3 Partnership Accounts

PARTNERSHIP ACCOUNTS
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CHAPTER:1 FUNDAMENTALS
Special Aspects of Final Accounts of Partnership 1. Fixed and Fluctuating Capital Accounts
The partners of a firm have the option to decide whether their capital accounts may remain fixed or fluctuating. This aspect is not much relevant in a sole trading business, where the capital account is usually fluctuating. Stability in capital balances is important in a firm, because the capital investment is usually one of the major aspects of partners business relationship. When the capital accounts are said to be fixed it implies that the capital accounts will remain steady for a reasonably long time. In other words the daily items of credit and debit to partners will not be recorded in the capital accounts. They will open current accounts in each partners name. These current accounts are regarded as subsidiary capital accounts. Daily transactions related to a partner are recorded in his current account, instead of capital account. Thus the current account keeps on changing as the transactions are posted into it, while the capital balance stays the same. However, if there is any additional capital investment by a partner or capital withdrawal, other than minor routine drawings, it will be recorded in the capital account, not in the current account. In the event of rescheduling of capitals transfers can be made from current accounts to capital or vice versa to adjust the capital balances. When the capital accounts are fluctuating there will not be a current account in the name of partner. All transactions related to a partner, such as salary to a partner, interest on capital, additional capital investment and similar items are directly credited to the capital accounts of partner. Drawings, interest on drawings capital withdrawal etc. are debited to the capital accounts. Thus the balance in the capital account keeps on changing with every transaction posted into it. The following comparative table shows the difference between fixed and fluctuating capital accounts:
Fixed Capital Fluctuating Capital
1. Opening and Closing balances in the capital account will remain the same. 2. Current Accounts will be opened in the name of partners when capitals are fixed. 3. Regular transactions related to partners are not entered in the capital accounts. 4. Fixed capital accounts always have credit balance
Opening and closing balances rarely remain the same. Current accounts are not required.
All regular transactions related to partners are recorded in their capital accounts. Fluctuating capital accounts can sometimes have debit balance
The following accounts with imaginary figures show the difference between Fixed and Fluctuating Capital Accounts. a. Fixed Capital Illustration 1.01 Abrahams Capital Account
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Date 2002 Dec 31
Particulars To Balance c/d
Amount 30,00030,000
Date 2002 Jan1
Particulars By Balance b/d
Amount 30,000
30,000
Abrahams Current Account
Date
2002 Dec 31 Dec 31
Particulars
To Drawings A/c To interest on drawings To balance c/d
Amount
Date
Particulars
By Balance b/d By Salary By Commission By Interest on capital By Net divisible profit
Amount
2,000 6,000 1,500 1,800 12,000 23,300
Dec 31
2002 18,100 Jan 01 200 Dec 31 Dec 31 5,000 Dec 31 Dec 31 23,300
b. Fluctuating Capital Abrahams Capital Account
Date
2002 Dec 31
Particulars
To Drawings To Interest Capital To Balance c/d
Amount
Date
Particulars
By Balance b/d * By Salary By Commission By Interest on capital By Net divisible profit
Amount
32,000 6,000 1,500 1,800 12,000 53,300
on
2002 18,100 Jan 01 200 Dec 31 35,000 Dec 31 Dec 31 53,300
* Note: Opening balance of capital account in part (b) includes current account balance also. 2. Division of Profit among Partners Profit making and profit sharing are the main objectives of partnership business. When the partners do not have any special conditions regarding the profit distribution the task of profit sharing is a simple, one-step operation of dividing the profit in the given ratio. But in actual practice the partners are compelled to include many conditions such as interest on capital, interest on drawings, salaries, commission on profit etc. The purpose of these special conditions is to fairly compensate extra capital, extra effort or similar additional factors contributing to the profitability of the firm. Thus the profit distribution becomes little more complex. A profit and loss appropriation account is prepared with full details of profit distribution. This is prepared as a supplementary account to the profit and loss account, prior to preparing the balance sheet.
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Illustration 1.02 A & B are equal partners in a firm with capitals of Rs.75,000 and Rs.50,000 on 1st January 2002. A is entitled to a salary of Rs.24,000 per annum and B is entitled to a salary of Rs.18,000 per annum. They have withdrawn 50% of their salaries during the year. A and B are entitled to commissions at the rate of 5% and 3% respectively on the net profit after salary. Net profit during the year 2002 before partners salary amounted to Rs.84,000. Prepare: a. Profit and Loss Appropriation Account b. Capital Accounts of partners (assuming capitals are fluctuating) c. Capital Accounts and Current Accounts of partners (assuming capitals are fixed)
Profit & Loss Appropriation A/c

Particulars To Salary A To Salary B Commission to A (42,000x5/100) Commission to B (42,000x3/100) Net Divisible Profit A B Amount Particulars 24,000 By P & L Accountprofit 18,000 2,100 1,260 19,320 19,320 84,000 Amount 84,000
84,000
Note: when profit sharing ratio is not given in the question; it should be shared equally.
a. When capital accounts are fluctuating.
Capital Accounts
Particulars
To Cash To Balance c/d
A
12,000 108,420 120,420
Particulars
A
75,000 24,000 2,100 19,320 120,420
B
50,000 18,000 1,260 19,320 88,580
9,000 By Balance b/d By Salary 79,580 By Commission By Net Divisible 88,580 Profit
b. When capital accounts are fixed
Capital Accounts
Particulars A B Particulars
By Balance b/d To Balance c/d 75,000 50,000 75,000 75,000
75,000 50,000
75,000 50,000
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Current Accounts
Particulars
To Cash To Balance c/d
A
12,000
Particulars
A
24,000 2,100 19,320 45,420
B
18,000 1,260 19,320 38,580
9,000 By Salary By Commission 33,420 29,580 By Net Divisible 45,420 38,580 Profit
Illustration 1.03 A & B started business on 1st January 2001 with capitals of Rs.75,000 and Rs. 50,000 respectively. On 31st December 2001, the drawings account of A showed a debit balance of Rs.8,000 and that of B showed a debit balance of Rs.5,000. The partnership deed provided for interest on capital @6%. Interest on drawings is to be charged @3% on the closing balance of the year irrespective of the date of drawing. Their firm earned a profit of Rs.22,110 for the year 2001. Prepare profit and loss appropriation account and capital accounts of the partners.
Particulars To Interest on Cap A B
Amount Particulars 4,500 By P&L account 3,000 By Interest on Drawings A B
Amount 22,110 240 150
To Net Divisible Prof. A B
7,500 7,500 22,500

Capital Accounts B Particulars
22,500
Particulars
To Drawings To Int. on drawings To balance c/d
5,000 By Cash - Op Capital 240 150 By Interest on capital 78,760 55,350 By Net Divisible Profit 87,000 60,500
8,000
75,000 50,000 4,500 7,500 3,000 7,500
87,000 60,500
Illustration 1.04 A & B started business with Rs.15,000 each on 1st January, 2001. A made monthly drawings of Rs.750 and B made monthly drawings of Rs.500 from the business. Their profit for the year 2001 amounted to Rs.18,000. The partners are entitled to interest on capitals @6% p.a. No interest is charged on drawings. Prepare profit and loss appropriation account and the capital accounts of partners.
PARTNERSHIP ACCOUNTS Profit & Loss Appropriation A/c
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Particulars To Interest on capital A B To Net Profit A B
Amount Particulars 900 By Profit & Loss A/c 900 8,100 8,100 18,000
A's Capital Account
Amount 18,000
18,000 Amount 15,000 900 8,100 24,000
Particulars To Drawings To balance c/d
Amount Particulars 9,000 By Cash - Op Capital By Interest on capital 15,000 By Net profit 24,000
B's Capital Account
Particulars To drawings To balance c/d
Amount Particulars 6,000 By Cash - Op Capital By Interest on capital 18,000 By Net profit 24,000
Amount 15,000 900 8,100 24,000
Illustration 1.05 A & B started business with capitals of Rs.75,000 and Rs.50,000 respectively. They have agreed to share profits and losses in the ratio 3:2. A is entitled to salary of Rs.12,000 p.a. and B is entitled to Rs.18,000 p.a. Interest at a flat rate of 5% would be charged on the drawings exceeding the amount of salary allowed. Interest on capital is allowed @ 12%. The total drawings of A amounted to Rs.20,000 and B Rs.23,000. Profit prior to partners salary amounted to Rs.44,000. Prepare profit and loss appropriation account and the capital accounts of partners.
Profit & Loss Appropriation A/c Particulars Amount Particulars To Salary A 12,000 By P&L Account -B 18,000 By int on drawings - A To Int. on Capital A 9,000 -B -B 6,000 By Net loss transferred A - 210 B - 140 45,000
Amount 44,000 400 250
350 45,000
A's Capital Account

Particulars Amount Particulars Amount
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To Drawings To Int on drawings To Net loss To balance c/d
20,000 By Cash - Op Capital 400 By Salary 210 By Interest on capital 75,390 96,000
75,000 12,000 9,000
96,000
B's Capital Account

Particulars Amount Particulars Amount
To Drawings To Int on drawings To Net loss To balance c/d
23,000 By Cash - Op Capital 250 By Salary 140 By Interest on capital 50,610 74,000
50,000 18,000 6,000
74,000
3. Past Adjustments
3.1. Omission of Interest on Capital / Interest on Drawings This step is almost like rectification of errors that you studied last year. Let us first consider omission of interest on capital. Interest on capital is taken out of the available net profit and distributed to partners. Thereafter the balance of net profit is distributed in the profit sharing ratio. So, when the interest on capital is omitted in the first place it means that the entire net profit is distributed. Now how do we correct it? Simple, take out the total amount required for paying interest on capital from the capital accounts of partners in the profit sharing ratio, and give it back to them as interest. What is the use of taking out from partners and give them back the same? We usually do not give back exactly what we take out. The profit sharing ratio plays a very important role here. See the next illustration. We take out the total interest divided equally from the three partners, and redistribute them as interest according to capital balance. The point to notice here is, that there is no definite relationship between profit sharing ratio and capital balance. In the illustration the partners are sharing profits and losses equally even though their capitals are not equal.
Illustration 1.06 A, B and C who are equal partners in a firm have capitals of Rs.30,000; Rs.30,000 and Rs.15,000 respectively. The profit for the year 2001 was distributed equally. However, interest on capital @10% was omitted. Pass a journal entry to rectify the error. Details A B C Total
PARTNERSHIP ACCOUNTS Interest to be credited The amount to be debited (7500/3)

Net adjustment
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500(Cr.) 500 (Cr.) 1,000(Dr)
Journal Entry Cs Capital account Dr. 1,000 To As Capital account 500 To Bs Capital account 500 (Capital adjustment for rectification of omission) Illustration 1.07 A, B and C sharing profits and losses in the ratio 2:2:1 had capitals of Rs.50,000 each.. The profit for the year 2001 was distributed without providing for interest on capital @10% as agreed in the Partnership Deed. Pass a journal entry to rectify the error. Details A B C Total
Interest credited
to
be
5,000 6,000
5,000 6,000
5,000 3,000
15,000 15,000
The amount to be debited (15000 at 2:2:1 1,000(Dr.)

Net adjustment
1,000(Dr.)
2,000(Cr)
Journal Entry
As Capital Account Dr.1,000 Bs Capital Account Dr.1,000 To Cs Capital Account 2,000 (Capital adjustment for rectification of omission)
PARTNERSHIP ACCOUNTS Illustration 1.08
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A, B and C have distributed their profit for the year 2001 in the ratio 2:1:1. However they left out the interest @10% on their fixed capitals of Rs.40,000, Rs,40,000 and Rs. 20,000 respectively. Pass a journal entry to rectify the omission.
Details
Total
Interest to be credited The amount to be
4,000 5,000
4,000 2,500
2,000 2,500
10,000 10,000
debited (10,000 at 2:1:1 Net adjustment 1,000(Dr.) 1,500(Cr.) 500(Dr) 0
Journal Entry As Current Account Dr. 1,000 Cs Current Account Dr. 500 1,500
To Bs Current Account
(Adjustment for rectification of omission
Note: When capitals are fixed, all adjustment should be done through current account.
Illustration 1.09
A, B and C have distributed their profit for the year 2001 in their profit sharing ratio 2:1:1 after crediting interest on capitals @10% instead of 8% on their fixed capitals of Rs.40,000, Rs.40,000 and Rs.20,000 respectively. Pass journal entry to rectify the error. Details A B C Total
Excess interest to debit (2%) The credit total amount to
800 1,000
800 500
400 500
2,000 2,000
PARTNERSHIP ACCOUNTS (2000 at 2:2:1
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Net adjustment Journal Entry Bs Current Account Dr.300 To As Current Account 200 To Cs Current Account 100 (Adjustment for rectification of omission) Illustration 1.10
200(Cr.)
300(Dr.)
100(Cr)
A, B and C started business with capitals of Rs.100,000 Rs.80,000 and Rs.60,000 respectively. They agreed to share profits and losses equally. Their partnership deed provided for interest on capital @ 10%. Interest on drawings have been estimated to be Rs.250 on A, Rs.200 on B and Rs.150 on C. Interest on capital had been credited to partners at 8% instead on 10%. Interest on drawings had been completely omitted. Pass a journal entry to rectify the above errors. Details A B C Total
Interest to credited @2% Interest on Drawings
+2,000 -250
+1,600 -200
+1,200 -150
4,800 -600
-1400 Total reversed (in ratio) Net adjustment profit sharing 350(Cr.) amount
-1,400
-1,400
4,200
350(Dr) 0
Journal Entry Cs Capital Account Dr. 350 As Capital Account 350 (Capital adjustment for rectification)
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3.2 Redistribution of Profit in a Different Ratio

Illustration 1.11 A B and C have distributed their profits and losses in the ratio 3:2:1. They have decided to share profits and losses equally with effect from the last three years. The previous three years profits have been Rs.21,000, Rs.18,000 and Rs. 24,000. You are required to pass a journal entry to give effect to the above arrangement. Details A B C Total
Profit
for
the
years
31,500 21,000
21,000 21,000
10,500 21,000
63,000 63,000
reversed Dr. The equally Cr. redistributed
10,500(Dr.) Net Adjustment Journal Entry As Capital Account Dr.10,500 To Cs Capital Account 10,500 (Adjustment to effect redistribution of profit)
10,500(Cr)
3.3 Omission of Outstanding Expenses and Incomes

Outstanding expenses and outstanding incomes have direct effect on the net profit. Outstanding expense is an expense in the first place and a liability as well. When it is omitted it means a higher profit is distributed to partners and a liability is not provided in the books. Outstanding income has the opposite effect. Rectification of these errors is a simple procedure.
i)
If the number of items is less, correct it by passing simple rectification entry, by debiting outstanding income, crediting outstanding expense and passing the difference into capital account. This way you are creating asset account in the books for the outstanding income, creating liability account for the outstanding expense, and transferring the net loss or gain into capital accounts.
ii)
When the number of items involved is more or when it is specifically asked in the question, you should open a profit and loss adjustment account.
iii)
P&L adjustment account can be safely assumed as a combined capital account of partners. When you want debit partners capital account you can debit P&L adjustment account instead.
PARTNERSHIP ACCOUNTS iv)
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When there is an outstanding expense, we usually debit capital accounts and credit outstanding expense account. Now you debit P&L adjustment account for any outstanding expense and credit it for the outstanding income.
v)
The net balance of profit and loss adjustment account is transferred to the capital accounts of partners in the profit sharing ratio.
Illustration 1.12 A, B and C have distributed their profit for the year ended 31st December, 2001 in their profit sharing ratio of 2:1:1. However it was found out in January, 2002 that outstanding expenses of Rs.3,500; and prepaid expenses Rs.1,500 have been left out while preparing the profit and loss account for the year 2001. You are required to rectify this error by: a) Passing Journal Entry (without Profit and Loss Adjustment Account) b) Through Profit and Loss Adjustment Account. a. Rectification without opening P&L Adjustment Account Details Credit Outstanding Exp (Rs.3500) and Dr.> Debit and Prepaid Cr.> Exp (Rs.1,500) A 1,750 750
-------------------------
B 875 375
--------------------------
C 875 375
-------------------------
1,000(Dr)
500(Dr.)
500(Dr.)
Rectification Entry: Prepaid Expenses Account Dr. 1,500 As Capital Account Bs Capital Account Cs Capital Account Dr. 1,000 Dr. Dr. 500 500 3500
To Outstanding Expenses (Rectification of omission)
b. Rectification through P&L Adjustment Account Journal Entries Profit and loss adjustment account Dr. 3,500
PARTNERSHIP ACCOUNTS To Outstanding Expenses (Outstanding expenses brought into books) ------------------------------------------------------------------------------------Prepaid expenses account Dr.1,500 To Profit and Loss Adjustment Account 1,500 (Omission of prepaid expenses brought into books) ------------------------------------------------------------------------------------As Capital Account Dr. 1,000 Bs Capital Account Dr. .500 Cs Capital Account Dr. 500 2,000 3,500
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To Profit and Loss Adjustment Account (Net balance in account transferred) Profit and Loss Adjustment Account Particulars To Outstanding expense Amount
Particulars
Amount 1,500
3,500 By Prepaid expense By Net adjustment A 1,000 B 3,500 C 500 500
2,000 3,500
Illustration 1.13 A, B and C have distributed their profit for the year ended 31st December, 2001 equally as provided in the partnership deed. However it was subsequently found out that commission received and credited in P& L account included Rs. 6,000 received in advance and interest accrued on investment Rs.4,500 are unaccounted. Pass a journal entry to give effect to the above items in the books and prepare profit and loss adjustment account. Journal Entries
PARTNERSHIP ACCOUNTS P&L Adjustment account Dr. 6,000 To Commission Recd in Advance (Omission of advance income rectified) -------------------------------------------------------------------------------------Accrued Interest Account Dr. 4,500 To P& L Adjustment Account (Omission of accrued income rectified) -------------------------------------------------------------------------------------As Capital Account Bs Capital Account Cs Capital Account Dr. 500 Dr.500 Dr.500 1,500 4,500 6,000
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To P&L Adjustment Account (Net difference transferred)
Profit and Loss Adjustment Account

