RECONSTITUTION OF PARTNERSHIP FIRM ----Change in Profit Sharing Ratio----

Topics covered:

v  Introduction

v  Calculation of Sacrificing Ratio and Gaining Ratio

v  Methods of valuation of Goodwill

v  Treatment Goodwill

v  Distribution of Accumulated Profit and Reserves

v  Revaluation of Assets & Reassessment of Liabilities

v  Treatment of Joint Life Policy

v  Adjustment of capital

v  Introduction

There is no restriction as per the Indian Partnership Act 1932, if the partners decided to change their profit sharing ratio. The old partners may change their profit sharing ratio through mutual understanding but this change may result in the sacrifice or gain to any partner. Hence the gaining partner must compensate the losing partner by way of goodwill.

v  Calculation of Sacrificing Ratio and Gaining Ratio;

That part of total profit share which is surrendered is called ‘Sacrificing Ratio’ while the share gained by each partner is called ‘Gaining Ratio’.

 

 SACRIFICING RATIO = OLD  RATIO  - NEW RATIO 

 v  Goodwill

Goodwill means the ‘good-name’ or the reputation earned by a firm through the hard work and honesty of its owners. If a firm renders good service to the customers, the customers who feel satisfied will come again and the firm will be able to earn more profits in future.

Thus, goodwill is the value of the reputation of a firm, which enables it to earn higher profits in comparison to the normal profits earned by other firms in the same trade.

Goodwill is an intangible real asset. It perhaps the most intangible of the intangibles. But it is not a fictitious asset. Goodwill is an asset, which has countless definitions.

According to Lord Macnaghten, “Goodwill is a thing very easy to describe, very difficult to define. It is the benefit and advantage of the good name, reputation and connections of a business. It is the attractive force, which brings in customers. It is one thing, which distinguishes an old established business from a new business at its first start.”

Lord Eldon says, “Goodwill is nothing more than the probability that the old customers will resort to the old place.”

In the words of Spicer and Pegler, “Goodwill may be said to be that element arising from the reputation, connection or other advantage possessed by a business which enables it to earn greater profits than the return normally to be expected on the capital represented by the net tangible assets employed in the business.”

Thus, goodwill may be described as the extra saleable value attaching to a prosperous business beyond the intrinsic worth of the net marks, copyrights, concessions, etc. It is non-visible. It does not become obsolete but it is subject to fluctuations. 

Write a short note on nature of goodwill.

Goodwill is an intangible asset, as it cannot be seen. It is not fictitious in the case of profitable concerns. It can be sold, though a sale will be possible only along with the sale of business itself.

v  Methods of valuation of Goodwill

(a)      Average Profits Method;

(b)      Super Profits Method;

(c)      Capitalization Method;

QUESTIONS FOR SELF PRACTICE

Problem 1.  Aditya and Isha are partners in a firm. State by giving reasons whether their claims are valid if partnership deed is silent in the following matters:-

(a)   Isha had advanced a loan to the firm. She claims interest at the usual interest rate charged by banks. The rate of interest is 12% p.a.

(b)   Aditya wants to introduce his brother Anuj into the business. Isha objects it.

(c)    Aditya spends twice the time that Isha devotes to the business. He wants a salary of Rs.2,000 per month for the extra time spent by him.

(d)   Aditya has invested Rs.3,00,000 and Isha only Rs.30,000 as capital. Aditya wants interest on capital @ 12% p.a.

(e)    Aditya used Rs.20,000 belonging to the firm and suffered a loss of Rs.5,000 in speculation. He wants to return only Rs.15,000.

(f)     Aditya wants to purchase goods from Oscar for the firm but Isha does not agree.

(g)   Aditya wants that profits should be shared in the capital ratio.

(h)   Aditya wants to inspect the books of the firm but Isha declines.

(i)     Aditya used the car of the firm for personal purpose and incurred a loss of Rs.2,000 and wants to record in the firms books.

(j)     Isha spent a week in a holiday resort with her family; wanted to record those expenses in firm’s books. Aditya object it.

Preparation of Profit & Loss Appropriation Account and Capital Accounts

Problem 2. The partnership agreement of Bunty and Babli provides that:

(a)   Profit will be shared equally.

