Class 12 Goodwill and Change in Profit Sharing: Complete Concepts and Practice

Big picture

A partnership is reconstituted whenever the agreement between partners changes: a change in the profit-sharing ratio, an admission, a retirement or a death. Every reconstitution raises the same three questions:

1. Goodwill: the firm's reputation has value. Who earned it, and who is now going to benefit from it?

2. Past profits and losses: reserves and accumulated profits were earned under the old ratio. Who do they belong to?

3. Changes in asset values: if an asset is really worth more or less than its book value, that gain or loss happened under the old ratio.

This chapter answers all three for the simplest reconstitution, a change in the profit-sharing ratio among existing partners. The next two chapters reuse every technique here.

Learning goals

• Explain the meaning, nature and causes of goodwill, and when it needs to be valued.

• Value goodwill by the average profit, weighted average profit, super profit and capitalisation methods.

• Normalise past profits before averaging them.

• Calculate the sacrificing ratio and gaining ratio.

• Pass the goodwill adjustment entry when the ratio changes, and write off existing goodwill.

• Distribute reserves and accumulated profits or losses, and treat workmen compensation reserve and investment fluctuation fund.

• Prepare a Revaluation Account, or adjust revaluation by a single entry without changing book values.

Core ideas

1. Meaning and nature of goodwill

Goodwill is the value of a firm's reputation, which lets it earn more than the normal profit that a similar firm with the same capital would earn. A long-standing pharmacy near a big hospital earns more than a new pharmacy with the same stock, because customers already trust it and come to it. That extra earning power is goodwill.

• Goodwill is an intangible asset: it has value and can be bought, but it cannot be seen or touched.

• It is not a fictitious asset. A fictitious asset (like preliminary expenses) has no realisable value; goodwill does have value and can be sold with the business.

• Goodwill cannot be sold separately; it goes with the business as a whole.

• Its value fluctuates with the firm's performance.

Factors that affect goodwill

When goodwill must be valued: change in the profit-sharing ratio, admission of a partner, retirement of a partner, death of a partner, amalgamation of firms, and sale of the business.

2. Valuing goodwill: average profit methods

Average profit method. Goodwill = Average profit × Number of years' purchase.

Example. Profits for four years: ₹80,000, ₹1,00,000, a loss of ₹20,000, and ₹1,40,000. Goodwill is valued at 2 years' purchase of the average profit.

Total profit   = 80,000 + 1,00,000 - 20,000 + 1,40,000 = 3,00,000
Average profit = 3,00,000 / 4 = 75,000
Goodwill       = 75,000 x 2  = 1,50,000

Normalising profits first. Past profits must show what the business normally earns. Before averaging:

• add back abnormal losses (loss by fire, theft, an unusual lawsuit) and deduct abnormal gains (profit on sale of a fixed asset, a one-off insurance claim);

• deduct income from non-trade investments, which is not earned by the business;

• correct errors, such as capital expenditure wrongly charged as revenue (add back, less depreciation on it);

• deduct a reasonable salary for a partner's work if the question says partners work without salary, and adjust for expected future changes in expenses.

Continuing the example. The loss of ₹20,000 included an abnormal loss by fire of ₹60,000. The normal result for that year is −20,000 + 60,000 = ₹40,000 profit.

Normal total   = 80,000 + 1,00,000 + 40,000 + 1,40,000 = 3,60,000
Average profit = 90,000
Goodwill       = 90,000 x 2 = 1,80,000

Weighted average profit method. Used when profits show a clear trend; the latest years matter most, so they get the highest weights.

Weighted average profit = 4,80,000 ÷ 6 = ₹80,000. At 3 years' purchase, goodwill = ₹2,40,000.

3. Valuing goodwill: super profit and capitalisation

These methods need two further terms.

• Normal rate of return (NRR): the return investors normally expect in this line of business.

• Capital employed = Total assets − Outside liabilities. In total assets, exclude goodwill already in the books, fictitious assets (like a debit balance of Profit and Loss) and non-trade investments.

• Normal profit = Capital employed × NRR ÷ 100.