Particulars To Commission Advance Amount Particulars Amount 4,500
6,000 By Acc. Interest By Net adjustment A 500 B 6,000 C 500 500
1,500 6,000
4. Guarantee of Profits
Sometimes partners agree to guarantee minimum profit to a partner as a special privilege. There can be many reasons for granting such a privilege. Attracting a reputed individual, who is unwilling to bear the risk of income fluctuations to become a partner, is one of such reasons. If the share of profit for such a partner falls short of the minimum amount guaranteed, the other partners will adjust that shortage form their share of profit according to the agreed conditions. If the share of profit of the partner holding guarantee privilege comes equal or more than the guaranteed sum, that actual share will be given without any adjustments.
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Illustration 1.14 A, B and C have agreed to share their profits and losses in the ratio 3:3:2 in which C is guaranteed a minimum profit of Rs.12,000. The divisible profit for the year 2001 amounted to Rs.42,000. Show distribution of profit.
Particulars Amount To A's Capital 15,750 less adjusted to C 15,000 750 To B's Capital 15,750 less adjusted to C 15,000 750 To C's Capital 10,500 add share adjusted 12,000 1,500 from A & B 42,000
Particulars By P & L Account
Amount 42,000
42,000
If the entries of deduction and subtraction seem confusing, you can directly put C's share of 12,000 in his name and divide the balance amount of 30,000 in the ratio 3:3 (equally). The next illustration is done that way. But remember when you do this way in the examination don't forget to show the steps/workings to convince the examiner that you know the concept clear. Illustration 1.15 A, B and C sharing profits and losses in the ratio of 3:2:1 in with C having a minimum guarantee of Rs.8,000. The profit available for distribution at the end of the year was found to be Rs.42,000. Show distribution of profit.
Particulars To A's Capital (34,000x3/5) To B's Capital (34,000x2/5) To C's Capital
Amount Particulars 20,400 By P & L Account 13,600 8,000 42,000
Amount 42,000
42,000
You can divide 42,000 in the ratio 3:2:1 and then rearrange the amount. But here we are directly crediting C's share and dividing the balance of Rs.34,000 in the ratio 3:2. Illustration 1.16 A, B and C are partners sharing profits and losses in the ratio 2:1:1, with capitals of Rs.40,000, Rs.30,000 and Rs.20,000 respectively. Cs minimum profit after interest on capitals @6% has been guaranteed to
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be not less than Rs.10,000. A & B have agreed that if Cs profit falls below the guaranteed sum such deficiency would be shared by them equally. The net profit before interest on capitals is estimated to be Rs.38,400. Prepare profit and loss appropriation account.
Here you cannot adopt direct distribution as in the previous case since the partners will bear the loss equally. When you distribute balance of profit after paying the partner with guarantee, the loss is automatically gets distributed in the profit sharing ratio. If any other ratio is to be applied for sharing the loss, you must adopt 'subtraction and addition' method.
Profit & Los Appropriation A/c
Particulars To Interest on Capitals: A B C Profit to A 16,500 Less: C's Share Adj. Profit share to B Less: C's Share Adj. Profit Share to C 8,250 Add: Share Adj A+B 1,750
Amount Particulars 2,400 By P&L Account 1,800 1,200
Amount 38,400
875 8,250 875
15,625
7,375
10,000 38,400 38,400
Illustration 1.17 A, B and C are partners sharing profits and losses in the ratio 2:1:1, with capitals of Rs.40,000, Rs.30,000 and Rs.20,000 respectively. Cs minimum profit after interest on capitals @6% has been guaranteed to be not less than Rs.10,000. A & B have agreed that if Cs profit falls below the guaranteed sum such deficiency would be shared by them in the ratio 3:2. The net profit before interest on capitals is estimated to be Rs.38,400. Prepare profit and loss appropriation account.
Particulars To Interest on Capitals: A B
Amount 38,400
C Profit to A 16,500 Less: C's Share Adj. 1,050
15,450
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Profit share to B 8,250 Less: C's Share Adj. 700 0Profit Share to C 8,250 Add: Share Adj A+B 1,750
7,550
10,000 38,400 38,400
Illustration 1.18 A, B and C are partners sharing profits and losses in the ratio 2:1:1, with capitals of Rs.40,000, Rs.30,000 and Rs.20,000 respectively. A has personally guaranteed that he shall bear the deficiency if Cs share of profit after interest on capitals of partners @6% falls below Rs.10,000. The net profit before interest on capitals is estimated to be Rs.38,400. Prepare profit and loss appropriation account.
Particulars To Interest on Capitals: A B
Amount 38,400
C Profit to A 16,500 Less: C's Share Adj. 1,750 Profit share to B 0Profit Share to C 8,250 Add: Share Adj A 1,750
14,750
8,250
10,000 38,400 38,400
5. Accounting for Joint Life Policy A partner ceases to be a partner either by retirement or death. At the time of retirement or death of a partner the continuing partners, have to settle his dues. Since retirement is a pre-planned event proper arrangement for this settlement can be made. Death comes unexpectedly. The firm suffers the loss of an experienced partner and it has the added burden of settling a huge amount of capital and other dues to the deceased partner. Unlike retirement, death of a partner results in a financial emergency, as the
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amount due cannot be delayed for long time. Unless adequate precautions are made, this emergency can turn into deep financial crisis. (Please refer Chapter 4 Retirement of Partners for details on Joint Life Policy) Interest on Capital
Interest is allowed on partners capitals only if there is a specific agreement in the partnership deed. When interest is allowed on partners capital it should be calculated on the basis of period of capital investment. Suppose a partner makes additional investment after three months from the starting of a year, interest on this additional capital is allowed for nine months only, not for the full year. Illustration - 1.19 A & B started business on 1st January 2001, with capitals of Rs.50,000 each. A introduced additional capital of Rs.25,000 on 1st July 2001 and B introduced the same amount on 1st October 2001. Calculate interest on capital @12%, payable to A and B at the end of the year. Interest on capital - A Opening capital for 12 months (50,000 x 12%) On Additional Capital 6 months Total interest payable to A Interest on capital - B On opening capital for 12 months (50,000 x 12%) On additional capital for 3 months (25,000x12%x3/12) 6,000 750 6,750 Illustration 1.20 On 1st January 2001 the capital accounts of A & B showed balances of Rs.70,000 and Rs.50,000 respectively. A introduced additional capital of Rs.50,000 on 31st March 2001 and B introduced additional capital of Rs.30,000 on 1st September, 2001. Interest on capital is allowed @ 12% p.a. Calculate interest on capital payable at the end of 2001. = 6,000 1,500 7,500
(25,000x 12%x6/12) =
When interest is allowed on the net monthly balance of capital account, interest on drawings will not be charged, because the drawings becomes deduction from capital, and the interest on capital is automatically reduced. Interest on As Capital On Opening capital for 12 months (70,000 x 12%) On Additional Capital 9 months = 8,400 4,500
(50,000x 12%x9/12) =
PARTNERSHIP ACCOUNTS Total interest payable to A Interest on Bs Capital On opening capital for 12 months (50,000 x 12%)= On additional capital for 4 months (30,000x12%x 4/12) = 6,000 1,200 7,200 12,900
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Illustration 1.21: A & B started business with Rs.100,000 each on 1st January, 2001. A introduced additional capital of Rs.50,000 on 1st July and B introduced Rs.50,000 on 1st September. A withdrew Rs.12,000, drawn in 4 installments of Rs.3000 each at the end of each quarter. B withdrew Rs.1,000 per month, at the end of each month. Interest on capital is allowed on the net monthly balance of capital account @12% p.a. Calculate interest payable to A & B. In this question interest is allowed on the net monthly balance of capital. But what is this monthly balance? Is it opening balance or closing balance? The idea behind interest on net balance is to give interest on the exact amount of capital used in the business. Suppose A added 10,000 at the end of January, he is not entitled to interest on this amount in the month of January, simply because it was not used in January. We cannot frame a that interest is allowed on the opening balance or closing balance. The main point to remember here is that the interest is allowed only on the capital used.
Net Monthly Balances in Capital accounts of A & B

Month Interest On January February March April May June July August September October November 100,000 100,000 100,000 97,000 97,000 97,000 144,000 144,000 144,000 141,000 141,000 January February March April May June July August September October November Month Interest on 100,000 99,000 98,000 97,000 96,000 95,000 94,000 93,000 142,000 141,000 140,000
PARTNERSHIP ACCOUNTS December Total 141,000 1,446,000 December Total 139,000 1,334,000
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As Capital Account April = 100,000-3,000 on 31 March July = Rs.97,000-3,000 on 30 June + 50,000 on 1 July October = 144,000 3000 December 31 3,000 has no effect on this years interest Bs Capital Account September = 93,000 1,000 + 50,000
st th st st
Interest Allowed to 1446000 x 12 %, for 1 month Rs. 14,460 A Interest Allowed to 1334,000 x 12 %, for 1 month B Rs. 13,340
Illustration 1.22. The closing balances in the capital accounts of A & B On 31st Dec. 2001 were Rs.78,000 and
Rs.65,000 respectively. During the year A introduced Rs.15000 on 1st July 2001 and withdrew @ Rs.1,000 at the end of each month. B introduced additional capital of Rs.25,000 on 31st March, 2001 and withdrew Rs.7,000 on 30th June and Rs.3,000 on 30th September. Calculate interest on capital @ 6% p.a. to be credited to each partner on 31st December, 2001 based on the net monthly capitals.
Read the question carefully. The capital balances given here are not the opening balances, but the closing balances of 2001, and you have the details of withdrawals during 2001. Now you must reverse to the beginning of the year and calculate the monthly balances to arrive at the correct interest on capital.
Opening Capital = Closing Capital + drawings additional capital. Opening Capital of A = 78,000 + 12,000 - 15,000 = 75,000 Opening Capital of B = 65,000 + 10,000 25,000 = 50,000
Net Monthly Balances in Capital Accounts of A & B

As Capital Month Interest On Month Bs Capital Interest On
PARTNERSHIP ACCOUNTS January February March April May June July August September October November December Total 75,000 74,000 73,000 72,000 71,000 70,000 84,000 83,000 82,000 81,000 80,000 79,000 924,000 January February March April May June July August September October November December Total 50,000 50,000 50,000 75,000 75,000 75,000 68,000 68,000 68,000 65,000 65,000 65,000 774,000
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Interest allowed to A = 924,000 x 6% x 1/12 = Rs. 4,620 Interest allowed to B = 774,000 x 6% x 1/12 = Rs. 3,870
Interest on Drawings
Illustration 1.23 Following is the details of drawings made by A & B from their firm during the year 2001.
Calculate interest on drawings @ 6% p.a. to be debited to their accounts at the end of the year. A's Drawings Rs. B's Drawings Rs.
31-1-2001 31-3-2001 1-5-2001 30-9-2001 31-12-2001
1,500 500 2,000 1,000 1,000 6,000
28-2-2001 1-4-2001 1-7-2001 1-10-2001 1-12-2001
1,000 1,500 1,000 1,500 1,000 6,000
This question clearly shows the effect of period of drawing on the amount of interest charged.
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See that both these partners have withdrawn the same amount during the year 2001. But the interests charged are different, because of difference in period of drawing.
Interest on As drawings
Interest on Bs drawings
Amount Withdrawn 1,500 500 2,000 1,000 1,000
Period till end 11 9 8 3 0
Equivalent 1 month 16,500 4,500 16,000 3,000 0
Amount
Period Equivalent 1 month 10,000 13,500 6,000 4,500 1,000
Withdrawn till end 1,000 1,500 1,000 1,500 1,000 10 9 6 3 1
6,000
40,000
6,000
35,000
Interest on As drawings = 40,000 x 6% x 1/12 = Rs. 200 Interest on Bs drawings = 35,000 x 6% x 1/12 = Rs. 175
Illustration 1.24 The closing balances in the drawings accounts of A, B and C show Rs.12,000 each on 31st December, 2001. They withdrew this amount in monthly installments of Rs.1,000. As drawings were made at the beginning of each month, B on 15th and C at the end of each month. Calculate interest on drawings @6% p.a. to be debited to them on 31st December 2001.
Interest on As Drawings = 12,000 x 6% x 6.5/12 = Rs.390 Interest on Bs Drawings = 12,000 x 6% x 6/12 = Rs.360
Interest on Cs Drawings = 12,000 x 6% x 5.5 /12 = Rs.330
PARTNERSHIP ACCOUNTS Commission to Partners
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Commission is allowed to a partner for his service if all partners agree to such a payment. Again, in the absence of a specific condition in the partnership deed, a partner is not entitled to any salary or commission for his service rendered to the firm. When commission is allowed it may be stated as payable on the profit before charging commission or payable on the profit after charging commission. If commission is payable on the profit before charging commission, it simply means that the commission is to be calculated at the given percent on the given amount of profit. But if it is a certain percentage after charging such commission, the amount of commission should be exactly the percentage specified on the balance of profit after deducting such commission, not the total amount. The following illustration will clarify the point.
The idea of commission on the net profit before charging such commission and after charging commission sounds confusing Butler English. But read it very carefully. This before charging condition is exactly what we all normally understand. If the profit is 100 and 10% commission is allowed it simply means the commission is Rs.10 and the balance of profit available is Rs.90. The trouble hare is to take out 10% of the profit left after taking out such commission. Does this sound confusing again? In the above example Rs.10 is not 10% of the balance of profit of Rs.90. This is the problem. Now how to solve it? Remember that the commission is 10% of the balance of profit, which means if the balance is 100 then commission is 10. In other words it is not to be calculated as 10 out of 100 but as 10 out of 110. Study carefully how Bs commission is calculated in illustration 1.25
Illustration 1.25 A & B are equal partners in a firm. Their partnership deed provided for commission to A @5% of the net profit before charging any commission. B is entitled to 5% commission on the profit after charging all commissions. Net profit before any such commission was Rs.42,000. Calculate commissions and profit share of each partner. Commission payable of to A = 5% of 42,000 ie. Rs.2,100. Commission payable to B = 5% of the N/P after all commissions. Net profit available after charging As commission = Rs.39,900 (42,000 2,100) Which is Bs commission + N/P after all commissions Now Bs commission is to be 5% of the balance after deducting Bs commission. If Bs commission is Rs.5, the balance available should be Rs.100 Which means the total should be 105. Again, if the total available is 105, B will get a commission of 5 and the balance of Rs.100 will remain. ie. for every 105, B will get a commission of Rs.5. Therefore Bs commission is Rs.39,900 x 5/105 = Rs.1,900 Notice that the balance available is Rs.38,000 and Bs commission of Rs.1,900 is exactly 5% of Rs.38,000.
Calculation of Capital Ratio

Capital ratio should be understood as investment ratio. Money is considered an important working factor in the business. When the capital contribution of a partner is higher, it also means that his money worked more in
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making the profit. In calculating the capital ratio the amount and the period of investment are to be considered. Suppose A contributes 10,000 in January and B contributes the same amount on 1st July, A's capital has worked double that of B due to earlier investment, even though both the amounts are the same at the end of the year. Therefore, capital ratio should be based on the amount of capital multiplied by the number of months the investment remained with the firm. Illustration 1.26 A started business on 1st January 2001, with a capital investment of Rs.50,000. B joined on 1st May with a capital contribution of Rs.75,000 and C joined with 1st July with Rs.50,000 as capital. They made a profit of Rs.25,000 in the first year. Distribute profit in the capital ratio.
Date & Amount
Months for which money was used
Effective Amount
A on 1st Jan Rs.50,000
12
600,000
B on 1st may Rs.75,000
600,000
C on Ist July Rs.50,000
300,000
Capital Ratio between A, B & C = 600000:600000:300000 ie. 2:2:1 Illustration 1.27 A & B started business on 1st January 2001. They have decided to share profits and losses in the capital ratio. Calculate their capital ratio form the following details
A's Capital Account

