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UNIT: 1 - ACCOUNTING FOR PARTNERSHIP FIRMS

CHAPTER: 1 – FUNDAMENTALS OF PARTNERSHIP FIRMS

PART: A – BASIC CONCEPTS

INTRODUCTION
• As the business expands, an individual i.e., a sole proprietor may not be in a position to cope up with the
financial and managerial demands of the contemporary business world. One needs more capital and a
greater number of people for managing the business and for sharing of risks. In such a situation, people
usually try to convert their business into partnership form of organisation.
• Unlike financial statements of sole proprietorship, financial statements of partnership firms have its own
peculiarities. On many issues that affect distribution of profits like Interest on capital, Interest on drawings
and maintenance of partners’ capital account have their own peculiarities. These peculiar situations need
specific treatment in accounting that need to be clarified.

DEFINITION
According to Section: 4 of the Indian Partnership Act, 1932 partnership is the ‘relation between persons who
have agreed to share the profits of a business carried on by all or any of them acting for all’.
Persons who have entered into partnership with one another are individually called ‘partners’ and
collectively called ‘firm’. The name under which the business is carried is called the ‘firm’s name’. A partnership
firm has no separate legal entity, apart from the partners constituting it.

ESSENTIAL FEATURES OF PARTNERSHIP BUSINESS

1. Two or More Persons:
• To form partnership, there should be at least two persons.
• By virtue of Section: 464 of the Companies Act, 2013, the Central Government is empowered to
prescribe maximum number of partners in a firm but the number of partners cannot be more than
100.
• The Central government has prescribed the maximum number of partners in a firm to be 50.
2. Agreement:
• Partnership is the result of an agreement between two or more persons (either oral or written) to do
business and share its profits and losses.
• To avoid future disputes between partners, it is preferred that the partners have a written
agreement.
3. Business:
• The agreement should be to carry on some Legal business.
• Mere co-ownership of a property does not amount to partnership. For example, if Rohit and Sachin
jointly purchase a plot of land, they become the joint owners of the property and not the partners.
But if they are in the business of purchase and sale of land for the purpose of making profit, they will
be called partners.
• If some persons join hands for the purpose of some charitable activity, it will not be termed as
partnership.
4. Mutual Agency:
• The business of a partnership concern may be carried on by all the partners or any of them acting for
all. This statement has two important implications. First, every partner is entitled to participate in
the conduct of the affairs. Second, that there exists a relationship of mutual agency between all the
partners.
• In accordance with the feature of mutual agency, each partner carrying on the business is the
principal as well as the agent for all the other partners. He can bind other partners by his acts and
also is bound by the acts of other partners with regard to business of the firm.
• It is to be understood that, there would be no partnership, if the element of mutual agency is absent.
5. Sharing of Profit: Another important element is that, agreement for sharing of profits and losses of a
business. It may be equal or any other proportion agreed between the partners.
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6. Liability of Partners:
• Each partner is liable jointly with all the other partners and also severally to the third party for all the
acts of the firm done while he is a partner.
• It means, the liability of partner in partnership firm is Unlimited. The word unlimited liability implies
that, his private assets can also be used for paying off the firm’s debts.

PARTNERSHIP DEED
• Partnership comes into existence as a result of mutual agreement among the partners. The Partnership
Act, 1932 does not require that the agreement must be in writing. It may be in Oral also. But wherever it
is in writing, the document which contains terms of the agreement is called ‘Partnership Deed’.
• To avoid disputes later on, agreement will be made by partners in written format only.
• It generally contains the details about all the aspects affecting the relationship between the partners.
Such details referred as clauses or contents of partnership deed.
• The contents of partnership deed can be altered only with the consent of all the partners.
• The deed should be properly drafted and prepared as per the provisions of the ‘Indian Stamp Act 1889’
and preferably registered with the Registrar of Firms.
Contents of the Partnership Deed:
The Partnership Deed usually contains the following details:
1. Names and Addresses of the firm and its main business.
2. Names and Addresses of all partners.
3. Amount of capital to be contributed by each partner.
4. The accounting period of the firm.
5. The date of commencement of partnership.
6. Rules regarding operation of Bank Accounts.
7. Profit and loss sharing ratio.
8. Rate of interest on capital, loan, drawings, etc.
9. Mode of auditor’s appointment, if any.
10. Salaries, commission, etc, if payable to any partner.
11. The rights, duties and liabilities of each partner.
12. Treatment of loss arising out of insolvency of one or more partners.
13. Settlement of accounts on dissolution of the firm.
14. Method of settlement of disputes among the partners.
15. Any other matter relating to the conduct of business.

• Two business firms cannot form a partnership business.

• Registration of partnership firm is optional but according to Section: 69 of Partnership Act, an unregistered
firm cannot file a suit against third parties in case of disputes.

PROVISIONS OF THE INDIAN PARTNERSHIP ACT 1932 IN THE ABSENCE OF PARTNERSHIP DEED
• Normally, the partnership deed covers all matters affecting relationship of partners amongst themselves.
• However, if there is no express agreement on certain matters, the provisions Section:13 of the Indian
Partnership Act, 1932 shall apply, which have a direct bearing on the accounting treatment of the
following areas as follows:

S.N Provision Treatment

1. Remuneration No remuneration for taking part in the conduct of business is to
(Salary or Commission etc.) be allowed to any partner as per section 13(a).
2. Sharing of Profits and Losses Irrespective of capital distribution of the firm, Profits and Losses
are to be shared equally as per section 13(b).
3. Interest on Capital No interest on capital is allowed as per section 13(c).
4. Interest on Advances/Loans by a Interest @ 6% is allowed on advances/loans as per section
partner 13(d). Such interest has to be paid even if there are losses.
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5. Interest on Drawings No interest is charged on drawings.

• In the absence of an agreement, the interest and salary payable to a partner will be paid out of Profits
only. In case of loss no interest/ Remuneration to partners is provided.
• But in case of insufficient profits the amount of profit is distributed in the ratio of capital. Insufficient
profits here mean, the net profit which is not sufficient to apportion the appropriations of partners
in profit and loss appropriation account.

ACCOUNTING TREATMENT IN THE BOOKS OF PARTNERSHIP FIRMS

Final Accounts of Sole Proprietorship Final Accounts of Partnership firm
1. Trading account 1. Trading account
2. Profit and loss account 2. Profit and loss account
3. Balance sheet 3. Profit and loss appropriation a/c
4. Balance sheet

• Preparation of Profit and Loss Appropriation a/c is not compulsory for all business entities. Mainly it is
prepared by partnership firms and some companies where partnership exists.

ACCOUNTING TREATMENT OF APPROPRIATIONS

• Appropriation: Appropriation is an expense which is not compulsory in nature. These are allowed to
partners in the form of interest on capital, salary, bonus and commission etc. Generally, partners are
entitled to these appropriations only when there is profit.
• Charge: Charge is an expense which is compulsory in nature. It is accounted in profit and loss account
irrespective of profits or losses. For example, office rent, salary to employees, interest on loan etc.
A. Interest on Capital
• Interest on capital is the interest paid by the business to partners for providing a firm with the
required capital to start a business.
• Interest on capital is an appropriation and allowed only when deed provides for it by debiting Profit
and Loss Appropriation account.
• Provisions relating to Interest on Capital:
Case Provision
a. If the partnership agreement is silent No interest on capital will be allowed
as to interest on capital
b. If the partnership agreement • According to Sec: 13(c) Interest on capital will be allowed only
provides for interest on capital but is if there are profits.
silent as to the treatment of interest • In case of Loss: Interest on capital is not allowed.
is a charge or an appropriation. • If the profit before allowing interest on capital is more than or
equal to interest – Interest on capital will be allowed fully.
c. If the partnership agreement Interest on capital will be allowed fully.
provides for interest on capital as
charge against profits.

• Interest on capital is to be calculated on opening capital with adjustment to any addition or

withdrawal of capital during the accounting period.
• Rationale behind the Provision for Interest on Capital:
a) When the partners contribute unequal amounts of capitals but share profits equally and
b) Where the capital contribution is equal but profit sharing is different proportion.
• No interest on capital is allowed when partners’ capital a/c shows negative balance.