(b)   Bunty will be allowed a salary of Rs.400 p.m.

(c)    Babli who manages the sales department will be allowed a commission equal to 10% of the net profit after allowing Bunty’s salary.

(d)   7% interest will be allowed on partner’s fixed capital.

(e)    5% interest will be charged on partner’s annual drawings.

(f)     The fixed capitals of Bunty and Babli are Rs.1,00,000 and Rs.80,000 respectively. Their annual drawings were Rs.16,000 and Rs.14,000 respectively. The net profit the year ending March 31, 2002 amounted to Rs.40,000.

Problem 3. Shyam and Kanwal are partners in Ultimate Success Point sharing profits in the ratio of 2:1 with capitals of Rs.20,000 and Rs.10,000 respectively. Each partner is entitled to 8% interest on his capital. Shyam is entitled to a salary of Rs.600 p.m. together with a commission of 10% of the Net Profit before charging any commission. Kanwal is entitled to a salary of Rs.500 p.m. together with a commission of 10% of Net profit after charging all commissions. The profits for the year prior to calaculation of interest on capital but after charging salary of partners amounted to Rs.8,000. Prepare Profit and Loss Appropriation A/c and Partners’ Capital Accounts: (i) When capitals are fixed, and (ii) When capitals are fluctuating.

Problem 4. Nidhi and Nisha are partners in a firm, sharing profits and losses in the ratio of 3:1. On April 1,1999 they had capitals of Rs.30,000 and Rs.60,000 respectively and on the same date their current accounts balances appears as Rs.30,000 (cr.) and Rs.15,000 (cr.) The profit and loss account of the firm for the year ending March 31,1999 shows a net profit of Rs.1,50,000. Interest on capitals was allowed @ 5% p.a. and interest on drawings was to be charged @ 6% p.a. at an average of six months. The partners Rs.12,000 to Nidhi and Rs.9,000 to Nisha. Prepare the Profit and Loss Appropriation Account and Loss show the partners’ currents accounts.

Problems 5. Anupam and Neeraj were partners in a firm sharing profit in the ratio of their capitals contributed on commencement of business, which were Rs.80,000 and Rs.60,000 respectively. The firm stared business on April 1,2005. According to the partnership agreement interest on capital and drawings are 12% and 10% p.a. respectively. Anupam and Neeraj are to get a monthly salary of Rs.2,000 and Rs.3,000 respectively. The profits for year ended March 31,2002 before making above appropriation was Rs.1,00,300. The drawings amounted to Rs.2,000 for Anupam and Rs.2,500 for Neeraj. Prepare Profit and Loss Appropriation Account and partners’ capital accounts assuming that their capitals are fluctuating.

Problems 6. Krishan and Radha started partnership business on 1^st January, 2002. They contributed Rs.80,000 and Rs.60,000 respectively as their capitals. The terms of the partnership agreement are as under:-

(a)   Interest on Capital and drawings @ 12% per annum.

(b)   Krishan and Radha to get a monthly salary of Rs.2,000 and Rs.3,000 respectively.

(c)    Sharing of Profit or loss will be in the ratio of their capital contribution.

The Profit for the year ended 31^st December 2002, before making above appropriation was Rs.1,00,300. The drawings amounted to Rs.2,000 for Krishan and Rs.2,500 for Radha.

Prepare Profit & Loss Appropriation Account and Partners’ Capital Account assuming that :

(a)   their capitals are fluctuating

(b)   their capitals are fixed.

Calculation of interest on drawings

Problem 7. Calculate the interest on Drawing of Rhythm @ 10% p.a. for year ended    31^st Dec. 2002 in each of the following cases:

(a)   If his drawings during the year were Rs.24,000;

(b)   If he withdrew Rs.2,000 p.m. in the beginning of every month.

(c)    If he withdrew Rs.2,000 p.m. at the end of every month.

(d)   If he withdrew Rs.2,000 p.m.;

(e)    January 31^st – Rs.6,000; March 31^st – Rs.4,000; July 1^st – Rs.8,000; Sept. 30^th – Rs.3,000; November 1^st – Rs.5,000.