Particulars Mar 1 To Cash Drawing.. Amount 9,000 Jan 1 Particulars By Cash Amount 65,000
PARTNERSHIP ACCOUNTS Oct 1 To Cash Drawing. Dec 31 To bal c/d 86,000 105,000 10,000 Jul 1 By Cash..addl. Cap.
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105,000
B's Capital Account

Date Particulars Amount Date Jan 1 Apr 1 To Cash Drwng. 19,500 Particulars By Cash Amount 50,000
Oct 1
To Cash Drwng.
5,500
Jul 1 By Cash.. addl. Cap. Sept 1 By Cash addl. Cap.
25,000 10,500
Dec 31
To bal c/d
60,500 85,500 85,500
This question is worked out twice. The first answer is based on the capital balances multiplied by the number of months for which such balances are maintained. Even though this method looks very simple, you may make mistake in calculating the number of months for which the capital balances are maintained as there are no definite sequence or order followed in the question. Most of the books follow the first method. I suggest the second; because there is very little chance of mistake this way.
Remember that the date of introduction or withdrawal is important. Capital for a month means capital available for use in that month. If capital is withdrawn at the beginning of a month, it means that the remaining balance only is available for that month. But if the capital is withdrawn at the end of the month that withdrawal has no effect on the capital for that month.
Answer (i) for Q.1.27 A's Capital Date & Amount Actual Balance Jan 1 Op Cpital 65,000 Mar 1 Drawing 9,000 + 96,000 3 288,000 56,000 4 224,000 + 65,000 2 Months Effective Amount 130,000
Jul 1 Addl Cap 40,000
PARTNERSHIP ACCOUNTS Nov 1 Drawings 10,000 86,000 3
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900,000
B's Capital Date & Amount Actual Balance Jan 1 Op Cpital Apr 1 Drawing Jul 1 Addl Cap + 50,000 - 19,500 + 25,000 + 10,500 5,500 50,000 30,500 55,500 66,000 60,500 3 3 2 1 3 Months Effective Amount 150,000 91,500 111,000 66,000 181,500 600,000 Capital Ratio = 900:600 = 3:2 Answer (ii) for Q.1.27
Sept1 Addl Cap Nov 1 Drawings
Month
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov
Bal.- A 65,000 65,000 56,000 56,000 56,000 56,000 96,000 96,000 96,000 86,000 86,000
Bal B 50,000 50,000 50,000 30,500 30,500 30,500 55,500 55,500 66,000 60,500 60,500
PARTNERSHIP ACCOUNTS Dec 86,000 60,500
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Total
900,000
600,000
Illustration 1.28
The capital accounts of A & B on 31 December 2007 show balances of Rs.48,750 and
Rs.56,000. The capital accounts for the year 2007 are given below. Calculate capital ratio (ratio in which their money was used in business).
Particulars Feb 1 To Cash Mar 1 To Cash Jul 1 To Cash
A 12,500 --8,750
Particulars --- Jan 1 - By Cash By Cash By Cash
50,000 25,000 30,000
14,000 Apr 1 --- Sept 1
30,000 25,000
Oct 1 To Cash Dec 31 To bal c/d
10,000 10,000 48,750 56,000
80,000 80,000
80,000 80,000
Month Jan Feb Mar Apr May Jun Jul
Bal.- A 50,000 37,500 37,500 37,500 37,500 37,500 28,750
Bal B 25,000 25,000 11,000 41,000 41,000 41,000 41,000
PARTNERSHIP ACCOUNTS Aug Sep Oct Nov Dec Total 28,750 58,750 48,750 48,750 48,750 500,000 41,000 66,000 56,000 56,000 56,000 500,000
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Capital Ratio = 1:1
Manager Admitted as a Partner

Illustration 1.29 A & B sharing profits and losses equally have decided to admit their manager C as a new partner. They have agreed to give him 1/5th share in future profits as well as the profits for the previous three years. His salary for the last three years is to be adjusted against his profit share. The profits for the last three years were Rs.76,000; Rs.83,000 and Rs.81,000 and his salary was Rs.1,500 p.m. Recalculate the profit distribution and pass a journal entry to adjust the same in accounts.
Total Profit for the last three years Salary to Manager for three years
240,000
54,000
Total Profit for redistribution
294,000
Details Profit distributed taken back (Dr.)
A 120,000
B 120,000
54,000
Salary paid to C taken back (Dr.)
PARTNERSHIP ACCOUNTS 117,600 Profit redistribution in new ratio (294,000 in 2:2:1) (Cr.) 117,600
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Amount to readjust
2,400(Dr)
2,400(Dr)
4,800 (Cr).
Journal entry
As Capital Account Dr .2 400 Bs Capital Account Dr. 2,400 To Cs Capital Account 4,800 (Profit readjustment) Illustration 1.30 A & B sharing profits and losses in the ratio 2:1, have decided to admit their manager C as a partner, giving him 1/4th share in profits with retrospective effect for the past three years. His salary during this period is to be adjusted against his profit share. The profit for the last three years have been Rs.48,000; Rs.43,000 and Rs.44,000. His salary was Rs.1,200 p.m. Recalculate the profit distribution and pass a journal entry to give effect to the same in accounts.
Total Profit for the last three years Salary to Manager for three years
135,000 43,200
Total Profit for redistribution
178,200
Details Profit out Salary Paid to C distributed Dr taken
A 90,000
B 45,000
C 0 43,200
PARTNERSHIP ACCOUNTS Dr. 89,100 Total the Amount Cr. Redistributed in 44,550
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44,550
(178,200 at 2:2:1) Net Adjustment 900 (Dr.) 450 (Dr.) 1,350(Cr.)
Journal entry
As Capital Account Dr .900 Bs Capital Account Dr. 450 To Cs Capital Account 1,350 (Profit readjustment)
Illustration 1.31 A & B are partners sharing profits and losses in the ratio 2:1. On 31st December,2001 they have decided to take C, their manager as partner for 1/4th share with retrospective effect from 1st January 1999. As manager he had been paid annual salary of Rs.18,000, which is reduced to annual salary of Rs.6,000 as partner. He had advanced a loan of Rs.50,000 to the firm at 10% interest which is converted as his capital carrying interest @6% per annum. Profits and losses for the last three years are as follows: 1999 2000 2001 Rs. 54,000 Rs.19,000 Rs.47,000
Recalculate the profit distribution and pass adjustment entry to give effect to the same.
Total Profit for the last three years Excess Salary to Manager
120,000 36,000 6,000
(12000x3) Excess interest paid to C
PARTNERSHIP ACCOUNTS Total Profit for redistribution 162,000
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Details Profit redistribution in new ratio (Cr.) (162000 at 2:1:1) Profit already distributed (120000at 2:1) (Dr.)
A +81,000
B +40,500
C +40,500 -
-80,000 -
-40,000 -36,000 - 6,000
Excess Salary given to C (12000x3) (Dr.)
Excess Interest given to C (Dr.)
Amount to readjust
1,000(Cr)
500(Cr)
1,500 (Dr)
Journal Entry Cs Capital Account Dr.1,500 To As Capital Account 1,000 To Bs Capital Account 500 (Profit readjustment)
Calculation of Capital Contribution

Illustration 1.32 A & B sharing profits and losses equally have agreed to admit C as a partner for 1/4th share from 1st January, 2002 who agreed to pay proportionate share of the total capital of the firm after necessary adjustments and appropriations at the end of the year 2001. The capital accounts of A & B on 1stJanuary 2001 stood at Rs.40,000 and Rs.30,000 respectively. Drawings during the year 2001 amounted to Rs.3,000 by A and Rs.4,000 by B. Calculate the capital to be invested by C.
Cs Share is of the total Capital of the firm. Therefore, combined capital of A& B is 3/4th of the total capital.
PARTNERSHIP ACCOUNTS Net Capital of A (40,000-3000) Net Capital of B (30,000-4000) 37,000 26,000
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Total capital of A & B Ie. 3/4th of the total capital = 63,000 Total capital = 63000 *4/3 = 84,000 Cs Capital = 21,000
63,000
Chapter:2 Reconstitution Of Partnership

(Changing Ratio or Admission of a New Partner)
A partnership business may undergo several structural changes during its lifetime. New partners may join or existing ones may leave the business. While making such major changes in the structure of business, partners carefully evaluate their accounts. They have to reset the system on a correct starting point. They check the values of assets and liabilities appearing in the books. If there are discrepancies they have to be rectified before introducing a major change. Reconstitution of a partnership business can take place under the following situations:

Admission of a new partner Changing profit sharing ratio among existing partners Retirement / death of a partner Amalgamation of two partnership firms
The most important accounting adjustment is resetting of old accounts. It is a common adjustment in all cases of reconstitution. In this chapter you will find reconstitution by admission and reconstitution by changing ratios. Reconstitution by admission is more important on examination point of view. The following are the common adjustments at the time of reconstitution of a partnership business. 1. Revaluation of assets and liabilities 2. Distribution of reserves and accumulated profits 3. Calculation of new ratio, sacrificing ratio and gaining ratio 4. Treatment of goodwill 5. Readjustment of capital accounts
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1. Revaluation of Assets and Liabilities

Assets and liabilities are often shown in the accounts at their historical value rather than realisable value. Due to conservatism the partners usually do not revise the values of assets even when their actual market values are much higher than book values. Similarly inadequate depreciation, change in technology etc. make the book values of certain assets more than their realisable value. It is not practical for the partners to keep on changing the book values of their assets every time there is a change in their market values. The difference between book value and market value is not a problem as long as the partnership business goes on normally. But when they change the structure of the partnership in the form of revision in profit sharing ratio, admission of a new partner, retirement or death of a partner, amalgamation of two partnership firms or absorption of a firm by another, the values of assets and liabilities are to be reassessed and difference if any, should be accounted.
What is the purpose of revaluation?

When the realisable value of asset or liability is different from the book value there is a profit or loss hidden in the difference in value. The partners should distribute all the profits and losses in the existing profit sharing ratio before changing the ratio. If the ratio remains unchanged there is practically no use in estimating the hidden profit or loss. However, if this profit or loss is not distributed prior to changing profit sharing ratio some partners will lose and others gain due to the change in ratio. For example: A&B, who were equal partners purchased land for Rs.10,000 in Jan 1975. They decided to share profits and losses in the ratio 2:1 from 1st January 2001. The actual market value of land on 1st January was Rs.70,000; whereas the book value remains at the purchase price of Rs.10,000. There is a hidden profit of Rs.60,000 in the value of land which A & B are entitled to share equally. Suppose they just ignored this factor and changed the profit sharing ratio to 2:1 and sold the land for Rs.70,000 next day, the profit on sale of land Rs.60,000 will go to A and B in the new ratio 2:1, which means A will get 40,000 and B will get only 20,000. In other words Rs.10,000 belonging to B will go to A. Vice versa can happen in case of a hidden loss. To prevent such problems the partners revalue the assets and liabilities and transfer the profit or loss into their capital accounts in the existing ratio before making a change.
Revaluation Account
When the value of one asset is to be increased in the books it can be easily done by debiting the asset and crediting the profit to partners capital accounts in the profit sharing ratio. But when there is a major shake up, values of almost every asset and liability have to be revised. Distributing each change to the partners would be a lengthily process. For the sake of convenience, all those profits and losses on change in values of assets and liabilities are brought into a temporary account called revaluation account. The revaluation account summarises the effect of revaluation of assets and liabilities.
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Revaluation account is a special profit & loss account representing the combined capital accounts of partners. Any gain on revaluation of asset or liability, to be credited to partners, will be credited in the revaluation account. Similarly any loss on revaluation will be debited in revaluation account instead of debiting the capital accounts. The final balance in revaluation account indicates the profit or loss on the entire revaluation process. The revaluation account is closed by transferring this profit or loss to partners capital accounts in the ratio before revision (old profit sharing ratio). All assets and liabilities will appear at their revised values in the books and in all future balance sheets. When the partners want to adjust the profit or loss on revaluation process without actually changing the values of assets and liabilities in the books they can do so by opening a memorandum revaluation account. This revaluation account has two parts. The first part is a normal revaluation account and the profit or loss on this part is transferred in the old profit sharing ratio. The second part of memorandum revaluation account is almost a mirror image of the first part. Whatever debited in the first section is credited in the second and whatever credited is debited. Naturally if there was profit in the first section, there will be loss in the second and vice versa. The profit or loss in the first part is transferred to capital accounts in the old ratio, and that at the second part will be transferred to capital accounts new profit sharing ratio. As a result of this exercise the effect of profit or loss on revaluation will be fairly embedded in the capital accounts of partners. 2. Distribution of Reserves and Accumulated Profits
Distribution of reserves and accumulated profits is the first step in any reorganisation process. They include general reserves, credit balance in P & L accounts or any other fund that are retained in the business. These are profits earned in the past, but not taken out by the partners, or profits kept aside. Therefore, when the partners decide to change their future profit sharing ratio, the past profits retained in the above accounts should be distributed to partners in the old ratio as a first step.
3. Calculating new ratio, sacrificing ratio and gaining ratio
When a new partner comes into the business, old partners have to give him his profit share from their portion. Thus change in profit sharing ratio is an important aspect to be considered on reconstitution by admission. In academic accounting, change in profit sharing ratio can be presented in various ways. The existing partners may decide to change their profit sharing ratio for various reasons. When the profit sharing ratio is revised among existing partners, there ought to be a partial sacrifice of profit share by some partners in favour of others. The sacrifice of one or a group of partners becomes the gain of the remaining partners. Following is the formula for calculating sacrificing ratio: Sacrificing ratio = Old ratio new ratio When the profit sharing ratio is revised it is important to calculate the sacrificing ratio and gaining ratio. These ratios are required to adjust the value of goodwill of a firm without raising goodwill account in the books. Gaining ratio is the opposite of sacrificing ratio. This is the ratio gain to the existing partners of a firm when they revise the profit sharing ratio, or when the profit share of the deceased or retired partner is shared by the other partners. This ratio is calculated by deducting the old ratio from the new ratio. The new share will be higher than the old when there is a gain.
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Gaining ratio = New ratio old ratio
Examples of ratio calculations on reconstitution by admission a. The new partners share is mentioned without specifying the old partners profit sharing
arrangement. In this case it is to be assumed that the profit available after paying the new partners 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. Illustration 2.1 Calculate new profit sharing ratio in the following cases: i) A & B sharing profits and losses equally admit C for 1/5th share in future profits Cs Share of profit = 1/5th of the profit of the firm. Balance of profit available for A & B = 4/5th of the profit, which is shared by them equally. As New share = 4/5 x 1/2 = 4/10 Bs New share = 4/5 x = 4/10 Ratio between ABC = 4/10:4/10:1/5 = 2:2:1 ii) A & B sharing profits and losses in the ratio 3:1 admit C for 1/5th share in future profits. Cs share of profit = 1/5 Balance available for A & B = 1-1/5 = 4/5 of the profit which is shared by them in the ratio 3:1 As New share = 4/5 x 3/4 = 3/5 Bs New share = 4/5 x = 1/5 New Ratio = 3/5 : 1/5 : 1/5 = 3:1:1 iii) A &B sharing profits and losses in the ratio 3:2 admit C for 1/5th share in future profits. Cs Share = 1/5 Balance available for A & B = 4/5 which is shared by them in the ratio 3:2 As new share = 4/5 x 3/5 = 12/25 Bs new share = 4/5 x 2/5 = 8/25 Cs share = 1/5 New profit sharing ratio = 12/25 : 8/25 : 1/5 12:8:5 iv) A & B sharing profits and losses in the ratio 2/3 and 1/3 admit C into partnership giving him 1/4th share in future profits Cs share of profit = 1/4 Balance available for A & B = 3/4 As new share = 3/4 x 2/3 = 2/4 Bs new share = 3/4 x 1/3 = 1/4 New profit sharing ratio = 2/4:1/4:1/4 ie. 2:1:1
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v) A & B who are equal partners admit C for 1/6th share in future profits Cs share of profits = 1/6 Balance available to A & B = 5/6 As new share = 5/6 x 1/2 = 5/12 Bs new share = 5/6 x 1/2 = 5/12 New profit sharing ratio = 5/12: 5/12: 1/6 = 5:5:2
The old partners give part of their share to the new partner (focus on the old partner)
Illustration .2.2 Calculate profit sharing ratio and sacrificing ratios in the following cases:
i) A & B who are equal partners admit C for which A surrenders of his share and B surrenders 1/4th of his share in favour of C a. As Old share = 1/2 b. Portion surrendered for C 1/2 of 1/2 i.e. 1/2x1/2 = 1/4 c. Balance available for A = 1/4 (a-b) d. Bs old share = 1/2 e. Portion surrendered for C = 1/4th of 1/2 i.e. 1/2x1/ 4 = 1/8 f. Balance available for B = 3/8 (1/2-1/8) g. Cs share = As contribution + Bs contribution i.e. 1/4 +1/8 = 3/8 g. New profit sharing ratio = 1/4:3/8:3/8 i.e. 2:3:3 ii) A & B sharing profits and losses in the ration 3:2 admit C for which each partner surrenders of his respective share. a. As Old share = 3/5 b. Portion surrendered for C 1/2 of 3/5 i.e. 3/5x1/2 = 3/10 c. Balance available for A = 3/10(a-b)
PARTNERSHIP ACCOUNTS d. Bs old share = 2/5 e. Portion surrendered for C = 1/2 of 2/5 ie. 2/5x1/2 = 2/10 f. Balance available for B = 2/10(d-e) g. Cs share = As contribution + Bs contribution i.e. 3/10+2/10= 5/10 h. New profit sharing ratio = 3/10:2/10:5/10 i.e. 3:2:5
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iii) A & b sharing profits and losses in the ratio 3:2 admit C into partnership for which A surrenders 1/4th of his share and B surrenders 1/2 of his share. a. As Old share = 3/5 b. Portion surrendered for C 1/4th of 3/5 i.e. 3/5x1/4 = 3/20 c. Balance available for A = 9/20(a-b) d. Bs old share = 2/5 e. Portion surrendered for C = 1/2 of 2/5 i.e. 2/5x1/2 = 2/10 f. Balance available for B = 2/10(d-e) g. Cs share = As contribution + Bs contribution i.e. 3/20+2/10= 7/20 h. New profit sharing ratio =9/20:2/10:7/20 i.e. 9:4:7
iv) A & B sharing profits and losses in the ratio 4:1 have admitted C by surrendering 1/2 of their respective shares. a. As Old share = 4/5 b. Portion surrendered for C 1/2 of 4/5 i.e. 4/5x1/2 = 4/10 c. Balance available for A = 4/10(a-b)
PARTNERSHIP ACCOUNTS d. Bs old share = 1/5 e. Portion surrendered for C = 1/2 of 1/5 i.e. 1/5x1/2 = 1/10 f. Balance available for B = 1/10(d-e) g. Cs share = As contribution + Bs contribution i.e. 4/10+1/10= 5/10 h. New profit sharing ratio = 4/10:1/10:5/10 i.e. 4:1:5
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The new partner acquires his share from old partners (focus on the new partners share)
Illustration.2.3 Calculate sacrificing ratio and new profit sharing ratio in the following cases: i) A & B sharing profits and losses equally admit C into partnership for 1/3rd share in future profits, which 2/3rd is acquired from A and 1/3rd is acquired from B a. Cs share = 1/3rd of future profits b. As contribution (sacrifice) = 2/3rd of 1/3rd i.e. 2/3 x 1/3 = 2/9 c. Balance available for A = As old share As sacrifice i.e. 1/2 2/9 = 5/18 d. Bs contribution =1/3rd of 1/3rd i.e. 1/3 x 1/3 = 1/9 e. Balance available for B = Bs old share Bs Contribution i.e. 1/2 1/9 = 7/18 Cs share = 2/9 +1/9 = 3/9 f. New profit sharing ratio = 5/18 : 7/18 : 6/18 i.e. 5:7:6 g. Sacrificing Ratio = 2/9 : 1/9 ie.2:1
ii) A & B sharing profits and losses in the ratio 2:1 admit C as a new partner. C acquired 1/18th from and 1/9 from B a. As contribution (sacrifice) to C = 1/18 of the total profit b. Balance available for A = As old share As contribution / sacrifice i.e. 2/3 1/18 = 11/18 c. Bs contribution =1/9 d. Balance available for B = Bs old share Bs Contribution i.e. 1/3 1/9 = 2/9 e. Cs share = 1/18 +1/9 = 3/18 f. New profit sharing ratio = 5/18 : 7/18 : 6/18 i.e. 11:4:3 g. Sacrificing ratio = 1/18:1/9 i.e.1:2
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iii) A & B sharing profits and losses in the ratio 3:2 admit C for 1/4th share which is acquired equally A and B As Contribution (sacrifice) to C = of =1/8 Bs Contribution (sacrifice) to C = of = 1/8 As new share = 3/5 1/8 = 19/40 Bs new share = 2/5 1/8 = 11/40 New ratio = 19/40:11/40:10/40 Sacrificing ratio = 1/8 :1/8 ie. 1:1
iv) A & B sharing profits in the ratio 3:1 admit C for 1/5th share in future profits. C acquires 7/8th of share from a and 1/8th from B As contribution to C = 7/8th of 1/5 ie. 7/40 Bs Contribution to C = 1/8th of 1/5 ie. 1/40 As new share = 3/4-7/40 = 23/40 B's new share = 1/4 1/40 = 9/40 Cs share = 7/40+1/40 =8/40 New ratio = 23:9:8 Sacrificing ratio 7:1
v) A & B who are equal partners admit C for 1/3rd share in future profits. C acquired 1/3rd of his sh from A and 2/3rd of his share form B. As sacrifice 1/3rd of 1/3rd = 1/9 Bs sacrifice 2/3rd of 1/3rd = 2/9 As new share = 1/2 1/9 = 7/18 Bs new share = 1/2 2/9 = 5/18 Cs share = 1/9+2/9 = 6/18 New ratio = 7:5:6
The entire sacrifice is made by one partner