Illustration: 1
Saloni and Srishti are partners in a firm. Their capital accounts as on April 01, 2016 showed a balance of
Rs.2,00,000 and Rs.3,00,000 respectively. On July 01, 2016, Saloni introduced additional capital of Rs.50,000
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and Srishti, Rs.60,000. On October.01 Saloni withdrew Rs.30,000, and on January 01, 2017 Srishti withdraw,
Rs.15,000 from their capitals. Interest is allowed @ 8% p.a.
Calculate interest payable on capital to both the partners during the financial year 2016–2017.
(Practice Assignment Problem: 1)

Illustration: 2
• Josh and Krish are partners sharing profits and losses in the ratio of 3:1. Their capitals at the end of the
financial year 2015 – 16 were Rs.1,50,000 and Rs.75,000.
• During the year 2015 – 16, Josh’s drawings were Rs.20,000 and the drawings of Krish were Rs.5,000, which
had been duly debited to partner’s capital accounts.
• Profit before charging interest on capital for the year was Rs.16,000. The same had also been credited in
their profit-sharing ratio.
• Krish had brought additional capital of Rs.16,000 on October 1, 2015.
Calculate interest on capital @ 12% p.a. for the year 2015-16.
(Practice Assignment Problem: 2)

Illustration: 3
Anupam and Abhishek are partners sharing profits and losses in the ratio of 3:2. Their capital accounts showed
balances of Rs.1,50,000 and Rs.2,00,000 respectively on Jan 01, 2017. Show the calculation of interest on
capital for the year ending December 31, 2017 in each of the following alternatives:
(a) If the partnership deed is silent as to the payment of interest on capital and the profit for the year is
Rs.50,000;
(b) If partnership deed provides for interest on capital @ 8% p.a. and the firm incurred a loss of Rs.10,000
during the year;
(c) If partnership deed provides for interest on capital @ 8% p.a. and the firm earned a profit of Rs.50,000
during the year;
(d) If the partnership deed provides for interest on capital @ 8% p.a. and the firm earned a profit of Rs.14,000
during the year.
(Practice Assignment Problem: 3)

B. Interest on Drawings
• Drawings mean the amount withdrawn by Partners in cash or in kind for domestic purposes.
• The partnership agreement may also provide for charging interest on money withdrawn by partners for
their personal use.
• In such a case, interest will be charged according to the time that elapses between the taking out of the
money and the end of the year.
• Interest on drawings is an appropriation and it is charged only when it is provided in partnership deed
and credited to Profit and Loss Appropriation account.
• Interest on drawings remained outstanding from the partners during an accounting year.

• No interest is charged on the drawings if there is no express agreement among the partners.
• Interest on drawings is to be calculated with reference to the time period which the money was
withdrawn.
• Charging interest on drawings discourages excessive amounts of drawings by the partners.

1. Depending up on the availability of information, when the fixed amount of withdrawals were made,
interest on drawings in various cases may be calculated as follows:
Average Period can be calculated with the help of the following formula:
A. If a fixed amount is withdrawn at the beginning of every month/ quarter/ six months.
Total period of drawings (in months) or No. of Instalments + 1 X Time interval between two consecutive drawings
2 (in months)
B. If a fixed amount is withdrawn in in the middle of every month/ quarter/ six months.

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Average Period = Total period of drawings (In months) X Time interval between two consecutive drawings
2 (in months)
C. If a fixed amount is withdrawn at the end of every month/ quarter/ six months.
Total period of drawings (in months) or No. of Instalments - 1 X Time interval between two consecutive drawings
2 (in months)

2. When varying amounts are withdrawn at different intervals:

• When the partners withdraw different amounts of money at different time intervals, the interest
is calculated using the ‘Product method’.
• Under the product method, for each withdrawal, the money withdrawn is multiplied by the period
(usually expressed in months) for which it remained withdrawn during the financial year.
• The period is calculated from the date of the withdrawal to the last day of the accounting year.
• The products so calculated are totalled, on the total of the products, interest at the specified rate
is calculated as: Total Products × Rate/100 × 1/12

3. When annual drawings were given and dates of withdrawal are not specified: When the total amount
withdrawn is given but the dates of withdrawals are not specified, it is assumed that the amount was
withdrawn evenly in the middle of the month throughout the year. Total Drawings X ROI/100 X 6/12

4. When the amount and date of drawings given and interest on drawings is to be calculated with
reference to time factor: When the total amount withdrawn is given and the date of withdrawal are
specified, it is assumed that the amount is to be calculated by taking time factor as per instructions
given.

Illustration: 4
John Ibrahim, a partner in Modern Tours and Travels withdrew money during the year ending March 31, 2017
from his capital account, for his personal use. Calculate interest in drawings in each of the following alternative
situations:
(a) If he withdrew Rs.3,000 per month at the beginning of every month. (Rate of Interest @ 10% p.a.)
(b) If an amount of Rs.2,000 per month was withdrawn by him at the end of each month. (Rate of Interest @
6% p.a.)
(c) If an amount of Rs.5,000 was withdrawn by him at the end of every quarter. (Rate of Interest @ 5% p.a.)
(d) If an amount of Rs.15,000 was withdrawn by him at the beginning of every six months. (Rate of Interest
@ 8% p.a.)
(e) If the amounts withdrawn were: Rs.12,000 on June 01, 2016; Rs.8,000 on August 31, 2016; Rs.3,000 on
September 30, 2016; Rs.7,000 on November 30, 2016; and Rs.6,000 on January 31, 2017. (Rate of Interest
@ 10% p.a.)
(f) If he drawn annually an amount of Rs.15,000. Rate of Interest @ 10% p.a.
(Practice Assignment Problem: 4, 5 & 6)

• In the absence of partnership deed, Interest on Advances/Loans by a partner is allowed @ 6% as per

section 13(d). Such interest must be paid even if there are losses.

C. Remuneration/ Commission/ Salary/ Bonus to a Partner:

• Salary or commission for the partner is provided usually when the partner is working partner, and when
the same is provided in partnership deed.
• Salary or commission to a profit is an appropriation out of profits and hence must be transferred to the
debit of profit and loss appropriation account.

• When partners agree to treat salary or remuneration as charge against profits, it must be treated as
expense irrespective of profits or losses.

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• While preparing profit and loss app. Account, if in question, there a point to create managers
commission, unless otherwise mentioned, calculate managers commission on net profit only and not on
the amount after deducting all the expenses like interest on capital, salaries etc.
(Practice Assignment Problem: 7)

Distribution of Profit among Partners

• The profits and losses of the firm are distributed among the partners in an agreed ratio.
• In the case of sole partnership after ascertainment of profit or loss in profit and loss account, it is transferred
to the capital account of the proprietor. But, in case of partnership, after ascertainment of profit in profit
and loss account, certain adjustments such as interest on drawings, interest on capital, salary to partners
and commission to partners are required to be made.
• For this purpose, it is customary to prepare a Profit and Loss Appropriation Account of the firm and ascertain
the final figure of profit and loss to be distributed among the partners in their profit-sharing ratio.

• If the partnership deed is silent, the firm’s profits and losses are to be shared equally by all the partners.

PREPARATION OF PROFIT AND LOSS APPROPRIATION ACCOUNT

• Profit and Loss Appropriation Account is merely an extension of the Profit and Loss Account of the firm.
• It shows how the profits are appropriated or distributed among the partners.
• It will be commenced with net profit or loss calculated in profit and loss account.
• All adjustments in respect of partner’s salary, partner’s commission, interest on capital is to be debited to
this account.
• It is credited with interest on drawings.
• The balance is transferred to the partner’s capital or current accounts in their agreed ratio.

• As per provisions of income tax law, preparation of profit and loss appropriation is not compulsory but
from firm’s point of view, it is compulsory for tax purpose.

Journal Entries for preparation of Profit and Loss Appropriation Account

1. Transfer of the balance of Profit and Loss Account to Profit and Loss Appropriation Account:
a) If Profit and Loss Account shows a credit balance (Net Profit):
Profit and Loss A/c Dr.
To Profit and Loss Appropriation A/c
b) If Profit and Loss Account shows a debit balance (Net Loss):
Profit and Loss Appropriation A/c Dr.
To Profit and Loss A/c
2. Interest on Capital:
a) For Allowing interest on capital:
Interest on Capital A/c Dr.
To Partner’s Capital/Current A/cs (individually)
b) For transferring interest on capital to Profit and Loss Appropriation Account:
Profit and Loss Appropriation A/c Dr.
To Interest on Capital A/c
3. Interest on Drawings:
a) For charging interest on drawings to partners’ capital accounts:
Partner’s Capital/Current A/c’s (individually) Dr
To Interest on Drawings A/c
b) For transferring interest on drawings to Profit and Loss Appropriation Account:
Interest on Drawings A/c Dr
To Profit and Loss Appropriation A/c
4. Partner’s Salary:
a) For Allowing partner’s salary to partner’s capital account:
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Salary to Partner A/c Dr.