Problem 8. Amit and Sumit are partners in a firm. They share profits and losses in the ratio of 3:2. As per their partnership agreement, interest on drawings is to be charged       @ 10% p.a. Their drawings during 2002 were Rs.48,000 and Rs.32,000 respectively. Calculate interest on drawings based on the assumption that the amounts withdrawn evenly throughout the year.

Problems 9. Francis is a partner in a firm. He withdraws the followings amounts during the year 2002: February 1^st - Rs.2,000; May 1^st - Rs.5,000; June 30^th - Rs.2,000; October 31^st - Rs.2,000; December 31^st - Rs.2,000. Interest on drawings is to be charged @ 7 ½ % p.a. Calculate amount of interest to be charged on Francis’s drawings for year 2002.                             

Problems 10. Shyam and Kanwal of Ultimate Success Point, D- 15/138, Sector – 3, Rohini, are partners in a firm. They share profits and losses equally. Their monthly drawings are Rs.4,000 each. Interest on drawings is to be charged @ 10% p.a. Calculate interest on Shyam’s drawings for the year 1989 assuming drawings are made:

(a)   in the beginning of every month,

(b)   in the middle of every month,

(c)    at the end of every month,

(d)   in the beginning of every quarter, and

(e)    at the end of every quarter.

Calculation of interest on capital

Problems 11.  Hindu and Muslim are partners sharing profits equally. Their capitals as on April 1, 2006 were Rs.5,00,000 and Rs.3,00,000 respectively. On July 1, 2006, they decided that their capitals should be Rs.4,00,000 each. The necessary adjustments in the capitals were made by introducing or withdrawing cash. Interest on capital is allowed at 8% p.a. Compute interest on capital for both the partners for the year ending on March 31, 2007.              

Problem 12. On March 31, 2003 after the close of books of accounts, the capital account of Jitender, Akhil and Varun showed balance of Rs.12,000, Rs.9,000 and Rs.6,000 respectively but, it was later discovered that interest on capital @ 5% p.a.  had been omitted. The profit for the year ended March 31, 2003 amounted to Rs.18,000 and the partners’ drawings had been Jitender Rs.1,800. Akhil Rs.2,250 and Varun Rs.1,350. The profit sharing ratio was 3:2:1. Calculate interest on capital

Calculation of Salary or commission to partners

Problem 13. Kanwal and Jeet are partners in a firm. Kanwal is to get a commission of 10% of Net Profit before charging any commission. Jeet is to get a commission of 10% on Net Profit after charging all commissions. Net Profit before charging all commission was Rs.55,000. Find out the commission of Kanwal and Jeet.

Calculate of Salary or Commission to partners

Problems 14. X and Y are partners sharing profits and losses in the ratio of 2:3 with capital of Rs.20,000 and Rs.10,000 respectively. On 1^st July, 2002 X and Y granted loan of Rs.40,000 and Rs.20,000 respectively to the firm. Show the distribution of profit/losses for the year 2002 in each of the following alternative cases:

(a)   If the profit before any interest for the year amounted to Rs.2,100.

(b)   If the profits before any interest for the year amounted to Rs.1,500.

(c)    If the losses before any interest for the year amounted to Rs.1,500.

Calculation of Capital Ratio

Problems 15. On 1^st January, 2001 L, M and N start a business in partnership. L puts in Rs.30,000 at first but withdraws Rs.10,000 at the end of six months. M introduces Rs.25,000 at first and increases it to Rs.55,000 at the end of four months but withdraws Rs.10,000 at the end of eight months. N brings in Rs.25,000 at first but increase it by Rs.20,000 at the end of seven months. During the year ended 31^st December, 2002 they make a Net Profit of Rs.36,000. Show how the partners should divide this amount on the basis of effective capital employed by each partner.

Treatment of Past Adjustments

Problem 16. The capital accounts of Saurabh, Mohit and Rahul stood at Rs.10,000; Rs.7,500; Rs.5,000 respectively after the necessary adjustments in respect of the drawings and the net profit for the year ended 31^st December, 1991. It was subsequently ascertained that 5% interest on capital and on the drawings of each partner had been omitted. The drawings of the partners have been: Saurabh Rs.1,000, Mohit Rs.750 and Rahul Rs.600. The interest on these amounted to Rs.20; Rs.15 and Rs.7.50 respectively. The profit for the year as already adjusted amounted to Rs.5,000. The partners share profits in the ratio of 2:2:1. Give the journal entries necessary for the above adjustment and show your workings clearly.