Illustration.2.4 Calculate new profit sharing ratio in the following cases: i) A & B sharing profits and losses equally admit C for 1/4th share. B has made the entire sacrifice for Cs share of profit. Bs new share = 1/2 1/4 = 1/4 New profit sharing ratio = 1/2:1/4:1/4 ii) A & B sharing profits and losses in the ratio 3:2 admit C for 1/5th share in future profit which is fully contributed by A. As contribution = 1/5 As new share = 3/5 1/5 = 2/5 New profit sharing ratio = 2/5:2/5:1/5 iii) A & B who are equal partners admit C into partnership. B has contributed of his share in favour of C New profit sharing ratio = 2:1:1
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iv) A & B who are sharing profits and losses in the ratio 3:1 admit c by contributing of As share in favour of C. As contribution for C = of = 3/8 New profit sharing ratio = 3/8 : 1/4: 3/8 = 3:2:3 v) A & B sharing profits and losses in the ratio 2:1 admit C by contributing 1/3rd portion of As share of profits. As contribution (Cs share) = 1/3rd of 2/3rd = 2/9 As new share = 2/3 2/9 = 4/9 New profit sharing ratio = 4:3:2
c. An entirely new profit sharing ratio is given

Illustration.2.5: Calculate sacrificing ratio in the following cases i) A & B sharing profits and losses equally admit C into partnership and decide to share future profits and losses in the ratio 3:2:2 As sacrifice = 1/2 3/7 =7/14 - 6/14 = 1/14 Bs sacrifice = 1/2 2/7 = 7/14 4/14 = 3/14 Sacrificing ratio = 1:3 ii) A & B sharing profits and losses in the ratio 3:1 admit C and decide to share future profits and losses in the ratio 3:2:4 As sacrifice = 3/4 - 3/9 = 27/36 12/36 = 15/36 Bs sacrifice = 1/4 2/9 = 9/36 8/36 = 1/36 Sacrificing ratio = 15:1 iii) A & B sharing profits and losses in the ratio 3:2 admit C and change their profit sharing as 3:2:3. As sacrifice = 3/5-3/8 = 24/40-15/40 = 9/40 Bs sacrifice = 2/5 2/8 = 16/40 10/40 = 6/40 Sacrificing ratio = 9:6 ie.3:2 iv) A &B having equal partnership admit C and change their profit sharing as 4:3:2 As sacrifice = 1/2 - 4/9 = 9/18 8/18 = 1/18 Bs sacrifice = 1/2 3/9 = 9/18 6/18 = 3/18 Sacrificing ratio = 1:3 v) A & B sharing profits and losses in the ratio 4:3 admit C and decide to share future profits and losses equally. As sacrifice = 4/7 1/3 = 12/21 7/21 = 5/21 Bs sacrifice = 3/7 1/3 = 9/21 7/21 = 2/21 Sacrificing ratio = 5:2 At the time of reconstitution by admission, the old partners generally sacrifice for the new partner. In other words, new partner is the gaining partner and the old partners are the sacrificing partners. However when the partners restructure the entire profit sharing arrangement even some of the old partners could turn out to be gaining partners. When reconstitution takes place by changing ratio among existing partners (without any admission or retirement) sacrifice by one or more partners will match with the gain of other partners.
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Calculation of sacrifice and gain are significant for several other adjustments on reconstitution.
What about a situation where there is sacrifice as well as gain. If you simply apply the formula without knowing what exactly is sacrifice or gain there will be lot of confusion while working out the problems. In many cases your common sense is more useful than the text book principles. For example if you find the new share of a partner is less than his old share for whatever reason, it is called SACRIFICE and if the new share is higher than the old it is called GAIN. Now you decide how to find out sacrificing ratio or gaining ratio.
Shortcut to calculate sacrificing ratio and gaining ratio

When there is a revision of profit sharing ratio by existing partners, there will be sacrifice as well as gain within the same partnership. Therefore it is easier to stick to one formula. Take the result of new ratio minus old ratio. If the result is negative it is sacrifice; and positive it is gain. Notice the steps once again: a. Write the new ratio in the first line (because I like to see sacrifice as negative and gain as positive number) b. Write the old ratio in the second line (remember to adjust the ratios to add up to the a convenient total) c. Deduct the old from new d. Negatives result indicates sacrifice; positive result indicates gain
a. Old and new ratios are given

Illustration 2.06 A,B,C and D sharing profits and losses in the ratio 4:3:2:1 have decided to share future profits and losses in the ratio 2:1:1:1. Find out the sacrifice or gain in the arrangement.
(Note: When you have to compare two different ratios, it will be easier if both add up to the same total)
A New Ratio(adjusted out of 10) Old Ratio (Sac) /Gain Bs Sacrifice 1/10; As Gain 1/10 4 4 0
B 2 3 -1
C 2 2 0
D 2 1 1
Total 10 10
Illustration 2.07 A, B, C and D sharing profits and losses in the ratio 3:3:2:2 have decided to share future profits and losses in the ratio 4:3:2:1. Find out the sacrifice or gain in the arrangement. A New Ratio(revised to add up to 10) Old Ratio Sac /Gain As Gain 1/10; Ds Sacrifice 1/10 Illustration 2.08 4 3 1 B 3 3 0 C 2 2 0 D 1 2 -1 Total 10 10
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A, B, C and D sharing profits and losses in the ratio 2:1:1:1 have decided to share future profits and losses in the ratio 3:3:3:1. Find out the sacrifice or gain in the arrangement. A 3 3 0 B 3 3 0 C 3 2 1 D 1 2 -1 Total 10 10
New Ratio Old Ratio(converted to add up to 10) Sac /Gain Cs gain 1/10; Ds sacrifice 1/10
Illustration 2.09 A, B, C and D sharing profits and losses in the ratio 2:1:2:1 have decided to share future profits and losses in the ratio 2:2:1:1. Find out the sacrifice or gain in the arrangement. A 2 2 0 B 2 1 1 C 1 2 -1 D 1 1 0 Total 6 6
New Ratio Old Ratio Sac /Gain Bs Gain 1/6; Cs sacrifice 1/6
Illustration 2.10 A, B, C and D sharing profits and losses in the ratio 4:3:2:1 have decided to share future profits and losses equally. Find out the sacrifice or gain in this arrangement. A 5 8 -3 B 5 6 -1 C 5 4 1 D 5 2 3 Total 20 20
New Ratio Old Ratio Sac /Gain
As Sacrifice 3/20; Bs Sacrifice 1/20; Cs Gain 1/20; Ds Gain 3/20 Illustration 2.11 A, B, C and D sharing profits and losses equally have decided to share future profits and losses in the ratio 2:2:1:1. Find out the sacrifice or gain in the arrangement. A 4 3 1 B 4 3 1 C 2 3 -1 D 2 3 -1 Total 12 12
New Ratio Old Ratio Sac /Gain
As Gain 1/12; Bs gain 1/12; Cs sacrifice 1/12; Ds sacrifice 1/12 Illustration 2.12
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A, B and C sharing profits and losses in the ratio 4:3:3 have decided to share future profits and losses in the ratio 2:2:1. Find out the sacrifice or gain in the arrangement. A 4 4 0 B 4 3 1 C 2 3 -1 Total 10 10
New Ratio Old Ratio Sac /Gain Bs gain 1/10; Cs sacrifice 1/10
Partners sacrifice is specified

Illustration 2.13 A, B and C sharing profits and losses in the ratio 3:2:1 have decided to change their ratios, to give more profit share to C who has agreed to work as managing partner. Both A and B have agreed to sacrifice 1/4th of their respective share in favour of C. work out the new ratio and the sacrificing ratio. As old share 3/6 As sacrifice = 1/4th of 3/6 = 3/6 x 1/4 = 1/8 As new ratio = 3/6 1/8 = 3/8 Bs old share = 2/6 Bs sacrifice = 1/4th of 2/6 = 2/6 x 1/4 = 1/12 Bs new share= 2/6 1/12 = 3/12 Cs new share = 1/6 +1/8 +1/12 = 4/24 + 3/24 + 2/24 = 9/24 New profit sharing ratio of AB and C = 3/8 : 3/12 : 9/24 =9:6:9 Sacrificing ratio of A & B = 1/8 : 1/12 = 3/24 : 2 / 24 = 3:2 Cs Gain = 3/24 + 2/24 = 5/24 Illustration 2.14 A, B and C sharing profits and losses in the ratio 3:2:1 have decided to rearrange their profit sharing ratio. A & B have agreed to contribute 1/5th of their respective shares in favour of C. Find out the sacrifice or gain the arrangement. As old share 3/6 As sacrifice = 1/5th of 3/6 = 3/6 x 1/5 = 3/30 As new ratio = 3/6 3/30 = 12/30 Bs old share = 2/6
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Bs sacrifice = 1/5th of 2/6 = 2/6 x 1/5 = 2/30 Bs new share= 2/6 2/30 = 8/30 Cs new share = 1/6 +3/30 +2/30 = 5/30 + 3/30 + 2/30 = 10/30 New profit sharing ratio of AB and C = 12 : 8 : 10 =6:4:5 Sacrificing ratio of A & B = 3 : 2 Cs Gain = the total sacrifice made by A & B; ie. 3/30 + 2/30 = 5/30 Illustration 2.15 A, B and C sharing profits and losses in the ratio 3:2:1 have decided that Cs future share of profit shall be doubled. A & B have agreed to sacrifice this portion equally. Work out the details of new profit sharing arrangement. As old share 3/6 As sacrifice = 1/2 of 1/6 = 1/12 As new ratio = 3/6 1/12 = 5/12 Bs old share = 2/6 Bs sacrifice = 1/2 of 1/6 = 1/12 Bs new share= 2/6 1/12 = 3/12 Cs new share = 1/6 +1/12 +1/12 = 2/6 New profit sharing ratio of AB and C = 5/12 : 3/12 : 2/6 =5:3:4 Sacrificing ratio of A & B = 1/12 : 1/12 Illustration 2.16 A, B & C sharing profits and losses in the ratio 2:1:1 have decided to share future profits and losses equally. Their goodwill was estimated to be worth Rs.18,000. Pass adjustment entry for treating goodwill.
Answer i (using ratios)

Sacrifice / Gain Old Ratio New Ratio Sac /Gain A 6 4 B 3 4 1 C 3 4 1 Total 12 12
A has a sacrifice of 2/12 portion of goodwill or which is Rs.3,000 (18,000 x2/12) This is becomes the gain of B and C equally.
Adjustment entry:
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Bs Capital Account Dr. 1,500 Cs Capital Account Dr.1,500 To As Capital Account 3,000. (The gaining partners margin of gain is adjusted to sacrificing partner)
Answer ii (using the value of goodwill directly, in place of ratios) A