To Partner’s Capital/Current A/c’s (individually)
b) For transferring partner’s salary to Profit and Loss Appropriation Account:
Profit and Loss Appropriation A/c Dr.
To Salary to Partner’s A/c
5. Partner’s Commission:
a) For crediting commission allowed to a partner, to partner’s capital account:
Commission to Partner A/c Dr.
To Partner’s Capital/Current A/c’s (individually)
b) For transferring commission allowed to partners to Profit and Loss Appropriation Account:
Profit and Loss Appropriation A/c Dr.
To Commission to Partners Capital/Current A/c
6. Share of Profit or Loss after appropriations:
a) If Profit:
Profit and Loss Appropriation A/c Dr.
To Partner’s Capital/Current A/c’s (individually)
b) If Loss:
Partner’s Capital/Current A/c (individually)
To Profit and Loss Appropriation A/c

• All the partners appropriations are non-cash items and required to be adjusted to capital account. So, no
cash entries are recorded.

Dr Proforma of Profit and Loss Appropriation a/c Cr

Particulars Amt. Particulars Amt.
To Profit and Loss a/c (Net Loss) XXX By Profit and Loss a/c (Net Profit) XXX
To Interest on Capital By Interest on Drawings
Jaya – XX XXX Jaya – XX XXX
Lakshmi – XX Lakshmi – XX
To Salary
Jaya – XX XXX By Partners Capital/ Current a/c
Lakshmi – XX (Transf. to capital a/c’s of XXX
To Commission Partners)
Jaya – XX XXX Jaya – XXX
Lakshmi – XX Lakshmi – XXX
To Transfer to Reserve/ Provisions
(if any) XXX
To Partners Capital/ Current Account XXX
(Transf. to capital a/c’s of Partners)
Jaya – XXX
Lakshmi – XXX
XXX XXX

• Interest on Partners Loan, rent for use of partners’ premises, if any etc. are all debited to P&L a/c itself.
Profit after charging and debiting these items, is only transferred to P&L App a/c.
• Profit & Loss Appropriation a/c differs from Profit and Loss Adjustment a/c which is prepared to show the
effect of revaluation of assets and liabilities at the time of reconstitution i.e., change in profit sharing ratio,
admission, retirement or death of partners.

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Illustration: 5
The capital accounts of Moli and Golu showed balances of Rs.40,000 and Rs.20,000 as on April 01, 2016. They
shared profits in the ratio of 3:2. They allowed interest on capital @ 10% p.a. and interest on drawings @ 12
p.a. Golu advanced a loan of Rs.10,000 to the firm on August 01, 2016.
During the year, Moli withdrew Rs.1,000 at the beginning of every quarter whereas Golu withdrew Rs. 1,000
at the middle of every quarter. Profit for the year, before the above-mentioned adjustments was Rs.20,950.
Calculate interest on drawings show distribution of profits by Preparing profit and Loss Appropriation account.

• If there are more appropriations along with interest on capital, it is to be appropriated at the end. Because,
if the profit before salary is not sufficient to appropriate interest on capital, Interest amount of profit is to
be distributed in capital ratio.

Illustration 6
Amit and Karan were partners in a firm sharing profits in 3:2 ratio, with capitals of Rs.50,000 and Rs.30,000
respectively. Interest on capital is agreed @ 6% p.a. Karan is to be allowed an annual salary of Rs.2,500. During
the year 2021 – 22, the profits prior to the calculation of interest on capital but after charging Karan’s salary
amounted to Rs.12,500. A provision of 5% of the profit is to be made in respect of commission to the manager.
Prepare profit and loss appropriation a/c.
(Practice Assignment Problem: 8)

CAPITAL ACCOUNTS OF PARTNERS

• All transactions relating to partners of the firm are recorded in the books of the firm through their capital
accounts.
• This includes the amount of money brought in as capital, withdrawal of capital, share of profit, interest
on capital, interest on drawings, partner’s salary, commission or bonus to partners etc.
There are two methods by which the capital accounts of partners can be maintained. These are:
1. Fixed Capital Method and
2. Fluctuating Capital Method.

1. Fixed Capital Method:

• Under this method, two accounts are maintained to record the transactions relating to each partner
viz., Partner’s Capital A/c and Partner’s Current A/c.
• Under the fixed capital method, the capitals of the partners shall remain fixed unless additional
capital is introduced or a part of the capital is withdrawn.
• All appropriations of partners like share of profit or loss, interest on capital, drawings, interest on
drawings etc. are recorded in a separate account called Partner’s Current Account.
• Under this method, the partners’ capital accounts will always show a credit balance, which shall
remain the same (fixed) year after year unless there is any addition or withdrawal of capital. The
partners’ current account on the other hand, may show a debit or a credit balance.
• Due to this reason, the partners’ capital account always appears on the liabilities side in the balance
sheet whereas the partners’ current account’s with credit balance will be shown on the liabilities
side, and debit balances will appear on the assets side.

Dr Partner’s Capital a/c Cr

Particulars Amt. Particulars Amt.
To Cash/Bank a/c XXX By Balance b/d (Opening bal.) XXX
(Withdrawal of capital) By Cash/Bank a/c XXX
To Balance c/d (Closing bal.) XXX (Additional capital)
XXX XXX

• In this method, Partners Capital a/c shows credit balance only.

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Dr Partner’s Current a/c Cr

Particulars Amt. Particulars Amt.
To Balance b/d (Opening bal.) XXX By Balance b/d (Opening bal.) XXX
To Drawings XXX By Interest on Capital XXX
To Interest on drawings XXX By Salary XXX
To Profit & Loss appropriation a/c XXX By Commission XXX
(Share of loss) By Profit and Loss Appropriation a/c XXX
(Share of Profit)
To Balance c/d (closing bal.) XXX By Balance c/d (closing bal.) XXX
XXX XXX

• Partners Current a/c may show either a debit balance or a credit balance at a time.

2. Fluctuating Capital Method

• Under this method, only one account i.e., Partner’s Capital Account is maintained for each partner.
• In this account, Capital along with additional capital brought or withdrawal of capital permanently, all
the appropriations relating to partners such as share of profit and loss, interest on capital, drawings,
interest on drawings, salary or commission to partners etc. are recorded.
• As all transactions of partners entered in this account, it makes the balance in the capital account to
fluctuate from time to time. For this reason, this method is called fluctuating capital method.

• In this method, Partners Capital a/c shows either Credit balance or Debit balance.
• In the absence of any instruction, the capital account should be prepared under Fluctuating Capital
Method only.

Dr Partner’s Capital a/c Cr

Particulars Amt. Particulars Amt.
To Balance b/d* XXX By Balance b/d * XXX
To Cash/bank a/c XXX By Cash/ bank a/c (Additional capital) XXX
(Withdrawal of capital) By Interest on Capital XXX
To Drawings XXX By Salary XXX
To Interest on drawings XXX By Commission XXX
To Profit & Loss App. a/c XXX By Profit and Loss App. a/c XXX
(Share of loss) (Share of Profit) XXX
To Balance c/d* XXX By Balance c/d*
XXX XXX

Distinction between Fixed and Fluctuating Capital Methods

Basis of distinction Fixed capital Method Fluctuating capital Method
1. Number of Two separate accounts are maintained Each partner has one account, i.e.,
accounts for each partner viz., ‘partner’s capital partner’s capital account.
account’ and ‘partners current account’.
2. Items related to All appropriations like drawings, salary, All appropriations like drawings, salary
deed interest on capital etc. are posted in the interest on capital, etc., are posted in the
current accounts and not in the capital capital accounts only.
accounts.
3. Fixed balance The partner’s capital account balance The balance of the partner’s capital
remains unchanged unless there is account fluctuates from year to year.
addition to or withdrawal of capital.

