Financial Accounting-II

DCOM104
FINANCIAL ACCOUNTING - II
 Copyright © 2012 KK Verma
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 SYLLABUS
Financial Accounting - II

Objectives: The course will enable the students to maintain the accounts of partnership firms, branch accounts, departmental
accounts and hire purchase accounts. The students will also be able to calculate the amount of claims in case of fire insurance
policy and loss of profit policy.

Sr. No. Content

1 Partnership Accounts: Meaning, Partnership deed, Guarantee, Adjustment of
closed partnership accounts
2 Distribution of Profit: Preparation of adjusted profit & loss a/c, Appropriation
of profit & Loss account.
3 Admission of partner: Adjustment regarding profit sharing ratio, Treatment of
goodwill, adjustment regarding revaluation of assets & liabilities, partner’s
capitals and Balance sheet of the new firm.
4 Retirement of partner: adjustment regarding goodwill, revaluation of assets and
liabilities, undistributed profits, computation of partners’ interest and mode of
payment.
5 Death of partner and joint life policy.
6 Dissolution of partnership. Garner v/s Murray rule including Insolvency of firm.
Piecemeal Distribution.
7 Departmental Accounts including inter departmental transfers at cost and invoice
price.
8 Branch Accounting.
9 Hire Purchase Accounts, Lease purchase accounts.
10 Insurance claim: Loss of stock Policy, Insolvency accounts.
 CONTENTS

Unit 1: Partnership Accounts 1

Unit 2: Distribution of Profit 13
Unit 3: Admission of Partner 28
Unit 4: Adjustment of Capitals 50
Unit 5: Retirement of Partner 60
Unit 6: Settlement of Retiring Partner’s Claim 71
Unit 7: Death of Partner 80
Unit 8: Joint Life Policy 91
Unit 9: Dissolution of Partnership 103
Unit 10: Departmental Accounts 132
Unit 11: Branch Accounting 144
Unit 12: Hire Purchase 164
Unit 13: Lease Purchase Accounts 184
Unit 14: Insurance Claim 203
Corporate and Business Law

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 Unit 1: Partnership Accounts

Unit 1: Partnership Accounts Notes

CONTENTS

Objectives

Introduction

1.1 Meaning

1.2 Partnership Deed

1.2.1 Contents of a Partnership Deed

1.2.2 Special Aspects of Partnership Accounts

1.2.3 Practical Problems for Computation of Interest on Capital and Drawings

1.3 Guarantee of Profit to a Partner

1.4 Summary

1.5 Keywords

1.6 Review Questions

1.7 Further Readings

Objectives

After studying this unit, you will be able to:

 Prepare partnership accounts

 Construct partnership deed

 Illustrate the guarantee of profit to a partner

Introduction

In the present unit, you will study about the accounts of partnership firm. After studying this
unit, you will be able to understand the nature of partnership firm, partnership deed, some
special aspects of partnership accounts like guarantee of profit to a partner. We know that the
sole proprietary firms have their operations at a small level. As the business expands, firms
need more capital and people to manage the business and share its risks. In such a situation,
people usually adopt the partnership form of organisation.

Notes The Indian Partnership Act was passed in 1932 to define and amend the law
relating to partnership. Indian Partnership Act is one of the old mercantile law. It is a
special type of Contract. Initially, this was a part of Indian Contract Act itself but later
converted into a separate Act in 1932.

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Financial Accounting - II

Notes 1.1 Meaning

A partnership is like a proprietorship in many ways except that it has two or more co-owners.
The partners share the profits and losses according to a sharing pattern already agreed. 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.

A partnership must be dissolved if the ownership changes, as when a partner leaves or dies.
If the business is to continue as partnership, a new partnership must be formed. Both, sole
proprietorship and partnership are convenient ways of separating the business owner’s
commercial activities from their personal activities. But legally, there is no economic separation
between the owners and the businesses.

!
Caution In India, partnership is restricted to 10 partners in case of business in banking
and to 20 persons in other cases.

The following are the key characteristics of a partnership firm:

1. Two or More Persons: A partnership firm should have at least two persons and their
objective should be the same. The Partnership Act does not put any restrictions on
maximum number of partners. However, section 11 of Companies Act prohibits partnership
consisting of more than 20 members, unless it is registered as a company or formed in
pursuance of some other law. If a firm is engaged in the banking business, it can have a
maximum of 10 partners while in case of any other business, the maximum number of
partners can be 20.

2. Agreement: As per normal provision of contract, a ‘partnership’ agreement can be either

oral or written. Agreement in writing is necessary to get the firm registered. Similarly,
written agreement is required, if the firm wants to be assessed as ‘partnership firm’ under
Income Tax Act. A written agreement is advisable to establish existence of partnership and
to prove rights and liabilities of each partner, as it is difficult to prove an oral agreement.
However, written agreement is not essential under Indian Partnership Act.

3. Business: The partnership agreement should be for some business purpose. For example,
if A and B 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.

4. Mutual Agency: The business of firm can be carried on by all or any of them for all. Any
partner has authority to bind the firm. Act of any one partner is binding on all the partners.
Thus, each partner is ‘agent’ of all the remaining partners. Hence, partners are ‘mutual
agents’.

5. Sharing of Profit: The partners must come together to share profits and losses of the
business. Thus, if one member gets only fixed remuneration (irrespective of profits) or
one who gets only interest and no profit share at all, is not a ‘partner’. Though the definition
contained in the Partnership Act describes partnership as relation between people who
agree to share the profits of a business, the sharing of loss is implied. Thus, sharing of
profits and losses is important. If some persons join hands for the purpose of some charitable
activity, it will not be termed as partnership.

6. Unlimited Liability: All the partners of a partnership firm are jointly and severally liable
to the third part for their act. The liability of a partner is unlimited it means there personal
property can be used to pay the debt of the firm.

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 Unit 1: Partnership Accounts

7. Minors admitted to the Benefits of Partnership: A person who is a minor according to the Notes
law to which he is subject may not be a partner in a firm, but, with the consent of all the
partners for the time being, he may be admitted to the benefits of partnership.

8. Partnership Firm is not a Legal Entity: Partnership firm is not a legal entity. It has limited
identity for purpose of tax law. As per section 4 of Indian Partnership Act, 1932, ‘partnership’
is a relation between persons who have agreed to share the profits of a business carried on
by all or any one of them acting for all. Under partnership law, a partnership firm is not a
legal entity, but only consists of individual partners for the time being.

Self Assessment

State whether the following statements are true or false:

1. A partnership firm has separate legal entity.

2. The maximum numbers of partners for a banking business are 20.

3. The liability of a partner is unlimited.

4. A minor can be a partner in a firm.

5. Under partnership law, a partnership firm is not a legal entity, but only consists of individual
partners for the time being.

1.2 Partnership Deed

Partnership deed is an agreement among the partners. The agreement can be either oral or
written. There is no legal obligation under the Partnership Act for written agreement. But
wherever it is in writing, the document, which contains terms of the agreement, is called
‘Partnership Deed’. The deed generally contains the details about all the aspects affecting the
relationship between the partners including the objective of business, contribution of capital by
each partner, ratio in which the profits and the losses will be shared by the partners and entitlement
of partners to interest on capital, interest on loan, etc. The clauses of partnership deed can be
altered with the consent of all the partners. The deed should be properly drafted and prepared as
per the provisions of the ‘Stamp Act’ and preferably registered with the Registrar of Firms.

1.2.1 Contents of a Partnership Deed

The following are the key contents of a partnership deed:

 Names and Addresses of the firm and its main business

 Names and Addresses of all partners

 Amount of capital to be contributed by each partner

 The accounting period of the firm

 The date of commencement of partnership

 Rules regarding operation of Bank Accounts

 Profit and loss sharing ratio

 Rate of interest on capital, loan, drawings, etc.

