Learning Materials For Accounting, Management , Finance And Economics.

Thursday, December 29, 2011

Preparation Of Cost Reconciliation Statement And Its Specimen

If there is a difference in the results shown by the cost accounts and financial accounts, then only a cost reconciliation statement is prepared to reconcile their results by removing their differences.
A cost reconciliation statement is prepared on the same footing on which a bank reconciliation statement is prepared. The preparation of cost reconciliation statement involves the following steps:

Step 1: Start with profit or loss shown by any one set of accounts ( profit or loss as per cost accounts or financial accounts) as the base

Step 2: Find out the reason of difference of profit between cost and financial account
( You are requested to refer above post 'Causes or reasons of difference in profits')

Step 3: Determine the addition or subtract (less) items

Step 4: Prepare cost reconciliation statement

Specimen Of Cost Reconciliation Statement
Taking the profit as per cost account or loss of financial account

Particulars...........................................................................................Amount
Profit as per cost account or loss as per financial account...................XXX
Add:
i. Overcharge of expenses in cost account............................................XXX
ii. Items of expenses recorded only in cost account...............................XXX
iii. Items of income recorded only in financial account...........................XXX
iv. Amount of understated income in cost account.................................XXX
v. Over-valuation of opening stock in cost account.................................XXX
Vi. Under valuation of closing stock in cost account................................XXX
Less:
i. Under charge of expenses in cost account..........................................(XXX)
ii. Items of expenses recorded only in financial account........................(XXX)
iii. Income shown in cost account, but not in financial account..............(XXX)
iv. Amount of income over state in cost account.....................................(XXX)
v. Under valuation of opening stock in cost account...............................(XXX)
vi. Over valuation of closing stock in cost account...................................(XXX)
Profit as per financial account or loss as per cost account......................XXX

Tuesday, December 27, 2011

Causes Or Reasons For Difference In Profits Or Losses Between Cost Account And Financial Account

The disagreement or difference between cost and financial accounts results (profit or loss) arise due to the following reasons:

1. Items shown only in financial account
2. Items shown only in cost account
3. Over or under absorption of overhead
4. Difference in valuation of stock
5. Difference methods of charging depreciation
6. Abnormal gain or loss

1. Items Shown Only In Financial Account

There are certain items of incomes and expenditures which are shown only in financial accounts not in cost accounts. As a result, the profit or loss as per cost accounts would be quite different from the profit or loss as per the financial accounts. These items of financial nature can be divided in three groups:
A. Items of expenditures shown only in financial account:
* Interest on capital
* Expenses on issue of shares and debentures
* Loss on revaluation
* Discount on debenture
* Penalties and fine
* Provision for bad and doubtful debts
* Loss on sale of fixed assets
* Donation
* Goodwill, preliminary expenses etc.

B. Items Of Income:
* Interest received, rent received, commission received, discount received
* Dividend received
* Share transfer fees
* Returned of income tax
* Gain of sale of fixed assets

C. Appropriation Of Profits:
* Income tax paid
* Dividend paid
* Transfer to general or specific reserves or funds
* Transfer to sinking fund
* Excess provision for depreciation
* Bonus

2. Items Shown Only In Cost Account

There are very few items, which are shown in cost accounts but not in the financial accounts as they do not represent any transaction with outsiders. These items are also responsible for the disagreement of the results shown by the two sets of accounts. These items are:
* Rent or depreciation of the own building of the proprietor
* Remuneration of the proprietor
* Depreciation on fully depreciated assets
* Interest on capital employed in production
* The losses due to defective and spoilage

3. Over Or Under Absorption Of Overhead

In cost account, overheads are charged on the basis of predetermined percentage. But in financial account they are charged with the actual amount. This results over or under absorption of overheads in cost account and may be the main reason for difference in profits disclosed by cost account and financial account.

The effect of over or under absorption of overhead to profit is shown below:

Overhead..........................................Result
Over subscription.............................Less Profit
Under subscription...........................More Profit

4. Difference In Valuation Of Stock

In financial account, stocks are valued at cost or market price, whichever is lower, but in cost account, stocks are valued only at its cost price. This result in some difference in result i.e. profit or loss.

