Reconstitution of a Partnership Firm

Reconstitution of a Partnership Firm

It means building partnership in a new way. If there is a change in the partnership agreement, it brings to an end of the existing partnership and a new agreement comes into force, because partnership is the result of an agreement between persons for a business. This change also changes the relationship of partners. In that case partnership continues with reconstitution. It may happen due to following circumstances:

·        When partners decide to change their profit sharing ratio.

·        When a new partner is admitted to the firm.

·        When an existing partner decides to take retirement from the firm.

·        When a partner dies.

·        When two or more firms decide to amalgamate.

In all these cases, the profit sharing ratio of partners changes from their existing ratio. Firm continues its business but with a different agreement. Let’s discuss in detail.

Change in the Profit Sharing Ratio among the existing Partners

Sometimes the existing partners decide to change their profit sharing ratio. This change results in sacrifice or gain for partners. Some partners may acquire extra share in Profit i.e. gain and some partners may have to lose their share i.e. sacrifice. The reasons for change in profit sharing ratio can be change in capital contribution, active participation in the management of business of the firm etc.in that case equity is maintained among the partners. So it is necessary to make some adjustments in assets & liabilities, profit & losses etc.

Some adjustments which are required at that time are:

·        Determination of Sacrificing or Gaining ratio

·        Accounting for Goodwill

·        Accounting treatment of Reserves and Accumulated Profits

·        Accounting for Revaluation of Assets & Liabilities

·        Adjustment of Capitals

When a new partner is admitted to the firm:

Admission of a new partner into the existing firm is possible only when all the existing partners are ready for it. It is one of the modes of reconstitution of the firm. A new partnership deed is prepared at that time because the old one comes to an end. Due to following reasons a new partner is needed into the business:

·        When more capital is needed for the expansion of the business.

·        When a competent and experienced person is needed for the efficient running of the business.

·        To encourage a capable employee by taking him into the partnership.

·        To increase the Goodwill and reputation of the business by taking a reputed and renowned person into partnership.

At the time of admission, the new partner also brings his share of goodwill along with his capital. Therefore, old partners have to sacrifice a share of their profits in favour of the new partner. New partner gets a share in the future profits of the firm.

Some adjustments are needed at the time of the admission of a new partner. These are:

·        Calculation of new profit sharing ratio of the partners

·        Accounting treatment of goodwill

·        Accounting treatment for revaluation of assets and liabilities

·        Accounting treatment of reserves and accumulated profits

·        Adjustment of capitals on the basis of new profit sharing ratio

Valuation of Goodwill - partnership accounting

Valuation of Goodwill

Goodwill is an intangible asset. Therefore it is very difficult to assess the value of it. Its value depends on the seller & purchaser’s mutual agreement. There are different methods of valuing goodwill. Some are discussed as below:

1.     Average Profit Method: This is a very simple method. Goodwill is calculated on the basis of the no. of past years profits. Because past profits indicate as to what profits are likely to accrue in the future. Therefore past profits are averaged. Average of such profits is multiplied by the agreed no. of years to find out the value of goodwill.

Value of Goodwill = Average Profit × Number of Years of Purchase

Some adjustment should be done while calculating the average profit:

·        Abnormal income of a year should be deducted out of the net profit of that year.

·        Abnormal loss of a year should be added back to the net profit of that year.

·        Income from investments should be deducted out of the net profit of that year.

Example: X sold his business to Y. Calculate the value of goodwill taking into consideration the following factors:

·        Goodwill is valued at three years purchase of the average profits of the last four years. Profits of the last four years were as : year 2011 – ₹40,000, year 2012 – ₹58,000, year 2013 – ₹53,000, year 2014 – ₹62,000.

·        Abnormal loss of ₹2,000 due to theft has reduced the profits of the year 2011.

·        Profits for the year 2012 include abnormal profit of ₹4,000.

·        A speculative and lottery profit of ₹5,000 was received during the year 2013 which was included in that year’s profit.

·        Profits of the year 2014 were reduced by ₹10,000 of the depreciation on such a machinery which was destroyed by the fire during the year.

