SPECTRUM STUDY CIRCLE15/22 2ND FLOOR ASHOK NAGAR ND-18 (PH- 55711031, 9810378235)

CLASS: XII ACCOUNTANCY Page 1 of 4

Definition of PartnershipAccording to the Indian Partnership Act, 1932 (Sec. 4), “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.”

According to Prof. L.H. Haney, “Partnership is the relation existing between persons, competent to make contracts who have agreed to carry on a lawful business in common with a view to private gain.”

The persons who have entered into a partnership with one another are called individually “partners” and collectively “a firm” and the name under which the business is carried is called “the firm’s name”.

Name and Characteristics of PartnershipThe essential elements or characteristics of partnership are as follows:

(1) Association of two or more persons. There should be at least two competent persons to form a partnership. The maximum number of partners in a firm carrying on banking business should not exceed ten and in any other business twenty.

(2) Agreement or contract. The partnership comes into existence by an agreement between the partners. The agreement may be express (i.e. oral or written) or implied. A written agreement, called partnership deed, is preferred to avoid any future disputes.

(3) Business. A partnership can be formed only for the purpose of carrying on some business to earn a profit. Business includes very trade, occupation or profession.

(4) Sharing of profits. The object of partnership must be to earn profits. Profits must be distributed among partners in an agreed ratio. The sharing of profits also includes sharing of losses.

(5) Mutual agency. The business of partnership may be carried on by all the partners or any of them acting for all. It means that each partner has right to participate in the conduct and management of the firm. Each partner is bound by the acts of other partners, done on the behalf of the firm.

(6) Unlimited liability. Liability of a partnership firm is unlimited. It means that if firm’s assets are insufficient to meet its liabilities in full then the personal assets of the partners can also be used to meet firm’s liability.

Partnership Deed – Meaning and ContentsThe agreement creating partnership may be express (i.e. oral or written) or implied. However, it is in the interest of the partners that the agreement must be i writing. Partnership deed is a document which contains this agreement. All the terms and conditions of partnership including the rights and obligations of partners are set out in it. The deed must be signed by all the partners and be stamped properly. Rules Applicable in Absence of Partnership DeedAs per the partnership Act, 1932, following are the important rules which are applicable in the absence of partnership agreement/deed:

(a) Profit Sharing Ratio. Profits or losses are divided equally among the partners irrespective of capital contributed by them.

(b) Interest on Capital. No interest is allowed on Partners’ capital.(c) Interest on Drawings. No interest is allowed on partners’ capital.(d) Interest on Partner’s Loan. Interest is payable on the amount of loan advanced by a

partner to the firm at an agreed rate of interest. If rate of interest is not given in the partnership deed, interest should be allowed to the partner @ 6% p.a.

SPECTRUM STUDY CIRCLE15/22 2ND FLOOR ASHOK NAGAR ND-18 (PH- 55711031, 9810378235)

CLASS: XII ACCOUNTANCY Page 2 of 4 (e) Salary to a Partner. No salary or commission is allowed to any partner, irrespective of time

devoted by the partners.(f) It should be noted that partners may change any of the above provisions by making contrary provision in their partnership deed.

Capital Accounts of PartnersCapital accounts of the partners can be maintained in the following two ways:

(i) Fixed Capital. Capital accounts are said to be fixed when the partners are not allowed to change their capital during the life time of business except in extraordinary circumstances. The balance of fixed capital accounts remain unaltered. If fixed capital is changed by partner’s agreement, additional capital introduced or withdrawn will be recorded in capital Account.

All other entries relating to drawings, interest on drawings, interest on capital, salary or commission, share in profits or losses, etc. are recorded in a separate account which is known as “Partner’s Current Account or Drawings Account.” The balance of this account may be debit or credit. Credit balance of current account will be shown on the liability side of the balance sheet and debit, balances, if any, on the asset side of the balance sheet.

(ii) Fluctuating capital. Capital accounts are called fluctuating when the balance of capital accounts do not remain the same but fluctuate frequently. All the entries relating to drawings, interest on drawings, interest on capital, salary or commission, share in profits or losses, etc. are recorded in capital accounts.

In the absence of any instruction, the partners’ capital accounts should be prepared under fluctuating capital method.Difference between Fixed Capital and Fluctuating Capital

Basic of difference Fixed Capital Fluctuating Capital1. Change of Capital

2. Number of Account

3. Adjustment

4. Debit balance

Under this method the balance of capital account normally remains fixed during the life of the firm except in extra ordinary circumstances.Under this method, two accounts are prepared for each partner – (i) Fixed Capital account (ii) Current account.Under this method, adjustment entries relating to drawings, salary, share in profit/loss, etc. are not recorded in capital account.Fixed capital A/c always shows credit balance while current account can also show a debit balance

Under this method the balance of the capital account fluctuates from one year to another.

