CAMBRIDGE COURT HIGH SCHOOL

CLASS – XII - ACCOUNTANCY

Topic: Change in Profit Sharing Ratio (Part-1)
SYNOPSIS
Introduction:
Change in profit sharing ratio means that the partners change their proportion of sharing
profits and losses in a partnership firm. This change can be because of the change in the
capital contribution of partners, the level of participation of partners in the activities of the
firm or due to any other agreement among the partners. This results in a change in the
partnership agreement.

It can be done in the following cases:

1. Change of ratio among existing partners
2. Admission of a new partner
3. Retirement or death of an existing partner
4. Amalgamation of two partnership firms

In any of the above cases whenever there is any change in PSR, the following adjustments are
to be made:
1. Calculation of Gaining and Sacrificing ratio.
2. Valuation of Goodwill.
3. Accounting treatment of Goodwill.
4. Accounting treatment of Accumulated profits and losses
5. Accounting treatment of Revaluation of assets & Reassessment of liabilities

1. GAINING & SACRIFICING RATIO

Gaining ratio is the ratio in which one or more partners stand to acquire a portion of the
profits of the other partners.
Sacrificing ratio is the ratio in which one or more partners sacrifice a part of their profit in the
favour of other partners.
Gaining ratio= New ratio- old ratio
Sacrificing ratio=Old ratio-New ratio
Sum of gaining ratio is always equal to the sum of sacrificing ratio.
Their calculation helps to find the amount of amount of compensation that the gaining partner
has to pay to the sacrificing partner, so that the gaining partner does not gain in future
because of the change in the profit-sharing ratio at present.

2. VALUATION OF GOODWILL

What is Goodwill?
Goodwill is an intangible asset that is associated with the purchase of one company by
another. Specifically, goodwill is the portion of the purchase price that is higher than the sum
of the net fair value of all of the assets purchased in the acquisition and the liabilities assumed
in the process. The value of a company’s brand name, solid customer base, good customer
relations, good employee relations, and proprietary technology represent some examples of
goodwill.
KEY TAKEAWAYS

• Goodwill is an intangible asset that accounts for the excess purchase price of another
company.
• Items included in goodwill are proprietary or intellectual property and brand
recognition, which are not easily quantifiable.
• Goodwill is calculated by taking the purchase price of a company and subtracting the
difference between the fair market value of the assets and liabilities.
• Companies are required to identify the value of goodwill on their financial statements
at least once a year and record any impairments.
• Goodwill is very different from other intangible assets, having an indefinite life, while
other intangible assets have a definite useful life.

Types of Goodwill
There are two distinct types:

• Purchased: Purchased goodwill is the difference between the value paid for an
enterprise as a going concern and the sum of its assets less the sum of its liabilities,
each item of which has been separately identified and valued.
• Inherent/Self-generated: It is the value of the business in excess of the fair value of
its separable net assets. It is referred to as internally generated goodwill and it arises
over a period of time due to the good reputation of a business.
For example, if you are selling an outstanding product or providing excellent service
consistently, there is a lot of chance that goodwill raises quicker.

Factors Affecting Goodwill

1. Quality Of Product: Better quality of product will increase the sales and profits
which will increase the value of goodwill.
2. Efficiency Of Management: A well-handled interest normally enjoys the merit of
more cost efficiency and productivity, which will increase the value of goodwill.
3. Location: The better location will attract more customers resulting in an increase in
sales and profits which in turn, will result in an increase in the value of goodwill.
4. Market Condition: The monopoly situation or limited competition facilitates the
concern to earn more gains which leads to the more value of goodwill
5. Access To Supplies (Raw Material Etc.): If a firm has better access to supplies or
assured supply of inputs then it enjoys a better reputation than others and higher
goodwill.
6. Special Advantages: If a firm enjoys special advantages like patents, trademarks,
brand image, or any other exclusive benefit, then the firm enjoys a higher value of
goodwill.
7. External resources: After sales service, Research & Development, Effectiveness of
Advertisement, the supply of electricity, import licenses, well-known collaborators,
long-term contracts for the supply of materials, trademarks, patents, etc. certainly
enjoy more value of goodwill.

Need for Valuation of Goodwill

Whenever the mutual rights of the partners changes then party which makes a sacrifice
must be compensated. This basis of compensation is goodwill so we need to calculate
goodwill. Mutual rights change under following circumstances:-

• The Change in the profit sharing ratio (PSR) amongst the existing partners
• Admission of a new partner
• Retirement of a partner
• Death of a partner
 • Dissolution of an enterprise involving the sale of the business as a trading concern
• Consolidation of partnership firms

Why it is necessary to value Goodwill?

• When there is any change in the profit sharing ratio of partners, Goodwill is valued. One
partner may gain a share of profit and others may sacrifice.

• So, we adjust Goodwill through capital accounts of partners. Debit the Gaining partner’s
capital account and credit the sacrificing partner’s capital account. The basis of this
adjustment is the profit sacrificing ratio.