Solution: Valuation of Goodwill

                                                                             ₹                     ₹

              Profit for 2011                             40,000              

Add:     Abnormal Loss                               2,000                42,000

             Profit for 2012                              58,000

Less:    Abnormal Gain                               4,000                54,000

             Profit for 2013                              53,000

Less:    Abnormal Gain                               5,000                48,000

             Profit for 2014                              62,000

Add:     Abnormal Loss                             10,000               72,000

              Total Profit                                                                 2,16,000

Average Profits = ₹ 2,16,000 / 4  = ₹ 54,000

Goodwill at 3 years purchase = ₹ 54,000 × 3 = ₹ 1,62,000       

                       

2.     Weighted Average Profit Method: It is considered better than the simple average profit method because each year’s profit is assigned a weight and highest weightage is given to the latest year. Then the each year’s profit is multiplied by the weight assigned to it and the total of their product is then divided by the total of weights in order to calculate the weighted average profits. Then goodwill is calculated by multiplying the weighted average profit obtained with the no. of year’s purchase agreed.

 

Weighted Average Profit=Total of Products of Profits/Total of Weights

           Goodwill = Weighted Average Profit × No. of Year’s of Purchase 

Example: The profits earned by a firm during the last four years were as follows:

Year ended 31^st March                         Profits (₹)

2009                                                             80,000

2010                                                           1,00,000

2011                                                           1,10,000

2012                                                           1,50,000

Calculate the value of goodwill on the basis of 3 year’s purchase of weighted average profits. Weights to be used 1, 2, 3 and 4 respectively to the profits for 2009, 2010, 2011 and 2012.

Solution: Valuation of Goodwill

Year ended 31^st March                   Profits (₹)             Weight               Products

2009                                                    80,000                     1                         80,000

2010                                                 1,00,000                     2                      2,00,000

2011                                                 1,10,000                     3                      3,30,000

2012                                                 1,50,000                     4                      6,00,000

                                                                                             10                   12,10,000

Weighted Average Profit = 12,10,000 / 10 = ₹ 1,21,000

Goodwill = ₹ 1,21,000 × 3 = ₹ 3,63,000

This method is preferred when the profits over the past 4 or 5 years have been continuously rising or falling.

3.     Super Profit Method: In this method goodwill is calculated on the basis of super profits. Super profit is the profit which a firm earns over normal profit. If it has no excess profit then it will have no goodwill. Goodwill is calculated by multiplying the super profits by a reasonable no. of years purchase.

Normal Profit = Capital Invested × Normal Rate of Return/100

 

Super Profit = Actual or Average Profit – Normal Profit

 

Goodwill = Super Profit × No. of years purchase

Example: A partnership firm earned net profits during the last four years as follows:

Year                                                            Profits (₹)

1                                                                                                                  56,000

2                                                                                                                  64,000

3                                                                                                                  60,000

4                                                                                                                  62,000

The Capital investment in the firm throughout the above mentioned period has been ₹ 3,00,000. Having regard to the risk involved, 15% is considered to be a fair return on capital. Calculate the value of goodwill on the basis of 3 years’ purchase of average super profits earned during the above mentioned 4 years.

Solution: Total Profits of four years=₹56,000+₹64,000+₹60,000+₹62,000

                                                                 = ₹ 2,42,000

Average Profit = ₹ 2,42,000 / 4 = ₹ 60,500

Normal Profit = 3,00,000 × 15 / 100 = ₹ 45,000

Super profit = ₹ 60,500 – ₹ 45,000 = ₹ 15,500

Value of Goodwill = 15,500 × 3 = ₹ 46,500

4.     Capitalisation of Average Profit Method:  In this method, Goodwill is calculated by deducting the actual capital employed from the capitalized value of average profits. First we calculate average profits and then we capitalized it on the basis of normal rate of return.

Capitalized value of Average Profit=Average Profits×100/Normal Rate of Return

Capital Employed = Assets – Liabilities

Goodwill = Capitalized Value of Average Profits – Capital Employed

There will be no goodwill if the actual capital employed in the business exceeds or equals the capitalized value of average profits.