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Illustration 7
Amit and Babu set up a partnership firm on April 1, 2019. They contributed Rs.50,000 and Rs.40,000 as their
capitals and agreed to share profits and losses in the ratio of 2:1.
• Amit is to be paid a salary of Rs.1,000 per month and Babu, a Commission of Rs.5,000.
• It is also provided that interest to be allowed on capital at 6% p.a. Babu withdrawn 10% of his capital at
the end of third quarter of the financial year.
• The drawings for the year were Amit Rs.6,000 and Babu Rs.4,000. Interest on drawings were to be
calculated @ 5%.
• The net profit as per Profit and Loss Account for the year ending March 31, 2020 was Rs.85,660.
Prepare Profit and Loss Appropriation Account to show the distribution of profit among the partners along
with transfer to capital accounts of partners under fixed capital method.
(Practice Assignment Problem: 9)

Illustration 8
Sameer and Yasmin are partners with capitals of Rs.15,00,000 and Rs.10,00,000 respectively. They agree to
share profits in the ratio of 3:2. Show how the following transactions will be recorded in the capital accounts
of the partners in case if partners Capitals accounts are Fluctuating.
The books are closed on March 31, every year.
Particulars Sameer Yasmin
Rs. Rs.
a) Additional capital contributed on Oct.1, 2019 3,00,000 2,00,000
b) Interest on capital 5% P.a 5% P.a
c) Drawings (during 2019-20) 30,000 20,000
d) Interest on drawings 1,800 1,200
e) Salary (Per month to Yasmin) 5,000 300
f) Commission 10,000 7,000
g) Share in Profit for the year 2019-20 60,000 40,000

Illustration 9
Amitabh and Babul are partners sharing profits in the ratio of 3:2 with capitals of Rs.50,000 and
Rs.30,000 respectively. Interest on capital is agreed @ 6% p.a. Babul is to be allowed an annual salary of
Rs.2,500. Manager is to be allowed commission Rs.5,000. Amitabh who manages the sales department will be
allowed a commission equal to 10% of the net profits, after allowing Babul salary and interest on capital.
Amitabh has also given a Loan on April 01, 2019 of Rs.50,000 to the firm without any agreement. During
the year 2019-20, the profits earned is Rs.22,250.
Prepare Profit and Loss Appropriation account showing the distribution of profit.
(Practice Assignment Problem: 10)

GUARANTEE OF PROFITS TO A PARTNER

• Sometimes a partner is admitted into the firm with a guarantee of certain minimum amount by way of his
share of profits of the firm.
• Such assurance may be given by all the old partners in a certain ratio or by any of the old partners,
individually to the new partner.
• The minimum guaranteed amount shall be paid to such new partner when his share of profit as per the
profit-sharing ratio is less than the guaranteed amount.

Illustration: 10
Mohit and Rohan share profits and losses in the ratio of 2:1. They admit Rahul as partner with 1/4 share in
profits with a guarantee that his share of profit shall be at least Rs.50,000. The net profit of the firm for the
year ending March 31, 2015 was Rs.1,60,000. Calculate the distribution of profit among the partners.
(Practice Assignment Problem: 11)

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Illustration: 11
Arun, Varun and Tarun were partners of a Law Firm sharing profits in the ratio of 5:3:2. Their partnership deed
provided the following:
a) Interest on partners' capital @ 5% p.a.
b) Arun guaranteed that he would earn a minimum annual fee of Rs.6,00,000 for the firm.
c) Tarun was guaranteed a profit of Rs.2,50,000 (excluding interest on capital) and any deficiency on account
of this was to be borne by Arun and Varun in the ratio of 2:3.
d) During the year ending March 31, 2019, Arun earned a fee of Rs.3,20,000 and net profits earned by the
firm were Rs.8,60,000. Partner's capital on April 01, 2018 were Arun - Rs.3,00,000; Varun - Rs.3,00,000
and Tarun - Rs.2,00,000.
Prepare Profit and Loss Appropriation account and show your workings clearly.
(Practice Assignment Problem: 12)

PAST ADJUSTMENTS
• Sometimes a few omissions or errors in the recording of transactions or the preparation of summary
statements are found after the final accounts have been prepared and the profits distributed among the
partners.
• The omission may be in respect of interest on capitals, interest on drawings, interest on partners’ loan,
partner’s salary, partner’s commission or outstanding expenses.
• There may also be some changes in the provisions of partnership deed or system of accounting having
impact with retrospective effect.
• All these acts of omission and commission need adjustments for correction of their impact.
• Instead of altering old accounts, necessary adjustments can be made either;
(a) Directly in the capital/ current accounts of the concerned partners (through single adjustment entry):
Under this method, after analysing the omissions and errors through a table, a single adjustment
entry is recorded by showing the net effect of such omissions or errors encountered.
(b) Preparing Profit and Loss Adjustment Account:
Under this method, no table is prepared to show the net effect of omissions and errors. Instead,
journal entries will be passed for each omission or error by debiting or crediting Profit and Loss
Adjustment account. After passing entries for adjustment of omissions or errors, Profit and Loss
Adjustment account is closed by debiting or crediting partners’ capital/ current accounts.

Retrospective Effect: Changes required to be done from the date decided rather than from the date of
happening.

Illustration: 12
Rameez and Zaheer are equal partners. Their capitals as on April 01, 2015 were Rs.50,000 and Rs.1,00,000
respectively. After the accounts for the financial year ending March 31, 2016 have been prepared, it is
discovered that interest at the rate of 6 per cent per annum, as provided in the partnership deed has not been
credited to the partners’ capital accounts before distribution of profit.
Make necessary adjustments to:
a) Show it directly in the capital accounts of concerned partners and
b) Through profit and loss adjustment account.
(Practice Assignment Problem: 13)

Illustration: 13
Following is the profit and loss appropriation account of the firm in which A, B and C are equal partners:
Dr. Profit and Loss Appropriation a/c Cr.
Particulars Amount Particulars Amount
To Partners Capital a/c By Profit and Loss a/c (Net Profit) 3,00,000
A’s Capital a/c 1,00,000

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B’s Capital a/c 1,00,000

C’s Capital a/c 1,00,000 3,00,000
3,00,000 3,00,000
After preparing the financial statements, it was noticed that interest on capital was not allowed to A - 12,000,
B – 9,600 and C – 10,500 and interest was not charged on drawings of A and B amounting to Rs.1,200 and
Rs.900 respectively.
Find the net effect of above omissions and write necessary adjustment entry.
(Practice Assignment Problem: 14)

WORK SHEET
Interest on Capital:
1. Amit, Charu and Babu set up a partnership firm on April 1, 2019. They contributed Rs.50,000, Rs.40,000
and Rs.30,000, respectively as their capitals. It is also provided that interest to be allowed on capitals at
6% p.a. On 01.10.2019 Babu brought additional capital of Rs.5,000. Calculate interest on capital of Babu
for the year ended 31.03.2020.
2. Sesha and Lalasa are have started a business in partnership on 01.07.2020. as per partnership deed
interest on capital to be allowed @ 10% p.a. and profits will be shared in the ratio of their capitals i.e.,
5:3. Total interest on capital at the end of the year 31.03.2021 of Rs.24,000. What is the capital brought
by Lalasa?
3. A, B and C are partners sharing profits and losses in the ratio of 1:2:3 with a capital of Rs.5,00,000 each.
On 01.08.2020, A introduced additional capital of Rs.1,00,00 0 and on 30.09.2020. A withdrew the amount
of additional capital. Interest on capital is allowed @ 12% p.a. interest on capital of A Rs. ________ and is
to be shown in the _________ side of partners’ capital a/c.

Interest on Drawings:
4. What is the time factor to be taken in each of the following cases:
a) If a partner withdrawn at end of each quarter for a period of nine months
b) If a partner drawn at the end of every six months during the year
c) If a partner withdrawn at the end of every month for a duration of first 8 months in a year
5. Govind and Gopal were partners in a partnership firm. Calculate interest on Drawings on each of the
following cases:
a) They drawn Rs.1,000 and Rs.2,000 each at the beginning of each quarter throughout the year. Find
the interest on drawings if interest is @ 5% p.a.
b) If they drawn Rs.1,500 and Rs.2,500 each at the beginning of each month throughout the year. Find
the interest on drawings if interest is @ 10% p.a.
6. Calculate the interest on drawings of Mr.B on 31.03.2021. A and B started business on 01.07.2020 and
during the year, Mr.B drawn an equal amount at the end of each quarter. First drawing was made on
30.09.2020 of Rs.1000.

