c Dr. 5,000

Provision for doubtful debts a/c Dr. 1,000

To Revaluation a/c 6,000

Revaluation a/c Dr. 1,500

To Stock a/c 1,500

Revaluation Dr. 4,500

To X’s Capital a/c 1,500

To Y’s Capital a/c 1,500

To Z’s Capital a/c 1,500


Revaluation A/C

Particulars Amou

nt

(Dr.)

Particulars Amount

(Cr.)

To stock 1,500 By Building 5,000

To Profit transferred to: By Provision for Doubtful Debts 1,000

X’s Capital A/c 1,500

Y’s Capital A/c 1,500

Z ’s Capital A/c 1,500 4,500

6,000 6,000


When revised values are to be recorded in books:

Partners’ Capital Accounts

Dr. Cr.

Particulars X Y Z Particulars X Y Z

To Balance c/d 14,000 14,000 10,500 By Balance b/d 12,500 12,500 9,000

By Revaluation a/c 1,500 1,500 1,500

14,000 14,000 10,500 14,000 14,000 10,500


Balance Sheetas on ……………………………….


Creditors 18,400 Cash 6,000

Capital A/cs: Debtors 22,500

X 14,000 Less: Provision for Doubtful Debts 3,000 19,500

Y 14,000 Stock (12,500-1,500) 11,000

Z 10,500 38,500 Machinery 5,400

Buildings (10,000+5,000) 15,000

56,900 56,900

Revaluation of Assets and LiabilitiesWhen revised values are not to be recorded in books:

If the partners decide that the revised values of assets and

liabilities are not recorded in the books and they also do

not want to distribute the general reserves and

accumulated profits, then in such a case revaluation /

change in the value of assets and liabilities are recorded by

passing a journal entry as illustrated below:

Gaining Partners’ capital A/c Dr.

To Sacrificing Partners’ Capital A/c


Example:

P, Q and R are partners sharing profits and losses in the ratio of 3:3:2. Their Balance

Sheet as on 31st March, 2019 was as follows:

Partners decided that with effect from 1st April, 2019 they would share profits and

losses in the ratio of 4:3;2. It was agreed that:


Creditors 24,000 Cash at Bank 37,000

General Reserve 36,000 Debtors 44,000

Capital A/cs: Stock 1,20,000

P 2,00,000 Machinery 1,59,000

Q 1,50,000 Buildings 2,00,000

R 1,50,000 5,00,000

5,60,000 5,60,000


Example:

Stock be valued at Rs. 1,10,000.

Machinery is to be depreciated by 10%.

A Provision for doubtful debts is to be made on debtors @5%.

Building to be appreciated by 20%.

A liability for Rs. 2,500 included in Sundry Creditors is not likely to

arise.

Partners agreed that the revised values are not to be recorded in

the books. They also do not want to distribute the general reserve. You

are required to pass Journal Entries and Prepare accounts and Balance

Sheet of the reconstituted firm.


When revised values are not to be recorded in books:

Solution:

Journal Entry:

P’s Capital A/c Dr. 3,500

To Q’s Capital A/c 2,100

To R’s Capital A/c 1,400



Working Notes:(1)

Particulars Amount Amount

Loss due to decrease in the value of Stock 10,000

Loss due to decrease in the value of Machinery 15,900

Loss due to Provision for doubtful debts 2,200 28,100

Profit due to increase in the value of Building 40,000

Profit due to decrease in Sundry Creditors 2,500 42,500

Profit on Revaluation 14,400

Add: General Reserve 36,000

Total 50,400



Working Notes:(2)

Old Ratio of P, Q and R = 3:3:2 and

New Ratio of P, Q and R = 4:3:2.

Sacrifice or Gain:

Sacrificing Ratio = Old Share – New Share

P = 3/8 – 4/9 = 5/72 (Gain), 50,400 x 5/72 = Rs. 3,500 (Dr.)

Q = 3/8 – 3/9 = 3/72 (Sacrifice), 50,400 x 3/72 = Rs. 2,100 (Cr.)

R = 2/8 – 2/9 = 2/72 (Sacrifice), 50,400 x 2/72 = Rs. 1,400 (Cr.)



Partners’ capital AccountsDr. Cr.

Particulars P Q R Particulars P Q R

To Q’s Capital A/c 2,100 ----- ----- By Balance b/d 2,00,000 1,50,000 1,50,000

To R’s Capital A/c 1,400 ----- ----- By P’s Capital A/c 2,100 1,400

To Balance c/d 1,96,00 1,52,100 1,51,400

2,00,000 1,52,100 1,51,400 2,00,000 1,52,100 1,51,400


Balance SheetAs on 1st April, 2019


Creditors 24,000 Cash at Bank 37,000

General Reserve 36,000 Debtors 44,000

Capital A/cs: Stock 1,20,000

P 1,96,500 Machinery 1,59,000

Q 1,52,100 Buildings 2,00,000

R 1,51,400 5,00,000

5,60,000 5,60,000

Need for

Preparing

Revaluation

Account

Need for preparing Revaluation Account

1. To bring the assets and liabilities of the firm to their

true values

2. To find out the profit or loss arising out of revaluation

Revaluation Account

Journal Entries:-

Increase in the value of asset:

Asset Account Dr.

To Revaluation Account

Revaluation Account

Journal Entries:-

Decrease in the value of asset:

Revaluation Account Dr.

To Asset Account

Revaluation Account

Journal Entries:-

Increase in the value of liability

Revaluation account Dr.

To Liability Account

Revaluation Account

Journal Entries:-

Decrease in the value of liability

Liability account Dr.


Revaluation Account

Journal Entries:-

Unrecorded Asset –

Asset Account Dr.


