Not-for-Profit Organisations & Partnership Accounts — Practice

Question 1

Distinguish the Receipts and Payments Account from the Income and Expenditure Account under four heads, and state which statement each of the following would appear in: purchase of furniture ₹80,000; subscriptions outstanding at year end ₹15,000.

Accepted Answer

Four distinctions.

Nature of account. The Receipts and Payments Account is a real account, being a summarised cash book. The Income and Expenditure Account is a nominal account, being the equivalent of a Profit and Loss Account.

Basis. The Receipts and Payments Account is prepared on the cash basis and records only actual receipts and payments. The Income and Expenditure Account is prepared on the accrual basis and records income earned and expenditure incurred whether or not cash has moved.

Items included by nature. The Receipts and Payments Account includes both capital and revenue items. The Income and Expenditure Account includes revenue items only.

Period. The Receipts and Payments Account includes amounts relating to any period — past, present or future — provided the cash moved this year. The Income and Expenditure Account includes only amounts relating to the current period.

A fifth distinction worth adding is that the Receipts and Payments Account opens and closes with cash and bank balances, whereas the Income and Expenditure Account has no opening balance and closes with a surplus or deficit.

Application.

Purchase of furniture ₹80,000 — appears in the Receipts and Payments Account as a payment, because cash moved this year. It does not appear in the Income and Expenditure Account, being capital in nature; the furniture is shown as an asset in the Balance Sheet, and only the depreciation on it is charged as expenditure.

Subscriptions outstanding at year end ₹15,000 — does not appear in the Receipts and Payments Account, because no cash was received. It is added to subscription income in the Income and Expenditure Account, since it relates to the current period and has been earned, and is shown as a current asset in the Balance Sheet.

Question 2

Subscriptions received during the year ended 31 March 2026 were ₹4,80,000, including ₹35,000 for 2024-25 and ₹28,000 for 2026-27. Subscriptions outstanding on 1 April 2025 were ₹52,000 and on 31 March 2026 were ₹61,000. Subscriptions received in advance on 1 April 2025 were ₹19,000. Compute subscription income for 2025-26.

Accepted Answer

The reliable method is to construct a Subscriptions Account, which forces every balance to be placed and cannot be half-applied.

Subscriptions Account

Debit side:
To Outstanding at beginning (b/d) ₹52,000
To Advance at end (c/d) ₹28,000
To Income and Expenditure Account (balancing figure) ₹4,71,000
Total ₹5,51,000

Credit side:
By Advance at beginning (b/d) ₹19,000
By Cash received ₹4,80,000
By Outstanding at end (c/d) ₹61,000
Total ₹5,60,000

Recomputing carefully by the direct method to confirm:
Cash received ₹4,80,000
Less amounts relating to 2024-25 ₹35,000
Less amounts received in advance for 2026-27 ₹28,000
Equals cash relating to 2025-26 ₹4,17,000
Add outstanding at 31 March 2026 ₹61,000
Add advance received last year relating to 2025-26 ₹19,000
Subscription income for 2025-26 = ₹4,97,000

The reasoning behind each adjustment. The ₹35,000 for 2024-25 was earned last year and belongs to last year's income, so it is excluded despite the cash arriving now. The ₹28,000 for 2026-27 has been received but not earned, so it is excluded and shown as a liability. The ₹61,000 outstanding has been earned but not received, so it is included and shown as an asset. The ₹19,000 received in advance last year relates to this year, so it is earned now and included.

Note that the ₹52,000 outstanding at the beginning is not used in the income computation. Of it, ₹35,000 was collected this year and the balance remains outstanding, but in either case it is last year's income. Confusing the opening outstanding with current income is the standard error, and building the account rather than manipulating a formula is what prevents it.

Question 3

State the treatment of each

Accepted Answer

A

Question 4

A partnership has no written deed. One partner claims interest on capital at 10%, a salary of ₹20,000 a month, and profits in proportion to capital contributed. Another partner has lent the firm ₹5,00,000 and claims interest on it. Advise, stating the statutory position.

Accepted Answer

Where there is no deed, or where the deed is silent on a matter, the default provisions of the Indian Partnership Act, 1932 apply.