Goodwill in old ratio cr. Goodwill in new ratio dr. Dr./cr. 9000 6000 Cr. 3000.
B
4500 6000 Dr. 1500
C
4500 6000 Dr. 1500
Total
18000 18000 0
I think the second method is easier. You need not worry about finding out the ratios and distributing them. But if the question wants you to write the ratios as part of answer, you have no choice other than the first. So learn both.
Illustration 2.17 A & B sharing profits and losses in the ratio 2:2:1 have decided to share future profits and losses equally. Their goodwill was estimated to be worth Rs.30,000 and which they do not want to remain in the books. Pass necessary Journal entries. A 6 5 B 6 5 1 C 3 5 2 Total 15 15
Old Ratio New Ratio Sac /Gain
Adjustment entry:
Cs Capital Account Dr.4,000 To As Capital Account 2,000 To Bs Capital Account 2,000 (The gaining partners margin of gain is adjusted to sacrificing partners)
Illustration 2.18 A & B sharing profits and losses in the ratio equally have decided to share future profits and losses in the ratio 2:2:1. Their goodwill was estimated to be worth Rs.18,000. Pass necessary Journal entries. A 5 6 B 5 6 1 C 5 3 2 Total 15 15
Old Ratio New Ratio Sac /Gain
Adjustment entry:
As Capital Account Dr.1,200
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Bs Capital Account Dr 1,200 To Cs Capital Account 2,400 (The gaining partners margin of gain is adjusted to sacrificing partners)
4. Accounting for Goodwill

Meaning of Goodwill
Goodwill is the monetary value assigned to the advantages of a reputed business in comparison with a new one. It indicates the extra earning capacity of the business. Goodwill is an intangible asset. But it is not a fictitious asset. Goodwill has a realisable value. It is acquired in a gradual consistent process of good business. Ideal location, experience of staff, reputation of owners, faithful customers etc. contribute to the creation of goodwill. Usually goodwill is not shown in books due to conservatism. However, it is essential to assess the value of goodwill and pass appropriate entries in the books prior to any change in profit sharing or ownership structure. If this step is ignored while making any rearrangement in profit sharing or ownership structure, some partners will lose and some others will make undue gain, since goodwill is a valuable hidden asset of the business. Nature of Goodwill 1. 2. 3. 4. Goodwill is an intangible asset Goodwill is a valuable asset. Goodwill generates extra income for the business It is acquired in a gradual process
Following are the major situations in which the goodwill of the firm is to be estimated. a. Change in profit sharing ratio b. Admission of a new partner c. Retirement or death of a partner d. Amalgamation of two partnership firms Factors Influencing Goodwill There are several factors that influence the formation of goodwill. The following are some of the important factors helping the formation of goodwill in a business. 1. Honest business dealings A firm builds up its reputation over a long period by consistent good dealing with the customers. Once the customers start identifying a business for clean and honest dealings they would prefer to stay with the firm, which in turn help the firm to earn higher profits.
PARTNERSHIP ACCOUNTS 2. Good quality of products
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A manufacturing concern maintaining a very good quality in their production will gradually build up reputation, which will help them while launching new products. Similarly trading concerns dealing only in good quality products will gradually build up their reputation. 3. Ideal Location Good location of the business is another favourable factor enhancing the profitability and thereby goodwill of the business. A business which is centrally located will naturally attract more business and more profit. 4. Special skill or Technical Know-how
The business builds up skill in dealing with their product line, dealing with the clients specific requirements, problems associated with the geographical location of their business etc. through experience. The problems are wide and varied, and solutions are also equally diverse. Thus the actual experience help develop skill in dealing with similar situations in future, which is naturally promote efficiency and goodwill of the business.
5. Monopoly of Business
Some established business concerns manage to build up their monopoly simply by being the first one in the market. This enables them to establish its position in and to some extent, restrict future competition. Even though, monopolies are undesirable from the customers point of view, they are unavoidable and harmless at a limited scale.
Methods of Valuation of Goodwill

Following are the most commonS methods adopted for valuation of Goodwill. a. Average Profit Method Average profit method, as the name suggests, is based on the average profit of the business. Under this method, average profits for the past three or four years as agreed by the partners will be taken. Goodwill is estimated as twice or thrice of this average profit. Illustration 2.19 ABC earned profits of Rs.20, 000, Rs.15,000 and Rs.25,000 in the past three years. They have decided that the Goodwill to be estimated at twice the average profit for the past three years. Estimate Goodwill.
Average profits = 45000 Value of Goodwill being twice the average = 45000 x2 = 90,000 b. Super Profit Method
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The existence of Goodwill is recognised in a firm only when its profitability is beyond the level of a new firm. Such excess profit earned by the firm is termed as super profit. Goodwill under super profit method is calculated in one of the following ways: i. Simple Super Profit
Illustration 2.20 The net profit earned by ABC in the previous year was Rs.50,000. The capital employed by the firm is Rs.400,000. The normal rate of return for similar business is 10% on capital. Goodwill is considered to be the value of 3 years purchase of Super Profit. Calculate Goodwill. Capital Employed = 400,000 Normal rate of return = 10% Normal profit on the capital employed = 400,000 x 10% = Rs. 40,000 Actual profit = Rs.50,000 Super profit = 50000 40000 = 10,000 Goodwill being 3 years purchase of super profit = Rs.30,000 ii. Average Super Profit
Illustration 2.21 The firm ABC earned R.17,500, Rs.22,500 and Rs.20,000 in the last three years. The mount of capital employed by the firm was Rs.150,000 and the normal rate of return for similar business is 10%. Goodwill is considered 5 times the value of average super profits. Calculate goodwill.
Average profit for the last three years = Rs.20,000 Normal profit on the capital employed = Rs.15,000 Average super profit = Rs.5,000 Value of Goodwill = 5000 x 5 = Rs. 25, 000 iii. Capitalisation of Simple Super Profit
Illustration 2.22
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ABC earned a profit of Rs.20,000 during the year 2001. The capital employed by the firm was Rs.120,000 and the normal rate of return on similar business is 10%. Calculate goodwill by capitalising super profit. Actual Profit = Rs.20,000 Normal profit on capital investment = 120000 x 10% = Rs.12,000 Super profit = 20,000 12,000 = Rs.8,000 Capitalised value of super profit =80000 x 100 / 10 = Rs.80,000
c. Capitalisation Method (Goodwill based on capital saved)

Capitalisation method considers goodwill as the value of capital saved due to higher profitability. Under this method the amount of effective capital is estimated on the basis of market condition. This effective capital is always higher than the actual capital due to better profitability. The excess of effective capital over the actual capital is regarded as capital saved which is considered the goodwill of the firm. Capitalisation of super profit and capitalisation of actual profit and estimation of capital saved as goodwill are practically the same.
Illustration 2.23 ABC earned a profit of Rs.20,000 on a capital investment of Rs.175,000. Normal rate of return is 10%. Goodwill is considered the value of capital saved based on normal rate of return. Estimate the value of Goodwill. (This sum is worked out in two ways to illustrate that both the methods are same) Estimation of Capital Saved Actual profit = Rs.20,000 Estimated capital for earning this profit = Rs.200,000 Actual capital employed = Rs.175,000 Capital saved = 200,000 175,000 = Rs.25,000 Capitalisation of Super Profit Actual profit = Rs.20,000 Normal profit on capital employed = 175,000 x 10% = Rs. 17,500 Super profit = 20,000-17,500 = Rs.2,500 Capitalised value of super profit = Rs.25,000
Accounting Treatment of Goodwill on Admission

Once the value of goodwill is estimated it should be properly accounted prior to the admission of a new partner. There are basically three methods of treatment of goodwill on admission, which are:
PARTNERSHIP ACCOUNTS Premium method Margin Adjustment Revaluation method Memorandum revaluation method Premium Method
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Under premium method the new partner pays cash for his share goodwill along with his capital. Cash account is debited for both these payments. The total amount brought in by the new partner (Capital + Goodwill) is credited to his capital account. The goodwill part of this payment belongs to the old partners. This amount is transferred to their capital accounts IN THE SACRIFICING RATIO. Since goodwill account is not opened in the book of the firm it will not appear in the balance sheet. If there is any goodwill partly appearing in the balance sheet of the firm and the new partner is willing to contribute for his share, there are two options available for its treatment.
First, the existing goodwill may be left intact, and collect the new partners share of the remaining value of goodwill only. Alternatively, write off the existing goodwill against the capital accounts of old partners in their old profit sharing ratio and collect the share for full value of goodwill from the new partner. Margin Adjustment Method This method is practically a variation of premium method. Here the new partner does not bring in money specifically for his share of goodwill. The best option in this situation is to raise goodwill. For unreasonable reasons, raising goodwill is not allowed. The last resort is margin adjustment. Here the goodwill is adjusted only through the capital accounts. This method will work fine for all cases of reconstitution. When profit sharing ratio is changed at reconstruction something is added or deducted from their old profit share. In other words the partners retain a major part of their old profit share for which no adjustment is required. Goodwill under this method is adjusted on the basis of marginal increase or decrease of profit share. The basic rule is that the gaining partner shall compensate the sacrificing partner. Following are the steps involved in goodwill adjustment. i) Find out the partners sacrifice / gain ii) Debit gaining partner and credit the sacrificing partner with the proportionate value of goodwill.
If you find the ratios bit difficult, you can arrive at the margin values by following memorandum revaluation in a different format in the workings. This is basically crediting full value of goodwill to partners capital accounts in the old ratio and debiting it in the new ratio. The net result is premium being adjusted in the account. You are not allowed to show these entries in the capital account. But the examiner has no problem if you do it in the workings.
Revaluation Method
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When the new partner does not pay cash for his share of goodwill the old partners will RAISE full value of goodwill in the books, by debiting goodwill account and crediting the capital accounts of old partners in the OLD PROFIT SHARING ratio. This method is termed as revaluation method. As a new goodwill account is opened in the books it will appear in the balance sheet of the firm. If a part of the goodwill is already appearing in the books of the firm the old partners are allowed to raise the only the remaining balance of goodwill to bring it to the full value. In other words, the value of goodwill the books should not exceed its estimated full value. (This method is explained in the previous chapter also)
Difference between Premium Method and Revaluation Method Premium Method

1. The new partner pays for his share of goodwill 2. Only the share of goodwill not the full value taken for distribution 3. Cash account, not the good will account is debited upon receiving the goodwill payment 4. Sacrificing ratio is applied for distribution of goodwill money. 5. Goodwill will not appear in the balance sheet after admission.
Revaluation Method
1. The new partner does not pay for his share of goodwill 2. Full value of goodwill is taken for distribution to old partners 3. Goodwill account is debited for raising the goodwill. Cash is not affected by goodwill.
4. Old profit sharing ratio is applied of distribution of full value of goodwill 5. Full value goodwill will appear in the balance sheet after admission.
Memorandum Revaluation Method

Memorandum revaluation method is basically same as revaluation method with a minute variation. Under this method the goodwill is raised in the books of the firm by debiting goodwill account and crediting the old partners capital accounts in the old profit sharing ratio same as the revaluation method. Thereafter the goodwill is written off against capital accounts of all partners (including the new partner), in the new profit sharing ratio. In this case goodwill will not appear in the balance sheet after admission. Illustration 2.24 A, B & C sharing profits and losses in the ratio 2:1:1 have decided to share future profits equally from 1 st January 2003. Their Balance Sheet on that date stood as follows:
PARTNERSHIP ACCOUNTS Balance Sheet Liabilities Capital A Capital B Capital C General reserve Creditors Amount Assets
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Amount 20,000 11,000 9,000
14,000 Machinery 10,000 Furniture 10,000 Cash 2,000 4,000 40,000
40,000
The assets and liabilities have been revalued as follows: Machinery 10% less; Furniture valued at Rs.13,000; Creditors include Rs.400 not to be paid. Pass necessary adjustment entries, make revaluation account and prepare new balance sheet of the firm.
Journal Entries:
General Reserve a/c Dr. 2000 As Capital Account 1,000 Bs Capital Account Cs Capital Account 500 500
(General reserve account transferred to partners capital account in the old ratio) --------------------------------------------------------------------------------------------------Revaluation Account Dr. 2,000 To Machinery Account (Value of machinery reduced) --------------------------------------------------------------------------------------------------Furniture Account Dr.2,000 To Revaluation (Value of furniture raised) --------------------------------------------------------------------------------------------------Creditors Dr. 400 2,000 2,000
PARTNERSHIP ACCOUNTS To Revaluation 400 (Value of Creditors reduced)
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Revaluation Account
Particulars To machinery To Profit A-200 B-100 C-100 400 Amount Particulars Amount 2,000 400
2,000 By Furniture Creditors
2,400
2,400
Capital Accounts
Particulars
To balance c/d
A
15,200
B
12,600
Particulars
A
14,000 1,000 200
B
12,000 500 100
C
10,000 500 100
10,600 By Balance b/d By General Res By Revaluation
15,200
12,600
10,600
15,200
12,600
10,600
Balance Sheet
Liabilities Capital A B C Creditors Amount Assets Amount 18,000 13,000 9,000
15,200 Machinery 12,600 Furniture 10,600 Cash 3,600 40,000
40,000
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Illustration 2.25 The following is the balance sheet of A & B. They have decided to revalue the machinery 10% more and furniture Rs.1,000 less for the purpose of admitting C as a new partner. Revise the balance sheet prior to admission. Balance Sheet Liabilities Capital A Capital B Creditors Amount Assets Amount 15,000 6,000 1,500 22,500
10,000 Machinery 10,000 Furniture 2,500 Cash 22,500
Here we have to do three things. 1. Prepare a revaluation account to summarise the effect of revaluation. ii. Prepare capital accounts iii. Prepare new balance sheet.
Revaluation Account Particulars

To Furniture
Amount
Particulars
Amount 1,500
1,000 By Machinery
To Revaluation Profit A 250 B 250 1,500 1,500 500
As Capital Account Particulars Amount Particulars Amount
PARTNERSHIP ACCOUNTS By Balance b/d

By Revaluation a/c
P a g e | 54 10,000 250
To balance c/d
10,250 10,250 10,250
Bs Capital Account Particulars Amount Particulars By Balance b/d

By Revaluation a/c
Amount 10,000 250
To balance c/d
10,250 10,250 10,250
Balance Sheet Liabilities Capital A Capital B Creditors Amount Assets Amount 16,500 5,000 1,500 23,000
Notice that the values of the two assets have changed and the effect is transferred to the capital account in the form of revaluation profit]
Illustration 2.26 A, B & C sharing profits and losses in the ratio 2:2:1 have decided to share future profits equally 1st January 2003. Their Balance Sheet on that date stood as follows:
Balance Sheet
Liabilities Amount Assets Amount
PARTNERSHIP ACCOUNTS Capital A Capital B Capital C General reserve Creditors 15,000 Machinery 10,000 Furniture 10,000 Cash 5,000 4,000 44,000
P a g e | 55 20,000 15,000 9,000
44,000
The assets and liabilities have been revalued as follows: Machinery 10% less Furniture valued at Rs.13,000 Creditors should include an additional bill for Rs.500.
Pass necessary adjustment entries and prepare new balance sheet of the firm.
Journal Entries:
General Reserve a/c Dr. 5,000 As Capital Account Bs Capital Account Cs Capital Account 2,000 2,000 1,000
(General reserve account transferred to partners capital account in the old ratio) --------------------------------------------------------------------------------------------Revaluation Account Dr. 2,000 To Machinery Account 2,000
(Value of machinery reduced and the loss debited to revaluation) --------------------------------------------------------------------------------------------Revaluation Account Dr.2,000 To Furniture Account 2,000
PARTNERSHIP ACCOUNTS (Value of furniture reduced and the loss debited to the revaluation account)
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--------------------------------------------------------------------------------------------Revaluation Account Dr. 500 To Creditors 500
(Creditors raised and loss transferred) -------------------------------------------------------------------------------------------As Capital Account Dr.1,800 Bs Capital Account Dr.1,800 Cs Capital Account Dr. 900 To Revaluation Account 4,500 (Revaluation loss transferred to capital accounts)
Revaluation Account
Particulars To machinery To Furniture To Creditors Amount Particulars Amount
2,000 By Loss transferred 2,000 500 A 1,800 B 1,800 C 4,500 900 4,500 4,500
Capital Accounts
Particulars
To Revaluation
A
1,800
B
1,800
Particulars
A
15,000 2,000
B
10,000 2,000
C
10,000 1,000
900 By Balance b/d By General Res
Balance c/d
15,200
10,200
10,100
17,000 12,000 11,000
17,000 12,000 11,000
Balance Sheet
PARTNERSHIP ACCOUNTS Liabilities Capital A B C Creditors Amount Assets
P a g e | 57 Amount 18,000 13,000 9,000
40,000
Illustration 2.27 (Memorandum Revaluation) A, B & C sharing profits and losses in the ratio 2:2:1 have decided to share future profits equally 1st January 2003. Their Balance Sheet on that date stood as follows:
Balance Sheet Liabilities Capital A Capital B Capital C General reserve Creditors Amount Assets Amount 40,000 25,000 14,000 7,000 8,000 94,000
25,000 Buildings 20,000 Machinery 20,000 Debtors 15,000 Stock 14,000 Cash 94,000
The assets and liabilities have been revalued as follows: Buildings appreciated to Rs.50,000 Machinery appreciated by Rs.4,000 Create provision for bad debts @10% on debtors. Stock to be valued at Rs.9,400. The partners want the values of assets and liabilities to remain the same. Prepare Memorandum Revaluation Account; Capital Accounts of Partners and the Balance Sheet of the firm after the necessary adjustments are carried out.
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Memorandum Revaluation Account

