Admission of a partner: goodwill, revaluation and proportionate capital
A and B are partners sharing profits and losses in the ratio 3 : 2. On 31 March their capital accounts show ₹3,00,000 and ₹2,00,000, and the balance sheet includes a General Reserve of ₹50,000. On 1 April they admit C for a 1/5 share; A and B continue between themselves in the ratio 3 : 2. C brings ₹1,50,000 as capital and ₹40,000 as his share of goodwill, both paid into the firm's bank account. On revaluation, stock is found to be overvalued by ₹20,000 and an unrecorded creditor of ₹15,000 is discovered; no other asset or liability changes. A student's draft solution credits the whole ₹40,000 of goodwill to A, B and C in the ratio 12 : 8 : 5, ignores the revaluation items, and fixes C's capital at one-fifth of (₹3,00,000 + ₹2,00,000 + ₹50,000 + ₹40,000), that is ₹1,18,000, so that C has brought ₹32,000 in excess. The student asks why the answer is marked wrong.
1. Identify the error in the goodwill treatment and give the correct distribution with the journal entry.
Read the worked answer
C's ₹40,000 is compensation to the partners who give up a share of future profits. C was not a partner when that goodwill was built up, so crediting any part of it to C is wrong; the student's 12 : 8 : 5 split gives C ₹10,400 he never earned.
Sacrificing ratio: new shares are A 12/25, B 8/25, C 5/25. Sacrifice of A = 3/5 − 12/25 = 3/25; of B = 2/5 − 8/25 = 2/25, i.e. 3 : 2 - the old ratio, because the old partners continue between themselves in the same proportion.
A gets 3/5 × 40,000 = ₹24,000; B gets 2/5 × 40,000 = ₹16,000.
Journal: Bank A/c Dr 40,000; To A's Capital A/c 24,000; To B's Capital A/c 16,000. C's capital account is not credited with goodwill.
2. Show the effect of the revaluation items and explain why ignoring them distorts the answer.
Read the worked answer
Stock is overvalued by ₹20,000, so stock must be reduced - a loss. The unrecorded creditor of ₹15,000 must be brought into the books - also a loss. Total revaluation loss = ₹35,000, borne by the old partners in the old ratio 3 : 2: A ₹21,000, B ₹14,000.
Entries: Revaluation A/c Dr 35,000; To Stock A/c 20,000; To Creditors A/c 15,000. Then A's Capital A/c Dr 21,000 and B's Capital A/c Dr 14,000; To Revaluation A/c 35,000.
Ignoring these overstates net assets by ₹35,000, overstates A's and B's capitals, and therefore inflates any capital figure computed for C. It also overstates the firm's balance sheet total, which a partner admitting into the firm is entitled to rely on.
3. Recompute C's capital on the revalued basis and explain what should be done with any excess he has brought.
Read the worked answer
Work in order. General Reserve of ₹50,000 is an accumulated profit and is transferred to the old partners in 3 : 2 - A ₹30,000, B ₹20,000.
Adjusted capitals: A = 3,00,000 + 24,000 (goodwill) + 30,000 − 21,000 = ₹3,33,000; B = 2,00,000 + 16,000 + 20,000 − 14,000 = ₹2,22,000. Combined = ₹5,55,000.
C holds 1/5, so the old partners' 4/5 corresponds to ₹5,55,000; C's proportionate capital = 5,55,000 × 1/4 = ₹1,38,750.
C brought ₹1,50,000, so the excess is ₹11,250, not ₹32,000. Either that amount is returned to C, or it is credited to C's current account (or treated as a loan), or the old partners' capitals are raised so that C's ₹1,50,000 becomes exactly 1/5 of the total. The student's base was wrong twice over: it used pre-revaluation capitals and counted goodwill as part of the capital base instead of as compensation to A and B.