• If partners decide to change the profit-sharing ratio in the future, the gaining partner shall
compensate the losing partner in the agreed ratio. The compensation will be the value of
goodwill represented by the gain.

• The change in profit-sharing ratio represents that one partner is purchasing the share of
profit from another partner. Suppose, X and Y, are partners sharing profits in the ratio of
3: 1 respectively. It is decided that in the future they will be equal partners; it means that
X is selling to Y 1/4th share of profits. Therefore, Y will pay X an amount equal to one-
fourth of the total Goodwill valued. In other words, suppose, the profit is 1,20,000,
previously X would get 90,000 and Y would get 30,000. After the change in their
agreed profit-sharing ratio, each would get 60,000, X loses annually 30,000 and Y
gains 30,000. If the goodwill is valued at 3,00,000, X must pay to Y one-fourth of
3,00,000 viz., 75,000.

Methods of Valuation of Goodwill

The significant methodologies of valuation are mentioned:

• Average Profits Method

• Super Profits Method
• Capitalisation Method

(i) Average Profit Method:

The profit earned by a Firm during previous accounting periods on an average basis is
called average profit. Goodwill is calculated on the basis of average profit due to future
expectations of earning capacity of the firm.
Value of goodwill = Actual Average Profit x No. of years’ purchase

(a) Actual Average Profit =Total of Profits / Total number of year for which profit and
loss is given
The following adjustments should be taken into account while calculating and loss
average profit:
(I) Abnormal loss of a year such as loss from fire or theft etc. should be added
back to that profit.
(II) Abnormal income of a year such as income from speculation or lottery
etc. should be deducted out of profit of that year.
(III) Normal expenses of a year, if not deducted out of profits, should be deducted
out of Profits of that year.
(IV) Normal income of a year, if not added in the profits, should be added to the
profit of that year.
 (V) Remuneration of proprietor of a year should be deducted out of profits of
that year.

(b) Number of year’s purchase means for how many years, the firm will earn the
same amount of profit because of its previous efforts, after being purchased by
another firm. After making the above adjustment the average profit is known as
actual average profit or average maintainable profit in future.

Weighted Average Profit Method

(a) Weighted Average Profit = Total of products of profits/losses

Total of weights

Value of Goodwill = Weighted average profit x No. of years’ purchase

Weighted average profit method for valuation of goodwill is better than the simple
average method because it gives a higher weight age to the profits to the recent
years. However, weighted average should be used only if specified.
(ii) Super Profit Method:
If a firm earns higher profit in comparison to normal profit (generally earned by other
firms of same industry) then the difference is called Super Profit. Goodwill is
calculated on the basis of Super profit due to future expectations of learning capacity of
the firm.

(a) Actual Average Profit = Total Profits/No. of years

Normal Profit = Capital Invested x Normal Rate of Return/100
(b) Where Capital Invested = Assets – External Liabilities
(c) Super Profit = Actual/Average Profit-Normal Profit

Value of Goodwill = Super profit x No. of years’ purchase

(iii) Capitalization of Profit Method:

In this method capitalized value of the firm is calculated on the basis of normal rate of
return. Difference between the capitalized value and actual capital employed is called
goodwill.
(a) Capitalization of actual/average method :

Value of Goodwill = Capitalized value of average profit – Net Capital employed

According to this method, the following steps should be adopted:

(I) Actual/ Average profit is calculated in the same manner which has been
explained earlier.
(II) Capitalized value of actual/average profit = Actual/ Average Profit X
100/Normal rate of return
(III) Actual capital employed (or Net Assets) = Total assets (excluding
goodwill) minus outside liabilities.

(b) Capitalization of Super Profit Method:

As the name suggests, this method tries to assess the capital needed for earning
the super profit. This capital is known as goodwill.
 Following formula can be used for calculating goodwill :

Value of goodwill = Super profit x Normal rate of return/100

Short Answers Questions

Q.1 Mention the occasions on which Reconstitution of partnership firm can take place.

Q.2 What is Sacrificing ratio & Gaining ratio?

Q.3 Why is the value of Goodwill ascertained when a firm is reconstituted.

Q.4 Who should compensate whom in case of a Change in the profit sharing ratio of the
existing partners?

Q.5 What do you mean by Change in the profit sharing among partners?

Q.6 How Sacrificing Share of each partner is calculated?

Q.7 How Gaining Share of each partner is calculated?

Q.8 Explain the meaning of Goodwill. Also explain the nature of goodwill in support of
your answer.

Q.9 State and explain the factors effecting the value of goodwill.

Q.10 Which ‘Accounting Standard’ prescribes the guidelines for the accounting treatment
of goodwill?

Q.11 Mention the condition according to which ‘Goodwill’ can be recorded in the books of
account.

Q.12 State the factors which influence the valuation of goodwill of partnership firm.

Q.13 What do you understand by purchased goodwill & self-generated goodwill?

Q.14 Give two features of goodwill.