Particulars
To Prov. For bad debts To profit Transferred A 6,000 B 6,000 C 3,000 16,000 16,400 16,400
Amount
Particulars
Amount
10,000 4,000 2,400
1,400 By Buildings By Machinery By Stock
10,000 By provision reversed To Buildings reversed To Machinery reverse To Stock - reversed 4,000 By Loss Transferred 2,400 A 5,000 B 5,000 C 5,000 16,400
1,400
15,000 16,400
Capital Accounts
Particulars A B C Particulars
By Balance b/d To Mem Reval. To balance c/d 5,000 32,000 5,000 27,000 5,000 21,000 By General Reserve ByMem. Revaluation
A
25,000 6,000 6,000
B
20,000 6,000 6,000
C
20,000 3,000 3,000
37,000
32,000
26,000
37,000
32,000
26,000
Balance Sheet Liabilities

Capital Accounts A
Amount Assets
32,000 Buildings
Amount
40,000
PARTNERSHIP ACCOUNTS B C 27,000 Machinery 21,000 Debtors Stock Creditors 14,000 Cash 94,000
P a g e | 59 25,000 14,000 7,000 8,000 94,000
5. Adjustment of Capital Accounts

When the partners change their profit sharing ratio, they may also change their capitals. Contribution of capital is not essentially the basis of profit sharing. But in most cases capital contribution is considered the most important factor in determining profit sharing ratio. Capital balances are usually adjusted by bringing in or taking out cash. However as a temporary measure capital balances can be adjusted by transferring the differences through current accounts.
Reconstitution by admission
The illustrations given below are carefully planned to explain each concept we discussed before. Work out each one of them. They will help you focus on each aspect of this chapter. They will also help you have a fresh look at the theory section.
Illustration 2.28 The following Balance Sheet shows the financial position of A & B sharing profits and losses equally before admission of C.
Balance Sheet Liabilities Capital A Capital B Creditors Amount Assets Amount 15,000 6,000 1,500 =SUM(ABOVE) 22,500
C paid Rs.12,000 as his capital and Rs.3,500 as his share of goodwill for equal partnership in future.
PARTNERSHIP ACCOUNTS sheet of the firm after Cs admission.
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Pass necessary journal entries; Prepare revaluation account, capital accounts of partners and the new balance
Journal Entries 1.. Cash Account Dr. Rs.12,000 To Cs Capital Account Rs.12,000 ( Cs share of capital credited to his account) ---------------------------------------------------------------------------2. Cash Account Dr. Rs.3,500 To As Capital Account Rs.1,750 Bs Capital Account Rs.1,750
(Cs goodwill contribution credited to old partners in the sacrificing ratio)
As Capital Account Particulars Amount Particulars By Balance b/d To balance c/d 11,750 By Cash G/w prem 11,750 Amount 10,000 1,750 11,750
Bs Capital Account Particulars Amount Particulars By Balance b/d To balance c/d 11,750 By Cash G/s prem 11,750 Amount 10,000 1,750 11,750
Cs Capital Account
PARTNERSHIP ACCOUNTS Particulars To balance c/d Amount Particulars
P a g e | 61 Amount 12,000
12,000 By Cash Account
12,000
12,000
Balance Sheet Liabilities Capital A Capital B Capital C Creditors Amount Assets Amount 15,000 6,000 17,000
38,000
Nothing is mentioned about the future profit sharing arrangement between A & B. Therefore it should be understood that they will continue to remain equal partners for the future as well.
Here C pays for his share of goodwill which has to be given to A & B in their sacrificing ratio. When the ratio between old partners remains the same for future; the old ratio itself will be the sacrificing ratio. (As Sac 1/2 1/3; Bs sacrifice is also the same. which means their sacrifice is equal]
Goodwill account will not appear in the books after admission.
Illustration 2.29 The following Balance Sheet shows the financial position of A and B sharing profits and losses in the ratio 2:1.
Balance Sheet Liabilities Capital A Capital B Amount Assets Amount 16,000 5,000
10,000 Machinery 10,000 Furniture
PARTNERSHIP ACCOUNTS Creditors 2,500 Cash 22,500 1,500 22,500
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They have decided to admit C and to share future profits and losses equally. C agreed to contribute Rs. 10,000 as his capital and Rs.2,500 as his share of goodwill. Pass necessary journal entries and prepare the new balance sheet after admission.
Here new partners share of goodwill is given to the old partners in the sacrificing ratio. This aspect is repeated because of its importance. Here you have a new ratio. Whenever there is a new ratio given in the question you must check if the ratio between old partners is still the same. For example suppose the old ratio was equal (1:1) and the new ratio is 2:2:1 here the ratio between old partners remains the same, even though 2/5 is smaller than their old 1/2. If the old partners continue to remain in the same ratio as before you need not calculate the sacrificing ratio, See the previous illustration, There you find the old partners were equal, getting each before admission and after admission they are getting 1/3rd each. Therefore we say their sacrifice also is same.
Here in this illustration you will really see the effect of sacrificing ratio. The old ratio was 2:1. This means As share was 2/3 and Bs share 1/3. The future profit sharing arrangement is agreed to be equal; which means all will get 1/3rd share. Now notice that A is the only loser in this arrangement. B continues to get his old 1/3rd. Therefore, goodwill is given only to A.
Journal Entries
1. Cash account Dr.12,500 To Cs Capital Account 12,500 (Cash contribution for Capital and Goodwill by C) -------------2. Cs Capital account Dr. 2,500 To As Capital 2,500
(Goodwill contribution transferred to the sacrificing partner)
You can credit the full contribution of the new partner to his capital and transfer it to the sacrificing partners afterwards.
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As Capital Account
Particulars Amount Particulars By Balance b/d To Balance C/d 12,500 By Cs Capital goodwill 12,500 Amount 10,000 2,500 12,500
Bs Capital Account
Particulars Amount Particulars By Balance b/d To balance c/d 10,000 10,000 10,000 Amount 10,000
Cs Capital Account
Particulars To As Capital Goodwill To balance c/d Amount Particulars Amount 12,500
2,500 By Cash 10,000 12,500
12,500
Balance Sheet
Liabilities Capital A
Capital B
Amount
Assets
Amount 16,000 5,000 14,000
Capital C Creditors
35,000
PARTNERSHIP ACCOUNTS Illustration 2.30
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Following balance sheet shows the financial position of A & B sharing profits and losses in the ratio 3:2.
Balance Sheet Liabilities Capital A Capital B Creditors Amount Assets Amount 15,000 6,000 1,500 22,500
They have decided to admit C for 1/6th share in the future profits for which C brings in Rs.10,000 as his capital and Rs.2,500 as his share of goodwill.
Pass necessary journal entries and present the balance sheet of the firm after Cs admission. You know this is also premium method of goodwill. The old partners share after admission is not specifically mentioned. You must understand the portion of profit left after paying Cs share will be divided in the old ratio. Here Cs share is 1/6th. The balance available for A & B is 5/6th. This portion will be shared in the ratio 3:2 which makes the new ratio 3:2:1. As the ratio between old partners continues to be 3:2, the sacrificing ratio also will be the same. Study the small illustrations on ratios carefully. Journal Entries
1. Cash Account Dr.12,500 To Cs Capital Account 12,500 (Capital and goodwill contribution by C is credited to his account) ----------------------------------------------------------------------------------------2. Cs Capital account Dr. 2,500 To As Capital Account 1,500 To Bs Capital Account 1,000 (Goodwill contribution is transferred to old partners in sacrificing ratio)
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As Capital Account
Particulars Amount Particulars By Balance b/d
To balance c/d
Amount 10,000 1,500
11,500 By Cs CapitalGoodwill 11,500
11,500
Bs Capital Account
Particulars Amount Particulars By Balance b/d To balance c/d 11,000 By Cs Capital goodwill 11,000 11,000 Amount 10,000 1,000
Cs Capital Account
Particulars To As Capital To Bs Capital To balance c/d Amount Particulars Amount 12,500
1,500 By Cash 1,000 10,000 12,500
12,500
Balance Sheet
Particulars
As Capital
Amount
Particulars
Amount 15,000 6,000 14,000
Bs Capital Cs Capital Creditors
PARTNERSHIP ACCOUNTS 35,000 Illustration 2.31
P a g e | 66 35,000
The following balance sheet shows the financial position of A & B sharing profits and losses in the ratio 3:2.
Balance Sheet
Liabilities Capital A Capital B Creditors Amount Assets Amount 15,000 6,000 1,500 22,500
They have decided to admit C into partnership, who agreed to pay Rs.15,000 as his share of capital for 1/4 share in future profits. He also paid premium for his share of goodwill Rs.2,500.
Pass necessary journal entries, open ledger accounts and prepare balance sheet after admission.
Journal Entries 1. Cash Account Dr.15,000 To Cs Capital Account 15,000 (Capital contribution by the new partner) ----------------------------------------------------------------------------2. Cash Account Dr.2,500 To As Capital To Bs Capital 1,500 1,000
(Full value of goodwill raised in the books on admission)
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As Capital Account
Particulars Amount Particulars By Balance b/d To balance c/d 11,500 By Cash goodwill 11,500 Amount 10,000 1,500 11,500
Bs Capital Account
Particulars Amount Particulars By Balance b/d To Balance c/d 11,000 By Cash goodwill 11,000 Amount 10,000 1,000 11,000
Cs Capital Account
Particulars Amount Particulars By Cash a/c To Balance c/d 15,000 15,000 15,000 Amount 15,000
Balance Sheet
Liabilities Capital A Capital B Capital C Creditors Amount Assets Amount 15,000 6,000 19,000
PARTNERSHIP ACCOUNTS 40,000 40,000
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Illustration 2.32 The following balance sheet shows the financial position of A & B.
Balance Sheet
Liabilities Capital A Capital B Creditors Amount Assets Amount 15,000 6,000 1,500 22,500
They have decided to admit C for 1/4th share in future profits. C pays Rs.15,000 as his capital. The goodwill of the firm is estimated to be worth Rs.12,000, C contributes for his share of goodwill. Pass journal entries; prepare ledger and present balance sheet after admission.
Journal Entries
1. Cash account Dr. 15,000 To Cs Capital Account 15,000 (Being capital contribution of new partner credited to his account)
2. Cash Account Dr. 3,000 To Premium Account (Cs share of goodwill contribution) 3,000
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3. Premium account Dr. 3000 To As Capital Account To Bs Capital Account 1,500 1,500
As Capital Account
Particulars Amount Particulars By Balance b/d To Balance c/d 11,500 By Premium g/w a/c 11,500 Amount 10,000 1,500 11,500
Bs Capital Account
Particulars Amount Particulars By Balance b/d To balance c/d 11,500 By Prem G/w a/c 11,500 Amount 10,000 1,500 11,500
Balance Sheet
Liabilities Capital A Capital B Capital C Creditors Amount Assets Amount 15,000 6,000 19,500
40,500
Illustration 2.33
PARTNERSHIP ACCOUNTS have decided to admit C into partnership for 1/4th share in future profits.
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The following balance sheet shows the financial position of A & B sharing profits and losses in the ratio 3:2. They
As Capital Account
Particulars Capital A
Capital B Creditors
Amount
Particulars
Amount
15,000 6,000 3,000 1,500 25,500
11,500 Machinery
11,500 Furniture 2,500 Equipment Cash 25,500
C has agreed to pay Rs.15,000 as his share of capital. He also agreed to pay for his share of goodwill Rs.2000. A and B agreed that they will divide their portion of profit equally.
Show the ledger accounts and the balance sheet after admission.
Note: Here the old partners are not continuing in the old ratio. The old partners are sharing their portion equally, which means they will give to C and the remaining will be shared equally. Their new profit sharing ration will be 3/8:3/8:1/4 ie.3:3:2. The sacrificing ratio here is 9:1
As Capital Account
Particulars Amount Particulars By Balance b/d To Balance c/d 13,300 By cash g/w 13,300 Amount 11,500 1,800 13,300
Bs Capital Account
Particulars Amount Particulars By Balance b/d Amount 11,500
PARTNERSHIP ACCOUNTS To Balance c/d 11,700 By Cash- Goodwill 11,700 200 11,700
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Balance Sheet
Liabilities Capital A Capital B Capital C Creditors Amount Assets Amount 15,000 6,000 3,000 18,500 42,500
13,300 Machinery 11,700 Furniture 15,000 Equipment 2,500 Cash 42,500
Illustration 2.34
The following balance sheet shows the financial position of A & B sharing profits and losses equally.
Balance Sheet
Liabilities
Capital A
Amount
Assets
Amount 15,000 6,000 3,000 1,500 25,500
11,500 Machinery 11,500 Furniture 2,500 Equipment Cash 25,500
Capital B Creditors
They have decided to admit C as a partner and to share future profits and losses in the ratio 2:1:1. C agreed to pay Rs.15000 as his share of capital. The full value of goodwill is estimated to be worth Rs.8,000. C paid for his share of goodwill.
Pass journal entries and prepare capital accounts and the balance sheet of the firm after Cs admission.
PARTNERSHIP ACCOUNTS Journal Entries Cash Account Dr. 15,000 To Cs Capital 15,000 (Cs capital contribution) -------------------------------------------------------------------------------------2. Cash Account Dr.2,000 To Bs Capital 2,000
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(Cs goodwill contribution credited to B)
Note: B is the only sacrificing partner
As Capital Account Particulars Amount Particulars By Balance b/d To balance c/d 11,500 11,500 `11,500 Amount 11,500
Bs Capital Account
Particulars Amount Particulars By Balance b/d To Balance c/d 13,500 By Cash goodwill 13,500 Amount 11,500 2,000 13,500
Cs Capital Account
Particulars Amount Particulars By Cash Account To Balance c/d 15,000 Amount 15,000
PARTNERSHIP ACCOUNTS 15,000
P a g e | 73 15,000
Balance Sheet
11,500 Machinery 13,500 Furniture 15,000 Equipment 2,500 Cash 42,500
Illustration 2.35 The balance sheet of A & B sharing profits and losses equally is given below.
Balance Sheet
Liabilities Capital A Capital B Creditors Amount Assets Amount 15,000 6,000 3,000 1,500 25,500
11,500 Machinery 11,500 Furniture 2,500 Goodwill Cash 25,500
They have decided to admit C for 1/4th share in the future profits. C has agreed to pay Rs.15,000 as his capital. The goodwill is valued at Rs.8000 and C pays Rs.2,000 for his share of goodwill. The old partners want the value of goodwill shown in the books shall remain unchanged.
Pass necessary journal entries, open ledger accounts and the new balance sheet after admission.
This is a complicated arrangement. Cs 1/4th share of goodwill is estimated at Rs.2,000. The new partner pays for goodwill on condition that the old partners do not raise their goodwill in the books. In fact the new partner is buying his share of that hidden asset of goodwill. Here the goodwill is appearing at Rs.3000 which means the old partners have already added that portion into their capital accounts. The new partner is required to pay only for the portion
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that is still hidden. If the new partner pays for his full share of goodwill, the old partners must remove the goodwill from accounts. If they insist on keeping it, the next option is to give them what is due for the hidden portion only. In this illustration, Cs contribution of Rs2000 is credited to his capital account and from there Rs.1,250 representing Rs.5000 of the goodwill not raised is transferred to old partners in their sacrificing ratio.
Is this explanation enough? Please read this slowly, carefully. Write down all the numbers above, and study the relation between them.
Journal Entries 1. Cash account Dr. 17,000 To Cs Capital account 17,000 (Cs share of capital and goodwill contribution credited to his capital account) -----------------------------------------------------------------------------3. Cs Capital account Dr.1,250 As Capital Account Bs Capital Account 675 675
(Proportionate amount for the hidden part of goodwill transferred in the sacrificing ratio)
As Capital Account
Particulars Amount Particulars By Balance b/d To balance c/d 12,175 By Cs Capital a/c 12,175 Amount 11,500 675 12,175
Bs Capital Account
Particulars Amount Particulars By Balance b/d To balance c/d 12,175 By Cs Capital a/c 12,175 Amount 11,500 675 12,175
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Cs Capital Account
Particulars To As Capital To Bs Capital To Balance c/d Amount Particulars Amount 15,000 2,000
675 By Cash a/c 675 By Cash a/c 15,650 17,000
17,000
Balance Sheet
12,175 Machinery 12,175 Furniture 15,650 Goodwill 2,500 Cash 42,500
CHAPTER:3 retirement or death of a partner

1. Change in profit sharing ratio 2. Treatment of goodwill 3. Revaluation of assets and liabilities 4. Accumulated profits; reserves; losses etc. 5. Adjustment of Joint Life Policy 6. Adjustment of capital
1. Change in profit sharing ratio

Retirement or death reduces the number of partners to share future profits or losses. Naturally the share of profit for the continuing partners will increase by the retirement or death of a partner. Recalculation of ratios is the first
PARTNERSHIP ACCOUNTS question:
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step in for further accounting procedures. Revision in ratio may be indicated in any of the following ways in a
a.
Old ratio is given and nothing is mentioned about the new arrangement after
retirement.
This is practically the easiest way of presenting new profit sharing arrangement. The new ratio under this method is found out simply by canceling the outgoing partners share of profit assuming that the ratio between the continuing partners does not change. When this method is followed the outgoing partners share merges into the continuing partners share in their profit sharing ratio.
Example: A, B and C have been sharing profits and losses in the ratio 3:2:1. B has retired from the business. Find out new ratio between A & C.
Here B is retired and nothing is mentioned about the arrangement between A & C. The new ratio is found out by simply canceling the Bs share of profit. New ratio = 3:1 Here Bs share of 2/3 of profit is merged in the shares of A and C in the ratio 3:1.
b.
The outgoing partners share is taken over by the continuing partners in a
certain ratio.
A & B have been sharing profits and losses in the ratio 3:2:1. B retired from the firm. His share of profit is divided equally between A & C. Find out new ratio.
Here Bs share of 2/6 is shared between A & C equally. The new share of A is his old share of 3/6 + 1/6 from B. Thus his new share is 4/6. Cs new share is his old share of 1/6 + 1/6 from B. Thus his new share is 2/6. New profit sharing ratio is 4:2 that is 2:1.
c. The new ratio is directly given.