5. Difference Methods Of Charging Depreciation

There are different methods of charging depreciation. In financial account, depreciation may be calculated on straight line or diminishing balance method as per Income Tax Act. But in cost account, depreciation is calculated on the basis of use of the asset (generally machine hours). The difference in depreciation methods also results in disagreement in profit or loss of these two accounts.

6. Abnormal Gains And Losses

Abnormal gains and losses are shown in financial account while they are completely excluded from cost account. Goods lost by fire, theft, accident or costs of abnormal idle time are examples of abnormal losses, which are shown in financial account but not in cost account. Such abnormal gains and losses also lead to disagreement of cost and financial account results.

Monday, December 26, 2011

Concept And Meaning Of Cost Reconciliation Statement And Need For Reconciliation

Cost Reconciliation Statement

A manufacturing concern may adopt either Integrated Accounting System or Non- Integral Accounting System. Under Integrated Accounting System, only one set of books is maintained to record both costing and financial transaction, therefore, under this system, both financial accounts and cost accounts give similar results. But in Non- Integral Accounting System, separate books are maintained for costing and financial transactions, which may exhibit different results i.e. profits or losses. In other words, when cost accounts and financial accounts are maintained independently by a concern, the profit or loss shown by the cost accounts may not agree with the profit or loss shown by the financial accounts. In this situation, it is needed to reconcile the profits or losses shown differently by cost accounts and financial account by preparing a statement called ' Cost Reconciliation Statement'

A statement which is prepared for reconciling the profit between financial account and cost account is known as cost reconciliation statement. A cost reconciliation statement is a statement reconciling the profits or losses shown by cost accounts and financial accounts. It is a statement wherein the causes responsible for the difference in net profit or loss between cost and financial accounts are established and suitable adjustments are made to remove them. In other words, cost reconciliation statement is prepared for the purpose of reconciling or agreeing the results of financial accounts with the results of cost accounts by making suitable adjustments for the items responsible for the disagreement. In short, it is the statement through which reconciliation or agreement between the results (profits or losses) of cost accounts and financial accounts is effected.

Need For Reconciliation

Reconciliation between the results of two sets of accounts is necessary due to the following reasons:

1. Reconciliation helps to check the arithmetical accuracy of both sets of accounts.

2. Management is enable to know the reasons for the difference in results of both cost and financial accounts.

3. Reconciliation explains reasons for difference which facilitate internal control.

4. Reconciliation ensures the reliability of cost data.

5. Reconciliation promotes co-ordination between cost and financial departments.

6. Reconciliation helps in formulation of policies regarding absorption of overheads and depreciation and stock valuation method.

7. Reconciliation ensures managerial decision-making.

Wednesday, December 14, 2011

Conversion Or Sale Of Partnership Firm To A Limited Company

Chiefly with the objective of limiting the personal liabilities of the partners, an existing partnership firm may sell its entire business to an existing limited company, or may convert itself into a limited company. The former is the case of absorption of a partnership firm by the joint stock company whereas, the latter is the case of flotation of a new joint stock company so as to take over the business of the partnership firm.

In both of these cases, the existing partnership firm is dissolved and all the books of accounts are closed. Thus when a partnership firm is sold or converted into a company, the same accounting procedure is followed as for simple dissolution of a firm.

The purchase consideration (price) in between the vendor (dissolving) firm and the purchasing company is fixed as mutually agreed upon. It may or may not be specified in a lump sum figure. When it is not specified in a lump sum figure, the difference of agreed values of acquired assets over agreed amount of liabilities are undertaken.

The purchase price is discharged by the purchasing company either in the form of cash or shares (equity or preference) or debentures or a combination of two or more of these. The shares or debentures may be issued by the purchasing company, at par, at a premium or at a discount.
In the absence of any agreement, the shares received from the purchasing company is distributed among partners in the ratio of their final claim i.e. in the ratio of their capital standing after all the adjustments.