 Mode of auditor’s appointment, if any

 Salaries, commission, etc., if payable to any partner

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Financial Accounting - II

Notes  The rights, duties and liabilities of each partner

 Treatment of loss arising out of bankruptcy of one or more partners

 Settlement of accounts on dissolution of the firm

 Method of settlement of disputes among the partners

 Rules to be followed in case of admission, retirement, death of a partner

 Any other matter relating to the conduct of business.

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 of the
Indian Partnership Act, 1932 shall apply.

1.2.2 Special Aspects of Partnership Accounts

Normally, a partnership deed covers all matters relating to the mutual relationship amongst the
partners but if the deed is silent on certain matters or in the absence of any deed or an express
agreement, the relevant provisions of the Partnership Act shall become applicable. It is, therefore,
necessary to know the provisions of the Act, which have a direct bearing on the accounting
treatment of certain items. These are as follows:

1. Profit Sharing: The partners shall share the profits of the firm equally irrespective of their
capital contribution.

2. Interest on Capital: No interest is allowed to partners on the capital contributed by them.

Where, however, the agreement provides for interest on capital, such interest is payable
only out of the profits of the business. In other words, if there are losses, interest on capital
will not be allowed even if the agreement so provides.

3. Interest on Advances: If any partner, apart from his share of capital, advances money to
the firm as a loan, he is entitled to interest on such amount at the rate of 6 percent per
annum. Such interest shall be paid even out of the assets of the firm. This means that
interest on loan shall be paid even if there are losses.

4. Interest on Drawings: No interest will be charged on drawings made by the partners.

5. Remuneration to Partners: No partner is entitled to get salary or other remuneration for

taking part in the conduct of the business of the firm unless there is a provision for the
same in the Partnership Deed.

1.2.3 Practical Problems for Computation of Interest on Capital and

Drawings

Computation of Interest on Capital

Interest on drawings can be calculated by the following methods:

1. Direct Method: Under direct method simple interest is to be calculated by taking the
principal amount, period and rate of interest.

2. Product Method: Alternately interest can be calculated by product method. Under this
method the amount of interest is calculated by converting the principal amount into
monthly products depending upon number of months for which principal amount
remained in business. Then the interest is calculated by taking monthly rate of interest.

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 Unit 1: Partnership Accounts

Notes
Example: Raj and Amit are partners with a capital of 1,00,000 and 1,60,000 on January
1,2009 respectively. Raj introduced additional capital of 30,000 on July 1, 2009 and another
20,000 on October 31, 2009. Calculate interest on capital for the year ending 2009. The rate of
interest is 6% p.a.

Solution:

Computation of Interest on capital of Raj

On 1,00,000 for 12 month @ 6% = 1,00,000 × 6/100 × 12/12 = 6,000

On 30,000 for 6 month @ 6% = 30,000 × 6/100 × 6/12 = 900

On 20,000 for 2 month @ 6% = 20,000 × 6/100 × 2/12 = 200

Total interest on Raj’s capital = 6,000 + 900 + 200

= 7100

Computation of Interest on Capital of Amit

On 1,60,000 for 12 month @ 6% = 1,60,000 × 6/100 × 12/12

= 9600

Example: (Product Method)

Using the above statement calculate the interest on capital by product method.

Solution:

Computation of Interest on capital of Raj

Amount ( ) Months Product

100000 12 1200000

30000 6 180000

20000 2 40000

Total product 1420000

6 1
Interest on Capital = 1420000 ×   7100
100 12

Computation of Interest on Capital of Amit

= 1,60,000 × 12 = 19,20,000

6 1
1920000 ×   9600
100 12

Computation of Interest on Drawings

The following are the methods of calculating interest on drawings:

1. Simple Average method

2. Product method

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Financial Accounting - II

Notes Simple Average Method

A fixed amount may be withdrawn every month/half yearly/annually. The interest has to be
calculated for the period for which the amount has been utilised for personal purposes by the
partners. The following example explains the computation of interest on drawings by using
simple average method.

Example: Mr. Rohit withdrew 2,000 per month from the firm for his personal use
during the year ending December 31, 2009. Money is withdrawn at the beginning of the period
and interest is charged at the rate of 12% per annum. Compute the amount of interest on
drawings.

Solution:

Date of drawings Amount withdrawn Period (in Month)

1 January 2009 2,000 12
1 February 2009 2,000 11
1 March 2009 2,000 10
1 April 2009 2,000 9
1 May 2009 2,000 8
1 June 2009 2,000 7
1 July 2009 2,000 6
1 August 2009 2,000 5
1 September 2009 2,000 4
1 October 2009 2,000 3
1 November 2009 2,000 2
1 December 2009 2,000 1
24,000 78 months

Average Period = Total of months/12

= 78 months/12

1
= 6 months
2

12 13 1
Interest on Drawings = 24000   
100 2 12
= 1560

Example 2: In the above example Rohit withdraws the money at the beginning of the
period but in case if he withdraws the money at the end of the period the interest on drawings
will be calculated as follows:

Date of drawings Amount withdrawn Period (in Month)

31 January 2009 2,000 11

28 February 2009 2,000 10

31 March 2009 2,000 9

Contd...

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 Unit 1: Partnership Accounts

30 April 2009 2,000 8 Notes

31 May 2009 2,000 7

30 June 2009 2,000 6

31 July 2009 2,000 5

31 August 2009 2,000 4

30 September 2009 2,000 3

31 October 2009 2,000 2

30 November 2009 2,000 1

31 December 2009 2,000 0

24,000 66 months

Average Period = Total of months/12

= 66 months/12

1
= 5 months
2

12 11 1
Interest on Drawings = 24000   
100 2 2
= 1320

In the same way if money is withdrawn at the middle of the month or after a fixed interval the
number of months and interest will be calculated accordingly.

Product Method

The following example illustrates the computation of interest on drawings by using product
method:

Example: The given below is the details of amount withdrawn by Mr X for his personal
use form the firm during the financial year 2009:

Date Amount ( )

Jan. 1, 2009 10,000

April 1, 2009 10,000

July 1, 2009 10,000

Oct. 1, 2009 10,000

The interest on drawings is calculated @ 8%. Compute the interest on drawings of Mr. X.

Solution:

Statement showing calculation of Interest on Drawings

Date Amount ( ) Time Period Product ( )

Jan. 1, 2009 10,000 12 months 1,20,000

April 1, 2009 10,000 9 months 90,000

Contd...

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Financial Accounting - II

Notes July 1, 2009 10,000 6 months 60,000

Oct. 1, 2009 10,000 3 months 30,000

Total 40,000 3,00,000

Interest on drawing = Total of Product × interest rate × 1/12

= 3,00,000 × 8/100 × 1/12

= 2,000

Self Assessment

Fill in the blanks:

6. ...................... is a written agreement among the partners.

7. No interest will be charged on drawings made by the partners in absence of the ......................

8. There is no legal obligation under the ...................... for written agreement.

9. If there is no express agreement on certain matters, the provisions of the ...................... shall
apply.

10. The partners shall share the profits of the firm ...................... irrespective of their capital
contribution.

11. If any partner, apart from his share of capital, advances money to the firm as a loan, he is
entitled to interest on such amount at the rate of ...................... per annum.

1.3 Guarantee of Profit to a Partner

Guarantee is an assurance that a partner will not get as his share of profit less than the guaranteed
amount. There may be two situations:

1. Guarantee to one partner by (others) the firm,

2. Guarantee to a partner by another partner individually

1. Guarantee to one partner by (others) the firm: Sometimes, a partner is guaranteed a

minimum amount by way of his share in the profits of the firm. Such a guarantee may be
given to an existing partner or to a new partner at the time of admission. Such guaranteed
amount shall be paid to partner when his share of profit, as calculated, according to his
profit sharing ratio is less than the guaranteed amount. The deficiency of such guaranteed
amount will be borne by the other partner’s in their profit sharing or agreed ratio as the
case may be.