Guarantee of Profits:
7. E, F and G are partners sharing profits in the ratio of 3:3:2. As per the partnership agreement, G is to get
a minimum amount of Rs.80,000 as his share of profits every year and any deficiency on this account is to
be personally borne by E. The net profit for the year ended 31st March, 2020 amounted to Rs.3,12 ,000.
Calculate the amount of deficiency to be borne by E?
8. P, Q and R are partners in a firm in 3:2:1. R is guaranteed that he will get minimum of Rs.20,000 as his
share of profit every year. Firm’s profit was Rs.90,000. Partners will get?

Past Adjustments:
9. A and B are partners sharing profits and losses equally. After preparation of financial statements, they
identified that the remuneration of Rs.1,200 per month is not provided for Mr. A. Write adjustment entry.
10. X, Y and Z are partners in a firm sharing profits and losses in the ratio of 5:3:2. Their fixed capitals were
Rs.3,00,000; Rs.2,00,000 and Rs.1,00,000 respectively. For the year ended 31.03.2020. interest on capital
credited to them @ 10% p.a. instead of 8% p.a. Write the adjustment entry.
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Others:
11. Net profit of the firm is Rs.25,000. Calculate Managers Commission @ 5% on net profit before and after
charging commission.
12. Commission to Manager is to be debited to ____________________, where as commission to partner is
to be debited to ______________________.
13. A, B and C are partners sharing profits and losses in the ratio of 1:2:3 with a capital of Rs.5,00,000 each.
On 01.04.2020, B advanced the loan to the firm Rs.50,000 without any agreement. On 30.09.2020, firm
has taken a loan from bank of Rs.1,50,000 with interest @ 8% p.a. and there is no agreement between
the partners about this loan. Find out the interest to be allowed to B and Bank.
14. Personal Profits earned by the partners (using firm’s name or its property) will be recovered from the
concerned partner and credited to ____________________.
15. Any penalty or fine payable by partner to the firm will be shown in ___________________.

Case based Question:

Lalasa and Sesha started a new business in partnership and decided to share profits and losses in the ratio of
3:1. They contributed Capitals of Rs.50,000 and Rs.30,000 respectively on 01.04.2018. Lalasa is a sleeping
partner whereas Sesha is a full-time working partner. During the year ended 31st March, 2019 they earned a
net profit of Rs.50,000.
The terms of partnership are:
a) Interest on capital is to allowed @ 6% p.a.
b) Lalasa will get a commission @ 2% on turnover.
c) Sesha will get a salary of Rs.500 per month.
d) Sesha will get commission of 5% on profits after deduction of all expenses including such commission.
Partners’ drawings for the year were: Lalasa Rs.8,000 and Sesha Rs.6,000. Turnover for the year was
Rs.3,00,000.
On the basis of the information given above, answer the following questions:
1. What will be Lalasa and Sesha’s Commission?
2. How much share of profits will be given to Lalasa and Sesha?
3. What will be the balance in Partners’ Capital Account at the end of the year?
4. Sesha wants that his share in profits should be higher than Lalasa as he is putting more efforts to carry on
the business. Is he correct in saying so?

ANSWER KEY
1. Rs.1,950.
2. Rs.1,20,000 i.e., 24,000 X 3/8 = Rs.9,000 and 9,000 X 100/10 X 12/9 = 1,20,000; If he asked Sesha capital
Rs.24,000 X 5/8 = 15,000 and 15,000 X 100/10 X 12/9 = 2,00,000; If he asked total capital of the firm
24,000 X 100/10 X 12/9 = 3,20,000.
3. Interest on capital is Rs.62,000 and recorded in credit side of Capital Account. i.e., 5,00,000 X 12/100 X
12/12 = 60,000 + 1,00,000 X 12/100 X 2/12 = 2,000.
4. Time factors are follows: A. 3; B. 3; C. 3.5.
5. Govind and Gopal
a) Rs.125 and Rs.250
b) Rs.500 and Rs.575
6. Interest on drawings of Vinod – Rs.2,340; Kumar – Rs.1,080; Shray – Rs.150. Interest on drawings is income
to firm. So, irrespective of losses or profits it can be charged from partners when there is an agreement
in firm.
7. Rs.2,000
8. P Rs.42,000; Q Rs.28,000; R Rs.20,000
9. B’s Capital a/c Dr. 7,200 To A’s Capital a/c 7,200.
10. Y’s Current a/c Dr 400 To Z’s Current a/c 400
11. Managers Commission:
Before charging such commission Rs.1,250
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After charging such commission Rs.1,190

12. Profit and Loss Account and Profit and Loss Appropriation a/c.
13. Interest on loan payable to B Rs.3,000 and Interest on Loan payable to Bank Rs.6,000.
Note: Default provisions of section 13 of Partnership Act, 1932 do not apply for loan agreements with
banks so, firm must pay interest on loan @ 8% p.a.
14. Profit and Loss Appropriation Account
15. credit side of Profit and Loss Appropriation Account

Case Based Question:

1. Lalasa - Rs.6,000, Sesha - Rs.1,581
2. Lalasa Rs.23,714, Sesha Rs.7,905.
3. Lalasa Rs.74,714, Sesha Rs.41,286.
4. No

ASSIGNMENT PROBLEMS
Interest on Capital:
Problem: 1
Sunflower and Pink Rose started partnership business on April 01, 2016 with capitals of Rs. 2,50,000 and
Rs.1,50,000, respectively. On October 01, 2016, they decided that their capitals should be Rs.2,00,000 each.
The necessary adjustments in the capitals are made by introducing or withdrawing cash. Interest on capital is
to be @ 10% p.a.
Calculate interest on capital.

Problem: 2
On March 31, 2017 after the close of accounts, the capitals of Mountain, Hill and Rock stood in the books of
the firm at Rs. 4,00,000, Rs.3,00,000 and Rs. 2,00,000, respectively. Subsequently, it was discovered that the
interest on capital @ 10% p.a. had been omitted. The profit for the year amounted to Rs.1,50,000. The partners
withdrawn - Mountain: Rs. 20,000, Hill Rs. 15,000 and Rock Rs. 10,000 on October 1, 2017.
Calculate interest on capital.

Problem: 3
Rahul, Rohit and Karan started partnership business on April 1, 2016 with capitals of Rs.20,00,000, Rs.18,00,000
and Rs.16,00,000 respectively. The profit for the year ended March 31, 2017 amounted to Rs.1,35,000 and the
partner’s drawings had been Rahul Rs.50,000, Rohit Rs.50,000 and Karan Rs.40,000. The profits are distributed
among partners in the ratio of 3:2:1. Calculate the interest on capital @ 5% p.a.

Interest on Drawings:
Problem: 4
Rakesh and Roshan are partners, sharing profits in the ratio of 3:2 with capitals of Rs. 40,000 and Rs. 30,000,
respectively. They withdrew from the firm the following amounts, for their personal use:
Rakesh Month Amt.
May 31, 2016 600
June 30, 2016 500
August 31, 2016 1,000
November 1, 2016 400
December 31, 2016 1,500
January 31, 2017 300
March 01, 2017 700
Rohan At the beginning of each month 400
Interest on drawings is to be charged @ 6% p.a.
Calculate interest on drawings, assuming that book of accounts are closed on March 31, 2017, every year.

Problem: 5
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Charan, Chetan and Karthik are partners in a firm.

a) Charan withdrew Rs.2,500 at the beginning of each quarter for the whole year (rate of interest is 10% p.a.).
b) Chetan withdrew Rs.2,500 at the beginning of each quarter for a period of 6 months (rate of interest is 10%
p.a.).
c) Karthik withdraws Rs.10,000 at the beginning of every half year period for his personal expenses. Calculate
interest on drawings if the Partnership deed provides for charging interest on drawings @ 12% p.a.

Problem: 6
Amit and Bhola are partners in a firm. They share profits in the ratio of 3:2. As per their partnership agreement,
interest on drawings is to be charged @ 10% p.a. Their drawings during 2017 were Rs.24,000 and Rs.16,000,
respectively.
Calculate interest on drawings based on the assumption that the amounts were withdrawn evenly, throughout
the year.

Salary or Remuneration:
Problem: 7
Ramu and Somu are partners sharing profits and losses in the ratio of 3:2. Their net loss before showing the
below appropriations is Rs.1,20,000 before showing the below transactions.
Commission to manager @ 10% on profits
Salary to Ramu and Somu was decided @ Rs.1,600 per month. It is decided by the firm that the salary of Ramu
is a charge to the firm.
Calculate the working note to Distribute the profit or loss to Ramu and Somu.