When a partnership firm is sold or converted into a company, the practical steps to close the books of the firm are given below:

Entries in the books of converting firm/vendor firm

Step 1: Transfer all recorded assets and liabilities(whether or not taken over by the purchasing company) to the Realization account, except cash and bank balance if not taken over by the purchasing company.
1.1 For transferring recorded assets:
Realization A/C..................Dr.
To sundry assets
1.2 For transferring recorded liabilities
Sundry liabilities..................Dr.
To Realization A/C

Step 2: Make purchase consideration(price) due.
2.1 For purchase price due:
Purchasing company...........Dr.
To Realization A/C

Step 3: If, there remain any assets(whether or not recorded) not taken over by the purchasing company, it may be sold, or may be taken by one of the partners or may be shared among the partners.
3.1 On sale of assets not taken over by the purchasing company:
Bank A/C..................Dr.
To realization A/C
3.2 Such assets taken over by any one of the partners:
Partner's capital A/C...............Dr.
To Realization A/C
3.3 On sharing such assets among the partners:
Partners' capital A/C(capital ratio)............Dr.
To realization A/C
Note: If such unsold assets are considered worthless, they should be shared among the partners in profit sharing ratio.

Step 4: The liabilities (whether or not recorded) by the purchasing company may be discharged or may be assumed by any one of the partners, or must be shared by the partners in their capital ratio.
4.1 On discharge of any liability not taken over by the purchasing company:
Realization A/C .............Dr.
To Bank A/C
If such liability assumed by one of the partners:
Realization A/C...............Dr.
To Partner's capital A/C
If such liability has to be assumed by all partners:
Realization A/C................Dr.
To Partners' capital A/C(capital ratio)

Step 5: When the realization expenses is paid, Realization account is debited.
5.1 For payment of realization expenses:
Realization A/C.............Dr.
To Bank

Step 6: Close the realization account by transferring the balance(profit or loss) to the capital of the partners in profit sharing ratio.
6.1 For profit on realization account:
Realization A/C..............Dr.
To Partners' capital A/C(profit sharing ratio)
6.2 For loss on realization account:
Partners' capital A/C............Dr.
To realization A/C

Step 7: On the receipt of purchase consideration(price), cash/bank account, equity shares in purchasing company or preference shares in purchasing company at their issue prices are debited and purchasing purchasing company's account is credited.
7.1 For the receipt of purchase price:
Cash/bank A/C....................................Dr.
Equity share in purchasing Co...........Dr.
Preference share in purchasing Co....Dr.
Debentures share in purchasing Co...Dr.
To purchasing Co.

Step 8: Transfer all accumulated reserves/profits/losses to the capital accounts of partners in profit sharing ratio.
8.1 For accumulated reserves, profits:
Reserve A/C.................Dr.
Profit and loss A/C.......Dr.
To partners' capital A/C
8.2 For accumulated losses:
Partners' capital A/C.............Dr.
To profit and loss A/C

Step 9: Transfer the current account, if any, in the books, to the capital accounts of the partners.
9.1 For transferring current account to the capital account:
Partners' current Account................Dr.
To partners' capital Account

Step 10: Pay off the partner's loan if any.
10.1 For the payment of partner's loan account:
Partner's loan A/C ..............Dr.
To bank A/C

Step 11: Make final settlement by paying off balances in capital accounts. In the absence of an agreement as to the division of shares(from purchasing company) among partners, such shares are distributed in the ratio of their final claims(i.e. in the ratio of capitals after all the adjustments).
11.1 For final settlement:
Partners' capital A/C ...........Dr.
To equity shares in purchasing Co.
To preference shares in purchasing Co.
To bank A/C


Entries in the books of purchasing company
Assets Account...........................Dr.
Goodwill Account........................Dr.
To liabilities
To share capital
To share premium
(Being assets and liabilities taken over)

Note: In case debit higher than credit, capital reserve is credited.

Monday, December 12, 2011

Concept Of Retirement Of A Partner And Adjustments Needed To Be Done At The Time Of Retirement Of A Partner

Concept Of Retirement Of A Partner

A partner or partners may retire from the firm due to the various reasons like old age, better opportunity, ill health, conflict between the partners and so on. The retirement of partner can took place in any of the following grounds:

i. In accordance with the constant or consensus among all the members.
ii. In accordance with the partnership agreement which has already been signed.
iii. In accordance with the written notice, if the partnership is at will.