Example: S and M are partners and they decide to admit A into the partnership firm. The
profit sharing ratio is agreed as 3 : 2 : 1 with a guaranteed amount of 5,000 to A. For the year
ended 2001, the business earns a profit of 24,000. A’s share works out to 4,000 (1/6 of
24,000). This is 1,000 less than the guaranteed amount of 5,000. Hence, A will get 4,000 as
her share of the profit in the profit sharing ratio and the deficiency of 1,000 (i.e. the amount by
which 4,000 falls short of the guaranteed amount) shall be transferred to the credit of A by
transfer from S and M in their profit sharing ratio, i.e. 3 : 2.

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 Unit 1: Partnership Accounts

Notes

Task X, Y and Z are in partnership sharing profits in the ratio of 3 : 2 : 1. Z share in

profit has been guaranteed by X and Y to be a minimum sum of 8,000. Profits for the year
ended March 31, 2006 was 36,000. Divide profit among the partners.

Hint: Profit to X 16,800; Y, 11,200; Z, 8,000.

2. Guarantee to a partner by another partner individually: The guarantee to an existing or

incoming partner may be given by all the old partners or any of them in their new profit
sharing ratio or an agreed basis.

Example: Kim and Lal are partners in a firm sharing profit in the ratio of 2 : 1. They
decide to include Mohit with 1/4th share in profits with a guaranteed amount of 25,000. Kim
undertook to meet the liability arising out of the guaranteed amount to Mohit. The profit
sharing ratio between Kim, Lal and Mohit will be 2 : 1 : 1. The firm earned profit of 76,000 for
the year ended March 31, 2001.

You are required to prepare Profit and Loss Appropriation Account and show the distribution of
profit amongst the partners.

Solution:

The Profit and Loss Appropriation Account will be prepared as follows:

The Profit and Loss Appropriation Account
for the year ended March 31, 2001

Dr. Cr.

Particulars Amount Particulars Amount

( ) ( )

Share of Profit Net Profit as per profit and loss account 76,000

Kim (2/4 of 76,000) 38,000

Less: Mohit's deficiency (2/3 of

9,000) 6,000 32,000

Lal (1/4 of 76,000) 19,000

Mohit (1/4 of 76,000) 19,000

Add: deficiency borne by Kim 6,000 25,000

76,000 76,000

Notes The minimum guaranteed amount to Mohit is 25,000 whereas, his share of
profit as per the profit sharing ratio works out to be 19,000 only. Hence, there is a
shortfall of 6,000. This amount will be borne by Kim.

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Financial Accounting - II

Notes Self Assessment

Fill in the blanks:

12. ................. is an assurance that a partner will not get as his share of profit less than the
guaranteed amount.

13. Guarantee can be provided by the firm or .................

14. The deficiency of guaranteed amount under guarantee to one partner by others will be
borne by the other partner’s in their profit sharing or ................. as the case may be.

15. The guarantee to an existing or incoming partner may be given by all the old partners or
any of them in their ................. or an agreed basis.

1.4 Summary

 “Partnership” is the relation between persons who have agreed to share the profits of
business carried on by all or any to them acting for all.

 Persons who have entered into partnership with one another are called individually
“partners” and collectively “a firm”, and the name under which their business is carried
on is called the “firm name”.

 The essential features of partnership are: (i) To form a partnership, there must be at least
two persons; (ii) It is created by an agreement; (iii) The agreement should be for carrying
on some legal business; (iv) sharing of profits and losses; and (v) relationship of mutual
agency among the partners.

 Partnership deed is the written agreement between the partners to run the business
smoothly.

 Normally, a partnership deed covers all matters relating to the mutual relationship
amongst the partners.

 If the deed is silent on certain matters or in the absence of any deed or an express agreement,
the relevant provisions of the Partnership Act shall become applicable.

 Sometimes, a partner is guaranteed a minimum amount by way of his share in the profits
of the firm.

 The guarantee to an existing or incoming partner may be given by all the old partners or
any of them in their new profit sharing ratio or an agreed basis.

1.5 Keywords

Drawings: Drawings is the amount borrowed by the partners from the firm for their personal
use.

Mutual Agency: The business of a firm can be carried on by all or any of them for all. Any partner
has the authority to bind the firm.

Partnership Deed: Partnership deed is the written agreement among the partners.

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1.6 Review Questions Notes

1. Normally, a partnership deed covers all matters relating to the mutual relationship
amongst the partners but if the deed is silent on certain matters or in the absence of any
deed or an express agreement, the relevant provisions of the Partnership Act shall become
applicable. What are the provisions of the act, which have direct bearing on the accounting
treatment of certain items?

2. Illustrate the accounting treatment for distribution of profit among the partners, when a
partner is guaranteed a minimum amount by way of his share in the profits of the firm.

3. Construct the proforma of partnership deed covering all the important aspects affecting
the relationship of partners.

4. A and B are partners in a firm. On January 1, 2006 their capital is 3,00,000 and
2,00,000 respectively. Their drawings during the year were 3,000 per month each. They
allowed 6% interest on capital. The profit for the year 4,00,000. Calculate interest on
capital when capitals are fixed.

5. X and Y are equal partners. They withdrew 4,000 each per month. Calculate interest
4% p.a. on drawing if they withdrew in the beginning of each month.

6. The deed generally contains the details about all the aspects affecting the relationship.
Discuss.

7. R and A are partners with a capital of 50,000 and 80,000 on April 2005, respectively.
R introduced additional capital of 50,000 on 1st Jan 2006. Calculate interest on capital
@10 p.a. on March 31, 2006.

8. Aman withdrew 2000 p.m. from business for personal use at the end of every month
during the year. Calculate interest on Drawing @10 p.a.

9. Critically evaluate the preparation of partnership deed by a partnership firm.

10. “Partnership is relation between persons who have agreed to share profits of a business
carried on by all or any of them acting for all”. Discuss.

Answers: Self Assessment

1. False 2. False

3. True 4. False

5. True 6. Partnership deed

7. partnership deed 8. Partnership Act

9. Indian Partnership Act, 1932 10. equally

11. 6 percent 12. Guarantee

13. individual partner 14. agreed ratio

15. new profit sharing ratio

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Financial Accounting - II

Notes 1.7 Further Readings

Books I.M. Pandey, Financial Management, Vikas Publishing, New Delhi.

Khan and Jain, Management Accounting.

Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.

Prasanna Chandra, Financial Management - Theory and Practice, Tata McGraw Hill,
New Delhi (1994).

R.L. Gupta and Radhaswamy, Advanced Accountancy.

S. Bhat, Financial Management, Excel Books, New Delhi.

S.N. Maheswari, Management Accounting.

V.K. Goyal, Financial Accounting, Excel Books, New Delhi.

Online link www.futureaccountant.com

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 Unit 2: Distribution of Profit

Unit 2: Distribution of Profit Notes

CONTENTS

Objectives

Introduction

2.1 Adjustment of Closed Partnership Accounts

2.2 Appropriation of Profit & Loss Account

2.3 Preparation of Adjusted Profit and Loss Account

2.4 Summary

2.5 Keywords

2.6 Review Questions

2.7 Further Readings

Objectives

After studying this unit, you will be able to:

 Make adjustment of closed profit partnership account

 Prepare adjusted profit and loss A/c

 Construct appropriation of profit and loss A/c

Introduction

In partnership form of business, the net profit is to be shared by all the partners in the agreed
profit sharing ratio after charging the interest on capital, partners’ salary and commission and
after taking into account the interest on drawings. As stated earlier, in the absence of any specific
agreement to this effect, the profit is to be distributed equally among the various partners.

2.1 Adjustment of Closed Partnership Accounts

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.

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Notes

Did u know? What are the different types of capital?