Interest on capital at 10% — not allowable. In the absence of agreement, no interest on capital is payable to any partner. Interest on capital is an appropriation of profit and requires the partners' agreement; it cannot be claimed as of right.

Salary of ₹20,000 a month — not allowable. In the absence of agreement, no partner is entitled to any salary or commission for taking part in the conduct of the business. A partner works for the firm as an owner, and remuneration for that work must be agreed.

Profits in proportion to capital — not allowable. In the absence of agreement, profits and losses are shared equally, regardless of the capital contributed or the effort expended. A partner who contributed more capital and wishes to receive more profit must obtain agreement to that effect.

Interest on the loan of ₹5,00,000 — allowable at 6% per annum. This claim stands on entirely different ground from the others. A loan is not capital: the partner has advanced money to the firm beyond their agreed capital contribution, and the Act provides that such an advance carries interest at 6% per annum in the absence of agreement.

The distinction carrying the marks is that interest on a loan is a charge against profit, debited to the Profit and Loss Account and payable whether or not the firm earns a profit, because it is a cost of borrowing. Interest on capital, a partner's salary and the share of profit are appropriations of profit, made only out of profit already earned and only where agreed.

The practical advice is that the partners should execute a deed. Every one of the first three claims is reasonable and could be agreed; none is enforceable without agreement.

Question 5

A and B share profits 3:2 with capitals of ₹6,00,000 and ₹4,00,000. The deed allows interest on capital at 8%, a salary of ₹1,20,000 a year to B, and charges interest on drawings. A drew ₹10,000 at the beginning of each month and B drew ₹15,000 at the end of each quarter. Interest on drawings is 6%. Net profit before these adjustments was ₹4,50,000. Prepare the Profit and Loss Appropriation Account.

Accepted Answer

Working Note 1 — interest on capital.
A: ₹6,00,000 × 8% = ₹48,000
B: ₹4,00,000 × 8% = ₹32,000

Working Note 2 — interest on A's drawings.
Equal monthly drawings at the beginning of each month, so the average period is 6.5 months.
Total drawings = ₹10,000 × 12 = ₹1,20,000
Interest = ₹1,20,000 × 6% × 6.5/12 = ₹3,900

Working Note 3 — interest on B's drawings.
Equal quarterly drawings at the end of each quarter. The four drawings are outstanding for 9, 6, 3 and 0 months respectively, a total of 18 months across 4 drawings, so the average period is 18 ÷ 4 = 4.5 months.
Total drawings = ₹15,000 × 4 = ₹60,000
Interest = ₹60,000 × 6% × 4.5/12 = ₹1,350

Profit and Loss Appropriation Account for the year

Credit side:
By Net profit ₹4,50,000
By Interest on drawings — A ₹3,900, B ₹1,350 = ₹5,250
Total ₹4,55,250

Debit side:
To Interest on capital — A ₹48,000, B ₹32,000 = ₹80,000
To B's salary ₹1,20,000
To Share of profit — A and B in 3:2
Amount available for distribution = ₹4,55,250 − ₹80,000 − ₹1,20,000 = ₹2,55,250
A: ₹2,55,250 × 3/5 = ₹1,53,150
B: ₹2,55,250 × 2/5 = ₹1,02,100
Total ₹4,55,250

Two points of method. Interest on drawings is credited to the Appropriation Account because it is a gain to the firm, recovered from the partners. And the average period for drawings at the end of each quarter is 4.5 months, not the 5.5 months applicable to monthly drawings in arrears — the shortcut must be derived from the actual pattern rather than recalled as a single number.

Question 6

A firm's profits for the last four years were ₹3,20,000, ₹3,80,000, ₹2,90,000 and ₹4,10,000. The third year's profit was after charging an abnormal loss of ₹60,000, and the fourth year included a non-recurring gain of ₹50,000. Capital employed is ₹18,00,000 and the normal rate of return is 12%. Compute goodwill by (a) three years' purchase of average profit and (b) two years' purchase of super profit.

Accepted Answer

Working Note 1 — adjusted profits.
Abnormal items are removed so that the average reflects sustainable earnings. An abnormal loss is added back because it will not recur; a non-recurring gain is deducted for the same reason.