Revaluation AccountJournal Entries:-

Unrecorded Liability:

Revaluation Account Dr.

To Unrecorded Liability Account


Transfer of balance in Revaluation account (profit

and loss adjustment account):

a. If the revaluation account shows a credit balance

ie; profit

Revaluation account Dr.

To Old Partners’ Capital (individually) account


Transfer of balance in Revaluation account (profit

and loss adjustment account):

b. If the revaluation account shows a debit balance,

ie; Loss.

Old Partners’ capital account Dr.

To Revaluation account

ADJUSTMENT OF

CAPIITAL

ACCOUNTS

OF PARTNERS

Adjustment of Partners’ CapitalsSometimes it is decided among partners to adjust

their capitals in new profit-sharing ratio. For thispurpose, first of all the adjusted capitals of partnersare calculated after making adjustments for generalreserve, undistributed profits and losses, goodwill,revaluation of assets and liabilities, etc. then totalrequired capital of the new firm is apportionedamong partners in new profit sharing ratio. In case,adjusted capital is more than the required capital,the surplus capital is withdraw by the partner(s) andvice versa.

Adjustment of Partners’ Capitals

Example:X, Y and Z are partners in the firm sharing profit and losses as 3:2:1. Their

Balance Sheet as at 31st March, 2019 was as follows:

From 1st April, 2019, they agreed to alter their profit-sharing ratio as 5:3:2. It is

also decided that:


Sundry Creditors 4,50,000 Cash in hand 60,000

General Reserve 2,40,000 Cash at Bank 60,000

Bank Loan 2,10,000 Sundry Debtors 1,80,000

Partners’ Capital a/cs: Stock 3,60,000

X 3,00,000 Bills Receivable 1,50,000

Y 2,40,000 Plant and Machinery 8,40,000

Z 2,10,000 7,50,000

16,50,000 16.50,000

Adjustment of Partners’ Capitals Plant and Machinery should be valued at Rs.9,00,000.

A provision of 5% on Sundry Debtors be made forDoubtful Debts.

The goodwill of the firm be valued at Rs. 3,00,000.

The stock be reduced to Rs. 3,30,000.

Total capital of the firm will be Rs. 12,00,000.

Goodwill was not to appear in the books.

Draft necessary journal entries, adjust the capitals ofpartners according to new profit-sharing ratio, preparepartners’ capital accounts and revised Balance sheet ofthe reconstituted firm.

Adjustment of Partners’ CapitalsSolution:

Journal Entries:Plant and machinery A/c Dr. 60,000

To Revaluation A/c 60,000

Revaluation A/c Dr. 39,000

To Stock a/c 30,000

To Provision for Doubtful Debts a/c 9,000

Revaluation A/c Dr. 21,000

To X’s Capital A/c 10,500

To Y’s Capital A/c 7,000

To Z’s Capital A/c 3,500

Adjustment of Partners’ CapitalsSolution:

Journal Entries:X’s Capital A/c Dr. 10,000


General Reserve A/c Dr. 2,40,000

To X’s Capital A/c 1,20,000


To Z’s Capital A/c 40,000

Cash A/c Dr. 1,92,500

To X’s Capital A/c 1,69,500


Z’s Capital A/c Dr. 3,500

To Cash A/c 3,500


Working Notes: (1)

Calculation of sacrifice or gain:

X = 3/6 – 5/10 = Nil,

Y = 2/6 – 3/10 = 2/60 (Sacrifice)

Z = 1/6 – 2/10 = 2/60 ( Gain)

Share of Goodwill credited to Y = 3,00,000 x 2/60

= Rs. 10,000.


Working Notes: (2)Calculation of new capitals of partners on the basis of new profit- sharing ratio

Total capital of the firm = Rs. 12,00,000

Capital of X = 12,00,000 x 5/10 = Rs 6,00,000,

Capital of Y = 12,00,000 x 3/10 = Rs 3,60,000,

Capital of X = 12,00,000 x 2/10 = Rs 2,40,000,

Working Notes: (3)

Balance of cash in hand = 60,000 + 1,69,000 + 23,000 –

3,500 = 2,49,000.


Working Notes: (4)

Revaluation AccountParticulars Amount (Dr.) Particulars Amount (Cr.)

To Provision for Doubtful Debts 9,000 By Plant and Machinery 60,000

To Stock 30,000

To Profit transferred to Capital a/cs:

X 10,500

Y 7,000

Z 3,500 21,000

60,000 60,000


Partners’ Capital AccountsDr. Cr.

Particulars X Y Z Particulars X Y Z

To Y’s Capital

A/c

------ ------ 10,000 By Balance b/d 3,00,000 2,40,000 2,10,000

To Cash ------ ------ 3,500 By Revaluation A/c 10,500 7,000 3,500

To Balance c/d 6,00,000 3,60,000 2,40,000 By General

Reserve

1,20,000 80,000 40,000

By Z’s Capital A/c ------ 10,000 ------

By Cash A/c 1,69,000 23,000 ------

6,00,000 3,60,000 2,53,500 6,00,000 3,60,000 2,53,500


Balance SheetAs on 1st April, 2019


Sundry Creditors 4,50,000 Cash in hand 2,69,000

Bank Loan 2,10,000 Cash at Bank 60,000

Partners’ Capital a/cs: Sundry Debtors 1,71,000

X 6,00,000 Stock 3,30,000

Y 3,60,000 Bills Receivable 1,50,000

Z 2,40,000 12,00,000 Plant and Machinery 9,00,000

18,60,000 18,60,000

ThanksPrepared by

Manoj Kumar

KV, OFN,

Rajgir

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