The capital may be fixed or fluctuating:

(a) Fixed Capital Account: Two separate accounts are kept for each partner, i.e. ‘capital
account’ and ‘current account’.

(b) Fluctuating Capital Account: Only one account for each partner is kept, i.e. capital
account.

The following procedure may be helpful in recording necessary adjustments:

1. If, interest on capital is one of the items of omissions, then first verify the partners’ capital
at the beginning. This can be done by deducting partners’ share of current year’s profit
from their capitals at the end and adding their drawings thereto.

2. Work out the amounts of omitted items that are to be credited to partners’ capital accounts
such as interest on capital, salaries to partners, etc. The following journal entry for the
adjustment is recorded:

Profit and Loss Adjustment A/c Dr.

To Partners’ Capital A/c (individually)

3. Work out the amounts of omitted items which are to be debited to the Partners’ Capital
Accounts such as interest on drawings. The following adjustment entry recorded:

Partners’ Capital (individually) A/c Dr.

To Profit and Loss Adjustment A/c

4. Work out the balance of the Profit and Loss Adjustment Account. The credit balance of the
Profit and Loss Adjustment Account reflects to the profit and the debit balance and the
loss. This is to be distributed among the partners.

5. The balance of the Profit and Loss Adjustment Account as worked out in point 4 above be
transferred to the partners’ capital accounts in their profit sharing ratio. Thus, the Profit
and Loss Adjustment Account will stand closed. It will involve the following journal
entry:

If it is a credit balance (profit)

Profit and Loss Adjustment A/c Dr.

To Partners’ Capital (individually) A/c

If it is a debit balance (loss)

Partners’ Capital (individually) A/c Dr.

To Profit and Loss Adjustment A/c

!
Caution The adjustment can also be made directly in the Partners’ Capital Accounts without
preparing a Profit and Loss Adjustment Account. In such a situation, we shall prepare a
statement to find out the net effect of omissions and commissions and then to debit the
capital account of the partner who had been credited in excess and credit the capital
account of the partner who had been debited in excess.

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 Unit 2: Distribution of Profit

Self Assessment Notes

Fill in the blanks:

1. If, interest on capital is one of the items of omissions, then first verify the partners’
..................... at the beginning.
2. The omission may be in respect of ....................., interest on drawings, interest on partners’
loan, partner’s salary, partner’s commission or outstanding expenses.
3. All the acts of omission and commission need ..................... for correction of their impact.
4. Sometimes a few omissions or errors in the recording of transactions or the preparation of
..................... are found after the final accounts have been prepared and the profits distributed
among the partners.
5. The adjustment can also be made directly in the Partners’ ..................... without preparing
a Profit and Loss Adjustment Account.

2.2 Appropriation of Profit & Loss Account

The net profit as shown by the profit and loss account of a partnership firm needs certain
adjustments with regard to interest on capitals, interest on drawings, salary, commission to the
partners, if provided, under the agreement. For this purpose, ‘Profit and Loss Appropriation
Account’ may be prepared. This is merely an extension of the profit and loss account and is
prepared to show how net profit is to be distributed among the partners. This account is credited
with net profit and interest on drawings, and debited with interest on capitals, salary or
commission to partners. If, however, the profit and loss appropriation account shows a net loss,
it will be shown on the debit side of the profit and loss appropriation account. After these
adjustments have been made, the Profit and Loss Appropriation Account will show the amount
of profit or loss, which shall be distributed among the partners in the agreed profit sharing ratio.
For preparing the profit and loss appropriation account, the following journal entries have to be
recorded for various items:
1. For Interest on Capital
(a) For Crediting Interest on Capital to Capital/Current Account:
Interest on Capital A/c Dr.
To Partners’ Capital/Current A/c
(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
2. For Interest on Drawings
(a) Interest on Drawings is a gain to the firm and is charged to Partner’s Capital/
Current Account
Partners Capital/Current A/c Dr.
To Interest on Drawings A/c
(b) For transferring Interest on Drawings to Profit and Loss Appropriation Account, the
following entry is to be recorded:
Interest on Drawings A/c Dr.
To Profit and Loss Appropriation A/c

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Financial Accounting - II

Notes 3. Partner’s Salary

(a) Salary allowed to a partner is a gain of the individual partner and charge against the
profits of the firm as per partnership agreement. For this following entry is recorded:

Salary to Partner A/c Dr.

To Partner Capital/Current A/c

(b) For charging salary allowed to a partner:

Profit and Loss Appropriation A/c Dr.

To Salary to Partner A/c

4. Partner’s Commission

(a) Commission is an expense for the firm and a gain to the partner. For this, the
following entry is made:

Commission to Partner A/c Dr.

To Partner’s Capital/Current A/c

(b) Commission paid to a partner is charged to Profit and Loss Appropriation account
by recording the following entry:

Profit and Loss Appropriation A/c Dr.

To Commission to Partners A/c

5. For Transfer to Reserve

Profit and Loss Appropriation A/c Dr.

To Reserve A/c

6. For Share of Profit or Loss on Appropriation

If Profit:

Profit and Loss Appropriation A/c Dr.

To Partner’s Capital/Current A/c

If Loss:

Partner’s Capital/Current A/c Dr.

To Profit and Loss Appropriation A/c

Figure 2.1 shows the proforma of profit and loss appropriation account.

16 LOVELY PROFESSIONAL UNIVERSITY

 Unit 2: Distribution of Profit

Notes
Figure 2.1: Profit and Loss Appropriation A/c

Date Particulars J.F. Amount Date Particulars J.F. Amount

( ) ( )
To Net Loss as ** By Net profit as per …….
per Profit and Profit and Loss A/c
Loss A/c (if profit)
(if loss)

To Interest on By Interest on
Capital drawings
A xx A xx
B xx ** B xx xxx
To Partner's ……. By Capital A/cs –
Salary Share of loss (if loss)
A xx
B xx
To Partner's …….
Commission
Reserve
(transfer)
To Capital A/c …….
Share of profit (if
profit)
A xx
B xx
……. …….

Example: Ajit, Choudhary and Vishal set up a partnership firm on January 1, 2001. They
contributed 50,000, 40,000 and 30,000 respectively as their capitals and decided to share
profits in the ratio of 3 : 2 : 1. The partnership deed provided that Ajit is to be paid a salary of
1,000 p.m. and Choudhary a commission of 5,000. It also provided that interest on capital be
allowed @ 6% p.a. The drawings for the year were: Ajit 6,000, Choudhary 4,000 and Vishal
2,000. Interest on drawings 270 on Ajit’s drawings, 180 on Choudhary’s drawings and 90
on Vishal’s drawings. The net amount of profit as per the profit and loss account for the year
ended 2001 was 35,660.

You are required to record the necessary journal entries relating to appropriation of profit and
prepare the profit and loss appropriation account and the partners’ capital accounts.

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Financial Accounting - II

Notes Solution:
Books of Ajit, Chaudhary and Vishal
Journal

Date Particulars L.F. Debit Credit

2001 Amount Amount
( ) ( )
End of the Profit and Loss A/c Dr. 35,660
year To Profit and Loss Appropriation A/c 35,660
(Transfer of Profit to Profit and Loss
Appropriation Account)
Ajit's Salary A/c Dr. 12,000
To Ajit's Capital A/c 12,000
(Amount of Ajit's Salary)
Profit and Loss Appropriation A/c Dr. 12,000
To Ajit's Salary A/c 12,000
(Transfer of Ajit's Salary to Profit and Loss
Appropriation Account)

Choudhary's Commission A/c Dr. 5,000

To Choudhary's Capital A/c 5,000
(Amount of Choudhary's Commission)
Profit and Loss Appropriation A/c Dr. 5,000
To Choudhary's Commission A/c 5,000
(Transfer of Choudhary's Commission to Profit
and Loss Appropriation Account)
Interest on Capital A/c Dr. 7,200
To Ajit's Capital A/c 3,000
To Choudhary's Capital A/c 2,400
To Vishal's Capital A/c 1,800
(Amount of interest on capital)
Profit and Loss Appropriation A/c Dr. 7,200
To Interest on Capital A/c 7,200
(Transfer of Interest on Capital to Profit and
Loss Appropriation Account)

Ajit's Capital A/c Dr. 270

Choudhary's Capital A/c Dr. 180
Vishal's Capital A/c Dr. 90
To Interest on Drawings A/c 540
(Amount of interest on drawings)
Interest on Drawings A/c Dr. 540 Contd...