Adjustments

The adjustments that need to be done at the time of retirement of a partner are as follows:

1. Calculation of new profit sharing ratio
2. Revaluation of assets and liabilities
3. Adjustment regarding undistributed profits and losses
4. Adjustment regarding goodwill
5. Adjustment of capital
6. Ascertainment of due amount to retiring partner
7. Mode of payment to the outgoing partners.


1. Calculation Of New Profit Sharing Ratio

When somebody left the firm, his share which left to the firm is gain to remaining partners. After retirement of someone, if the new profit sharing ratio is not given, then it has to be understand that they will continue old ratio. The new profit sharing ratio of the remaining partners is determined in the following way:
Suppose, three partners A,B and C are sharing profits and losses in the ratio of 2:3:1, as there is no fresh or new agreement between between A and B, the new profit sharing ratio between A and B will be 2:3 by eliminating the share of C.
In the above calculation, gaining ratio of A and B will be:
A= 2/5-2/6 = 1/15
B = 3/5-3/6 = 1/10

Thus, gaining ratio is calculated by deducting old ratio from new ratio i.e.
Gaining ratio = New profit sharing ratio - Old profit sharing ratio

In the case of new ratio between the remaining partners are given, the gaining ratio calculation will be the same. However, it should not be confused with the sacrificing ratio which is calculated at the time of admission of a new partner and change in profit sharing ratio. Sacrificing ratio is calculated by deducting new ratio from old one. On the other hand, gaining ratio is computed by subtracting old ratio from new one.

2. Revaluation Of Assets And Liabilities

The retiring partner has the right to share the increase or decrease in value of assets and liabilities of the firm during the retirement period. To find out the profit or loss, a revaluation account is opened as in the case of admission of a partner. If there is an increase in the value of any assets then concerned asset account will be debited and revaluation account will be credited. In the same way, if there is decrease in the value of any asset then concerned asset will be credited and revaluation account will be debited. Similarly, if there is an increase in the value of liabilities, revaluation account is debited and concerned liability account is credited and vice versa.
The profit or loss on revaluation is to be divided among all the remaining and outgoing partners in their old profit sharing ratio. After the revaluation, the assets and liabilities will appear in the balance sheet either at original value (book value) or at revised value. If assets and liabilities are to be recorded at unchanged value then a memorandum revaluation account will have to prepared.

3. Adjustment Regarding undistributed Profits And Losses

At the time of retirement of a partner, there may be some accumulated profits or losses in the forms of any reserve or credit balance of profit and loss account or debit balance of profit and loss account etc. All such amount should be distributed among all the partners, outgoing or remaining, in their old profit sharing ratio. Sometimes, only the share of outgoing partners may transfer to his capital account and balance is shown in the balance sheet. Such can be done only when the remaining partners agreed for it.

4. Adjustment Regarding Goodwill

The valuation of goodwill has been discussed in admission of a partner. The same process should be followed here too. But during the time of retirement, the retiring partner has the right to get his share of goodwill of the firm. Therefore, to give effect to the same, the following adjustment must be carried out.

A. Goodwill already appears in the books

i. if old value of goodwill is equal to new valuation of goodwill:
- Adjustment entry is not needed

ii. If the existing value of goodwill is less than the new valuation:
Goodwill A/C.........Dr.(excess value)
To all partners' capital A/C
Note: The excess amount of goodwill is transferred to remaining and outgoing partners according to old profit sharing ratio.

iii. If the existing value of goodwill is greater than new valuation:
All partners' capital A/C..........Dr.(less value)
To Goodwill A/C


B. Goodwill not already appeared in the book

i. Goodwill raised at its full value:
Goodwill A/C.............Dr.
To All partners' capital A/C

ii. Goodwill raised at its full value and written off immediately:
Goodwill A/C ...........Dr.
To all partners' capital A/C (old profit sharing ratio)

iii. Goodwill raised at only retired partner's capital account and immediately written off:
Goodwill A/C............Dr.
To retired partner's capital A\C