• Super profit = Average profit − Normal profit.

Working example. A firm's total assets are ₹7,20,000, including goodwill of ₹40,000 and non-trade investments of ₹30,000. Outside liabilities are ₹1,50,000. Average profit is ₹84,000 and NRR is 12%.

Capital employed = 7,20,000 - 40,000 - 30,000 - 1,50,000 = 5,00,000
Normal profit    = 5,00,000 x 12% = 60,000
Super profit     = 84,000 - 60,000 = 24,000

Super profit method. Goodwill = Super profit × Number of years' purchase. At 3 years' purchase: 24,000 × 3 = ₹72,000.

Capitalisation of average profit.

Capitalised value of average profit = 84,000 x 100/12 = 7,00,000
Goodwill = Capitalised value - Capital employed
         = 7,00,000 - 5,00,000 = 2,00,000

Capitalisation of super profit. Goodwill = Super profit × 100 ÷ NRR = 24,000 × 100/12 = ₹2,00,000.

Note. The two capitalisation methods always give the same answer, which is a useful check. Capitalisation treats goodwill as the capital that would be needed to earn the super profit forever at the normal rate.

Finding capital employed when only partners' capitals are given. Capital employed = Partners' capitals + Reserves and accumulated profits − Goodwill in books − Fictitious assets (− non-trade investments, if any).

4. Sacrificing ratio and gaining ratio

When the ratio changes, some partners give up part of their share and others take it.

• Sacrificing ratio = Old ratio − New ratio (for partners whose share falls).

• Gaining ratio = New ratio − Old ratio (for partners whose share rises).

• Total sacrifice always equals total gain.

Example. A, B and C share 5:3:2 and decide to share equally in future. Use the common denominator 30.

A sacrifices 5/30; B and C gain 1/30 and 4/30. Total sacrifice equals total gain (5/30).

5. Accounting for goodwill on a change in ratio

Under AS 26, goodwill that a firm has built up itself (not paid for) cannot be shown in the books. So the gaining partners pay the sacrificing partners for the share they gave up, through their capital accounts:

Gaining Partners' Capital A/cs Dr (goodwill × their gain) To Sacrificing Partners' Capital A/cs (goodwill × their sacrifice)

Continuing the example. Goodwill of the firm is valued at ₹1,80,000.

Entry: B's Capital A/c Dr ₹6,000, C's Capital A/c Dr ₹24,000, To A's Capital A/c ₹30,000.

Existing goodwill in the books was earned under the old arrangement. Write it off first among the old partners in the old ratio: Partners' Capital A/cs Dr, To Goodwill A/c. If goodwill of ₹30,000 appears in the books above: A ₹15,000, B ₹9,000, C ₹6,000.

6. Reserves and accumulated profits or losses

Reserves, credit balance of Profit and Loss, and similar balances were earned under the old ratio, so they belong to the partners in the old ratio. Debit balances (accumulated loss, deferred revenue expenditure) are borne in the old ratio too.

Method 1: distribute them.

• General Reserve A/c Dr, Profit and Loss A/c (credit balance) Dr, To Partners' Capital A/cs (old ratio).

• Partners' Capital A/cs Dr (old ratio), To Profit and Loss A/c (debit balance).

Method 2: leave them in the books and pass a single adjusting entry for the net amount, in the sacrificing and gaining ratios.

Example. A, B and C (5:3:2 to 1:1:1) have a General Reserve of ₹45,000 and a credit Profit and Loss balance of ₹15,000, total ₹60,000, which the partners want to keep in the books.

Entry: B's Capital A/c Dr ₹2,000, C's Capital A/c Dr ₹8,000, To A's Capital A/c ₹10,000.

Workmen Compensation Reserve (WCR). This reserve is set aside for claims by workers.

• No claim: the whole reserve is distributed to the old partners in the old ratio.

• Claim less than the reserve: pay the claim from the reserve and distribute the rest. WCR ₹20,000 with a claim of ₹12,000: WCR A/c Dr ₹20,000, To Provision for Workmen Compensation Claim ₹12,000, To Partners' Capital A/cs ₹8,000.