When the new ratio is directly given, the need for calculating it is taken away. But it is important to remember that new ratio is only a first step for further adjustments in accounts on retirement or death.
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2. Accounting Treatment of goodwill

Accounting treatment of goodwill on retirement and death is very close to that in admission Following are the different methods followed:
1. The outgoing partners share adjusted in the books (Margin Adjustment)

This method is similar to the premium method adopted in admission of partners. Under this method the outgoing partners share of goodwill is credited to his capital account and the continuing partners capital accounts are debited for the same in the gaining ratio.
Gaining ratio
Gaining ratio is the ratio of gain. You have seen this in the earlier chapters. Retirement or death of partners is one situation where gaining ratio is applied for adjusting goodwill. When a partner leaves the firm the ratio is revised and the continuing partners will share the outgoing partners portion of profit in addition to their old ratio. It is calculated by deducting the old ratio from the new.
Calculation of gaining ratio is important when the partners decide to adjust the outgoing partners share of goodwill without raising the goodwill account in the firm.
[Notice that we use sacrificing ratio when the new partner brings in cash for the share of goodwill on admission. Compare the two situations carefully learn thoroughly the difference in accounting treatment.]
2. Goodwill raised in the books

This is the revaluation method of treatment of goodwill. Goodwill is raised in the books of the firm by debiting goodwill account and crediting all partners capital accounts in the old ratio. With this journal entry goodwill account is actually opened in the books and will appear in the future balance sheets at its full value. The outgoing partner gets his share of goodwill along with the continuing partners. If the continuing partners decide to reduce the value of goodwill or to write it off completely they can do so by debiting their capital accounts in the new ratio and crediting the goodwill account with the amount to be reduced. The outgoing partners share or his position is in no way affected due to this step.
3. Revaluation of assets and liabilities

Revaluation of assets and liabilities are done exactly the same way it is done on admission of a partner. The reason behind revaluation in admission or retirement is to make the balance sheet reflect a true and fair view of the assets and liabilities of the firm, prior to making any other major changes in the ownership structure of the
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business. Any loss or gain in this rearrangement should go to those persons, only to those persons, who are responsible. In other words the incoming new partner in admission or the outgoing partner in retirement or death shall not lose or gain due to wrong valuation of assets and liabilities. Revaluation is done in the books through a revaluation account. Profit or loss on revaluation is transferred to the capital accounts of all partners (including the outgoing partner) in the old profit sharing ratio. Remember the rule we follow in admission; old partners in old ratio. Here also we apply the same rule. We dont call them old partners just because we dont have any new partner in retirement. Also notice that the expression outgoing partner is used in this book as a convenient term to refer the retiring partner as well as the deceased partner. Again deceased partner means dead partner. The term deceased sounds less deadly.
4. Reserves and Accumulated profits losses etc.

Accumulated profits, reserves, losses etc. are treated on retirement or death exactly the way they were done in admission. The profits or reserves are transferred to the credit of capital accounts of all partners in the old profit sharing ratio. As a result these items will disappear from the books and from future balance sheets as well. Accumulated losses that are appearing on the asset side of the balance sheet are transferred to the debit side of all partners in the old profit sharing ratio.
5. Adjustment of Joint Life Policy

Joint life policy is a precautionary measure to protect the firm from financial crisis, on account of death of a partner. This is a life insurance policy by which more than one life is insured. In case of a partnership firm all partners are covered usually by a single life insurance policy. The firm, not the partner, pays the premium on this policy. In the event of death of any one of the partners, the insurance company will
pay the full amount assured sum to the firm. This amount will be regarded as a special income
to the firm and credited to capital accounts of all partners in the profit sharing ratio.
Does it sound little unfair on the part of the continuing partners to share the insurance amount in the profit sharing ratio? How can someone share the life insurance money on the death of another man? This doubt is quite natural. A person is allowed to take any number of policies on his own life and pay from his private income. Nobody except the legal heirs will get the insurance amount. But the joint life policy discussed here is different. The main aim of this policy is not supporting the family of the partner, but to save the firm from landing into financial crisis due to death of a partner. However this indirectly helps the family of the deceased by quick settlement of dues. Here all the partners (including the deceased one) decided together to insure their lives jointly and pay the premium from the firms funds. There is another aspect also to this problem. Suppose the entire insurance claim is credited only to the deceased partner. This will defeat the very purpose for which the policy is taken. The capital account or the amount payable to the executors will directly increase to the extent of the insurance claim. Now firm has to find out other sources of finance to settle original capital investment and reserves. Therefore it is perfectly logical to consider the insurance amount as a business income and share the amount in the normal profit sharing ratio.
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Sometimes the partners insure their lives separately and pay the premium from the firm. This will help the continuing partners to keep their life insurance policy valid even after the death of a partner. When there are separate life insurance policies, the full amount due on the policy of deceased partner and the surrender values of the policies of the continuing partners will be credited to all partners in their profit sharing ratio. The surrender values will appear in the subsequent balance sheets. The following are the three methods of accounting treatment of joint life policies:
i. The insurance premium treated as normal business expense

When insurance premium is treated as normal business expense, the premium paid will be initially debited to the premium account and later on transferred to the profit and loss account just like any other business expense.
Journal entries
a) For payment of premium: Joint life insurance premium account Dr. To Cash
b)
For Transfer of expense to P & L account P & L account Dr. To Joint Life Premium Account
c)
At the time of maturity (claim due to death) Insurance Claim Account Dr. (full amount of insurance policy) To All Partners Capital Accounts (in the profit sharing ratio)
d) For cash received Cash / Bank account Dr. To Insurance Claim
Illustration 3.01 A, B, and C sharing profits and losses in the ratio 2:1:1 have taken a joint life policy for Rs.100,000 with an annual premium of Rs.1,000 on 1st January 2000. C died on 10th February 2002. The Insurance Company settled the claim
PARTNERSHIP ACCOUNTS Insurance Claim accounts. First Year Jan 1, 2000 JLP Premium account Dr.1,000 To Cash Account (JLP premium paid) ---------------------------------------------------------------------------------------Dec.31, 2000 Profit and Loss Account Dr.1,000 To JLP premium Account 1,000 1,000
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on 15th Feb 2002..Pass necessary journal entries in the books of the firm and show the Joint Life Premium and
(JLP Premium written off as expense)
Second Year Jan1, 2001 JLP Premium Account Dr.1,000 To Cash (JLP Premium paid) ---------------------------------------------------------------------------------------Dec.31, 2001 Profit and Los Account Dr.1,000 To JLP Premium (JLP Premium written off) 1,000 1,000
Third Year Jan1st, 2002 JLP Premium Account Dr.1,000 To Cash 1,000
PARTNERSHIP ACCOUNTS (JLP Premium paid) ---------------------------------------------------------------------------------------Feb10, 2002 Insurance Claim Account Dr.100,00 To As Capital Account To Bs Capital Account 40,000 40,000
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To Cs Capital Account 20,000 (Insurance claim/policy maturity due to Cs death) ---------------------------------------------------------------------------------------Feb 15, 2002 Bank Account Dr.100,000 To Insurance Claim (Insurance claim settled) 100,000
JLP Premium Account

Date Particulars Amount Date Particulars Amount 1,000
1Jan,2000 To Cash
1,000 31 Dec2000 By P&L Account 1,000
1,000
1 Jan 2001
To Cash
1,000 31 Dec, 2001 1,000
By P&L Account
1,000
1,000
1 Jan 2002
To Cash
1,000 31 Dec 2002
By P &L Account
1,000
1,000
1,000
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Insurance Claim Account

Date Feb 10,2002 Particulars To As Cap 40,000 To Bs Cap 40,000 To Cs Cap 20,000 100,000 Amount Date Feb 10, 2002 Particulars By Bank Amount 100,000
100,000
100,000
ii. The surrender value is retained as asset.

Surrender value of an insurance policy is the amount which the insurance company will pay back to the insured if he decides to cancel the policy before maturity. The insurance company usually would not pay anything if the policy is cancelled in the first year. But thereafter, they company will agree to refund a small portion of the premium paid if the customer decides to discontinue the policy. With each payment of premium some portion it is added to the surrender value of the policy. The portion thus added into the surrender value is not considered a capital expense. Only the remaining part is written off to Profit and Loss account as expense.
Journal entries:
a. For Payment of Premium

Joint life policy account Dr. To cash (Notice that the joint life policy (asset) account, not the premium (expense) account is debited) ------------------------------------------------------------------------------------------------
b. For the premium above surrender value is transferred:

P & L account Dr. To Joint Life Policy Account ------------------------------------------------------------------------------------------------
c. At the time of maturity (claim due to death)

Insurance Claim Account Dr. (full value insured) To Joint Life Policy ------------------------------------------------------------------------------------------------
d. For the Claim Settlement

Bank/cash Account Dr. To Insurance Claim ------------------------------------------------------------------------------------------------
e. For Closing JLP account

JLP account Dr. (balance amount) To All Partners Capital Accounts (Profit sharing ratio)
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Illustration 3.02 A,B, and C sharing profits and losses in the ratio 2:1:1 have taken a joint life policy for Rs.100,000 with an annual premium of Rs.1,000 on 1st January 2000.The surrender values for the policy were: 31st Dec. 2000-nil; 31st Dec. 2001-Rs.300; 31st Dec. 2002- Rs.750 31st Dec. 2003- Rs.1,250 C died on 10th February 2003. The Insurance Company settled the claim on 15th Feb, 2003. Pass necessary journal entries in the books of the firm and show the Joint Life Policy and Insurance Claim accounts. The full amount of premium paid in the first year Rs. 1,000 would be regarded an expense in that year. The premium paid in the second year resulted in surrender value of Rs300, and therefore only Rs. 700 will be considered an expense in the second year. The third premium payment resulted in an addition of Rs. 450 to the surrender value and therefore only Rs.550 is considered to be the expense. Journal Entries First Year Jan1, 2000 Joint life policy account Dr.1,000 To Cash 1,000 (Premium paid on the joint life policy) -------------------------------------------------------------------------------------31 Dec.,2000 P&L account Dr. Rs.1000 To Joint life policy account Rs.1,000 (Premium paid transferred to the P&L) Note: There is no surrender value in the first year in the above example. Second Year Jan1, 2001 Joint Life Policy account Dr.1,000 To Cash 1,000 (Premium paid on the policy) -------------------------------------------------------------------------------------------31 Dec. 2001 P&L account Dr.700 To Joint Life policy 700 (The premium payment above the surrender value transferred to P&L) (Note: Here the premium payment is Rs.1,000 out of which only Rs.700 is considered expense surrender due to value of Rs.300. The joint life policy will appear as asset in the balance sheet.) Third Year Jan 1 2002 Joint Life Policy account Dr.1,000 To Cash
1,000
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(Premium paid on the policy)

-------------------------------------------------------------------------------------------------------------------------------------------
31 Dec.2002 P&L account Dr.550 To Joint Life policy 550 (The premium payment above the surrender value transferred to P&L) Fourth Year 10 Feb 2003 Insurance Claim Account Dr.100,000 To Joint Life Policy 100,000 (Insurance Claim credited to policy account)
--------------------------------------------------------------------------------------------------------------------------------------------
Joint Life Policy Account Dr. 98,250 To As Capital 39,300 To Bs Capital 39,300 To Cs Capital 19,650 (Joint Life policy balance transferred to capital accounts) 15 Feb 2003
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Bank Account Dr. 100,000 To Insurance Claim 100,000 (Insurance claim settled)
Joint Life Policy Account

Date Particulars 1Jan,2000 To Cash Amount Date 1,000 31 Dec2000 1,000 1,000 31 Dec, 2001 1,000 300 31 1,000 Dec.2002 1,300 750 10 Feb 1,000 2003 Particulars Amount By P&L Account 1,000 1,000 700 300 1,000 550 750 1,300 100,000
1 Jan 2001 1 Jan 2002
To Cash
By P&L Account By Balance c/d By P& L Account By Balance c/d By Insurance Claim
To balance b/d To Cash
1 Jan 2003 10 Feb 2003
To balance b/d To cash To As Cap 39,300 To Bs Cap 39,300 To Cs Cap 19,650
98,250
100,000
100,000
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Insurance Claim Account

Date 10 Feb 2003 Particulars To Joint Life Policy Amount Date 100,000 15 Feb 2003 100,000 Particulars Amount ByBank 100,000 100,000
iii. Joint life policy reserve account is maintained.

Under this method surrender value of Joint life policy is shown as asset (same as the second method). A joint life policy reserve equivalent to the surrender value is maintained in the books. There are three steps involved in the accounting. Journal Entries Step 1: Debit Join Life Policy and Credit Cash for payment of Premium Joint Life Policy Account Dr. To Cash ------------------------------------------------------------------------------------------------Step 2 Debit P&L Appropriation account and Credit Joint Life policy reserve to create reserve equivalent to that of policy. P& L Appropriation Account Dr. To Joint Life Policy Reserve Account ------------------------------------------------------------------------------------------------Step 3 Debit Joint life policy reserve and Credit Joint life policy account, to adjust the amounts in both the accounts to the actual surrender value. Joint Life Policy Reserve Account Dr. To Joint Life Policy Account
At the time of death of a partner the insurance related accounts are closed in the following way: Journal Entries 1. Insurance Claim Insurance Claim account Dr. To Joint Life policy Account ------------------------------------------------------------------------------------------------2. Closing of Reserve Joint Life Policy Reserve Account Dr. To Joint Life Policy Account (There is no strict rule that you must transfer the reserve into the policy account only. You can transfer this account directly to the capital accounts of partners) ------------------------------------------------------------------------------------------------3. Closing the Policy Account Joint Life Policy Account Dr. To All Partners Capital Accounts
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------------------------------------------------------------------------------------------------4. Receiving Claim Amount Bank/Cash Account Dr. Insurance Claim Note: The above section may sound a complicated accounting treatment. More formal explanation will make more confusion. Just notice that you are creating a joint life policy account on the asset side (first entry), creating the same amount on the liability side as reserve (second entry), and trim down both the asset and liability by mutual transfer / elimination (third entry). Illustration 3.03 A,B, and C sharing profits and losses in the ratio 2:1:1 have taken a joint life policy for Rs.100,000 with an annual premium of Rs.1,000 on 1st January 2000.The surrender values estimated for the policy were: 31st Dec. 2000-nil; 31st Dec. 2001-Rs.300; 31st Dec. 2002- Rs.750 31st Dec. 2003- Rs.1,250 C died on on 10th February 2003. The Insurance Company settled the claim on 15 th Feb, 2003. Pass necessary journal entries and related ledger accounts keeping treating the surrender value of the insurance policy as asset and maintaining a reserve against the policy. First Year Jan1, 2000 Joint life policy account Dr.1,000 To Cash 1,000 (Premium paid on the joint life policy) 31 Dec.,2000 P&L Appropriation Account Dr. Rs.1000 To Joint Life Policy Reserve Account Rs.1,000 (Reserve created for the premium payment) 31st Dec, 200 Joint Life Policy Reserve Account Dr.1,000 To Joint Life Policy Account 1,000 (Balances in reserve and policy accounts eliminated by mutual transfer)
Note: There is no surrender value in the first year in the above example. Second Year Jan1, 2001 Joint Life Policy account Dr.1,000 To Cash (Premium paid on the policy)
1,000
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31 Dec. 2001 P&L Appropriation Account Dr 1,000 To Joint Life Policy Reserve Account 1,000 (Reserve created for the premium payment) 31st Dec.2001 Joint Life Policy Reserve Account Dr.700 Joint Life Policy Account 700 (Both JLP and Reserve reduced to the surrender value by mutual elimination) (Note: Here the premium payment is Rs.1,000, but Joint life policy and JLP reserve accounts will appear at Rs.300 on the either side of the Balance Sheet.) Third Year Jan 1 2002 Joint Life Policy account Dr.1,000 To Cash 1,000 (Premium paid on the policy) 31 Dec. 2002 P&L Appropriation account Dr.1,000 To Joint Life policy Reserve Account 1,000 (The reserve created against premium payment) 31st Dec.2001 Joint Life Policy Reserve Account Dr.550 Joint Life Policy Account 550 (Both JLP and Reserve reduced to the surrender value by mutual elimination) Fourth Year 1st January 2003 Joint Life Policy account Dr.1,000 To Cash (Premium paid on the policy
1,000
10 Feb 2003 Insurance Claim Account Dr.100,000 To Joint Life Policy 100,000 (Insurance Claim credited to policy account) 10 Feb 2003 Joint Life Policy Reserve Account Dr. 750 To Joint Life Policy Account 750 (Reserve account closed by transfer to policy account) Note: You can transfer the reserve directly to the capital accounts of partners.
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10 Feb 2003 Joint Life Policy Account Dr.100,000 To As Capital 39,600 To Bs Capital 39,600 To Cs Capital 19,800 (Joint Life policy closed by transfer to capital accounts) 15 Feb 2003 Bank Account Dr. 100,000 To Insurance Claim 100,000 (Insurance claim settled)
Joint Life Policy Account