Q.15 What is the need for valuation of goodwill?

Q.16 What are the methods to evaluate goodwill ?

Q.17 What is a Super profit method?

Q.18 State two features of Purchased goodwill.

Objective Type Questions

Q.1 In valuation of Goodwill, the Weighted Average Profit Method is preferred over
average method when profits are _____________.

Q.2 Goodwill is an _________ Assets.

Q.3 While computing goodwill, abnormal incomes and expenses are not ignored to
calculate the value of goodwill. (True/ False)

Q.4 Weighted Average Method is preferred over Average Profit method at the time of
falling profits. (True/ False)

Q.5 Calculate the value of goodwill when capital employed 5,00,000, average profit
60,000 and normal rate of return is 10% -
(a) 6,000 (b) 50,000
(c) 60,000 (d) 1,00,000

Q.6 Goodwill of the firm on the basis of 3 year’s purchase of average profit of the last
three years is 50,000. Find average profit :
(a) 1,00,000 (b) 50,000
(c) 20,000 (d) 25,000

Q.7 A, B, C and D are partners. They change their profit sharing ratio to 2 : 2 : 1 : 1. C’s
sacrifice is :
(a) 1/6 (b) 1/12
(c) 1/24 (d) 2/6

Q.8 Self-generated Goodwill is recorded in the books of accounts and shown in the
Balance Sheet as an asset as per Accounting Standard -26,( Intangible Assets).True or
False?

Q.9 Gaining Partner(s) compensate Sacrificing Partner(s) when Profit-sharing Ratio

changes. True or False?

Q.10 Goodwill appearing in the Balance Sheet means Purchased Goodwill. True or False?

Q.11 The ratio in which a partner loses his share of profit in favour of other partners is
called the __________ ratio.

Long Answers Questions

Q .1 Calculate the value of goodwill on the basis of four and half year’s purchase of
average profit of preceding three years. The profits of last three years were, 2007:
50,000, 2008; 60,000 and 2009: 75,000. Following is the additional information:
(a) On July 1, 2007, wages paid 20,000 to lbourers for installation of machinery
was treated as revene expenditure. It is to be treated as capital expenditure and
depeciation is to be charged on the basis of 10% per annum on written down value
method.
(b) 5,000 spent on 30th August, 2009 by proprietor for his personal trip was
charged erroneously to trevelling expense account.
(c) Closing stock for the year 2007 and 2008 was under valued by 5,000 and
10,000 respectively.
Q .2 Capital of the firm is 9,50,000 and balance in P&L a/c is 50,000 . Average profit
of the firm was 1,80,000 and the expected rate of return in such type of business is
12% . Calculate goodwill of the firm by capitalising super profit.
Q .3 Calculate the value of goodwill on the basis of two year’s purchase of last three year’s
average profits . The profits of last three years were:
31st March, 2008: 1,20,000(including 30,000 paid for rent of owner’s residence)
31st March, 2009: 1,40,000(including profit on sale of shares 10,000)
 31st March, 2010: 1,30,000(including 20,000 Insurance claim received)
Q .4 The capital of the firm of A and B is 1,00,000 and the market rate of Interest is
15%. Annual Salary to partner’s 6,000 each. The profit for last 3 years (before
charging partner’s salary) were 30,000 , 36,000 and 42,000. Goodwill is to be
valued at 2year’s purchase of the average super profit of the last three years. Calculate
the goodwill of the firm.
Q .5 Ajit and Baljit were sharing profits in the ratio of 3:2. They decided to admit Chaman
into the partnership for 1/6th share of the future profits. Goodwill valued at 4 times the
average super profit of the firm was, 18,000. The firm had assets worth
15,00,000 and liabilities of 12,00,000. The normal earning capacity of such firm is
expected to be 10%. Find the average profit earned by the firm.
Q .6 Calculate goodwill of the firm on the basis of three year’s purchase of past five year’s
average profit which were 2005: 90,000, 2006: 80,000 2007: 85,000, 2008:
1,00,000 and 2009 : 1,10,000. Following additional information is available:
(a) Commission of 10,000 per annum is to be paid every year which was omitted
to be recorded earlier.
(b) Closing stock for the year. 2007 and 2008 was overvalued by 15,000 and
10,000 respectively.
(c) Loan of 2, 00,000 was taken from bank on 30th June, 2008. Interest @ 10% per
annum was not recorded in the books of account. It is to be recorded now.
Q .7 A and B are partners sharing profits and losses in the ratio of 5:3. On 1st April, 2007 C
is admitted to the partnership for ¼th share of profits for this purpose, goodwill is to
be valued at 2 year’s purchase of last three years profit (after allowing partner’s
remuneration). Profit to be weighed 1:2:3, the greatest weight being given to last year.
Net profit before partners remuneration were 2004-05 : 2,00,000, 2005-06 :
2,30,000, 2006-07 : 2,50,000. The remuneration of the partners is estimated to be
90,000 per annum. Calculate the amount of goodwill.