NCERT Solutions for Class 12 Accountancy Chapter 3 Reconstitution of a Partnership Firm – Admission of a Partner

1. Do you advise that assets and liabilities must be revalued at the time of admission of a partner? If so, why? Also describe how is this treated in the book of account?

Ans. Yes, it is advisable to revalue the assets and liabilities at the time of admission of a new partner for ascertaining the current value of the assets and liabilities. This is done because the value of assets and liabilities may have increased or decreased and consequently their corresponding figures in the old balance sheet may either be understated or overstated. Moreover, it may also be possible that some of the assets and liabilities are left unrecorded. Thus, in order to record the increase and decrease in the market value of the assets and liabilities, Revaluation Account is prepared and any profits or losses on the increase or decrease are distributed among the old partners of the firm in old profit sharing ratio.

Accounting Entries in the Books of Accounts:

The following Journal entries are recorded in the Revaluation Account on the date of admission of a new partner.
(i) For increase in value of assets:
     Assets A/c                                            Dr.
        To Revaluation A/c
(Increase in the value of assets)
(ii) For decrease in value of assets:
      Revaluation A/c                                  Dr.
        To Asset A/c
(Decrease in the value of assets)
(iii) For increase in liabilities:
       Revaluation A/c                                 Dr.
         To Liabilities
(Increase in the value of liabilities)
(iv) For decrease in liabilities:
         Liability A/c                                      Dr.
          To Rev aluation A/c
(Decrease in the value of liabilities)
(v) For recording of unrecorded assets:
       Unrecorded Assets A/c                        Dr.
         To Rev aluation A/c
(Recording of unrecorded assets)

(vi) For recording of unrecorded liabilities:
       Revaluation A/c                                   Dr.
          To Unrecorded Liabilities A/c
(Recording of unrecorded liabilities)
(vii) For transfer of credit balance of Revaluation Account:
       Revaluation                                          Dr.
           To Old Partner’s Capital A/c
(Profit on revaluation is transferred to the Old Partner’s Capital Account in their old profit sharing ratio)
                                               OR
(viii) For transfer of debit balance of Revaluation Account:
        Old Partner’s Capital A/c                      Dr.
           To Revaluation A/c
(Loss on revaluation is transferred to the Old Partner’s Capital Account in their old profit sharing ratio)

2. What is goodwill? What are the factors that effect goodwill?

Ans. Goodwill is an intangible asset of a firm. It is the value of a firm’s reputation and its good brand name in the market. A firm earns goodwill by its hard work and thereby winning the blind trust and faith of the customers by fulfilling their demands in both qualitative and quantitative aspects. A positive goodwill helps a firm to earn supernormal profits compared to its competitors that earns normal profits (as their goodwill is zero). In other words, goodwill ensures greater future profits as there will be greater number of satisfied customers in the future.

Characteristics of Goodwill: The following are the characteristics of goodwill:

(i) It is an intangible asset.

(ii) Ascertaining the exact value of goodwill is difficult.

(iii) The future as well as the present earning capacity of a business in enhanced.

(iv) It helps in earning supernormal profits against the normal profits.

(v) It assists the business to enjoy its upper hand over its counterparts.

Factors Affecting Goodwill: The following are the important factors that affect the goodwill of a firm.

(i) Best Quality Products: If a company produces product of the best quality and in large scale, then automatically the company earns more goodwill.

(ii) Location: If a business is located at easily attainable and appropriate place, then more number of consumers will be attracted again and again which will lead to enhance in sales and, therefore, the firm will earn higher goodwill.

(iii) Management: Coherent management leads to cost efficiency and increases productivity. If a firm’s management is efficient, then superior quality products can be produced at lower cost .These can be sold at lower price. Superior quality at lower price enables a firm to earn higher goodwill.

(iv) Market Structure: If a firm is operating in a monopoly market with no close substitutes, then there will be more goodwill of the firm.

(v) Economies of Scale: If a firm enjoys special advantages like, continuous supply of power, fuel and raw materials at a low price and produces quality product at a large scale, then the firm enjoys higher value of goodwill.

3. Explain various methods of valuation of goodwill.

Ans. The following are the various methods of valuation of goodwill.

(i) Average Profit Method: Under this method, goodwill is calculated on the average basis of the profits of past few years. The formula for calculating goodwill is:

Goodwill = Average Profit × No. of Years Purchase

$$Average Profit= \frac{Total Profit of Past Given Years}{Number of Years}$$

Number of Years Purchase implies number of years for which the firm expects to earn the same amount of profits.

Steps to Calculate Goodwill by Average Profit Method:

Step 1: Ascertain the total profit of past given years.

Step 2: Add all abnormal losses like, loss by fire, theft etc.

Step 3: Add all normal income, if not added previously.

Step 4: Less all non-business incomes and all abnormal gains and incomes like, speculation, lottery etc.

Step 5: Less all normal expenses, if not deducted previously.

Step 6: Calculate Average Profit, by dividing the total profit ascertained in Step 5 by number of years.

Step 7: Multiply the Average Profit to the Number of Year’s Purchases to calculate the value of goodwill.

Example:

The profits for last 5 years are 1,00,000, 3,00,000, (2,00,000), 5,00,000, 8,00,000.
Calculate goodwill on the basis of 4 years purchase

$$Average=\frac{1,00,000+3,00,000+5,00,000+8,00,000-2,00,000}{5}\\=\frac{15,00,000}{5}=₹3,00,000$$

Goodwill = 3,00,000 × 4 years = ₹12,00,000.

(ii) Weight Average Method: It is the modified version of the Average Profit Method. Under this method, the weights are assigned for each year’s profit. Highest weights are assigned to the recent year’s profit and lower weights are assigned to the past year’s profits. The products of the profits and the weights are added and divided by the total weights to calculate Weighted Average Profits. The formula for calculating goodwill by this method is:

$$Weighted\space Average\space Profit =\frac{Total\space of\space Proudcts\space of\space Profits}{Total\space of\space Weights}$$

Goodwill = Weighted Average Profit × Number of Years Purchase

Steps to Calculate Goodwill by Weight Average Method:

Step 1: Assign highest weights to the recent year’s profit and lower weights to the past year’s profits, like 4,3,2,1.

Step 2: Multiply the weights with its associating year’s profits.

Step 3: Calculate the total of the products.

Step 4: Divide the total of the product by the total of the weights in order to calculate Weighted Average Profit.

Step 5: Multiply the Weighted Average Profit by the number of years purchase.

For example:

The profits for the last 5 years are ₹1,00,000, ₹3,00,000, ₹(2,00,000), ₹5,00,000, ₹8,00,000.
Calculate goodwill on the basis of 4 years purchase.