To Profit and Loss Appropriation A/c 540

18 (Transfer
LOVELY of Interest on drawings
PROFESSIONAL to Profit and
UNIVERSITY
Loss Appropriation Account)
 Unit 2: Distribution of Profit

Notes
Interest on Drawings A/c Dr. 540
To Profit and Loss Appropriation A/c 540
(Transfer of Interest on drawings to Profit and
Loss Appropriation Account)
Profit and Loss Appropriation A/c Dr. 12,000
To Ajit's Capital A/c 6,000
To Choudhary's Capital A/c 4,000
To Vishal's Capital A/c 2,000
(Amount of profit on appropriation)

Profit and Loss Appropriation Account

for the year ended December 31, 2001

Dr. Cr.
Particulars Amount Particulars Amount
( ) ( )
To Ajit's Salary 12,000 By Net profit as per profit and 35,660
loss account

To Choudhary's Commission 5,000 Interest on Drawings:

To Interest on Capital: Ajit's Capital 270

Ajit's Capital 3,000 Choudhary's 180

capital

Choudhary's 2,400 Vishal's Capital 90

Capital

To Vishal's Capital 1,800 7,200 540

Capital Accounts: (Share of Profit)

Ajit's Capital 6,000

Choudhary's 4,000
Capital

Vishal's Capital 2,000 12,000

36,200 36,200

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Financial Accounting - II

Notes Ajit’s Capital Account

Dr. Cr.
Date Particulars J.F. Amount Date Particulars J.F. Amount
2001 ( ) 2001 ( )
To Drawings 6,000 By Cash 50,000
To Interest on 270 By Salary 12,000
Drawings
To Balance c/f 64,730 By Interest on Capital 3,000
By Profit and Loss 6,000
Appropriation (Share
of profit)
71,000 71,000

Choudhary’s Capital Account

Dr. Cr.
Date Particulars J.F. Amount Date Particulars J.F. Amount
2001 ( ) 2001 ( )
To Drawings 4,000 By Cash 40,000
To Interest on 180 By Salary 5,000
Drawings
To Balance c/f 47,220 By Interest on Capital 2,400

By Profit and Loss 4,000

Appropriation (Share
of profit)
51,400 51,400

Vishal’s Capital Account

Dr. Cr.
Date Particulars J.F. Amount Date Particulars J.F. Amount
2001 ( ) 2001 ( )
To Drawings 2,000 By Cash 30,000
To Interest on 90 By Interest on Capital 1,800
Drawings
To Balance c/f 31,710 By Profit and Loss 2,000
Appropriation (Share of
profit)
33,800 33,800

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 Unit 2: Distribution of Profit

Notes

Task R and S were partners in a firm sharing profits in the ratio of their capitals
contributed on commencement of business which were 80,000 and 60,000 respectively.
The firm started business on April 1, 2005. According to the partnership agreement, interest
on capital and drawings are 12% and 10% p.a., respectively. R and S are to get a monthly
salary of 2,000 and 3,000, respectively.

The profits for year ended March 31, 2006 before making above appropriations was
1,00,300. The drawings of R and S were 40,000 and 50,000, respectively. Interest on
drawings amounted to 2,000 for R and 2,500 for S.

Prepare Profit and Loss Appropriation Account and partners’ capital accounts, assuming
that their capitals do vary.
Hint: Profit transferred to R’s Capital 16,000 and S’s Capital, 12,000.

Self Assessment

6. There are two methods by which the ....................... of partners can be maintained.

7. Under ......................., two accounts are maintained for each partner viz., (i) Capital Account,
and (ii) Current Account.

8. Profit and loss appropriation A/c is merely an extension of the .......................

9. Profit and loss appropriation account is ....................... with net profit and interest on
drawings.

10. Profit and loss appropriation account is ....................... with interest on capitals, salary or
commission to partners.

2.3 Preparation of Adjusted Profit and Loss Account

The following example illustrates the preparation of adjusted profit and loss account:

Example: Asha and Bony are partners in a firm sharing profits equally. Their capital
accounts as on December 31, 2000 showed balances of 60,000 and 50,000 respectively. After
taking into account the profits of the year 2000, which amounted to 20,000, it was subsequently
found that the following items have been left out while preparing the final account of the year
ended 2000.

1. The partners were entitled to interest on capitals @ 6% p.a.

2. The drawings of Asha and Bony for the year 2000 were 8,000 and 6,000, respectively.
The interest on drawings was also to be charged @ 5% p.a.

3. Asha was entitled to salary of 5,000 and Bony, a commission of 2,000 for the whole year.

It was decided to make the necessary adjustments to record the above omissions. Give the
necessary journal entries and prepare the profit and loss adjustment account and Partners’ capital
accounts.

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Financial Accounting - II

Notes Solution:

1. Partners capital at the beginning

Asha ( ) Bony ( )
Capital at the end 60,000 50,000
Less: Share of Profit ( 20,000 shared equally) (10,000) (10,000)
50,000 40,000
Add: Drawings 8,000 6,000
Capital at the beginning 58,000 46,000

2. Interest on Capital
For Asha: 58,000 × 6/100 = 3,480
For Bony: 46,000 × 6/100 = 2,760
3. Interest on Drawings
For Asha: on 8,000 @ 5% p.a. for 6 months.

5 6
8,000    200
100 12
For Bony: on 6,000 @ 5% p.a. for 6 months

5 6
6,000    150
100 12

Books of Asha and Bony

Journal

Dr. Cr.

Date Particulars L.F. Debit Credit

2000 Amount ( ) Amount ( )
Dec 31 Profit and Loss Adjustment A/c Dr. 6,240
To Asha's Capital A/c 3,480
To Bony's Capital A/c 2,760
(Amount of interest on capital )

Asha's Capital A/c Dr. 200

Bony's Capital A/c Dr. 150
To Profit and Loss Adjustment A/c 350
(Amount of interest on drawings)

Profit and Loss Adjustment A/c Dr. 5,000

To Asha's Capital A/c 5,000
(Amount of salary)

Profit and Loss Adjustment A/c Dr. 2,000

To Bony's Capital A/c 2,000
(Amount of commissions)

Asha's Capital A/c Dr. 6,445

Bony's Capital A/c Dr. 6,445
To Profit and Loss Adjustment A/c 12,890
(Amount of loss on adjustment)

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 Unit 2: Distribution of Profit

Profit and Loss Adjustment Account Notes

for the year ended December 31, 2000

Particulars Amount Particulars Amount

( ) ( )
To Capital (Interest on capital) By Capital (Interest on Drawings)
Asha 3,480 Asha 200
Bony 2,760 6,240 Bony 150 350

To Asha's capital (Salary) 5,000 By Capital (Loss on adjustments)

To Bony's capital (Commission) 2,000 Asha 6,445
Bony 6,445 12,890
13,240 13,240

Partners’ Capital Account

Dr. Cr.