Problem 17. Jasleen, Harleen and Loveleen sharing profits & lossess equally have capitals of Rs.1,20,000, Rs.90,000 and Rs.60,000. For the year, 2001, interest was credited to them @ 12% p.a. instead of 10% p.a. Give adjusting entry.

Problem 18. Profits earned by a partnership firm for the year ending 31^st December 1993 were distributed equally among the partners – Nidhi & Nisha – without allowing interest on capital (Rs.3,000 due to Nidhi and Rs.1,000 due to Nisha). Pass an adjusting entry.

Problem 19. A and B are partners in a firm. Their respective capital contributions are Rs.3,00,000 and Rs.1,50,000 and their profit sharing ratio is 3:2. Immediately after the allocation of Rs.90,000 as profit for the year ended 31^st December 2001, it was discovered that in arriving at the profits for 2001 the following two items had been ignored:

(a)   Outstanding expenses of Rs.7,000 and

(b)   Accrued interest on investment of Rs.4,000.

Pass adjusting journal entries.

Problems 20. Sun, Moon and Star are partners. They have omitted on capital @ 10% p.a. for three years ended 31^st December, 2003. Their fixed capital on which capital on which interest was to be calculated throughout were Sun Rs.10,000, Moon Rs.8,000 and Star Rs.7,000. Their profit sharing ratios were – 2001 – 1:2:2; 2002 – 5:3:2; 2003 – 4:5:1. Give the necessary adjustment journal entry.

Problem 21. On December 31, 2001 the capital accounts of Ena, Meena and Deeka after making adjustments for profits, drawings, etc. were as, Ena – Rs.80,000, Meena – Rs.60,000, and Deeka – Rs.40,000. Subsequently, it was discovered that interest on capital and interest on drawings had been omitted. The partners were entitled to interest on capital @ 5% p.a. The drawings during the year were: Ena – Rs.20,000; Meena – Rs.15,000 and Deeka – Rs.9,000. Interest on drawings chargeable to the partners was Rs.500, Rs.360 and Rs.200 respectively. The net profit during the year amounted to Rs.1,20,000. The profit sharing ratio of the partners was 3:2:1. Record the necessary adjustment entries for rectifying the above errors of omission. Show your workings.

Problem 22. Simran and Kanwal are equal partners. Their capitals are Rs.40,000 and Rs.80,000 respectively. After the accounts for the year have been prepared it is discovered that interest at 5% p.a. as provided in the partnership agreement has not been credited to the capital accounts before distribution of profits. It is decided to make an adjustment entry at the beginning of the next year. Record the necessary journal entry.

Calculate of Guarantee to a partner

Problem 23. X, Y and Z are partners in a firm. Their profit-sharing ratio is 5:3:2. However, Z is guaranteed a minimum amount of Rs.10,000 as share of profit every year. Any deficiency arising on that account shall be met by Y. the profits for the two years ending 31^st December 1993 and 1994 were Rs.40,000 and Rs.60,000 respectively.

Prepare Profit and Loss Appropriation Account for the two years.

Problem 24. Alpha, Beeta and Gama are partners in a firm. Their profit sharing ratio is 2:2:1. However, Gama is guaranteed a minimum amount of Rs.10,000 as share of profit every year. Any deficiency arising if any, on that account shall be met by Beeta. The profits for two year ending December 31,2000 and 2001 were Rs.40,000 and Rs.60,000 respectively. Prepare the Profit and Loss Appropriation Account for the two years.

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Calculation of interest on Capital, interest on capital and interest on drawings

Calculation of interest on Capital

Note: Interest on Capital will be allowed on Capital in the beginning unless and otherwise stated.

Calculation of Capital in the beginning:

Particulars	Amount
Capital at the end of the year Add: Drawings made during the year Add: Interest on drawings for the year (if any) Add: Capital withdrawn during the year Less: Additional Capital introduced during the year Less: Profit share earned during the year Less: Interest on capital for the year (if any) Less: Loss incurred during the year	xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx
Capital in the beginning of the year  (Opening Capital)	xxxxx

Calculation of Salary or Commission to Partners

·         When to Allow – Salary or Commission to a partner is to be allowed if the partnership agreement provides for the same.