Example: The average profit of a firm is ₹ 48,000. The total assets of the firm are ₹ 8,00,000. Value of other liabilities is ₹ 5,00,000. Average rate of return in the same business is 12%. Calculate the goodwill from capitalization of average profits method.

Solution: Capitalized value of Average profits=₹48,000×100/12=₹4,00,000

Capital employed = ₹ 8,00,000 – ₹ 5,00,000 = ₹ 3,00,000

Goodwill = ₹ 4,00,000 - ₹ 3,00,000 = ₹ 1,00,000

5.     Capitalisation of Super Profit Method: In this method Goodwill is calculated on the basis of super profits. We have to calculate the capital needed for earning of super profits on the basis of normal rate of return. This capitalized value of super profit is actually called the Goodwill.

Super Profit = Average Profit – Normal Profit

Goodwill = Super Profit ×100 / Normal Rate of Return

Example: From the figures given below, calculate goodwill according to the capitalization of super profit method:

(i)                Actual Average Profits = ₹ 72,000

(ii)              Normal Rate of Return = 10%

(iii)            Assets = ₹ 9,70,000

(iv)            Liabilities = ₹ 4,00,000

Solution: Capital Employed = Assets – Liabilities

                                                  = ₹ 9,70,000 - ₹1,00,000 =₹ 5,70,000       

Normal Profit=Capital Employed×Normal Rate of Return/100

                          = ₹ 5,70,000 × 10 / 100 = ₹ 57,000

Super Profit = Average Profit – Normal Profit

                       = ₹ 72,000 - ₹ 57,000 = ₹ 15,000

Goodwill = Super Profit×100/Normal Rate of Return

                 = ₹ 15,000×100/10 = ₹1,50,000

 

Goodwill - Partnership accounting

GOODWILL

It means the reputation of a firm. It can be earned by a firm through the hard work and honesty of its owners. If the customers feel satisfied with the services of a firm they will come again and again. So we can say that Goodwill is the value of the reputation of a firm in respect of the profits expected in future over and above the normal profits earned by the other similar firms belonging to the same type of industry.

Main features:-

·        It is an intangible asset like patents, trademarks, copy rights etc.

·        It is a valuable asset. It can be purchased or sold with any other asset.

·        It is helpful in earning excess profits.

·        It cannot be sold in part. It can be sold with the entire business only.

·        The value of goodwill may fluctuate from time to time. It does not remain constant.

·        It is difficult to place an exact value of goodwill because it is fluctuating due to changing circumstances of the business.

·        It is not a fictitious asset. It has a value in case of profit making concerns.

 

CATEGORIES OF GOODWILL

There are two main categories of goodwill.

1.     Purchased Goodwill:

·        It arises on purchase of a business. It is acquired by making a payment.

·        It is recorded in the books of accounts because consideration is paid for it.

·        It is shown in the Balance Sheet in Assets side.

·        It can be amortized i.e. depreciated over its useful life.

·        It can be calculated by the excess of purchase consideration over its net assets on the time of purchase of a business.

 

2.     Self-Generated or Inherent Goodwill:

·        It is internally generated over a long period of time.

·        It arises from attributes of an on-going business.

·        Its valuation depends upon the judgement of the valuer.

·        It is not recorded in the books of accounts as per AS-26.

Factors affecting the value of Goodwill: Many factors are there which can be affect the value of a firm’s goodwill. Main are:

·        Location of the Business

·        Management’s efficiency

·        Nature of goods dealt by business firm

·        Possession of import-export licence

·        Longevity of the business i.e. how old your business is?

·        Risk involved in the business

·        Monopolististic & other special rights such as patents, trademarks, copyrights, concessions etc.

·        Increasing trend of profits

·        Possibility of increased future competition

·        Good industrial relations

·        Amount of capital required for the business

·        Favourable Government regulations

·        Research and Development efforts by the firm

·        Effective advertising to establish brand popularity

·        Stable political conditions of the country

·        Popularity of product in terms of quality

Need for valuation of Goodwill:- In partnership, need for valuing the goodwill arises:-

·        When there is a change in the profit sharing ratio among the existing partners;

·        When the firm is sold;

·        When a partner retires or dies;

·        When a new partner is admitted;

·        When the firm is amalgamated with another firm.