Year 1: ₹3,20,000
Year 2: ₹3,80,000
Year 3: ₹2,90,000 + ₹60,000 abnormal loss added back = ₹3,50,000
Year 4: ₹4,10,000 − ₹50,000 non-recurring gain deducted = ₹3,60,000
Total ₹14,10,000

Average adjusted profit = ₹14,10,000 ÷ 4 = ₹3,52,500

(a) Average profit method.
Goodwill = ₹3,52,500 × 3 = ₹10,57,500

(b) Super profit method.
Normal profit = Capital employed × Normal rate of return = ₹18,00,000 × 12% = ₹2,16,000
Super profit = Average adjusted profit − Normal profit = ₹3,52,500 − ₹2,16,000 = ₹1,36,500
Goodwill = ₹1,36,500 × 2 = ₹2,73,000

Comment on the difference. The two figures differ greatly because they measure different things. The average profit method values the whole earning stream, which includes the return the capital would earn in any business at the normal rate. The super profit method values only the excess over that normal return, which is what goodwill actually represents — the earning power attributable to reputation, connection and location rather than to the assets themselves.

On that reasoning the super profit method is superior in principle, and it is the method that responds correctly to a change in capital employed: a firm with the same profits but twice the capital has less goodwill, which the average profit method cannot reflect at all. The number of years' purchase is separately agreed and reflects how long the advantage is expected to persist.

Question 7

X and Y share profits 5:3. They admit Z for a quarter share, which he acquires entirely from X. Compute the new profit-sharing ratio and the sacrificing ratio, and explain which ratio governs the credit of goodwill brought in by Z and why.

Accepted Answer

Old ratio: X 5/8, Y 3/8.

Z acquires 1/4, taken entirely from X.

New shares:
X = 5/8 − 1/4 = 5/8 − 2/8 = 3/8
Y = 3/8, unchanged, since he gave up nothing
Z = 1/4 = 2/8

New profit-sharing ratio = 3 : 3 : 2
Check: 3/8 + 3/8 + 2/8 = 8/8.

Sacrificing ratio = Old share − New share.
X: 5/8 − 3/8 = 2/8
Y: 3/8 − 3/8 = nil
Sacrificing ratio = X alone, the entire sacrifice being 2/8.

Which ratio governs goodwill, and why. Goodwill brought in by Z is credited to the old partners in the sacrificing ratio, so the whole amount goes to X and nothing to Y.

The reasoning is that goodwill is payment for a share of the firm's future earning power. Z is buying a quarter of that earning power, and the question is who is selling it. Here X alone has given up share; Y's entitlement to 3/8 of future profits is exactly what it was before Z arrived. Y has parted with nothing and is therefore owed nothing.

Crediting goodwill in the old ratio of 5:3 would give Y a payment for a sacrifice he did not make, at X's expense — a transfer of value between the continuing partners that nothing in the transaction justifies. Crediting it in the new ratio would be worse still, since it would give part of the payment to Z, who is the buyer.

This is why the sacrificing ratio must be computed explicitly and labelled before any entry is passed. Where the incoming partner acquires share from the old partners in their old ratio, the sacrificing ratio coincides with the old ratio and the distinction appears to vanish — which is precisely why candidates who never learned to compute it separately fail on a question like this one, where it does not.

Question 8

On the admission of a partner, state which ratio applies to each of the following and give the reason

Accepted Answer

A

Question 9

P, Q and R share profits 4:3:2. R retires and P and Q agree to share future profits 3:2. Goodwill of the firm is valued at ₹5,40,000, and it does not appear in the books. Compute the gaining ratio, show the goodwill adjustment entry, and explain why the gaining ratio rather than the new ratio is used.

Accepted Answer

Old ratio: P 4/9, Q 3/9, R 2/9.
New ratio between P and Q: 3:2, that is P 3/5, Q 2/5.

Gaining ratio = New share − Old share.
P: 3/5 − 4/9. Taking a common denominator of 45: 27/45 − 20/45 = 7/45
Q: 2/5 − 3/9. Again over 45: 18/45 − 15/45 = 3/45
Gaining ratio = 7 : 3

Check: total gain = 10/45 = 2/9, which is exactly R's old share. The gains of the continuing partners must sum to the retiring partner's share, and this check should be performed every time.