5. Adjustment Of Capital

When a partner retires from the business and if he is to be paid off his due amount immediately, the total capital of the firm is reduced. In such case, the retiring partner may be requested to keep the amount due to him as loan to the firm, so as to be paid gradually in the future. On the other hand, the remaining partner may bring necessary amount in new profit sharing ratio or in same agreed ratio to make payment to the retiring partner. Then afterwards, if agreed, the capitals of remaining partners may be required to be adjusted in new profit sharing ratio in any one of the following three ways:

A. When the total capital is not given:
Step 1: Calculation of the total capital of the new firm as:
Total capital of the new firm = Aggregate of adjusted old capitals of remaining partners.
Step 2: Calculations of new capitals of remaining or continuing partners:
New capital of a continuing partner= Total capital X New ratio
Step 3: Any excess of new capital of a remaining partner, is to be paid off in cash and for the deficiency, the continuing partner has to bring in cash.

B. When the total capital is given:
Step 1: Calculation of continuing partners' new capital
New capital of continuing partner= Total capital given X New ratio
Step 2: Any excess capital to be paid to and any deficiency is to be brought by the continuing partners.

C. When the retiring partner is to be paid through cash brought by the remaining partners so that their capitals would be in accordance with new ratio:
Step 1: Calculation of total capital of new firm
Total capital = Aggregate of old capitals after all adjustment + Shortage of cash to make payment to retiring partner
Step 2: Calculation of new capital of continuing partners
= Total capital of new firm X New ratio
Step 3: Deficiency to be brought in by the remaining or continuing partners.


6. Ascertainment Of Due Amount To The Outgoing Partners

The total amount to be given to the retiring partners includes the following:
i. The balance shown by retired partnering capital account.
ii. The balance shown by retired partnering current account.
iii. Any interest or commission due to retiring partners.
iv. Any salary due to retiring partners.
v. Any share of profit or loss till the date of retirement.
vi. Share in the goodwill of the firm.
vii. Gain or loss on revaluation of assets and liabilities.
viii. Any share in the accumulated profits or funds as well as losses appearing in the balance sheet till the date of retirement.
ix. Share of joint life policy.
x. With drawing and interest on with drawing till the time of retirement.

The net amount due to the retiring partner is determined after the necessary addition and deduction of the above items.


7. Mode Of Payment To The Outgoing Partners

There are different ways of treating the due amount to the outgoing partner. Some of them are as follows:
A. If the due amount is paid off immediately:
Outgoing partner's capital A/C...............Dr.
To bank/cash A/C

B. Payment is made privately (if the remaining partners purchase the share of retiring partner in some agreed ratio or in the profit sharing ratio):
Retiring partner's capital A/C.............Dr.
To remaining partners' capital A/C

C. If payment is not made privately (remaining partners bring cash in the business and there after the retiring partner is paid off):
* When cash brought in by the old partners:
Cash/Bank A/C..............Dr.
To remaining partners' capital A/C
* When outgoing partner is paid off:
Outgoing partner's capital A/C.............Dr.
To Cash/Bank A/C

D. With due agreement the amount due to the outgoing partner may be transferred to a loan account to be paid gradually with or without interest:
* While due amount is transferred to loan account:
Retiring partner's capital A/C...........Dr.
To Retiring partner's loan A/C
* If interest has to be paid and due:
Interest A/C................Dr.
To retiring partner's loan A/c
* Paying of the installment:
Retiring partner's loan A/C.............Dr.
To Bank A/C

Friday, December 2, 2011

Guarantee Of Minimum Profit To A New Partner

Sometimes, as per agreement, a new partner can be admitted with a minimum guaranteed amount of share in profit while distributing the profits of the firm. In other words, a minimum amount of profit is guaranteed to a newly admitted partner even if there is no profit or his share of profit falls short of the minimum guaranteed amount. Such guarantee may be provided by the firm, or one or more than one partner in the existing profit sharing or in some other agreed ratio.

Guarantee By The Firm

When a minimum amount of profit to be credited to the new partner is guaranteed by all the partners/firm, we have to calculate, first the two figures: 1. minimum guaranteed amount and 2. new partner's share of profit as per profit sharing ratio. Of the two figures, the higher one is credited to the new guaranteed partner. Then, the balance of profit will be shared by the remaining partners in their profit sharing ratio.