Date Particulars 1Jan,2000 To Cash Amount Date 1,000 31 Dec2000 1,000 1,000 31 Dec, 2001 1,000 300 31 Dec, 1,000 2002 1,300 1 Jan 2003 To balance b/d To Cash 10 Feb To As Capital 2003 39,600 To Bs Capital 39,600 To Cs Capital 19,800 750 10 Feb 1,000 2003 By JLP Reserve By Insurance Claim Particulars Amount By JLP Reserve a/c 1,000 1,000 700 300 1,000 550 750 1,300 750 100,000
1 Jan 2001 To Cash
By JLP Reserve a/c By Balance c/d By JLP Reserve a/c By Balance c/d
1 Jan 2002 To balance b/d 31 Dec To Cash 2002
99,000
100,750
100,750
JLP Reserve Account

Date 31 Dec 2000 31 Dec Particulars To JLP Account Amount Date 1,000 31 Dec2000 1,000 700 31 Dec, Particulars By P&L Appropriation By P&L Amount 1,000 1,000 1,000
To JLP Account
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2001 31 Dec 2002
To Balance c/d To JLP Account To Balance c/d
10 Feb 2003
To JLP Account
300 2001 1,000 550 1 Jan, 750 2002 31 Dec, 2002 1,300 750 1 Jan, 2003 750
Appropriation By Balance b/d By P&L Appropriation 1,000 300 1,000
By Balance b/d
1,300 750 750
6. Adjustment of Capital Accounts

Capital accounts of the continuing partners may be readjusted on the basis of new profit sharing ratio. Generally partners bring in or take out cash to adjust the capital balances. They can even do this adjustment by opening current accounts and passing the surplus or deficiency there, without bringing in or taking out cash.
Chapter:4 dissolution of the partnership

Meaning of Dissolution
Dissolution of a partnership firm is the process by which the existence of a partnership firm comes to an end. This involves the sale or disposal of assets, settlement of liabilities and closing of books of accounts. Once the outside liabilities of the firm are settled, the partners take away their capital investment. If there is any surplus or deficit in this process it will be shared by the partners in their profit sharing ratio. Dissolution of a partnership firm can take place on account of any of the following reasons: a. Dissolution by Agreement: When the partners themselves reach an agreement to discontinue their business for whatever reason, it is known as dissolution by agreement. b. Compulsory Dissolution: Compulsory dissolution takes place when the business of the firm is declared illegal, or the partners become insolvent or the citizen of an enemy country happens to be partner of the firm. c. Dissolution by notice: A partner can demand dissolution of a partnership at will, by serving a notice to the firm. d. Dissolution by Court: Court may initiate dissolution of a firm under the following circumstances: i) When one of the partners has become of unsound mind ii) When a partner is guilty of misconduct which may affect the business iii) When a partner commits wilful breach of contract iv) Any other reason which the court may find adequate e. Dissolution by the expiry of a pre determined period or completion of event: This dissolution takes place in case of particular partnerships which are formed for a specific period or the completion of a specific project. Such partnerships will be dissolved at the completion of the specific period of or the project as the case may be. Dissolution of Partnership and Dissolution of Partnership Firm The term dissolution, referred in relation to a partnership business generally denotes the winding up of the business. However, there is a difference between dissolution of partnership and dissolution of the partnership firm. The former
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indicates ending of agreement only to replace it with a new one, but the latter indicates the ending of partnership business altogether. The following points may be noted in comparison between the two:
Dissolution of Partnership Only the agreement is dissolved, no physical disposal takes place. The partners will continue to run the business with a new agreement. Limited effect on employees or debtors and creditors of the business
Dissolution of Partnership Firm The Firm is dissolved, by selling off assets and settling liabilities. The partners will discontinue the business Since the business is closed down it affects the workers, debtors and creditors of the firm Dissolution of firm can take place only once in the lifetime of a partnership business. None of these events can lead to a compulsory dissolution of the firm.
Many dissolutions of agreement can take place during the life of a partnership business. Admission, retirement and or death of a partner can result in compulsory dissolution of existing agreement. Settlement of Accounts on Dissolution
The first step in dissolution is the realisation of assets followed by the settlement of outside liabilities. All individual accounts for assets and liabilities, except cash, are closed by transferring their balances to a Realisation Account. Realisation account is the temporary account for accumulating all assets and liabilities for convenient accounting treatment. All ledger accounts except partners capital accounts and cash account are closed prior to realisation procedure. Accumulated profits or losses are directly transferred into the capital accounts in the profit sharing ratio. The following is the order of priority in settlement of liabilities and capital upon dissolution: i) Expense incurred on realisation of assets such as commission, cartage, brokerage etc. ii) All outside creditors iii) Partners Loan accounts iv) Balances in Capital Accounts of partners
Special Items in Accounting for Dissolution 1. Realisation Account: This is the most important account prepared to facilitate dissolution of firms. This is equal in importance to Revaluation Account in Reconstitution. There is no scope of revaluation of assets and liabilities of a firm under liquidation. Realisation account is used to accumulate all assets and liabilities in one place for convenient accounting steps for disposal and settlement of liabilities. 2. Treatment of Goodwill: Goodwill is the most prominent item in Reconstitution of partnership. But goodwill does not have any special treatment in dissolution. If it appears in the books it has to be transferred into Realisation Account. This will automatically gets transferred into the Capital Accounts of Partners, by way of realisation profit or loss. If goodwill does not appear in the books it is just ignored. There is no meaning in raising it or treating it in any way when the firm is being dissolved. 3. Realisation Expenses: Expenses of realisation such as commission paid to brokers for the disposal of assets, expenses on transportation of items, registration documentation charges for the assets sold etc. are debited to Realisation Account and credited to Cash Account. However if any partner agrees to bear the expense for a certain fees, the fees charged by the
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partner becomes the common expense which is debited in Realisation Account; whereas the actual realisation expense, if mentioned, should be treated as personal drawing of the partner concerned. 4. Wifes Loan: Loans from a partners wife is to be treated as normal creditor. The basic aim of providing a loan in the name of partners wife is to by-pass the legal restrictions on the Loan from a Partner to the firm. 5. Provident Fund: Provident fund should be understood as a liability payable to the employees. It should be paid off even when the question is silent about its treatment. Same rule applies to all other outside liabilities, such as creditors, bills payable etc. 6. Specific Funds: Specific funds such as Investment Fluctuation Funds are preferably credited to Realisation account along with the transfer of related asset, which will get transferred to capital accounts by way of profit of loss on Realisation. Provision for doubtful debts, accumulated depreciation etc. must be credited to Realisation Account along with the transfer of assets. 7. Profits Kept Aside: General Reserve; credit balance in P& L Account etc should be directly transferred into the Capital Accounts of Partners, in the profit sharing ratio. 8. Unrecorded Assets: Unrecorded assets or assets which are completely written off may fetch some cash at the time of dissolution. There is no need of bringing them into books and selling them afterwards. It can be directly treated by crediting realisation account and debiting cash account. 9. Creditors Purchasing Some Assets in Part Settlement of Claim: When creditors purchase some of the assets in part settlement, this is not specifically recorded by way of a journal entry, since the asset and liability are appearing in the same Realisation Account. The balance amount due to the creditors is aid in full satisfaction of the claim. If the value of asset taken over is more than the amount due, the creditors will pay the excess amount to the firm. Please note: The treatment of creditors taking over part of the assets mentioned above is a questionable accounting treatment. What I mentioned above is only on examination point of view. The correct account treatment is to debit the Creditors account in the Ledger by passing a journal entry and transferring the balance of creditors into Realisation Account Profit or loss on realization will be transferred to the Capital Accounts of partners in the profit sharing ratio. At the final stage of the realization process, only Cash Account and Capital Accounts will be left. The final balances of each other will match exactly, and the cash will be paid off to capital accounts to close both the accounts. This is the last transaction in the books of the firm. The entire accounting steps in realization can be summarized as follows: Step 1: Reduce the Number of Accounts into THREE: As you are aware each item in a detailed Balance Sheet represents an account in the Ledger. You have to reduce them into just three accounts, namely i) Realisation Account ii) Capital Accounts of Partners (considered one account) iii) Cash Account Step 2: Reduce the Number of Accounts into TWO: Major activities of realisation process take place at this stage. Sell assets one by one and add it to (debit) Cash and reduce it from (credit) Realisation Account. Take out cash and pay to liabilities placed in the Realisation Account. Now the Realisation Account is reduced to a residue, without any active accounts inside. This balance is transferred into capital accounts as realisation profit or loss. Now you have only two accounts, the Cash Account and the Capital Account. Step 3: Reduce the Number of Accounts to NIL: This is the most interesting step. Here the cash balance has to be exactly equal to the credit balance in capital account. Take out cash (cr); Pay off Capital (Dr.), and there ends the Partnership Business. Journal Entries in Dissolution
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Accounting for dissolution begins with the closing of assets and liabilities accounts by transferring them to Realisation Account. i) For transfer of assets Realisation Account Dr. To Asset Account ii) For Transfer of liabilities Liability Account Dr. To Realisation Account Accumulated profits such as General Reserves, Profit and Loss Account Credit Balance etc. are transferred to capital Accounts in the profit sharing ratio. iii) For transfer of accumulated profits Accumulated Profit Account (General Reserve; P&L etc.) Dr. To Realisation Account Note: Provision for doubtful debts; Investment fluctuation fund etc. are credited to realization account and ignored thereafter. These are internal provisions having no claim against the firm and therefore these amounts will merge into realization profit or loss and finally get transferred to Capital Accounts of partners. iv) For assets realized Cash/Bank account Dr To Realisation Account Note: We do not have separate asset account anymore. Realisation account is the common account representing all assets and liabilities transferred into it. Please check the next entry also. v) For Liabilities paid off Realisation Account Dr. To Cash Account vi) For asset taken over by a partner Partners Capital Account Dr. To Realisation Account vii) For Liability taken up by the partner Realisation Account Dr. To Partners Capital Account viii) For unrecorded asset taken over by a partner Partners Capital Account Dr. To Realisation Account ix) Unrecorded Liability settled by the firm Realisation Account Dr. To Cash account x) Realisation expense Realisation Account Dr. To Cash xi) Asset taken over by creditors No entry; Only settlement of balance amount is shown in the books. Authors Comment
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This is the easiest chapter in Partnership accounts. You have 10 marks for this chapter under revised syllabus. Here you need not remember different methods of treatment of goodwill, no ratio calculations etc. Everything is plain and simple. Pay serious attention to this chapter to secure full 10 marks. Look at some of the important adjustments in the previous chapters becoming very simple here. 1. Goodwill You must have spent maximum time in understanding various ways of treatment of goodwill in the earlier chapters. Here it is very simple; if there is goodwill given in the Balance Sheet, just debit it in the realisation account and forget it, yes, forget it. If it does not appear in the Balance Sheet, just ignore it; who cares about the goodwill of a firm under liquidation anyway? Simple, simple indeed! 2. Old Ratio, New Ratio, Sacrificing Ratio, Gaining Ratio, any other ratio? See the long list of ratios you need NOT apply here. You have just one profit sharing ratio, to transfer the profit or loss on realisation. 3. Revaluation: You need not struggle with the revaluation of assets and liabilities. There are no provisions to be kept. Here you just have a Realisation Account to move your ledger account items for the time being to help you transfer them to cash as and when realised. 4. Balance Sheet In dissolution you have to prepare NO Balance Sheet at all. Instead you have to destroy one Balance Sheet given in the question. Too good to be true, but it is very true. What you have to do here is to break up old Balance Sheet, extract cash out of it, pay to creditors and finally to owners. Remember how funny it looked when you played video cassettes in reverse mode, cars running backwards at full speed, food taken out of mouth and put back into plate and all those funny stuff. Dissolution is the action replay of partnership formation in the reverse mode. The process of forming cash and other assets and liabilities in a business forming a Balance Sheet in the beginning of a business is now reversed to show how a Balance Sheet melts into cash, finally goes from the cash box to the owners pockets as return of capital.

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PARTNERSHIP ACCOUNTS

Date 2002 Dec 31

Particulars To Balance c/d

Date 2002 Jan1

Particulars By Balance b/d

Abrahams Current Account

b. Fluctuating Capital Abrahams Capital Account

2002 18,100 Jan 01 200 Dec 31 35,000 Dec 31 Dec 31 53,300

Profit & Loss Appropriation A/c

a. When capital accounts are fluctuating.

b. When capital accounts are fixed

Particulars To Interest on Cap A B

Amount Particulars 4,500 By P&L account 3,000 By Interest on Drawings A B

Amount 22,110 240 150

To Net Divisible Prof. A B

7,500 7,500 22,500

To Drawings To Int. on drawings To balance c/d

75,000 50,000 4,500 7,500 3,000 7,500

PARTNERSHIP ACCOUNTS Profit & Loss Appropriation A/c

Particulars To Interest on capital A B To Net Profit A B

18,000 Amount 15,000 900 8,100 24,000

Particulars To Drawings To balance c/d

Particulars To drawings To balance c/d

Amount 15,000 900 8,100 24,000

Amount 44,000 400 250

A's Capital Account

To Drawings To Int on drawings To Net loss To balance c/d

75,000 12,000 9,000

B's Capital Account

To Drawings To Int on drawings To Net loss To balance c/d

50,000 18,000 6,000

PARTNERSHIP ACCOUNTS Interest to be credited The amount to be debited (7500/3)

Page |7 3,000 2,500 3,000 2,500 1,500 2,500 7,500 7,500

500(Cr.) 500 (Cr.) 1,000(Dr)

The amount to be debited (15000 at 2:2:1 1,000(Dr.)

PARTNERSHIP ACCOUNTS Illustration 1.08

Interest to be credited The amount to be

debited (10,000 at 2:1:1 Net adjustment 1,000(Dr.) 1,500(Cr.) 500(Dr) 0

(Adjustment for rectification of omission

Excess interest to debit (2%) The credit total amount to

PARTNERSHIP ACCOUNTS (2000 at 2:2:1

Interest to credited @2% Interest on Drawings

3.2 Redistribution of Profit in a Different Ratio

reversed Dr. The equally Cr. redistributed

3.3 Omission of Outstanding Expenses and Incomes

PARTNERSHIP ACCOUNTS iv)

To Outstanding Expenses (Rectification of omission)

3,500 By Prepaid expense By Net adjustment A 1,000 B 3,500 C 500 500

To P&L Adjustment Account (Net difference transferred)

Profit and Loss Adjustment Account

6,000 By Acc. Interest By Net adjustment A 500 B 6,000 C 500 500

Particulars By P & L Account

Particulars To A's Capital (34,000x3/5) To B's Capital (34,000x2/5) To C's Capital

Amount Particulars 20,400 By P & L Account 13,600 8,000 42,000

Profit & Los Appropriation A/c

Amount Particulars 2,400 By P&L Account 1,800 1,200

875 8,250 875

10,000 38,400 38,400

Particulars To Interest on Capitals: A B

Amount Particulars 2,400 By P&L Account 1,800 1,200