A new partner can be admitted only with the concent of all the existing partners. A new partner is not liable for any profit or loss occured before his admission. Such a partner is called a new partner or incoming partner.
purpose of Admission of a partner:
1. For additional capital
2. for progress of the firm
3. For acquiring additional managerial skill
4. For reducing compitition
Effect of Admission of a PartnerAdmission of a new partner is a major event in a partnership business. A new admission can take place only with the unanimous consent of all the existing partners. New partners are admitted for several reasons. Additional capital contribution, fresh ideas more contacts etc. are some of the advantages in admitting a new partner.Following are the most important accounting aspects to be considered at the time of admission of a new partner.1. Change in profit sharing ratio2. Accounting treatment of Goodwill3. Revaluation of assets and liabilities4 Treatment of reserves and accumulated profits / losses5. Adjustment of Capital Accounts
1. Change in Profit Sharing RatioWhen a new partner comes into the business, old partner have to adjust his profit share from their portion. Thus change in profit sharing ratio is the first accounting aspect to be considered on admission of a new partner. In academic accounting, change in profit sharing ratio can be presented in various ways:
2. The new partner's share is mentioned without specifying the old partner's profit sharing arrangement.In this case it is to be assumed that the profit available after paying the new partner?s share is to be divided by the old partners in their old profit sharing ratio. In other words the even though the overall profit sharing ratio changes, the old ratio is still maintained between the old partners, within the new 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
As stated earlier, the new partner is required to compensate the old partner’s for their loss of share in the super profits of the firm for which he brings in an additional amount known as premium or goodwill. This amount is shared by the existing partners in the ratio in which they forego their shares in favour of the new partner which is called sacrificing ratio.
The ratio is normally clearly given as agreed among the partners which could be the old ratio, equal sacrifice, or a specified ratio. The difficulty arises where the ratio in which the new partner acquires his share from the old partners is not specified. Instead, the new profit sharing ratio is given. In such a situation, the sacrificing ratio is to be worked out by deducting each partner’s new share from his old share.
3. Revaluation of Assets and LiabilitiesRevaluation of assets and liabilities is another major step prior to admission or retirement. Revaluation is important, as there are hidden profits or losses in the difference between book value and actual market value of assets or liabilities. Revaluation is necessary whenever there is a change in profit sharing ratio, even without admission or retirement. The hidden profits or losses should be distributed in the ratio prior to change (Old ratio).Revised values of assets and liabilities are brought into books by opening a temporary account called ?revaluation account?. The purpose of revaluation account is to summarise effect of revaluation of assets and liabilities.Revaluation account represents the combined capital account of partners. Any gain on revaluation of asset or liabilities, which are to be credited to partners, will be credited in revaluation account. Similarly any loss on revaluation will be debited in revaluation account instead of capital accounts. The revaluation account is closed by transferring its net balance to partner?s capital accounts in the profit sharing ratio.
4. Treatment of Reserves and Accumulated ProfitsAccumulated profits such as general reserve, credit balance in profit &loss account etc. will be transferred to the capital accounts of old partners in the old profit sharing ratio. Similarly accumulated losses shall be transferred to the debit side of old partner?s capital accounts. Therefore these items will not appear in the new balance sheet.
5. Adjustment of Capital AccountsWhen the partners change their profit sharing ratio at admission, retirement or any other reason, they also rearrange their capital accounts. Capital contribution is not essentially the basis of profit sharing. However the in most partnerships capital contribution is considered as the major factor in determining profit sharing ratio.At the time of admission, capital contribution will be raised as an important condition. When a new partner is admitted for a certain share of profit for a certain amount of capital contribution he would naturally expect the other also maintain a capital balance matching with their profit share. Admission of a partner is not the only situation when a capital rearrangement is considered. Retirement, death or any other change in profit sharing ratio would prompt rescheduling the capital balances. The basic purpose of following ?fixed capital method? is to maintain a steady capital ratio. When capital is readjusted on the basis of new partner?s capital contribution, the first step is to determine the revised capital balances of each partner. Readjustment in capital account is usually done by bringing in or taking out cash. Sometimes, in place of cash transactions, old partners may adjust their capital balances by transferring the excess or deficit in the capital accounts to their current accounts as a temporary measure. Once the capital balances are adjusted current accounts can be settled in due course.
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 well-established business develops an advantage of good name, reputation and wide business connections. This helps the business to earn more profits as compared to a newly set up business. In accounting, the monetary value of such 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 in respect of the profits expected in future over and above the normal profits. It is generally observed that when a person pays for goodwill, he/she pays for something, which places him in the position of being able to earn super profits as compared to the profit earned by other firms in the same industry.
In simple words, goodwill can be defined as “the present value of a firm’s anticipated excess earnings” or as “the capitalised 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 is incurring losses has no goodwill.
Factors Affecting the Value of Goodwill
The main factors affecting the value of goodwill are as followsNature 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.
Location: If the business is centrally located or is at a place having heavy customer traffic, the goodwill tends to be high.
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.
Market situation: The monopoly condition or limited competition enables the concern to earn high profits which leads to higher value of goodwill.
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.
Methods of Valuation of Goodwill:
1. Average Profits Method
2. Supper Profits Method
3. Capitalisation Method.
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.
For example, if the past average profits of a business works out at Rs. 20,000 and it is expected that such profits are likely to continue for another three years, the value of goodwill will be Rs. 60,000 (Rs. 20,000 × 3),
Supper 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. Hence, the person who purchases an existing business has to pay in the form of goodwill a sum equal to the total profits he is likely to receive for the first ‘few years’. But it is contended that the buyer’s real benefit does not lie in total profits; 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
Suppose an existing firm earns Rs. 18,000 on the capital of Rs. 1,50,000 and 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 in this case will be Rs. 3,000 (Rs. 18,000 – 15,000). The goodwill under the super profit method is ascertained by multiplying the super profits by certain number of years’ purchase. If, in the above example, it is expected that the benefit of super profits is likely to be available for 5 years in future, the goodwill will be valued at Rs. 15,000 (3,000 × 5). Thus, 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.
Under this method the goodwill can be calculated in two ways: (a) by capitalizing the average profits, or (b) by capitalizing the super profitsCapitalisation 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:
(i) Ascertain the average profits based on the past few years’ performance.
(ii) 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 Liabilities
(iv) Compute the value of goodwill by deducting net assets from the capitalised value of average profits, i.e. (ii) – (iii)