Guarantee By One Or More Than One Partners

When the guarantee of minimum profit to the new partner is provided by one or more than one partner, firstly, we have to calculate the share of profits among the partners as if there is no guarantee. Secondly, if the share of the new partner is less than the minimum guaranteed amount, the deficiency is to be fulfilled by deducting the original share of partner/partners who gave the guarantee.

Re-adjustment Of Partners' Capital Giving Due Influence Of New Admittance

Sometimes, after the admission of the new partner, all the partners may decide to make their capital proportionate to the new profit sharing ratio or any other ratio. In this case, the base capital determined at first and the adjustments are done accordingly.

If the new partner's capital is taken as the base, the other old partners' capitals are calculated and due adjustments (withdrawals/introduction) of capital are done.

Again if the combined capital of old partners is taken as the base, firstly, the total capital of the new firm is calculated as per profit sharing ratio and then only the new partner's capital to be brought in is determined.

Journal entries are as follows:

In case of deficiency of capital:
Cash A/C....................Dr.
To partner's capital A/C
(Being shortage of capital brought in by........in cash)

In case of excess over new capital:
Partners' capital A/C..................Dr.
To Cash A/C
or
Partners' current/loan A/C
( Being excess capital withdrawn by..../transferred to current/loan A/C)

Note: In the absence of any agreement, deficiency or surplus should be adjusted in cash, not by transferring current account.

Adjustment Of Life Insurance Policy Of Partners At The Time Of Admission Of New Partner

Partners may take out a joint life insurance policy on the lives of all the partners. It enables the firm to make payment to the executors/representatives of deceased partner, without upsetting the working capital of the firm. Premiums of such policy are paid out of the profit earned by the firm. Since the payment of premiums are done before the date of admission of new partner. Only the old partners must get credit for the surrender value of joint life insurance policy.

On the date of admission of new partner, accounting treatment of joint policy in each of the following cases are:
1. If joint life insurance policy is appearing in the books: No journal entry is required because the old partners have already got the credit to their capital accounts with surrender value of the life insurance policy.

2. If joint life insurance policy is appearing in the books, but all the partners including new one, decide not to show joint life policy in the books of new firm:
All partner's capital A/C.............Dr. (new ration)
To joint life policy
(Being surrender value of policy written off in new ratio)

3. If joint life policy is not appearing in the book and all the partners including new one decide not to show the same in the books of new firm:
i) Joint life policy A/C.................Dr.
To old partners. capital A/C(old ratio)
(Being the surrender value of insurance policy taken into A/C)
ii) All partners' capital A/C..............Dr.
To joint life policy
(Being the surrender value of insurance policy written off in new ratio)

4. If joint life insurance policy is not appearing in the book, but all of them decide to show in the new book:
Joint life insurance policy A/C..................Dr.
To old partners' capital A/C (old ratio)
(Being the surrender value of insurance policy taken into a/c)

5. If joint life insurance policy and joint life policy reserve both are appearing in the books and all the partners decided to show in the books:
Joint life policy reserve A/C....................Dr.
To old partners' capital A/C (old ratio)
(Being joint life policy reserve credited to old partners)
* by this entry, joint life policy is seen in asset side of balance sheet.

6. If both joint life policy and joint life policy reserve are appearing in the books, but the partners decide not show both of these in new book:
i) Joint life policy reserve A/C..................Dr.
To old partners' capital A/C (old ratio)
(Being reserve of life policy credited to old partners)
ii) All partners' capital A/C...............Dr.
To Joint life policy
(Being joint life policy debited to all partners in new ratio)

Thursday, December 1, 2011

Re-arrangement Of Reserve And Surplus And Accumulated Loss Of The Firm At The Time Of Admission Of New Partner

At the time of admission of new partner, if there exists any reserve or accumulated profit in the books of the firm, these should be transferred to the old partners' capital/current accounts in the old profit sharing ratio. Because these items belong to the old partners, not the new partner.
In the same manner, old partners' capital/current accounts should be debited in old ratio if there appears any accumulated losses in the assets side of balance sheet. The journal entries are:


