Accounting treatment of Goodwill and Change in Profit Sharing Ratio 

CHANGE IN PROFIT SHARING RATIO AMONG EXISTING PARTNERS AND GOODWILL

Reconstitution of a Partnership Firm

 Partnership is the outcome of an agreement between the partners. There are various factors which result in the change in the partnership agreement. In that case, the old partnership agreement is discarded and new partnership agreement comes into force. In this case, the firm continues but the partnership firm is reconstituted.

Reconstitution happens because of the following reasons:

  1. 1.Change in the Profit sharing ratio among the existing partners
  2. 2.Admission of a new partner
  3. 3.Retirement or Death of an existing partner
  4. 4.Amalgamation (2 or more firms joining hands together) of firms

 

CHANGE IN PROFIT SHARING RATIO AMONG THE EXISTING PARTNERS:

The partners may decide to change their profit sharing ratios at any point of time. Hence, some partners lose their share and some partners gain.

Some adjustments are made at the point of change in the profit sharing ratio.

So, the Gaining partner compensates the Sacrificing (loser) partner.

 

ADJUSTMENTS REQUIRED AT THE TIME OF CHANGE IN THE PROFIT SHARING RATIO:

    1. Determination of Sacrificing ratio and Gaining ratio
    2. Accounting for goodwill
    3. Accounting treatment of reserves and Accumulated Profits
    4. Accounting for Revaluation of Assets and Liabilities.
    5. Adjustment of capitals.

Sacrificing Ratio:

Sacrificing Ratio= Old ratio- New Ratio

 Gaining Ratio:

Gaining Ratio= New ratio- Old ratio

= Negative sacrificing ratio

Goodwill

It is the established reputation of a business regarded as a quantifiable asset and calculated as part of its value when it is sold. It is the 'Good Name' of the business earned over the years. In a layman’s language the meaning of goodwill is “Reputation”. A suitable definition for goodwill can be studied according to the definition of Lord Elton. According to Lord Elton, “Goodwill is nothing more than the probability that the old customers will resort to the old place”.

Characteristics of Goodwill:

    1. a.It is an intangible asset
    2. b.It helps to earn higher profits
    3. c.It is a Valuable Asset
    4. d.It is difficult to value the goodwill in exact terms
    5. e.Fluctuations keep on occurring in the value of goodwill
    6. f.It helps to determine the true value of business

Occasions when valuation of Goodwill is Necessary:

    1. a.When there is change in the profit sharing ratio.
    2. b.When a new Partner is Admitted.
    3. c.When a Partner retires or dies.
    4. d.When a Partnership firm is Sold.

 Factors that affect the value of goodwill:

a. Quality of products/services offered

b.Management

c.Favourable location

d.Favourable contracts

e.Past performance

 

Nature of Goodwill

Goodwill is a valuable Intangible Asset.

Accounting Standard 26 (AS - 26), prescribes that Goodwill should not be recorded in the books of accounts unless consideration is paid for it.

 Classification of Goodwill

a. Purchased Goodwill

b.Self-Generated Goodwill

 

Purchased Goodwill- It is a type of goodwill which is acquired by firm, for a consideration, whether paid in cash or in kind. If the purchase consideration is more than the value of net assets, the “excess” is considered to be a ‘Goodwill’.

 Features of Purchased Goodwill:

    • ïIt can be shown in the balance sheet as an asset.
    • ïIt can be recorded in the books, since consideration has been paid for it
    • ïIt arises out of an agreement between the purchaser and the seller.
    • ïAS 26 prescribes that purchased goodwill be shown as an asset.

 Self-generated Goodwill- It is a Goodwill which is not purchased but is earned by the efforts of the management. It is generated internally.

 

Features of self-generated Goodwill:

    • Generated internally
    • It cannot be shown in the books of accounts, as per AS 26
    • Valuation is subjective to the valuer

 

Treatment of Goodwill:

When goodwill already appears in the books: It will be written off first-

Old Partners Capital A/C            Dr.

To Goodwill A/C

(in old ratio)

When valued Goodwill is given:

Gainer Dr.

To Sacrificer

i.e.

Gaining partners' Capital A/C          Dr.