Profit and Loss Appropriation A/c and Capital Accounts:

Problem: 8
Yadu, Madhu and Vidu are partners sharing profits and losses in the ratio of 2:2:1. Their fixed capitals on
April 01, 2019 were: Yadu Rs.5,00,000, Madhu Rs.4,00,000 and Vidhu Rs.3,50,000.
• As per the partnership deed, partners are entitled to interest on capital @ 5% p.a., and
• Yadu has to be paid a salary of Rs.2,000 per month while Vidu would be receiving a commission of
Rs.18,000.
On the basis of above information, prepare profit and loss appropriation account for the year ending
March 31, 2020:
a) When there is Net loss of the firm as per profit and loss account amounted to Rs.75,000.
b) When there is Net Profit of the firm as per profit and loss account amounted to Rs.1,50,000.

Problem: 9
Triphati and Chauhan are partners in a firm sharing profits and losses in the ratio of 3:2. Their capitals were
Rs.60,000 and Rs.40,000 as on April 01, 2015. During the year they earned a profit of Rs.30,000 (Net profit for
the year is after charging salary). According to the partnership deed both the partners are entitled to Rs.1,000
per month as salary and 5% p.a. interest on their capital. They are also to be charged an interest of 5% on their
drawings, irrespective of the period, which is Rs.12,000 for Tripati, Rs.8,000 for Chauhan. A provision of 5% of
profits is to be made in respect of manager’s commission.
Prepare Partner’s capital/current Accounts when, capitals are fixed and Fluctuating.

Problem: 10
Harshad and Dhiman are in partnership since April 01, 2016. No Partnership agreement was made. They
contributed Rs.4,00,000 and Rs.1,00,000 respectively as capital. In addition, Harshad advanced an amount of
Rs.1,00,000 to the firm, on October 01, 2016. Due to long illness, Harshad could not participate in business
activities from August 1, to September 30, 2016. The profits for the year ended March 31, 2017 amounted to
Rs.1,80,000. Dispute has arisen between Harshad and Dhiman.
Harshad Claims:
a. He should be given interest @ 10% per annum on capital and loan;

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b. Profit should be distributed in proportion of capital;

Dhiman Claims:
a. Profits should be distributed equally;
b. He should be allowed Rs. 2,000 p.m. as remuneration for the period he managed the business, in the
absence of Harshad;
c. Interest on Capital and loan should be allowed @ 6% p.a.
You are required to settle the dispute between Harshad and Dhiman. Also prepare Profit and Loss
Appropriation Account.

Guarantee of Profit to the Partners:

Problem: 11
Abhay, Siddharth and Kusum are partners in a firm, sharing profits in the ratio of 5:3:2. Kusum is guaranteed
Rs.10,000 as her share in the profits. Any deficiency arising on that account shall be met by Siddharth. Profits
for the years ending March 31, 2016 and 2017 are Rs. 40,000 and 60,000 respectively.
Prepare Profit and Loss Appropriation Account.

Problem: 12
Amit, Babita and Sona form a partnership firm, sharing profits in the ratio of 3:2:1, subject to the following:
a. Sona’s share in the profits, guaranteed to be not less than Rs. 15,000 in any year.
b. Babita gave guarantee to the effect that gross fee earned by her for the firm shall be equal to her average
gross fee of the proceeding five years, when she was carrying on profession alone (which is Rs. 25,000).
The net profit for the year ended March 31, 2017 is Rs. 75,000. The gross fee earned by Babita for the firm
was Rs. 16,000.
You are required to prepare P & L Appropriation Account.

Past Adjustments:
Problem: 13
Nusrat, Sonu and Himesh are partners sharing profits and losses in the ratio of 5:3:2. The partnership deed
provides for charging interest on drawings @ 10% p.a. The drawings of Nusrat, Sonu and Himesh during the
year ending March 31, 2015 amounted to Rs. 20,000, Rs. 15,000 and Rs.10,000 respectively.
After the final accounts have been prepared, it was discovered that interest on drawings has not been taken
into consideration. Give necessary adjusting journal entry.

Problem: 14
Anju, Manju and Mamata are partners whose fixed capitals were Rs.10,000, Rs.8,000 and Rs.6,000,
respectively. As per the partnership agreement, there is a provision for allowing interest on capitals @ 5% p.a.
but entries for the same have not been made for the last three years. The profit-sharing ratio during three
years remained as follows:
Year Anju Manju Mamata
2014 4 3 5
2015 3 2 1
2016 1 1 1
Make necessary changes and write adjustment entry at the beginning of the fourth year i.e., April 2017.

ANSWER KEY
PART: A – BASIC CONCEPTS
Interest on Capital:
1. Total interest on Sunflower’s Capital Rs. 22,500 and on Pink Rose’s Capital, Rs. 17,500.
2. Interest on Capital: Mountain, Rs.37,000; Hill, Rs.26,500; Rock, Rs.16,000.
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3. Rahul, Rs. 1,00,000, Rohit, Rs. 90,000, Karan Rs. 80,000.

Interest on Drawings:
4. Interest on Rakesh’s Drawings: Rs. 126.50; Rohan’s Drawings Rs. 156 (rounded off to nearest rupee)
5. Interest on Drawings of –
a) Charan = 10,000 X 10/100 X 7.5/12 = 625
b) Chetan = 5,000 X 10/100 X 4.5/12 = 187.5
c) Karthik = 20,000 X 12/100 X 9/12 = 1,800
6. Interest on Amit’s Drawings, Rs. 1,200 and Bhola’s, Rs.800.

Profit and Loss Appropriation Account:

7. Case: A - Distribution of Loss to Yadu Rs.30,000; Madhu Rs.30,000 and Vidu Rs.15,000.
Case: B - Distribution of Profit to Yadu Rs.18,200; Madhu Rs.18,200 and Vidu Rs.9,100.
8. Distribution of Profit to Tripati – Rs.13,980; Chauhan – Rs. 9,320.
9. Harshad’s share in profit Rs. 88,500, Dhiman’s share in profit Rs. 88,500.

Guarantee of Minimum Profit:

10. Year 2015 - Abhay Rs.20,000, Siddharth Rs.10,000, Kusum Rs.10,000;
Year 2016- Abhay Rs.30,000, Siddharth Rs.18,000, Kusum Rs.12,000.
11. Profit transferred to Capital Accounts of; Amit, Rs. 41,400, Babita, Rs.27,600 and Sona, Rs.15,000.

Past Adjustments:
12. S Dr. Rs.75; H Dr. Rs.50 and N Cr. Rs.125.
13. Mamta (Dr.) Rs. 200, Anju (Cr.) Rs. 100 and manju (Cr.) Rs. 100.

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PART: B - GOODWILL
Meaning of Goodwill
• Over a period of time, a well-established business develops an advantage of good name, reputation and
wide business connections. This helps the business to earn more profits as compared to a newly set up
business. In accounting, the monetary value of such advantage is known as “goodwill”.
• Goodwill is as an intangible asset.
• In other words, goodwill is the value of the reputation of a firm in respect of the profits expected in future
over and above the normal profits.
• It is generally observed that when a person pays for goodwill, he/she pays for something, which places
him in the position of being able to earn super profits as compared to the profit earned by other firms in
the same industry.
• In simple words, goodwill can be defined as “the present value of a firm’s anticipated excess earnings” or
as “the capitalized value attached to the differential profit capacity of a business”.
• Thus, goodwill exists only when the firm earns super profits. Any firm that earns normal profits or is
incurring losses has no goodwill.
Note: For understanding the procedure of goodwill calculation, problems also include losses to the
partnership firms. Losses has differential treatment while calculating goodwill.

Goodwill is also one of the special aspects of partnership accounts which requires adjustment (also
valuation if not specified) at the time of reconstitution of a firm viz., a change in the profit-sharing ratio, the
admission of a partner or the retirement or death of a partner.

Factors Affecting the Value of Goodwill

The main factors affecting the value of goodwill are as follows:
1. Nature of business: A firm that produces high value-added products or having a stable demand is able to
earn more profits and therefore has more goodwill.
2. Location: If the business is centrally located or is at a place having heavy customer traffic, the goodwill
tends to be high.
3. Efficiency of management: A well-managed concern usually enjoys the advantage of high productivity and
cost efficiency. This leads to higher profits and so the value of goodwill will also be high.
4. Market situation: The monopoly condition or limited competition enables the concern to earn high profits
which leads to higher value of goodwill.
5. Special advantages: The firm that enjoys special advantages like import licences, low rate and assured
supply of electricity, long-term contracts for supply of materials, well-known collaborators (persons/
organisations who work for common goal), patents, trademarks, etc. enjoy higher value of goodwill.
6. Quality of products
7. After sales services
8. Management’s attitude towards fulfilment of commitments (Example: Timely delivery of goods to
customers, Timely payment of trade payables, Delivery of goods to customers at committed prices in spite
of increase in market prices).