Goodwill adjustment.
R's share of goodwill = ₹5,40,000 × 2/9 = ₹1,20,000
This is borne by P and Q in their gaining ratio of 7:3:
P: ₹1,20,000 × 7/10 = ₹84,000
Q: ₹1,20,000 × 3/10 = ₹36,000

Entry: P's Capital A/c Dr. ₹84,000; Q's Capital A/c Dr. ₹36,000 / To R's Capital A/c ₹1,20,000.

Since goodwill does not appear in the books and is not to be raised, the adjustment is made directly through capital accounts rather than by opening a Goodwill Account.

Why the gaining ratio rather than the new ratio. R is leaving and is entitled to be paid for the share of future earning power he is giving up. The question is who is acquiring that earning power and in what proportions, because those are the partners who must pay for it.

P and Q are not acquiring R's share in their new ratio of 3:2. They are acquiring it in the ratio by which each of their shares has actually increased, which is 7:3. Note how different these are: charging in the new ratio would put ₹72,000 on P and ₹48,000 on Q, whereas P has in fact gained more than twice as much share as Q and should bear correspondingly more.

The general principle is symmetrical with admission. There, the sacrificing ratio identifies who gave up share and is therefore credited; here, the gaining ratio identifies who acquired share and is therefore debited. In both cases the ratio measures the actual transfer, and the new ratio measures only the position afterwards.

Revaluation profit or loss and any accumulated reserves would be distributed separately among all three partners including R, in the old ratio of 4:3:2, since those accrued while R was still a member.

Question 10

L, M and N share profits equally. N died on 31 August 2025; the firm's year ends 31 March. Last year's profit was ₹7,20,000 and last year's turnover was ₹48,00,000. Turnover from 1 April to 31 August 2025 was ₹22,00,000. Compute N's share of profit to the date of death on both the time basis and the turnover basis, and discuss which is preferable.

Accepted Answer

Elapsed period: 1 April to 31 August 2025 is five months.
N's share: one third.

Time basis.
Profit for the elapsed period = ₹7,20,000 × 5/12 = ₹3,00,000
N's share = ₹3,00,000 × 1/3 = ₹1,00,000

Turnover basis.
Profit for the elapsed period = ₹7,20,000 × (₹22,00,000 ÷ ₹48,00,000) = ₹7,20,000 × 0.4583 = ₹3,30,000
N's share = ₹3,30,000 × 1/3 = ₹1,10,000

The two differ by ₹10,000 in N's share, because turnover in the five months to 31 August was proportionately higher than five twelfths of the previous year's turnover — ₹22,00,000 is about 45.8% of ₹48,00,000, against 41.7% on a straight time apportionment.

Which is preferable. The turnover basis is generally the better measure, because profit is generated by trading rather than by the passage of time. Where a business is seasonal, the time basis can be seriously misleading: a firm earning most of its revenue in a festival quarter would have a partner dying just after that quarter credited with far too little on a time basis, and one dying just before it credited with far too much.

The turnover basis assumes that the rate of profit on sales in the elapsed period matches that of the previous year, which is itself an assumption but a considerably weaker one than assuming profit accrues evenly across the calendar.

The time basis is nonetheless common because it requires only the previous year's profit and is simple to apply, and it is adequate where trade is reasonably even through the year.

In practice the partnership deed usually specifies which basis applies, and where it does, that basis governs regardless of which is theoretically preferable. In an examination, apply the basis the question directs, and where both are asked for, compute both and state the reasoning above.

The amount so computed is credited to N's Capital Account and, together with his capital, his share of revaluation profit, his share of accumulated reserves and his share of goodwill, forms the amount due to his legal representatives. Where that amount is not paid immediately, section 37 of the Partnership Act entitles the representatives, in the absence of agreement, to interest at 6% per annum on the amount left in the firm or, at their option, the share of profits attributable to the use of that amount.

Question 11

Explain the purpose and construction of a Realisation Account on dissolution. State specifically which items are not transferred to it and why, and set out the order in which payments are made.

Accepted Answer

Purpose. On dissolution the firm ceases to exist, its assets are sold, its liabilities discharged, and whatever remains is returned to the partners. The Realisation Account is the account through which this is done. Its function is to bring together the book values of what is being disposed of and the amounts actually realised or paid, so that the difference — the profit or loss on realisation — emerges as a single figure to be shared among the partners.