·         Nature of Payment – Salary or Commission to a partner is an appropriation out of profits and not a charge against the profits. In other words. It is to be allowed only if there are profits.

·         Calculation:

Case 1. Commission as % of Net Profit before charging such Commission

                                          = Net Profit before Commission × Rate of Commission

                                                                                                             100

Case 2. Commission as % of Net Profit after charging such Commission

                                         = Net Profit before Commission ×  Rate of Commission         

                                                                                                 100 + Rate of Commission

 Calculation of Interest on Partners’ Loan to Firm

·         Rate of Interest – In case, any partner has given a loan to firm; he is entitled to an interest on such loan at an agreed rate of interest. If there is no agreement as to rate of interest on loan, partner is entitled to interest on loan @ 6% per annum [Sec 13 (d)].

·         Nature of Interest – It may be noted that such interest on loan is a charge against the profits. In other words, such interest is to be allowed whether there are profits or not.

 Calculation of Capital Ratio

Sometimes, the partners decide to share the profits and losses of the firm in the capital ratio. When the capitals are fixed, the profits and losses are shared in the ratio of fixed capitals. But when the capitals are fluctuating and partners introduce or withdraw capital during the year, the effective Capital Ratio is calculated with reference to the time period for which capital has been used in business.

 Treatment of Past Adjustments

If after the final accounts have been prepared and the profits have already been distributed, some omission or commission are found in respect of interest on capital, interest on drawings, interest on partners’ salary or commission or change in the provisions of partnership deed or change in the system of accounting is required, the necessary adjustment can made either through profit and loss adjustment account or directly through the capital accounts of the concerned partner.

Sometimes, after the accounts for the year have been made up, it comes to light that some matters are left out of consideration by mistake or have been omitted or allowed/ charged at a higher or lower rate, profits and losses have been distributed in one year or in several years among the partners in a wrong proportions, and so on.

Calculation of Guarantee of minimum profit to a partner

Sometimes a partner may be guaranteed a minimum amount of his share in Profit. Such a partner to whom such guarantee has been provided is called ‘Guaranteed Partners’. The partner(s) who has (have) given such guarantee is (are) called ‘Guaranting Partners’ Such minimum amount is called ‘Guaranteed Amount’. One or some or all of the partners in an existing profit sharing ratio or in some other agreed ratio may provide such guarantee. If in any year, the actual share of Profit of a Guaranteed Partner is less than the Guaranteed Amount, then the deficiency is borne by the Guaranteeing Partners in their agreed ratio.

The distribution of profits under guarantee arrangement consists of the following steps:

Step 1. Calculate the Actual Share of Profit/Loss of Guaranteed Partner.

Step 2. Calculate the amount of deficiency as follows:

                              Deficiency = Guaranteed Amount – Actual Share of Profit

Step 3. Distribute the deficiency among the guaranteeing partners in the guaranteeing ratio.

Step 4. Recover share of deficiency from the guaranteeing partners and give credit for the

 same to guaranteed partner.

Calculation of interest on drawings:

Drawings mean the amount withdrawn by the partners, in cash or kind for personal purposes and interest on drawings is to charge form the partners if the partnership agreement provides for the same.

     Methods of calculating interest on drawings:

1.      Simple Interest Method.

2.      Product Method.

1.      Simple Interest Method: This method is applicable when a fixed amount is withdrawn regularly at a fixed interval of time.

(a)   When the drawings were made in the beginning of every month then interest will be charged for 6 ½ months.

(b)   When the drawings were made in the middle of every month then interest will be charged for 6 months.

(c)    When the drawings were made at the end of every month then interest will be charged for 5 ½ months.

(d)   When the drawings were made in the beginning of every quarter then interest will be charged for 7 ½ months.

(e)    When the drawings were made at the end of every quarter then interest will be charged for 4 ½ months.