Date Particulars J.F. Asha’s Bony’s Date Particulars J.F. Asha’s Bony’s
2000 ( ) ( ) 2000 ( ) ( )

Dec Profit and Dec 31 Balance b/f 60,000 50,000

31 Loss
Profit and Loss 3,480 2,760
Adjustment: Adjustment: (Interest
(interest on on capital)
drawings) 200 150

Profit and Profit and Loss 5,000

Loss Adjustment: (Salary)
Adjustment:
(Loss on
Adjustment) 6,445 6,445

Balance c/f 61,835 48,165 Profit and Loss 2,000

Adjustment:
(Commission)

68,480 54,760 68,480 54,760

Balance b/f 61,835 48,165

For a single adjustment entry an analysis table to find out the amount to be debited or credited
to the capital accounts of the partners individually.

Particulars Asha ( ) Bony ( )

Amount credited (Interest on capital, salary and commission) 8,480 4,760
Amount debited (Interest on drawings and share of loss) 6,645 6,595
Cr. 1,835 Dr. 1,835

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Financial Accounting - II

Notes
Bony’s Capital A/c Dr. 1,835
Asha’s Capital A/c 1,835

Alternatively: A detailed statement can be prepared as follows:

Particulars Amount already recorded Amount as should Adjustment

have been recorded
Dr. ( ) Cr. ( ) Dr. ( ) Cr. ( ) Dr./Cr. ( )
Asha’s Capital: – – –
Interest on Capital – – 3,480
Interest on Drawings – 200
Salary – – 5,000
Share of Profit 10,000 3,555
200 12,035
Net 10,000 – 11,835 Cr. 1,835
Bony’s Capital:
Interest on Capital – – – 2,760
Interest on Drawings – – 150 –
Commission 2,000
Share of Profit – 10,000 – 3,555
150 8,315
Net 10,000 – 8,165 Dr. 1,835

Note: Share of Profit has been worked out as under:

Profit and Loss Appropriation Account
for the year ended December 31, 2000

Dr. Cr.
Particulars Amount Particulars Amount
( ) ( )
To Interest on Capital By Profit as per Profit and Loss A/c 20,000
Asha 3,480 By Interest on Drawings:
Bony 2,760 6,240 Asha's 200
To Asha's Capital (Salary) 5,000 Bony's 150 350
To Bony's Capital (Commission) 2,000
To Share of Profit:
Asha 3,555
Bony 3,555 7,110
20,350 20,350

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 Unit 2: Distribution of Profit

2.4 Summary Notes

 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.

 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.

 The adjustment can also be made directly in the Partners’ Capital Accounts without
preparing a Profit and Loss Adjustment Account.
 The distribution of profits among the partners is shown through a Profit and Loss
Appropriation Account, which is merely an extension of the Profit and Loss Account.

 This account is credited with net profit and interest on drawings, and debited with interest
on capitals, salary or commission to partners.
 After these adjustments have been made, the Profit and Loss Appropriation Account will
show the amount of profit or loss, which shall be distributed among the partners in the
agreed profit sharing ratio.

2.5 Keywords

Capital: The contribution made by the partner’s in a business is called capital.

Partnership Deed: Partnership deed is the written agreement among the partners.
Profit and Loss Appropriation Account: All adjustments such as partner’s salary, partner’s
commission, interest on capital, interest on drawings, etc. are made through this account.

2.6 Review Questions

1. Why the Profit and Loss Appropriation Account is prepared?

2. Neeraj and Amit started business with capital of 1,00,000 each on January 1, 2006. Their
drawings during the year were ` 1,000 and ` 500 per month respectively. The interest on
drawing was ` 200 and ` 100 respectively. They are allowed interest on capital at 8% p.a.
Neeraj is allowed a salary of ` 2,000 per month. They earned a profit of ` 94,000 before
interest and salary. They share profit is the ratio of 2 : 1.

Prepare Profit and Loss Appropriation Account.

3. R and B were partners in a firm and their balances on March 1, 2006 are as under:

R B
(`) (`)

Capital accounts 90,000 1,20,000

Current account 8,000 (Cr) 4,000 (Dr.)

Drawings 5,000 6,000

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Financial Accounting - II

Notes Net profit before charging interest on capital and partners salary was 25,600. They agree
on the following:

(i) Profit and losses to be shared equally.

(ii) 6% interest is to be allowed on capital.

(iii) B will be paid a monthly salary 9,000.

Prepare Profit and Loss Appropriation Account and partners capital accounts.

4. The partnership agreement of Mohit and Raj provides that:

(i) Profit will be shared is the ratio of 3 : 2.

(ii) Mohit will be allowed a salary of 500 p.m.

(iii) 8% interest will be allowed on partner’s fixed capital accounts.

(iv) 6% interest to be charged on partners drawings.

(v) The fixed capital of Mohit and Raj is 2,00,000 and 1,50,000, respectively. Their
drawings were 10,000 and 12,000 respectively. The net profit for the year ending
December 2006 amounted to 62,000.

Prepare Profit and Loss Appropriation Account.

5. Pass the necessary entries for preparing adjusted profit and loss account.

6. Prepare the proforma of profit and loss adjustment account with explanation.

7. Pass the necessary entries for preparing profit and loss appropriation account.

8. Construct the proforma of profit and loss appropriation account.

9. List the items which usually appear on the debit side of Profit and loss appropriation
account.

10. If, balance of profit and loss account is debit, what entry to be recorded for transferring the
amount to Profit and Loss Appropriation account?

Answers: Self Assessment

1. Capital 2. Interest on capitals

3. Adjustments 4. Summary statements

5. Capital Accounts 6. Capital accounts

7. Fixed capital method 8. Profit and loss account

9. Credited 10. Debited

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 Unit 2: Distribution of Profit

2.7 Further Readings Notes

Books I.M. Pandey, Financial Management, Vikas Publishing, New Delhi.

Khan and Jain, Management Accounting.

Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.

Prasanna Chandra, Financial Management - Theory and Practice, Tata McGraw Hill,
New Delhi (1994).

R.L. Gupta and Radhaswamy, Advanced Accountancy.

S. Bhat, Financial Management, Excel Books, New Delhi.

S.N. Maheswari, Management Accounting.

V.K. Goyal, Financial Accounting, Excel Books, New Delhi.

Online link www.futureaccountant.com

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Financial Accounting - II

Notes Unit 3: Admission of Partner

CONTENTS

Objectives

Introduction

3.1 Adjustment Regarding Profit Sharing Ratios

3.2 Treatment of Goodwill

3.2.1 Methods of Calculating Goodwill

3.2.2 Goodwill (Premium) Paid Privately

3.2.3 Goodwill/Premium brought in Cash by the New Partner and retained in the
Business

3.2.4 When the new Partner does not bring his/her share of Goodwill in Cash

3.3 Adjustment Regarding Revaluation of Assets and Liabilities

3.4 Summary

3.5 Keywords

3.6 Review Questions

3.7 Further Readings

Objectives

After studying this unit, you will be able to:

 Make adjustments regarding profit sharing ratio

 Prepare accounts for treatment of goodwill

 Construct adjustments regarding the revaluation of assets & liabilities

Introduction

When a business enterprise requires additional capital or managerial help or both for expansion
of the business it may admit a new partner to enhance its existing resources. In case of a sole
proprietorship, it is converted into a partnership on the admission of a new person as an owner
of the business enterprise. According to the Partnership Act, 1932, no new partner can be introduced
into a firm without the consent of all the existing partners. On admission of a new partner, the
partnership firm is reconstituted with a new agreement. For example, Amit and Sumit are
partners sharing profit in the ratio of 5 : 3. On April 1, 2009 they admitted Neha as a new partner
with 1/4th share in the profit of the firm. In this case, with the admission of Neha as partner, the
firm stands reconstituted.

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 Unit 3: Admission of Partner

Notes

Notes A newly admitted partner acquires two main rights in the firm:
1. Right to share in the assets of the partnership firm

2. Right to share in the profit of the partnership firm.

3.1 Adjustment Regarding Profit Sharing Ratios

The new partner acquires his share in profits from the old partners. It means, on the admission
of a new partner, the old partners sacrifice a share of their profit in favour of the new partner.
As a result, the profit sharing ratio in the new firm is decided mutually between the existing
partners and the new partner. The incoming partner acquires his/her share of future profits
either incoming from one or more existing partner.