Construction.

Debit side: all assets to be realised, transferred at their book values; the amounts actually paid to discharge liabilities; and the expenses of realisation.

Credit side: all external liabilities, transferred at their book values; and the amounts actually realised on the sale of assets.

The balance is the profit or loss on realisation, transferred to the partners' capital accounts in their profit-sharing ratio. It is shared in the profit-sharing ratio because it is a trading result of the firm, arising from assets realising more or less than their carrying amounts.

What is not transferred, and why.

Cash and bank balances. These are not realised — they are the money with which payments are made. Transferring them would treat the firm's own cash as an asset being sold to someone.

Partners' loan accounts. A loan from a partner is not an external liability. It ranks after all outside creditors but before capital, and is settled separately at its own stage. Including it among external liabilities in the Realisation Account would misstate the profit on realisation and would obscure the ranking.

Fictitious assets and any debit balance of the Profit and Loss Account. These represent accumulated losses, not assets capable of realisation. They are transferred directly to the partners' capital accounts in the profit-sharing ratio.

Accumulated reserves and undistributed profits. Similarly transferred directly to capital accounts, since they are already partners' funds.

Partners' capital and current accounts. These are the accounts to which the result is carried, not items being realised.

Order of payment. The sequence is fixed and reflects the ranking of claims:

First, the expenses of realisation and all external liabilities — creditors, outstanding expenses, bank overdraft and any secured creditors out of the proceeds of their security.

Second, partners' loans and advances, being amounts due to partners otherwise than as capital.

Third, the partners' capitals, in whatever balances remain after the realisation profit or loss and all other adjustments have been posted.

Where the assets realised are insufficient to meet the capitals in full, the partners bear the shortfall as a loss in their profit-sharing ratio. Where a partner's capital account then shows a debit balance which that partner cannot pay, the deficiency is borne by the solvent partners, and in the absence of contrary agreement the rule in Garner v Murray requires that it be borne in the ratio of their capitals standing just before dissolution rather than in the profit-sharing ratio.

Question 12

State the rule in Garner v Murray, explain its rationale, and discuss the circumstances in which it does not apply. Illustrate with a firm where, after posting the realisation loss, the capital accounts stand at A ₹4,00,000 credit, B ₹2,00,000 credit and C ₹90,000 debit, C being insolvent and able to pay nothing.

Accepted Answer

The rule. Where a partner's capital account shows a debit balance on dissolution which that partner is unable to pay, the deficiency is borne by the solvent partners in the ratio of their capitals standing just before dissolution, and not in their profit-sharing ratio. This applies only in the absence of an agreement to the contrary.

Rationale. The deficiency does not arise from the business. The loss of the business itself has already been shared among all the partners in their profit-sharing ratio when the realisation loss was posted, and C's debit balance is the result of that sharing. What remains unrecovered arises from C's personal inability to pay, which is a matter of C's private circumstances rather than of the firm's trading.

Since the loss is not a trading loss, the profit-sharing ratio is not the appropriate measure for bearing it. The court in Garner v Murray took the view that the solvent partners bear it in proportion to what each had at stake in the firm — their capitals — because the deficiency is in the nature of a loss of capital rather than a loss of profit. A partner who had more capital in the firm was exposed to more, and bears proportionately more.

Application to the figures.
Solvent partners' capitals just before dissolution: A ₹4,00,000 and B ₹2,00,000, a ratio of 2:1.
C's deficiency: ₹90,000.
A bears ₹90,000 × 2/3 = ₹60,000
B bears ₹90,000 × 1/3 = ₹30,000

After absorbing the deficiency, A receives ₹4,00,000 − ₹60,000 = ₹3,40,000 and B receives ₹2,00,000 − ₹30,000 = ₹1,70,000.

Had the deficiency been shared in a profit-sharing ratio of, say, 1:1, each would have borne ₹45,000, and B would have been worse off by ₹15,000 despite having had half A's capital at stake.

When the rule does not apply.

Where the partnership deed provides otherwise. The rule is a default position supplying a term the partners did not agree, and an express agreement on how deficiencies are to be borne displaces it entirely.