Under this method only one account, i.e. capital account is opened. Under this method all adjustment entries are recorded in the partner’s capital account.

Fluctuating capital A/c usually shows a credit balance but may show a debit balance in exceptional cases.

“GOODWILL”Meeting of Goodwill According to Lord Macnagnten, “Goodwill is the benefit and advantage of the good name reputation and connections of a business. It is the attractive force, which brings in customers. It is one thing which distinguishes an old established business from a new business at its first start”.

Goodwill may be defined as the value of the earning capacity by which the firm earns more profit than the normal profits.

SPECTRUM STUDY CIRCLE15/22 2ND FLOOR ASHOK NAGAR ND-18 (PH- 55711031, 9810378235)

CLASS: XII ACCOUNTANCY Page 3 of 4

Nature and Characteristics of GoodwillTo understand the nature of goodwill, we have to study the characteristics of goodwill which are as follows:

(i) It is an intangible asset of business.(ii) It is not fictitious asset in case of a profitable concern.(iii) It helps in earning excess profits.(iv) It is an attractive force, which brings in customer to old place of business.

Factors Affecting the Value of GoodwillGoodwill of a firm is affected by all factors which increase the earning capacity of the firm. The following are the important factors affecting the value of goodwill:

(i) Management. If there is efficient management and is capable to fulfill the requirements of the customers. The firm will earn good profits and that will raise the value of goodwill.

(ii) Quality. The firm providing the goods and service of high quality, can earn reputation in comparison to other firms.

(iii) Location. If the business is located at a favourable place, resulting in good sales or in economies, it will increase its goodwill.

(iv) Access to raw material. When supplies of raw materials difficult to get, there will be a high a\value of goodwill of a firm which has access to raw materials.

(v) Contracts. If a firm has long-term contract for sale of its products or for purchase of materials at favourable prices. This will increase the goodwill of the firm.

(vi) Other factors. Following are the other factors affecting the value of goodwill: (a) Patents, (b) After sale service, (c) Past performance of the firm etc.

Need for Valuation of Goodwill for Partnership FirmsFor partnership firms the need for valuation of goodwill arises in the following circumstances:

(a) A change in the profit sharing ratio of the existing partners.(b) When a new partner is admitted;(c) When a partner retire or dies;(d) When the business is sold or partnership is converted into a joint stock company.(e) When two or more firms are amalgamated.

Method of Valuation of Goodwill The value of goodwill is affected by many factors. In case of sale of business, goodwill is valued by purchaser and seller of the business. Following are the methods for valuation of goodwill.

(1) Average profit method. In this method goodwill is calculated on the basis of average of profits earned by the firm in the past years. Steps are as follows:(i) First of all average profits are calculated on the basis of past years’ profits.Average Profits = Total Profit for N years N (No. of years)While calculating average profits, abnormal profits, should be deducted and abnormal losses should be added back to profits. An adjustment should be made for further incomes and expenses.(ii) To find out goodwill average profits are multiplied by a certain number of years, called number of years purchased Goodwill = Average profits No. of years purchased

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CLASS: XII ACCOUNTANCY Page 4 of 4

(2) Super profit method. The excess of average actual profit over the normal profit is called super profit. In this method, goodwill is valued on the basis of super profits earned by firm and the same multiplied by the number of years purchased. Steps are as follows:

(i) Calculation of average profits (already explained).(ii) Calculation of normal profits:(iii)

Normal Profits = Capital Employed Normal Rate of Profit 100

If capital employed is not given, then it will be calculated by using accounting equation, i.e.,Capital = Assets – Liabilities

(iii) Calculation of super profits:Super Profits = Actual average profit – Normal profits

(iv) Valuation of goodwill:Goodwill = Super profits No. of years’ purchased

(3) Capitalisation method. This method is based on the capitalized value of the firm which is calculated on the basis of capitalization of actual profits on the basis of normal rate. Of profits. under this method goodwill can be calculated in two ways:

(a) Capitalisation of Average Profits – Under this method, to calculate the value of goodwill actual capital employed is deducted from the capitalized value of the average profits on the basis of normal rate of profits. Formula is as follows:

Average Profit 100 - Capital EmployedNormal Rate of Return

(b) Capitalisation of Super Profits. Under this method goodwill is calculated by capitalizing super profits by the rate of normal profits. Formula is as given below: Super Profits 100 Normal Rate of Return