Example: A and B are two partners sharing their profit in the ration of 4 : 3. The admitted
C as a partner for 1/7 share in profit. Calculate the new profit sharing ratios of all the partners.

Solution:

Let total Profit = 1

New partner’s share = 1/7

Remaining share = 1 – 1/7 = 6/7

A’s new share = 4/7 of 6/7 = 24/49

B’s new share = 3/7 of 6/7 = 18/49

C’s Share = 1/7

The new profit sharing ratio of A, B and C is:

= 24/49 : 18/49 : 1/7

= 24/49 : 18/49 : 7/49

= 24 : 18 : 7

Sacrificing Ratio

The ratio in which the old partners agree to sacrifice their share of profit in favour of the
incoming partner is called sacrificing ratio. Some amount is paid to the existing partners for
their sacrifice. The amount of compensation is paid by the new partner to the existing partner for
acquiring the share of profit which they have surrendered in the favour of the new partner.

Did u know? How to calculate the sacrificing ratio?

Sacrificing Ratio is calculated as follows:

Sacrificing Ratio = Existing Ratio – New Ratio

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Financial Accounting - II

Notes Following cases may arise for the calculation of new profit sharing ratio and sacrificing ratio:

Case 1: Only the new partner’s share is given.

In this case, it is presumed that the existing partners continue to share the remaining profit in the
same ratio in which they were sharing before the admission of the new partner. Then, existing
partner’s new ratio is calculated by dividing remaining share of the profit in their existing ratio.
Sacrificing ratio is calculated by deducting new ratio from the existing ratio.

Example: Rohit and Mohit are partners sharing profit in the ratio of 3 : 2. They admit
Sumit as a new partner for 1/5 share in profit. Calculate the new profit sharing ratio and
sacrificing ratio.

Solution:

Calculation of new profit sharing ratio:

Let total Profit = 1

New partner’s share = 1/5

Remaining share = 1 – 1/5 = 4/5

Rohit’s new share = 3/5 of 4/5 = 12/25

Mohit’s new share = 2/5 of 4/5 = 8/25

Sumit’s Share = 1/5

The new profit sharing ratio of Rohit, Mohit and Sumit is:

= 12/25 : 8/25 : 1/5

= 12/25 : 8/25 : 5/25

= 12 : 8 : 5

Calculation of Sacrificing Ratios

Rohit Sacrificed = 3/5 – 12/25 = 15 – 12/25 = 3/25

Mohit Sacrificed = 2/5 – 8/25 = 10 – 8/25 = 2/25

Sacrificing Ratio =3:2

Sacrificing ratio of the existing partners is same as their existing ratio.

Case 2: When new partner acquired his/her share of the profit from the existing partner in a
particular ratio.

It means the incoming partner has purchased some share of profit in a particular ratio from the
existing partners.

Example: Neha and Parteek are partners, sharing profit in the ratio of 3 : 2. They admit
Nisha as a new partner for 3/10 share in profit. She acquires this share as 2/10 from Neha and
1/10 share from Parteek. Calculate the new profit sharing ratio and sacrificing ratio.

Solution:

Neha’s and Parteek existing ratio is 3 : 2

Neha’s new share = 3/5 – 2/10 = 4/10

Parteek’s new share = 2/5 – 1/10 = 3/10

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 Unit 3: Admission of Partner

Nisha’s share = 3/10 Notes

The new profit sharing ratio of Neha, Parteek and Nisha is

= 4/10 : 3/10 : 3/10

=4:3:3

Case 3: Existing partners surrender a particular portion of their share in favour of a new
partner.

In this case, sacrificed share of the each partner is ascertained by multiplying the existing partner
share in the ratio of their sacrifice. The share sacrificed by the existing partners should be
deducted from his existing share. Therefore, the new share of the existing partners is determined.
The share of the incoming partner is the sum of sacrifice by the existing partners.

Example: Him and Raj shared profits in the ratio of 3 : 2. Jolly was admitted as a partner.
Him surrendered 1/4th of his share and Raj 1/3 rd of his share in favour of Jolly. Calculate the new
profit sharing ratio.

Solution:

Him’s Old Share = 3/5

Share surrendered by Him = 1/4

Him’s sacrifice = 1/4 of 3/5 = 3/20

Him’s new share = 3/5 – 3/20 = 9/20

Raj’s old share = 2/5

Share surrendered by Raj = 1/3

Raj’s sacrifice = 1/3 of 2/5 = 2/15

Raj’s new share = 2/5 – 2/15 = 4/15

Jolly’s share = Him’s sacrifice + Raj’s sacrifice

= 3/20 + 2/15 = 17/60

Therefore, the new profit sharing ratio of Him, Raj and Jolly will be 27 : 16 : 17

Self Assessment

Fill in the blanks:

1. According to the Partnership Act, 1932, no new partner can be introduced into a firm
without the ...................... of all the existing partners.

2. The new partner acquires his share in profits from the ......................

3. The ratio in which the old partners agree to sacrifice their share of profit in favour of the
incoming partner is called ......................

4. Sacrificing Ratio = ...................... – New Ratio

5. The share sacrificed by the existing partners should be deducted from his ......................
share.

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Financial Accounting - II

Notes 3.2 Treatment of Goodwill

The term goodwill means the value of the reputation of a firm in respect of the profit earned in
future over and above the normal profit. Goodwill is the result of the efforts made by the
existing partners in the past. Therefore, on the eve of the admission, the new partner who is
going to acquire the right to share future profits must compensate the existing partners by
making payment to them. This amount is called the share of goodwill.

!
Caution As per Accounting Standard 10(AS-10) that goodwill should be recorded in the
books only when some consideration in money has been paid for it. Thus, if a new partner
does not bring necessary cash for goodwill, no goodwill account can be raised in the
books. He/she should pay for goodwill in addition to his/her contribution for capital.

From accounting point of view, there may be different situations related to treatment of goodwill
which are discussed here:

 When the amount of goodwill is paid privately by the new partner.

 When the new partner brings his/her share of goodwill in cash.

 When the new partner does not bring his/her share of goodwill in cash.

3.2.1 Methods of Calculating Goodwill

The following are the key methods of calculating goodwill:

1. Average Profit Method

2. Super Profit Method

3. Capitalisation Method

Average Profit 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 is calculated as follows:

Value of goodwill = Average Profit × Number of year of purchase

Example: The profit for the last five years of a firm were as follows year 1999 5,00,000;
year 2000 4,45,000; year 2001 4,50,000; year 2002 3,98,000 and year 2003 4,00,000. Calculate
goodwill of the firm on the basis of 4 years purchase of 5 years average profits.

Solution:

Years Profit

( )

1999 5,00,000

2000 4,45,000

2001 4,50,000

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 Unit 3: Admission of Partner

2002 3,98,000 Notes

2003 4,00,000

Total 21,93,000

Average Profit = Total Profit/No. of years

= 2,19,3000/5 = 4,38,600

Goodwill = Average Profit × No. of years Purchased

= 4,38,600 × 4 = 17,54,400

Super Profit Method

The goodwill under the super profits method is ascertained by multiplying the super profits by
certain number of years’ purchase. The steps involved under the method are:

1. Calculate the average profit,

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.

Capital employed  Normal rate of return

Normal profit =
100

Super Profit = Actual Profit – Normal Profit

Example: A firm earns profit of 65,000 on a capital of 4,80,000 and the normal rate of
return in similar business is 10%. Then the normal profit is 48,000 [10% of the 4,80,000]. The
actual profit is 65,000.