To Sacrificing Partners' Capital A/C

(In sacrificing ratio)

Methods of Valuation of Goodwill

Methods used for calculation of Goodwill:

a.Average Profit Method

b.Super Profit Method

c.Capitalisation Method

AVERAGE PROFIT METHOD

a.Simple Average Profit Method:

Average Profit= (Total Profit of all the years)/Number of Years

 Goodwill= Average Profit X Number of Year's Purchase

a.Weighted Average Profit Method:

Step 2: Calculate Weighted Average Profit

            Weighted Average Profit= Total of Products/Total Weights

Continuing with the above example,

Weighted Average Profit= 1,40,000/10= 14,000

Step 3: Calculate Goodwill

          Goodwill= Weighted Average Profit X Number of year's purchase

Continuing with the above example, assuming number of year's purchase= 3

Goodwill= 14,000 X 3=42,000

 

NOTES:

a.Abnormal Income/gain should be deducted from that particular year's profits and hence, the profits should be revised. This is done because abnormal income/gains don't occur on a recurring nature.

b.Abnormal Loss of a Year should be added back to the net profits of that year. This is done because they don't occur on a recurring of regular basis.

c.In Weighted Average Profit method, weights will be assigned by keeping the following rule in the mind- The oldest year will be assigned the least weight i.e. 1 because recent profits of the business are valued more than the olden  year's profits. And each subsequent year after the oldest year will be assigned weight of the previous year+1.

For example, the question has years: 2015,2016,2017,2018 and 2019. So, the oldest year is 2015. Hence, 2015 will be assigned weight one. And the subsequent year i.e. 2016 will be assigned 1+1 and so on. Hence, the final weights will be 2015 ~ 1, 2016 ~ 2, 2017 ~ 3, 2018 ~ 4, 2019 ~ 5.

a.Rectifications in the closing stock of one year would result in the rectification of the opening stock of the next year.

b.Income from Investments should be deducted out of the net profits of that year, because this income is received from outside the business and not from the revenue operations.

c.Expenses of partners need to be deducted from the Profits.

d.Expenses with which year is not given, need to be subtracted from Average Profit.

 

SUPER PROFIT METHOD

 Super Profit is the excess profits which a firm earns as compared to the Normal rate of return (or profit earning capability) of the other firms in the same industry. The following are the Formulas:   

 

Normal Profit = (Capital Invested X Normal rate of return)/100

Super Profit = Actual or Average Profit - Normal Profit

Goodwill = Super Profit X Number of years purchased

 

For example, if the normal rate of earning applicable in a particular type of business is 20% and if our firm is also engaged in the same type of business and we have invested 3,00,000 of capital and we are earning 1,00,000 of profits. Now, the Normal Profits should be 3,00,000 X 20% =60,000. Whereas, the Actual Profits earned by the firm = 1,00,000. Therefore, Super Profits = 1,00,000 - 60,000 = 40,000

 

 

 

CAPITALISATION METHOD

 

Under this method, Goodwill can be calculated in two ways:

By capitalising the average profits

OR

By capitalising the super profits

 a. Capitalised Value of Average Profits = Average Profits X 100/Normal Rate of Return

Goodwill = Capitalised Value of Average Profits - Net Assets

    1. a. :

Goodwill = Super Profit X 100/Normal Rate of Return

 

NOTE:

    • Capital Employed= Net Assets= Assets- Liabilities (external) OR Capital+ Reserves

 

Accounting Treatment of Reserves and Accumulated profits when there is change in the profit sharing ratio of existing partners

Case 1: When Reserves and Accumulated profits/losses are to be transferred to Capital Accounts

Case 2: When Reserves and Accumulated profits/losses are not to be transferred to Capital Accounts

Case 1: When Reserves and Accumulated profits/losses are to be transferred to Capital Accounts

When at the time of change of profit sharing ratio, there exist balances of Reserves/Losses in the Balance Sheet, they are distributed among partners through Partner's Capital Account or Partner's Current Account as the case may be, in their old profit sharing ration 

Following entries are passed for this purpose:

    1. For transfer of reserves or accumulated profits:

Reserves A/c                                           Dr.

Profit and Loss A/c                                 Dr.

Workmen's Compensation A/c            Dr.

Investment Fluctuation Reserve A/c   Dr.

                 To Old Partner's Capital or Current A/c

(In Old Ratio)

For transfer of losses:

Old Partner's Capital or Current A/c   Dr.

To Profit and Loss A/c

                             To Deferred Revenue Expenditure A/c

(In Old ratio)

 

Example of Deferred Revenue Expenditure is Advertisement Suspense A/c

Workmen Compensation Reserve:

    1. If there is no claim against Workmen Compensation Reserve:

Workmen Compensation Reserve A/C    Dr.

To Partner's Capital/Current A/C

(Being entire amount of Workmen Compensation Reserve credited to Partners Capital {Current} Accounts in their old profit sharing ratio)

 

    1. If the claim for Workmen Compensation is lower than the amount of Workmen Compensation Reserve:

Workmen Compensation Reserve A/c                    Dr.          (100%)

    To Provision for Workmen Compensation Claim A/c         (Amount of claim)

      To Partner's Capital/Current A/c                                   (100% - Amount of claim)

(Being amount of claim transferred as a liability and the balance of reserves transferred to Partners Capital {Current} Accounts in their old profit sharing ratio)

 If the claim is equal to Workmen Compensation Reserve:

Workmen Compensation Reserve A/c                    Dr.           (100%)

To Provision for Workmen Compensation Claim A/c            (Amount of claim)