Need for Valuation of Goodwill

Normally, the need for valuation of goodwill arises at the time of sale of a business. But, in the context of a
partnership firm it may also arise in the following circumstances:
1. Change in the profit-sharing ratio amongst the existing partners;
2. Admission of new partner;
3. Retirement of a partner;
4. Death of a partner; and
5. Dissolution of a firm involving sale of business as a going concern.
6. Amalgamation of partnership firms.

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Methods of Valuation of Goodwill

Since goodwill is an intangible asset, it is very difficult to accurately calculate its value. Various methods have
been advocated for the valuation of goodwill of a partnership firm. Goodwill calculated by one method may
differ from the goodwill calculated by another method. Hence, the method by which goodwill is to be
calculated, may be specifically decided between the existing partners and the incoming partner.
The important methods of valuation of goodwill are as follows:
1. Average Profits Method
2. Super Profits Method
3. Capitalisation Method

1. Average Profits Method:

• Under this method, the goodwill is valued at agreed number of ‘years’ purchase of the average profits
of the past few years.
• It is based on the assumption that a new business will not be able to earn any profits during the first few
years of its operations. Hence, the person who purchases a running business must pay in the form of
goodwill a sum which is equal to the profits he is likely to receive for the first few years.
• The goodwill, therefore, should be calculated by multiplying the past average profits by the number of
years during which the anticipated profits are expected to accrue.
• For averaging the past profits under this method there are two approaches:
a. Simple Average Method
b. Weighted Average Method.
A. Simple Average Method: Goodwill under this method is calculated when there exists no clear trend
in profits i.e., fluctuations in profits. Goodwill under this method is ascertained by multiplying the
Average Future Maintainable Profit by certain number of years’ purchases.
The steps to be followed are given below:
a. Calculate past profit for each of the relevant years (given) by adding abnormal losses and by
deducting abnormal gains and income from Non – Trade investments.
b. Calculate total profits by adding each relevant year’s past profit
c. Calculate average profits as under: Average profits = Total Profit/No of relevant years.
d. Calculate Goodwill as: Goodwill = Average Future Maintainable Profits × No. of years’ Purchase.

Illustration: 1
The profit for the five years of a firm are as follows – 2013 Rs.4,00,000; 2014 Rs.3,98,000; 2015 Rs.4,50,000;
2016 Rs.4,45,000 and 2017 Rs.5,00,000. Calculate goodwill of the firm on the basis of 4 years purchase of 5
years average profits.
(Practice Assignment Problem: 1)

B. Weighted Average Method: Weighted Average method is followed when there exists clear
increasing or decreasing trend of profits; increasing at decreasing trend and decreasing at increasing
trend. It is better to give more weight to the profits of the recent years than those of earlier years. If
the weights are not given in the problem, they should be assigned as follows:
• Increasing Trend: 1,2,3,4……………
• Decreasing Trend: 4,3,2,1…………….
Steps Involved to calculate the Weighted Average Profits:
a. Calculate profits for each of the given years.
b. Select the weights to be assigned
c. Calculate the weighted profit for each of the years by multiplying the simple profits by the
respective weight.
d. Calculate the total of weights and total of weighted profits.
e. Calculate the weighted average profits as follows:
Weighted average profits = Total of weighted profits/Total of weights.
f. Calculate the value of goodwill as under
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Goodwill = Weighted Average Profit X Agreed Number of Years of Purchase.

• Weighted average should be used only if specified. Otherwise, calculation of goodwill under
average profits method will be done under simple average profits method only.
• While calculating goodwill of the firm, loss in any year, it must be deducted from the sum of
amount of all years’ profits.

Illustration: 2
The profits of firm for the five years are as follows:
Year Profits
2012–13 20,000
2013–14 24,000
2014–15 30,000
2015–16 35,000
2016–17 45,000
Calculate the value of goodwill on the basis of three years’ purchase of weighted average profits.
(Practice Assignment Problem: 2)

Illustration: 3
Calculate goodwill of a firm on the basis of three year’ purchase of the weighted average profits of the last four
years. The profit of the last four years was: 2012 Rs.20,200; 2013 Rs.24,800; 2014 Rs.20,000 and 2015
Rs.30,000. The weights assigned to each year are: 2012 – 1; 2013 – 2; 2014 – 3 and 2015 – 4.
You are supplied the following information:
1. On September 1, 2014 a major plant repair was undertaken for Rs.6,000, which was charged to revenue.
The said sum is to be capitalised for goodwill calculation subject to adjustment of depreciation of 10% p.a.
on reducing balance method.
2. The Closing Stock for the year 2013 was overvalued by Rs.2,400.
3. To cover management cost an annual charge of Rs.4,800 should be made for purpose of goodwill
valuation.
(Practice Assignment Problem: 3)

2. Super Profits Method:

• The basic assumption in the average profits (simple or weighted) method of calculating goodwill is
that if a new business is set up, it will not be able to earn any profits during the first few years of its
operations. Hence, the person who purchases an existing business has to pay in the form of goodwill
a sum equal to the total profits he is likely to receive for the first ‘few years’.
• But it is contended that the buyer’s real benefit does not lie in total profits; it is limited to such
amounts of profits which are in excess of the normal return on capital employed in similar business.
• Therefore, it is desirable to value, goodwill on the basis of the excess profits and not the actual profits.
The excess of actual profits over the normal profits is termed as super profits.
Normal Profit = Capital Employed (Firm’s Capital) × Normal Rate of Return/ 100

Firm’s capital can be calculated under two approaches. They are: Liabilities Side Approach and Assets
side Approach.
• Liabilities Side Approach: Capital employed = Capital + Reserves and Surplus but excludes fictitious
assets and goodwill if any existed in the books.
• Assets Side Approach: All assets (Except goodwill, Non – Trade Investments and Fictitious Assets)
– Outside Liabilities.
Note: Unless otherwise mentioned as trade investments, Investments are treated as Non – Trade
Investments only.
Thus, the steps involved under the method are:
1. Calculate the average profit,
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2. Calculate the normal profit on the capital employed on the basis of the normal rate of return,
3. Calculate the super profits by deducting normal profit from the average profits, and
4. Calculate goodwill by multiplying the super profits by the given number of years’ purchase.

Illustration: 4
The capital of the firm of Anu and Benu is Rs.1,00,000 and the market rate of interest (normal rate of return)
is 15%. Annual salary to partners is Rs.6,000 each. The profits for the last 3 years were Rs.30,000; Rs.36,000
and Rs.42,000. Goodwill is to be valued at 2 years purchase of the last 3 years’ super profits. Calculate the
goodwill of the firm.
(Practice Assignment Problem: 4)

Illustration: 5
On April.1.2014, an existing firm had assets of Rs.75,000 including the cash of Rs.5,000 and fictitious assets
Rs.5,000. Its creditors amounted to Rs.5,000 on that date. If the normal rate of return is 20%. The profits and
losses for the last 5 years of a firm are 2001 – Profit Rs.40,000; 2002 – Profit Rs.92,000; 2003 – Profit Rs.55,000
and 2004 - Loss Rs.70,000 and 2005 – Profit Rs.90,000. Calculate the goodwill of the firm under super profits
method with 2 years purchase of super profits.
(Practice Assignment Problem: 5)

3. Capitalisation Method: Under this method the goodwill can be calculated in two ways:
(a) By capitalizing the average profits, or (b) By capitalising the super profits.
a. Capitalisation of Average Profits: Under this method, the value of goodwill is ascertained by deducting
the actual firm’s capital (net assets) in the business from the capitalized value of the average profits
on the basis of normal rate of return.
This involves the following steps:
1. Ascertain the average profits based on the past few years’ performance.
2. Capitalize the average profits on the basis of the normal rate of return to ascertain the capitalised
value of average profits as follows: Average Profits × 100/Normal Rate of Return
3. Ascertain the actual firm’s capital by deducting outside liabilities from the total assets (excluding
goodwill and fictitious assets). Firms’ Capital = Net Assets i.e., Total Assets (excluding goodwill) –
outside Liabilities.
4. Compute the value of goodwill by deducting net assets from the capitalised value of average profits,
i.e. (2) – (3).