Formula calculating interest:

Interest on drawings = Principal × Rate × Time

                                                                                                  100

2.      Product Method: This method is applicable when different amount is withdrawn at different intervals of time. Under this method, the products of the amount withdrawn and relevant period are totaled and interest for one month on the total product is computed. The procedure for calculation of interest by product method is explained in following example:

Illustration 1. In a partnership, partners are charged interest on drawings at 15% p.a. During the year ended 31^st December 2005 a partner drew as follows:

February 1                                           Rs.1,000

May 1                                                  Rs.2,500

June 30                                                Rs.1,000

October 31                                          Rs.3,000

December 31                                       Rs.1,000

What is the interest chargeable to the partner?

Solution:

Product Method

When drawings are made in uneven amount at different dates, interest on drawings can be calculated by ‘Product Method’ as follows:

Date	Amount (Rs.)	Period in months	Product (Rs.)
February 1 May 1 June 30 October 31 December 31	1,000 2,500 1,000 3,000 1,000	11 8 6 2 0	11,000 20,000 6,000 6,000 0
	Total		43,000

Interest on drawings =    43,000 × 15 × 1          = Rs. 537.50

                                                        100 × 12

Interest can also be computed using Product Method on daily balances. Product is determined by multiplying amount with the number of days interest is computed product total for one day.

Note: When the date of withdrawal of the amount of drawings is not clearly mentioned

         in the question then interest will be charge for 6 months on whole amount.

Preparation of Profit and Loss and Loss Appropriation Account

Profit & Loss Appropriation account is mere an extension of Profit Loss account. It is prepared to ascertain the net distributable profit to be credited among the partners in a partnership firm. All the entries related to interest on partners’ capital, interest on partners’ drawings, partners’ salaries or commission, amount transferred to reserve fund etc. should be recorded in this account.

Format:

Dr.                                     Profit & Loss Appropriation A/c                                             Cr.

Date	Particulars	Amount	Date	Particulars	Amount
	To tfd. to Reserve To Partners’ Capital A/c       (Interest on capital) To Partners’ Capital A/c       (Salary/ Commission) To Profit tfd. to Capital       A/c of :       Partner A            xxxx       Partner B            xxxxx	xxxxx xxxxx xxxxx xxxxx		By Net Profit as per       Profit & Loss A/c By Partners’ Capital A/c       (Interest on Drawing)	xxxxx xxxxx
		xxxxxx			xxxxxx

v  Preparation of Capital Accounts

Capital Accounts: There is not much difference between the accounts of a partnership firm and that of sole proprietorship. The only point to remember is that instead of one capital account, there will be a capital account. The capital accounts of partners may be maintained in any one of the following two methods:

1. Fixed Capital Accounts
2. Fluctuating Capital Accounts

1. Fixed Capital Accounts: In the case of Fixed Capital, the partners are not allowed to change their capitals during the lifetime of business except in extra ordinary circumstances. Under this method, the capital balances of the partners remain unaltered and all the transactions, which can affect the balances of the partners, are passed through current accounts. So under this arrangement, capital accounts and current accounts of the partners are prepared. All the entries relating to drawings, interest on drawings, salary to partner, share of profit or loss etc., is made in a newly opened account for each partner, this account is called current account.
2. Fluctuating Capital Accounts: When the capitals need not to be fixed the balances of capital accounts go on changing from time to time. The reason is that no separate Current Accounts are maintained, but al the entries relating to drawings, interest on capitals, interest on drawings, salary to partners, share of profit or loss etc., are recorded in the capital accounts itself.

Distinction between Fixed Capital Accounts and Fluctuating Capital Accounts:

S. No.	Basis of Distinction	Fixed Capital Accounts	Fluctuating Capital Accounts
1.	Change in Capital	When the Capitals are fixed, the balances in capital accounts usually remain unchanged during the lifetime of business, except in extraordinary circumstances.	When the capitals are fluctuating the balances in capital accounts go on changing from time to time.
2.	Number of Accounts	When the Capitals are fixed, each partner has two accounts, namely, Capital Account and a Current Account.	When the Capitals are fluctuating each partner has only one account, namely, capital Account.
3.	Recording of Transactions	When the capitals are fixed, transactions relating to drawings, interest on capital, interest on drawings, salary, share of profit or loss etc. are not made in Capital Accounts but are entered in separate Current Accounts.	In this case all transactions relating to partners are made directly in the capital accounts itself.
4.	Can a Capital Account Show a negative balance?	Fixed Capital Account can never show a negative balance.	Fluctuating Capital Account can show a negative balance.