(Being entire amount of Workmen Compensation Reserve transferred as a liability)

    1. If the claim is more than the amount of Workmen Compensation Reserve:

Say, Workmen Compensation Reserve= 40,000

And Workmen Compensation Claim= 70,000

Hence, Excess claim=30,000 (since, 70000-40000) 

 Journal entries:

a.Workmen Compensation Reserve A/c   Dr. 40,000

        Revaluation A/c                                           Dr. 30,000

                To Provision for Workmen Compensation Claim A/c    70,000

(Amount of claim debited to Workmen Compensation Reserve and Revaluation Account)

a.Partner's Capital or Current A/c    Dr.      30,000

                    To Revaluation A/c                                    30,000

(Being loss of revaluation transferred to partner's capital {or current} accounts in their old profit sharing ratio)

 Investment Fluctuation Reserve:

Investments made by a concern are subject to market fluctuations and thus, the value of an investment can any time decrease suddenly in the market. So, Investment Fluctuation Reserve is maintained to overcome any sudden loss incurred due to a sudden fall in the realizable value of Investments.

a. When Book Value and Market value of Investments is same:

Investment Fluctuation Reserve A/c    Dr.

               To Partner's Capital/Current A/c

(Being entire amount of Investment Fluctuation Reserve transferred to partners in the old profit sharing ratio)

a. When Market value of Investments is less than the Book Value:

There may arise three cases:

a. Fall in the value is less than Investment Fluctuation Reserve:

Investment Fluctuation Reserve A/c    Dr. (100%)

               To Investments A/c                           (Book Value- Market Value=A)

               To Partner's Capital/Current A/c    (100%-A)

(Being Investment Fluctuation Reserve credited to investments and the balance being distributed among the partners in the old ratio)

 a. Fall in the value is equal to Investment Fluctuation Reserve:

Investment Fluctuation Reserve A/c    Dr.  (100%)

               To Investments A/c                                           (100%)

(Being entire amount of Investment Fluctuation Reserve credited to Investments A/c)

a. Fall in the value is more than Investment Fluctuation Reserve:

b. Investment Fluctuation Reserve A/c    Dr. (100%)

Revaluation A/c                                        Dr. (Fall in value- Investment Fluctuation Reserve)

              To Investments A/c                                     (Fall in value)

(Being investment adjusted for fall in value)

 a.Partner's Capital/Current A/c Dr.

To Revaluation A/c

(Being loss distributed among partners in the old ratio)

  a. When Market Value of Investments is more than the Book Value:

In such a case 3 entries are passed:

 a.Investment Fluctuation Reserve A/c    Dr.

               To Partner's Capital/Current A/c

(Being entire amount of Investment Fluctuation Reserve transferred to partners in the old profit sharing ratio)

 a.Investments A/c          Dr.    (Market Value- Book Value)

              To Revaluation A/c            (Market Value- Book Value)

(Being the value of investments increased)

 a.Revaluation A/c           Dr.     (Market Value- Book Value)

              To Partner's Capital A/c

(Being profit credited to partners in the old ratio)

 Case 2: When Reserves and Accumulated profits/losses are not to be transferred to Capital Accounts

 In this case the balances of reserves and accumulated profits and losses will still appear in the future balance sheets of the firm and will not be distributed among the partners.

 However, the Gaining partner will compensate the benefits of change in profit sharing ratio to the sacrificing partner. Hence, an adjustment entry will be passed which is as follows:

 Gaining partners' Capital A/C            Dr.

       To Sacrificing Partners' Capital A/C

  (In sacrificing ratio)

 The amount of the total reserves and/or losses will be divided in the sacrificing ratio.

 Accounting for Revaluation of Assets and Liabilities when there is change in the profit sharing ratio of existing partners

 

Revaluation means valuing the assets or liabilities again according to the latest actual or realisable value. The change in the value that occurs belongs to the period of old partners. Hence, the profit or loss on revaluation is borne by the old partners in the old ratio.

 

Revaluation of Assets and Liabilities can be adjusted in two ways:

    1. When revised values are to be recorded in the books, and
    2. When revised values are not to be recorded in the books.

 

Case 1: When revised values are to be recorded in the books

In this case Revaluation A/c, also known as Profit and Loss Adjustment A/c, is prepared. This account is of nominal nature. Hence, losses due to revaluation are debited in the revaluation A/c. And profits due to revaluation are credited in the Revaluation A/c.

 Concept of Revaluation:

    • An increase in the assets and decrease in its liabilities is credited because it is gain,
    • A decrease in the value of assets and increase in its liabilities is debited because it is a loss,
    • Unrecorded assets are credited, and
    • Unrecorded liabilities are debited

 If the account finally shows a credit balance then it indicates net gain and if there is a debit balance then it indicates the net loss. Profit or loss will be transferred to the capital accounts of the old partners in old ratio.