Where all partners are insolvent, since there is no solvent partner to bear the deficiency and the creditors' claims are then dealt with under insolvency law.

Where only one solvent partner remains, in which case that partner necessarily bears the whole deficiency and no ratio question arises.

A point of practical importance is which capital figure is used. The rule refers to capitals standing just before dissolution, meaning after adjusting for accumulated reserves, revaluation and any other entries but before the realisation loss is posted. Using the post-realisation figures is a common error and produces a different and incorrect apportionment.

Where fixed capitals are maintained, the ratio is taken on the capital accounts as adjusted, and the treatment of current account balances should follow the question's instruction.

Question 13

A club treasurer prepares only a Receipts and Payments Account and tells members it shows the club's financial performance. Evaluate this claim, and explain what the members are not being told.

Accepted Answer

The claim is wrong, and identifying precisely why requires distinguishing what the Receipts and Payments Account measures from what performance means.

What the account does show. It is a summarised cash book: a real account prepared on the cash basis, opening and closing with the cash and bank balance and recording every receipt and payment during the year. It answers the question of where the money came from and where it went, which is genuinely useful information and is the reason such accounts are prepared at all.

Why that is not performance. Three separate defects follow from its construction.

It mixes capital with revenue. The purchase of ₹8,00,000 of gymnasium equipment appears as a payment alongside the electricity bill, so a year in which the club invested heavily appears as a year of heavy outgoings. Conversely the sale of an old asset appears as a receipt alongside subscriptions, so disposing of assets appears to improve the position. A member reading the account cannot tell whether the club spent its money on running itself or on building itself.

It mixes periods. Subscriptions received for last year and subscriptions received in advance for next year both appear in full, while subscriptions earned this year but not yet collected do not appear at all. A year in which arrears were vigorously collected looks strong; a year in which members paid late looks weak. Neither reflects the club's actual activity in the year.

It ignores everything that did not involve cash. Depreciation on the club's building and equipment is nowhere, so the consumption of assets over the year is invisible. Outstanding expenses are absent, so the club may have incurred obligations it has not disclosed. Consumables used from stock rather than bought during the year are unrecorded.

What members are not being told.

Whether ordinary income covered ordinary expenditure — the surplus or deficit, which is the actual measure of whether the club is living within its means. This requires an Income and Expenditure Account.

What the club owns and owes — its assets, its outstanding liabilities, its accumulated Capital Fund. This requires a Balance Sheet.

Whether money held is free or restricted. A specific donation for building a pavilion appears in the Receipts and Payments Account as a receipt like any other, and a healthy closing cash balance may consist largely of funds the club is not free to spend. Only a Balance Sheet showing the fund separately reveals this.

The conclusion is that a Receipts and Payments Account is a necessary starting point but not a statement of performance. Proper accountability requires all three statements: the Receipts and Payments Account for cash accountability, the Income and Expenditure Account for performance, and the Balance Sheet for position. The treasurer's duty in a members' organisation is precisely to provide the second and third, since members have no other means of knowing whether their subscriptions are sustaining the club.

Question 14

Two partners disagree. One says goodwill should be raised in the books at its full value whenever a partner is admitted; the other says it should never appear in the books at all. Evaluate both positions and explain the treatment ordinarily adopted and why.

Accepted Answer

Both positions have a rationale and both are wrong as stated, and setting out why requires being clear about what goodwill is.

Goodwill is the value of a business's capacity to earn more than a normal return on its net assets — the reputation, customer connection, location and management quality that make profits exceed what the assets alone would command. It is real in the sense that a buyer will pay for it, but it is not separately identifiable, cannot be sold apart from the business, and its value rests entirely on an estimate of future earnings.

The first position: raise goodwill at full value on every admission.

Its merit is that it recognises something of genuine value which the incoming partner is in fact paying for, and it makes the transaction transparent.

Its defect is that it records as an asset an amount that has not been paid for by the firm. Self-generated goodwill has no cost — it accumulated through years of trading whose costs were already charged as expenses. Capitalising it creates an asset out of an estimate of the future, inflating the balance sheet with a figure that no transaction supports and that prudence would not permit. The valuation also depends on the number of years' purchase agreed, which is a matter of negotiation rather than of measurement, so the asset recorded is as much a bargain as a fact.