1. For Accumulated Profits/Reserves:

Profit and loss A/C.....................................Dr.
General reserves A/C................................Dr.
Workmen compensation reserve A/C......Dr.
(excess over actual liability)
Investment fluctuation reserve A/C.........Dr.
Joint life policy reserve A/C........................Dr.
To old partners' capital/current A/C
(Being transfer of reserves and profit to old partners in their old profit sharing ratio)

2. For Accumulated Loss

Old partners' capital/current A/C.................Dr.
To profit and loss A/C
To Deferred revenue expenditure A/C
To Preliminary expenses A/C
( Being transfer of accumulated losses to the old partner in old ratio)

However, all the partners(including new) may also decide to show the reserves in the books at its original or same agreed value. In such situation, all the partners' capital A/Cs are debited in new profit sharing ratio and reserves are credited at agreed value:
All partners' Capital A/C................Dr.
To General Reserves A/C
(Being general reserve brought)

Impact Of Admission Of New Partner In The Value Of Goodwill Of The Firm

When a new partner is admitted in the firm, the existing/old partners have to sacrifice, what is given to the new partner, from their future profits, the reputation they have gained in their past efforts and the side of capital they have taken before. The new partner when admitted, has to compensate for all these sacrifices made by the old ones. The compensation for such sacrifice can be termed as 'goodwill'. Hence, at the time of admission of the new partner, it is necessary to account the valuation of goodwill in the firm.

If the new partner brings in cash for his share of goodwill, in addition to his capital, it is known as premium method. When the new partner brings nothing but only the capital, and the value of goodwill is erected or raised, this method of treatment is called Revaluation Method. However, once creating the value of goodwill and writing of the same after admission is done, it can be said to be Memorandum Revaluation Method. Thus, keeping in mind, all these methods, the various ways of treating goodwill in the books of the firm at the time of admission of the new partner, are as follows:

1. Share of goodwill brought by the new partner in cash.
2. Share of goodwill brought by the new partner in kind.
3. Nothing is brought by the new partner as his share of goodwill.
4. Share of goodwill brought by the new partner in cash only a portion not as a whole.
5. Hidden goodwill

1. When the new partner brings his share of goodwill in cash
When the new partner brings his share of goodwill in cash, the payment ma be made to the old partners, as if outside/private transaction. It may be retained in the business or after recording the same in the firm, the old partners may withdraw the whole amount or some portion only,

a. When the amount of goodwill brought by the new partner is not recorded in the books and the payment is made to the old partners as outside or private transaction, it does not affect in the transaction of the firm and hence no entry is passed in the books of the firm.

b. When the amount of goodwill brought in by the new partner is retained in the business to increase cash resources, and if there exists already no-goodwill:
i) Cash/Bank A/C.......................Dr.
To Goodwill A/c
(Being goodwill brought in by the new partner)
ii) Goodwill A/C...........................Dr.
To old partners' capital A/C
(Being goodwill credited to old partners in the sacrificing ratio)

c. When there is no-goodwill already appeared in the books and the amount of goodwill brought in by the new partner, is fully or partially withdrawn by the old partners:
i) Cash A/C.......................Dr.
To Goodwill A/C
(Being goodwill brought by the new partner)
ii) Goodwill A/C................Dr.
To old partners' capital A/C
(Being goodwill divided among old partners)
iii) Old partners' capital A/C...............Dr.
To Cash/Bank A/C
(Being the amount withdrawn)

d. When there is goodwill already appeared in the books and even then if the new partner brings his share of goodwill in cash, the amount may be retained or withdrawn by the old partners. If the amount of goodwill brought in by the new partner is retained in the business:
i) Old partners' capital A/C..............................Dr.
To Goodwill A/C
( Being goodwill appearing in the book written off in the old ratio)
ii) Cash/Bank A/C.......................Dr.
To Goodwill A/C
(Being goodwill brought in by the new partner)
iii) Goodwill A/C.......................Dr.
To old partners' capital A/C
(Being goodwill brought in by new partner shared by the old partners)

If the goodwill amount brought by the new partner is withdrawn by the old partners, the following extra entry should also be passed:
Old partners' capital A/C.............Dr.
To Cash/Bank
(Being amount withdrawn)