• Claim more than the reserve: the excess is a loss. WCR ₹20,000 with a claim of ₹26,000: the extra ₹6,000 is debited to the Revaluation Account.

Investment Fluctuation Fund (IFF). This reserve covers a fall in the value of investments.

• If market value is below book value, use the fund to cover the fall and distribute the rest. IFF ₹15,000, investments at book value ₹1,00,000 and market value ₹92,000: ₹8,000 reduces investments; the remaining ₹7,000 goes to the old partners.

• If the fall is more than the fund: market value ₹80,000 means a fall of ₹20,000. The fund covers ₹15,000 and the other ₹5,000 is debited to the Revaluation Account.

• If market value is above book value, the whole fund goes to the partners and the rise is credited to the Revaluation Account.

7. Revaluation of assets and liabilities

Revaluation Account (a nominal account) records increases and decreases in value at the time of reconstitution. The profit or loss on it belongs to the old partners in the old ratio.

Example. On the change from 5:3:2 to 1:1:1: buildings are revalued up by ₹36,000; stock is reduced by ₹6,000; a provision for doubtful debts of ₹3,000 is created; and an unrecorded outstanding expense of ₹3,000 is brought in.

Revaluation Account

Without altering book values. If the partners want to keep the old values in the books, find the net gain (₹24,000 here) and adjust it in the sacrificing and gaining ratios with one entry: A 24,000 × 5/30 = ₹4,000 Cr; B ₹800 Dr; C ₹3,200 Dr. The entry is B's Capital A/c Dr ₹800, C's Capital A/c Dr ₹3,200, To A's Capital A/c ₹4,000.

One combined entry. Exams often ask for a single entry covering goodwill, reserves and revaluation together. Add up the net amount for each partner and pass one entry. Here A is credited 30,000 + 10,000 + 4,000 = ₹44,000; B is debited 6,000 + 2,000 + 800 = ₹8,800; C is debited 24,000 + 8,000 + 3,200 = ₹35,200.

A reliable problem-solving routine

1. Write old and new ratios over a common denominator. Find who sacrifices and who gains, and check the totals match.

2. Value goodwill: normalise the profits, then apply the method the question names.

3. Write off any goodwill already in the books in the old ratio.

4. Gaining partners compensate sacrificing partners for goodwill through capital accounts.

5. Distribute reserves, accumulated profits and losses in the old ratio, or adjust them by a single entry if they are to stay in the books.

6. Deal with WCR and IFF, sending any excess loss to the Revaluation Account.

7. Prepare the Revaluation Account and share its result in the old ratio (or adjust by a single entry without altering book values).

Connections that matter

• Partnership fundamentals gives the profit-sharing ratio and capital account formats used here.

• Admission of a partner uses the same goodwill, reserve and revaluation steps, with the new partner as the gaining partner.

• Retirement and death use the gaining ratio: the continuing partners compensate the outgoing partner.

Common mistakes

• Calling goodwill a fictitious asset. It is intangible but has real value.

• Averaging profits without removing abnormal items or non-trade income.

• Including existing goodwill or non-trade investments in capital employed.

• Mixing up the ratios. Goodwill compensation uses sacrificing and gaining ratios; reserves and revaluation profit (when distributed) use the old ratio.

• Raising goodwill in the books. Under AS 26 self-generated goodwill is not recorded; adjust through capital accounts.

• Taking a partner whose share is unchanged into the goodwill entry. They neither pay nor receive.

• Debiting the whole workmen compensation claim to Revaluation. Only the excess over the reserve goes there.

Revision checklist

• I can explain goodwill, its nature and the factors that create it.

• I can normalise past profits and value goodwill by all four methods.

• I can calculate capital employed correctly.

• I can find sacrificing and gaining ratios for any change in ratio.

• I can pass the goodwill adjustment entry and write off existing goodwill.

• I can treat reserves, WCR and IFF, and prepare a Revaluation Account.

• I can combine goodwill, reserves and revaluation into one adjusting entry.