• Firms’ Capital = Net Assets i.e., Total Assets (excluding goodwill) – outside Liabilities.
• Sometimes Question specifies to apply Average Capital Employed. Average Capital Employed =
Opening Capital Employed + Closing Capital Employed/ 2.

b. Capitalisation of Super Profits: Goodwill can also be ascertained by capitalising the super profit directly.
Under this method there is no need to work out the capitalised value of average profits. It involves the
following steps.
• Calculate normal profits on capital employed.
• Calculate average profit for past years, as specified.
• Calculate super profits by deducting normal profits from average profits.
• Multiply the super profits by the required rate of return multiplier i.e.,
Goodwill = Super Profits × 100 / Normal Rate of Return.
• In other words, goodwill is the capitalised value of super profits.

• The amount of goodwill worked out by this method will be the same as calculated by capitalising
the average profits.

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Illustration: 6
The profits of the last five years which are as follows:
Year Profits
2012 1,60,000
2013 1,40,000
2014 2,70,000
2015 1,50,000
The Total Assets of the firm is Rs.11,00,000 and normal rate of return is 10%. Outside Liabilities of the firm
were Rs.1,00,000.
Find the Goodwill of the firm under:
• Capitalisation of Average Profits Method and
• Capitalisation of Super Profits Method
(Practice Assignment Problem: 6)

ASSIGNMENT PROBLEMS
Problem: 1
Calculate goodwill of the firm based on 3 years purchase of 5 years average profits. The profits and losses for
the last 5 years of a firm are 2002 – Loss Rs.40,000; 2003 – Profit Rs.92,000; 2004 – Profit Rs.55,000 and 2005
- Profit Rs.70,000 and 2006 – Profit Rs.90,000

Problem: 2
The profits of firm for the five years are as follows:
Year Profits
2015–16 20,000
2016–17 30,000
2017–18 40,000
2018–19 50,000
2019–20 55,000
Calculate the value of goodwill on the basis of three years’ purchase of average profits.

Problem: 3
The following are the profits of last 3 years
Year 1 – Rs.5,00,000 (Including the abnormal gain Rs.1,50,000)
Year 2 – Rs.4,00,000 (after charging an abnormal loss Rs.2,00,000)
Year 3 – Rs.6,00,000 (Excluding the amount Rs.2,00,000 payable for Insurance on Plant and Machinery)
Calculate goodwill under average profits method having 2 years purchase of average profits.

Problem: 4
The books of a business showed that the firm’s capital employed on December 31, 2015, Rs. 5,00,000 and the
profits for the last five years were: 2011–Rs.40,000: 2012-Rs.50,000; 2013-Rs.55,000; 2014- Rs.70,000 and
2015-Rs.85,000. You are required to find out the value of goodwill based on 3 years purchase of the super
profits of the business, given that the normal rate of return is 10%.

Problem: 5
Calculate the value of goodwill on the basis of 4 years purchase of super profits and 2 years purchase of average
profits.
Profits of the firm were:
2011 – Profit Rs.40,000; 2012 – Profit Rs.45,000; 2013 – Loss Rs.10,000; 2014 – Profit Rs.52,000; 2015 – Profit
Rs.55,000. Capital of the firm Rs.1,50,000. Rate of return on the capital employed is 10% per annum.

Problem: 6
The profits and losses of the last four of firm were 2012 – Profit Rs.10,000; 2013 - Loss Rs.17,000; 2014 – Profit
Rs.50,000; and 2015 – Profit Rs.75,000.
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The Capital Employed in the business was Rs.2,00,000, the rate of interest expected from capital invested is
10%. Calculate goodwill under Capitalization of Average Profits Method and Super Profits Method.

ANSWER KEY
PART: A – BASIC CONCEPTS
1. Average Profits = Rs.53,400; Goodwill = Rs.1,60,200.
2. Goodwill under Average Profits Method = Rs.4,50,000; Goodwill is Rs.9,00,000.
3. Weighted average profits = Rs.45,000 and Goodwill = Rs.1,35,000.
4. Average Profits = Rs. 3,00,000/5 = Rs. 60,000; Super Profit = Rs. 67,333 – Rs. 50,000 = Rs. 17,333; Goodwill
= Rs. 17,333 × 3 = Rs. 51,999.
5. Average Profits = 36,400; Goodwill as per Average Profits Method = Rs.72,800; Normal Rate of Return =
Rs.15,000; Super Profits = Rs.21,400; Goodwill under Super Profits Method = Rs.85,600.
6. Capitalised Value of Average Profits = Rs.2,95,000; Goodwill under Capitalisation of Average Profits
Rs.95,000 and Super Profits Rs.29,500 – 20,000 = Super Profits Rs.9,500 X 100/10 = 95,000.

WORKSHEET
1. Total assets Rs.5,00,000; Liabilities Rs.2,00,000 and Purchase Consideration Rs.3,50,000. Goodwill of the
firm will be_____________.
2. Goodwill of the firm is valued at 3 years purchase of simple average profits of the last 4 years. Goodwill is
calculated Rs.1,68,000. Total profit of last four years were ____________.
3. Profits of past 4 years were as follows: 2017 – 18 Rs.1,70,000; 2018 – 19 Rs.1,50,000; 2019 – 20 Rs.80,000
(Loss) and 2020 – 21 Rs.1,00,000. What is the Goodwill of the firm under simple average profits if number
of years purchase is 3 years _____________
4. Weighted average profits =
5. Profits of past 3 years were as follows: 2018 – 19 Rs.50,000; 2019 – 20 Rs.80,000; 2020 – 21 Rs.1,00,000.
What is the weighted average profits if Weights will be – 1, 2, 3 ______________ and goodwill if number
of years purchase is 2 years.
6. The net profits for the last 3 years were – First Year Rs.80,000; Second Year Rs.1,20,000 and Third Year
Rs.1,50,000. Included in the profits, there were an abnormal gain of Rs.20,000 and closing stock was
overvalued at Rs.10,000 in second year. Adjusted average profit will be ____________.
7. Average Profits - ____________ = Super Profits
8. Goodwill under super profits method = ____________
9. The capital employed by A and B in the firm is Rs.2,30,000 and B Rs.2,70,000. The normal rate of interest
in the market is 7%. What will be the normal rate of return?
10. Total capital of the firm was Rs.1,00,000 and the market rate of interest is 15%. The net profit for the last
3 years were Rs.30,000; Rs.36,000 and Rs.42,000. Goodwill is to be valued at 2 years purchase of the last
3 years profits. Goodwill under super profits method will be ________________
11. Goodwill under capitalisation of average profits =
12. Profits of past 3 years were as follows: 2018 – 19 Rs.50,000; 2019 – 20 Rs.60,000; 2020 – 21 Rs.70,000.
Total assets of the firm Rs.10,00,000 and Normal rate of return is 5%. Outside liabilities were Rs.3,00,000.
Goodwill of the firm by capitalisation of average profits method will be ____________
13. A and B are partners in a firm with capitals Rs.3,00,000 and Rs.2,00,000 respectively. The NRR was 20%
and the capitalised value of average profits was Rs.7,50,000. Goodwill of the firm by capitalisation of
average profits method will be ____________
14. Goodwill under capitalisation of super profits =
15. Find the goodwill under capitalisation of super profits method for Problem number 12.

Answers:
1. Rs.50,000
2. Rs.2,24,000
3. Average Profits is Rs.85,000; Goodwill under average profits method is Rs.2,55,000
4. Total Products/ Total Weights.
5. Weighted Average Profits is Rs.85,000; Goodwill under weighted average profits method is Rs.1,70,000
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6. Rs.1,10,000 (overvaluation of stock in current year will be decreased and profits will increase and for the
next year it will increase the profits)
7. Normal Profits
8. Super Profits X No. of Years Purchase
9. Rs.35,000
10. Rs.42,000.
11. Capitalised value of average profits – Net Assets
12. Goodwill under capitalisation of average profits method is Rs.5,00,000.
13. Rs.2,50,000 (If outside liabilities were not given, total capital = total assets and net assets is equal to total
assets)
14. Super profits x 100/ NRR
15. Goodwill under capitalisation of super profits method is Rs.5,00,000.

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CBSE Class XII Accountancy Bharatiya Vidya Bhavan, Tirupati, AP. 2024 – 25.