If they agree to show the original value of goodwill in the books, it is raised by passing the entry:
Goodwill A/C ......................Dr.
To All partners capital A/C
(Being goodwill raised)

2. When the new partner brings his share of goodwill in kind
The new partner may bring his share of goodwill and capital in kind i.e. the form of assets instead of cash. Again, new partner may have an established name in the market among the customers. In such case, he may be recognized for his goodwill. As a result he will bring a lesser amount of assets than the amount of credited to him. This requires two journal entries:
i) All assets A/C............................Dr.
Goodwill A/C/New partner's capital A/C
(Being goodwill brought in kind by the new partner)
ii) Goodwill A/C/New partner's capital A/C................Dr.
To old partners' capital A/C
(Being goodwill shared by the old partners)

3. When the new partner is unable to bring his share of goodwill in cash or kind
When the new partner cannot bring anything for his share of goodwill, first of all we have to see if there exists goodwill already or not. If there is no-goodwill already appearing in the books of the firm, goodwill is raised at its full value. If goodwill already appears in the books, it is compared to the full value of goodwill raised or created and the adjustment is done accordingly.
a. When the new partner is unable to bring his share of goodwill and if there is no-goodwill already appearing in the books, goodwill is raised at its full value:
i) Goodwill A/C.................Dr.
To old partners' capital A/C
(Being goodwill is created at its full value and credited to the old partners in old ratio)
* By this entry, goodwill A/C then appears as an asset in the balance sheet of the firm.

b.If the new partner cannot bring his share of goodwill and there appears goodwill already in the books, even then goodwill is raised at its full value. If the raised value of goodwill is equal to the existing value of goodwill, no entry what so ever is needed. If the raised goodwill is more than the existing goodwill, then goodwill will be credited to the old partner's capital A/C by the excess amount only:
Goodwill A/C......................Dr. (excess value)
To old partners' capital A/C
( Being the value of goodwill increased to..../increased by......)
* Goodwill then appears at its full value in the balance sheet of the firm

c. If the raised value of goodwill is less than the existing value of goodwill, then excess over raised value of goodwill is written off:
Old partners' capital A/C................Dr.
To Goodwill A/C
(Being the goodwill written off by the reduction in value)

d. Whatever the case may be stated in a,b,c, the partners may not wish goodwill in the books for an indefinite period after the admission of new one, as the value of goodwill changes constantly. They may write off the whole or some portion of the value of goodwill. For writing off the goodwill:
All partners' capital A/C.............Dr.
To Goodwill A/C
(Being goodwill written off)

4. When the new partner can bring only a portion of his share of goodwill
When the new partner cannot bring the entire amount of his share of goodwill and he brings only a part of this, it is shared by the old partners in sacrificing ratio. Then goodwill A/C is raised in the books for the portion not brought by the new partner which is also credited to the old partners in their sacrificing ratio. Goodwill raised for the part of goodwill not brought in by the new partner is calculated as under:
= (Full value of goodwill/share of goodwill of new partner) X goodwill not brought in

But it should be remembered that , if there exists any goodwill in the books, first it should be written off by crediting to the old partners in old ratio. Therefore, the entries are:
i) Old partners' capital A/C..................Dr.
To Goodwill A/C
(Being goodwill written off)
ii Cash/Bank A/C........................Dr.
To Goodwill A/C
(Being the portion of goodwill brought in by new partner)
iii) Goodwill A/C.......................Dr.
To old partners' capital A/C
(Being the goodwill brought in by new partner credited to old partners)
iv) When the goodwill is raised for the part of goodwill not brought in by the new partner, the amount of goodwill is calculated as said above. The entry would be the same as in iii), only the amount being different, which is shared by the old partners in their old profit sharing ratio.

5. Hidden Goodwill
When the value of goodwill is not given in the question, the value of goodwill has to be calculated on the basis of total capital/net worth of the firm and profit sharing ratio.

A. New partner's capital X Reciprocal of the share of new partner....XXX
B. Less net worth(excluding goodwill) of new firm...............................XXX
C. A-B = Value of goodwill........................................................................XXX