Reconstitution of a Partnership Firm: Admission of a Partner

When a new partner is admitted, the existing partners surrender a fraction of their profit share in favor of the new partner. The ratio in which they surrender their shares is called the Sacrificing Ratio (SR):

Standard Calculation Cases:

• Case 1: When New Partner acquires share from old partners in their old ratio:
  Let total profit $= 1$. Remaining share $= 1 - \text{New Partner's Share}$. Each old partner's new share $= \text{Old Share} \times \text{Remaining Share}$. Here, Sacrificing Ratio = Old Ratio.
• Case 2: When New Partner acquires share in a specified ratio:
  Sacrifice of Old Partner $= \text{New Partner's Share} \times \text{Fraction Surrendered}$.
  New Share $= \text{Old Share} - \text{Sacrifice}$.

A. Three Valuation Methods:

1. Average Profit Method: $\text{Goodwill} = \text{Adjusted Average Profit} \times \text{Number of Years' Purchase}$. (Abnormal gains deducted, abnormal losses added back).
2. Super Profit Method: Super Profit is the excess of actual average profit over normal profit earned by industry peers: $$\text{Normal Profit} = \text{Capital Employed} \times \left( \frac{\text{Normal Rate of Return}}{100} \right)$$ $$\text{Super Profit} = \text{Average Maintainable Profit} - \text{Normal Profit}$$ $$\text{Goodwill} = \text{Super Profit} \times \text{Number of Years' Purchase}$$
3. Capitalization Method: $$\text{Capitalized Value of Firm} = \frac{\text{Average Profit}}{\text{NRR}} \times 100$$ $$\text{Goodwill} = \text{Capitalized Value} - \text{Net Assets (Capital Employed)}$$ $$\text{OR } \text{Goodwill} = \frac{\text{Super Profit}}{\text{NRR}} \times 100$$

B. Accounting Treatment of Goodwill (AS-26 Mandate)

Accounting Standard 26 (Intangible Assets) strictly mandates: Goodwill cannot be raised in the books unless valuable money consideration has been paid for it! Therefore, internally generated goodwill is adjusted strictly through partner accounts:

• Case 1: Premium paid privately to old partners: NO ENTRY is passed in firm books.
• Case 2: New partner brings Premium for Goodwill in Cash:

  Cash / Bank A/c ................................ Dr. [Total Cash]
      To New Partner's Capital A/c .................... [Capital Brought]
      To Premium for Goodwill A/c ..................... [Goodwill Brought]
  
  Premium for Goodwill A/c ....................... Dr.
      To Sacrificing Partners' Capital/Current A/c .... [In SACRIFICING RATIO!]

• Case 3: New partner is UNABLE to bring Goodwill in Cash:

  New Partner's CURRENT A/c ...................... Dr. [His share of Goodwill]
      To Sacrificing Partners' Capital/Current A/c .... [In SACRIFICING RATIO!]

At the time of admission, old assets and liabilities must be revalued so that the new partner neither gains nor suffers from past price fluctuations. A nominal Revaluation Account (Profit & Loss Adjustment A/c) is prepared:

• Debit Side (Losses): Decrease in asset value, Increase in liability value, Unrecorded liability discovered.
• Credit Side (Gains): Increase in asset value, Decrease in liability value, Unrecorded asset discovered.
• Profit / Loss on Revaluation: Transferred exclusively to OLD PARTNERS in their OLD PROFIT SHARING RATIO!