A further problem is that the goodwill, once raised, remains in the books indefinitely, misleading later readers about the firm's asset base and being carried at a value fixed by a transaction that may be years old.

The second position: goodwill should never appear at all.

Its merit is that it avoids recording a self-generated intangible, which is consistent with modern accounting practice and with prudence.

Its defect is that it ignores a real transfer of value. When an incoming partner acquires a share of future profits, the old partners have parted with something worth money, and they must be compensated. Simply refusing to account for goodwill would let the incoming partner acquire a share of the firm's established earning power for nothing.

The treatment ordinarily adopted.

Goodwill is adjusted through the partners' capital accounts without being raised in the books. Where the incoming partner brings in cash for goodwill, it is credited to the old partners in the sacrificing ratio. Where no cash is brought in, the incoming partner's capital account is debited and the old partners' capital accounts credited in the sacrificing ratio, so the value is transferred between the partners directly.

Where goodwill already appears in the books from some earlier occasion, it is written off among the old partners in their old ratio before any other adjustment, since it belongs to them in those proportions.

Why this is right. It compensates the partners who gave up share, which the second position fails to do, while keeping an unpurchased self-generated intangible off the balance sheet, which the first position fails to do. The adjustment is confined to the partners, which is where the transaction actually occurred — the firm's assets and liabilities are unchanged by a change in who owns it.

The same reasoning applies in reverse on retirement, where the continuing partners' capital accounts are debited in the gaining ratio and the retiring partner's credited.

Question 15

Explain why every reconstitution of a partnership — admission, retirement or a change in the profit-sharing ratio — requires the same four adjustments, and why the ratio used differs between them.

Accepted Answer

A reconstitution is any event that changes the proportions in which partners share future profits, while the firm itself continues. Admission, retirement, death and a simple agreed change in the ratio are all instances of it.

The four adjustments are required in every case because a reconstitution creates a single problem: some partners' entitlement to future profits increases and others' decreases, but the firm's assets, its accumulated past profits and its earning power were all built up under the old arrangement. Unless those are settled at the moment of change, partners whose share is rising would acquire a portion of what belonged to others, without paying for it.

Adjustment one: revaluation of assets and liabilities. Assets carried at cost may be worth more or less than book value, and liabilities may be understated. Those differences accrued under the old arrangement. Recognising them at reconstitution ensures the resulting gain or loss goes to the partners who were entitled to it, and it is therefore distributed in the old ratio. Left unrecognised, an undervalued asset would silently transfer value to whoever gains share.

Adjustment two: distribution of accumulated reserves and undistributed profits or losses. These are past profits not yet divided, earned wholly under the old arrangement. They are distributed in the old ratio for the same reason, and leaving them in the books would give a share of past earnings to a partner whose entitlement begins only now.

Adjustment three: goodwill. This is the firm's capacity to earn more than a normal return, built up under the old arrangement, and a change in the ratio transfers part of it. It must be paid for by those acquiring it to those giving it up. The ratio here is neither the old nor the new but the ratio of the actual transfer.

Adjustment four: adjustment of capitals. Where the partners agree that capitals should stand in the new profit-sharing ratio, the necessary amounts are brought in or withdrawn, or transferred through current accounts.

Why the ratio differs.

The governing question for each adjustment is which period the amount relates to.

Amounts accruing before the reconstitution — revaluation gains and losses, accumulated reserves, existing goodwill in the books — belong to the partners as they were, and go in the old ratio.

Amounts arising after it — future profits — go in the new ratio.

The transfer of share itself belongs to neither period; it is the price of the change. So it goes in the ratio measuring the change: the sacrificing ratio on admission, where old partners give up share and are credited; the gaining ratio on retirement, where continuing partners acquire share and are debited. In a pure change of ratio between existing partners, both are computed — some partners sacrifice and others gain, and the goodwill adjustment runs from the gainers to the sacrificers.

The practical consequence for an examination answer is that the ratios must be derived and labelled as working notes before any account is written, because every figure that follows depends on them, and an error in a ratio propagates through the entire question.

Practice — Not-for-Profit Organisations & Partnership Accounts

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