Admission of a Partner and a Shortfall Nobody Wants
Ravi and Sana have traded as a partnership, sharing profits 3:2. At 31 December 2024 their capital accounts were Rs 2,400,000 and Rs 1,600,000. The agreement provides interest on capital at 5% a year and salaries of Rs 360,000 to Ravi and Rs 240,000 to Sana. Profit before appropriation for 2024 was Rs 1,100,000. On 1 January 2025 they admitted Tariq for a 25% share. Tariq paid Rs 1,500,000, of which Rs 900,000 was credited to capital and Rs 600,000 to his current account. Goodwill was agreed at Rs 2,000,000 but is not to remain in the books. Immediately before admission, premises with a carrying amount of Rs 1,200,000 were revalued at Rs 1,900,000. No new profit-sharing agreement was signed after admission, and Tariq's 25% is the only share expressly stated. Profit before appropriation for 2025 was Rs 900,000, Rs 300,000 below the figure Ravi had forecast. Ravi argues the whole shortfall should be charged to Tariq because he joined knowing the projections.
1. Appropriate the 2024 profit among Ravi and Sana and show each partner's total share.
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Order of appropriation. Interest on capital and salaries are charged first if the agreement provides for them; the residual profit is then shared in the profit-sharing ratio. All figures are for the year ended 31 December 2024, before Tariq joined.
| Ravi | Sana | Total | |
|---|---|---|---|
| Interest on capital (5%) | 120,000 | 80,000 | 200,000 |
| Salaries | 360,000 | 240,000 | 600,000 |
| Residual 300,000 shared 3:2 | 180,000 | 120,000 | 300,000 |
| Total | 660,000 | 440,000 | 1,100,000 |
Workings. Interest: 2,400,000 x 5% = 120,000; 1,600,000 x 5% = 80,000. Residual: 1,100,000 - 200,000 - 600,000 = 300,000, split 3:2 = 180,000 and 120,000.
Judgement points. The interest and salaries are appropriations of profit, not expenses, so they do not reduce the partnership's profit before appropriation and must not appear in the statement of profit or loss. If the residual had been a loss, it would be shared 3:2 and the interest and salaries would still be credited if the agreement provides for them, subject to checking whether the agreement makes them payable only out of profits. The amounts are credited to current accounts, not capital accounts, unless the agreement says otherwise.
2. Show how the goodwill and the revaluation of premises are dealt with on Tariq's admission, including the net effect on each partner's capital. Explain why the goodwill is not retained as an asset.
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New profit-sharing ratio. Tariq has 25%. The remaining 75% continues between Ravi and Sana in their old 3:2, giving Ravi 45% and Sana 30%. Ratio = 45:30:25.
Revaluation before admission. The gain of 700,000 (1,900,000 - 1,200,000) belongs to the old partners in 3:2: Dr Premises 700,000; Cr Capital – Ravi 420,000; Cr Capital – Sana 280,000.
Goodwill – raise and write off.
| Entry | Dr | Cr |
|---|---|---|
| Raise goodwill at agreed value | Goodwill 2,000,000 | Capital – Ravi 1,200,000; Capital – Sana 800,000 (3:2) |
| Write off in new ratio 45:30:25 | Capital – Ravi 900,000; Capital – Sana 600,000; Capital – Tariq 500,000 | Goodwill 2,000,000 |
Net effect on capital. Ravi +300,000; Sana +200,000; Tariq -500,000. Tariq is effectively paying the old partners Rs 500,000 for his share of the goodwill they built, through a reduction in his capital account. The same result can be achieved by a direct adjustment: Dr Tariq capital 500,000; Cr Ravi 300,000; Cr Sana 200,000.
Why goodwill is not retained. Internally generated goodwill is not a separable asset with a reliable cost; keeping it on the balance sheet would overstate partnership capital and could later be written off at a loss. The raise-and-write-off approach records the sacrifice once and leaves the statement of financial position with only identifiable net assets. The agreed Rs 2,000,000 is a valuation of the existing business, not the price Tariq paid for a 25% share, so the two should not be confused.
3. Evaluate Ravi's argument that the 2025 shortfall should be charged entirely to Tariq. What is the correct treatment?
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Correct treatment. The 2025 profit of Rs 900,000 is appropriated among the three partners in the ratio 45:30:25, after interest on capital and salaries as provided by the agreement. A shortfall against a forecast is not a special loss item; it is simply a lower residual profit, shared in the same ratio. There is no basis for charging it to Tariq alone.
Why Ravi's argument fails. (1) Partners share profits and losses in the agreed ratio; a partner cannot unilaterally vary that ratio because a forecast was missed. (2) The forecast was Ravi's, not a contractual guarantee by Tariq. (3) No guarantee clause exists under which Tariq guaranteed a minimum profit to the firm; without such a clause, the risk of lower profits stays with the partnership as a whole. (4) Under the Partnership Act, in the absence of an agreement on sharing, profits and losses are shared equally; here there is an agreement, so the stated ratio prevails and the residual 75% is shared in the old 3:2 between Ravi and Sana.
What would change the answer. A written guarantee in the admission deed – for example, Tariq guaranteeing the firm a minimum annual profit, with any deficiency debited to his current account – would alter the appropriation. The absence of such a clause is decisive.
Practical point. If Ravi believes the forecast was relied on, that is a commercial discussion about the agreement, not a year-end accounting adjustment; any change must be agreed by all partners and applied prospectively.