Solution:

Super profit = Actual profit – Normal profit

= 65,000 – 48,000

= 17,000

If value of Goodwill is calculated by 3 years’ purchase of super profit then goodwill is equal to:

= 17000 × 3 = 51,000

Example: The profits by a business for the last five years were: 1997 - 40,000;
1998 - 50,000; 1999 - 55,000; 2000 - 70,000 and 2001 - 85,000. The books of business showed
that the capital employed on December 31, 2001, is 5,00,000. 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%.

Solution:

Capital employed  Normal rate of return

Normal profit =
100

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Financial Accounting - II

Notes
10
= 5,00,000 
100

= 50,000

Total Profit = 40,000 + 50,000 + 55,000 + 70,000 + 85,000 = 3,00,000

Average Profit = 3,00,000/5

= 60,000

Super Profit = Actual Profit – Normal Profit

= 60,000 – 50,000 = 10,000

Goodwill = 10,000 × 3 = 30,000

Capitalization Method

Under this method the goodwill can be calculated in two ways:

(a) By capitalising the average profits

(b) By capitalising the super profits

(a) Capitalisation of Average profit: In this method, the value of goodwill is assumed to be
excess of the capital value of average profit over the actual capital employed. The key
steps involved in this method are as follows:

1. Computation of average profit

Average Profits × 100/Normal Rate of Return

2. Computation of capital employed

Capital Employed = Total Assets (excluding goodwill) – outside liabilities

3. Computation of goodwill

Goodwill = Capitalised value of profits – Capital employed

Example: A business has earned average profits of 40,000 during the last few years and
the normal rate of return in a similar type of business is 10%. Ascertain the value of goodwill by
capitalization method, given that the value of net assets of the business is 3,10,000.

Solution:

Capital Employed = 3,10,000

Capitalised value of average profit = Average Profit × 100/Normal rate of profit

= 40,000 × 100/10

= 4,00,000

Goodwill = Capitalised value – Capital employed

= 4,00,000 – 3,10,000

= 90,000

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(b) Capitalisation of Super profit: In this method, the value of goodwill is calculated on the Notes
basis of super profit method. Following formula is applied for Calculation of capital
employed:

Example: A firm earns a profit of 25,000 and has invested capital amounting to
2,20,000. In the same business normal rate of earning profit is 15%. Calculate the value of
goodwill with the help of Capitalisation of super profit method.

Solution:

Actual profit = 25,000

Normal profit = 2,20,000 x 10/ 100 = 22,000

Super Profit = Actual Profit – Normal Profit

= 25,000 – 22,000

= 3,000

Goodwill = Super profit × 100/normal rate of profit

= 3,000 × 100/15

= 20,000

3.2.2 Goodwill (Premium) Paid Privately

If the goodwill premium is paid privately by the new partner to the old partners outside the
business then the same is not recorded in the books of accounts and hence no journal entry is
recorded.

3.2.3 Goodwill/Premium brought in Cash by the New Partner and

retained in the Business

When, the new partner brings his/her share of goodwill in cash, the amount brought in by the
new partner is transferred to the existing partner in the sacrificing ratio. If there is any goodwill
account in the balance sheet of existing partner, it will be written off immediately in existing
ratio among the partners. The journal entries are as follows:

1. For bringing premium (share of goodwill)

Cash/Bank A/c Dr

To Goodwill A/c

2. For transferring goodwill to the capital accounts of the old partners in their sacrificing
ratio.

Goodwill A/c Dr

To Sacrificing Partner’s Capital A/c (Individually)

However, instead of these two entries one can record only one entry given below:

Cash/Bank A/c Dr

To Sacrificing Partner’s Capital A/c (Individually)

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Financial Accounting - II

Notes
Example: Tanaya and Sumit are partners in a firm sharing profit in the ratio 5 : 3. They
admitted Gauri as a new partner for 1/5 th share in the profit. Gauri brings 20,000 for her share
of goodwill. Make journal entries in the books of the firm after the admission of Gauri. The new
profit sharing ratio will be 3 : 1 : 1.

Solution:
Books of Tanaya, Sumit and Gauri

Date Particulars L.F. Debit Amount Credit

( ) Amount
( )
Bank A/c Dr. 20,000
To Goodwill A/c 20,000
(Cash brought by Gauri for her share
of goodwill)

Goodwill A/c Dr. 20,000

To Tanaya’s A/c 2,500
To Sumit’s A/c 17,500
(Goodwill brought by Gauri
transferred to the capital accounts of
Tanaya and Sumit in their sacrificing
ratio)

Working Notes:

5
Tanaya’s old share =
8

3
Tanaya’s new share =
5

5 3 1
Tanaya’s sacrificing ratio =  
8 5 40

3
Sumit’s old share =
8

1
Sumit’s new share =
5

3 1 7
Sumit’s sacrificing ratio =  
8 5 40

 Sacrificing ration will be 1 : 7

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3.2.4 When the new Partner does not bring his/her share of Goodwill in Notes
Cash

Sometimes the new partner is not able to bring goodwill in cash. In this case, the amount of
goodwill existing in the books is written off by debiting the capital account of existing partners
in their existing profit sharing ratio.

Example: A and B are partners sharing profit in the ratio of 2 : 3. They agree to admit C
for 1/5 share in future profit. C brings 2,50,000 as capital and enable to bring her share of
goodwill in cash, the goodwill of the firm to be valued at 1,80,000. At the time of admission
goodwill existed in the books of the firm at 80,000. Make necessary journal entries in the books
of the firm.

Solution:
Books of A, B and C

Date Particulars L.F. Debit Amount Credit

( ) Amount
( )
Bank A/c Dr. 2,50,000
To C’s capital A/c 2,50,000
(cash brought by C for her capital)

A’s capital A/c Dr. 32,000

B’s capital A/c Dr. 48,000
To goodwill A/c 80,000
(Goodwill written off)

C’s capital A/c Dr. 36,000

To A’s capital A/c 14,400
To B’s capital A/c 21,600
(The accounts of A and B are credited
for goodwill on C’s admission in their
sacrificing ratio)

Working Note:
A and B sacrifice their profit in favour of C in their existing profit sharing ratio i.e. 2 : 3.
Therefore, the sacrificing ratio is 2 : 3.
Value of Goodwill = 1,80,000
C’s share in Profit = 1/5
C’s share of Goodwill = 1,80,000 × 1/5 = 36,000

Task Anshu and Anup are partners in a firm sharing profits in the ratio of 5 : 3.
On Jan. 1, 2003 they admit Shilpi as a new partner. The new profit sharing ratio will be
4 : 3 : 2. Shilpi brought 1,00,000 for her capital but could not bring any share of goodwill.
The firm’s goodwill on Shilpi’s admission was valued at 1,80,000. At the time of Shilpi’s
admission goodwill existed in the books of the firm at 2,40,000. Record necessary journal
entries on Shilpi’s admission.

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Notes Self Assessment

State whether the following statements are true or false:

6. The term goodwill means the value of the reputation of a firm in respect of the profit
earned in future over and above the normal profit.

7. Goodwill has no relation with the efforts made by the existing partners in the past.

8. When, the new partner brings his/her share of goodwill in cash, the amount brought in by
the new partner is transferred to the existing partner in the sacrificing ratio.

9. If there is any goodwill account in the balance sheet of existing partner, it will be written
off immediately in new ratio among the partners.

10. If a new partner does not bring necessary cash for goodwill, no goodwill account can be
raised in the books.

3.3 Adjustment Regarding Revaluation of Assets and Liabilities

At the time of admission of a new partner, it is always desirable to ascertain whether the assets
of the firm are shown in books at their current values. In case the assets are overstated or
understated, these are revalued. Similarly, a reassessment of the liabilities is also done so that
these are brought in the books at their correct values. At times there may be some unrecorded
assets with the business, these are also recorded and similarly if there is any unrecorded liability
which the firm has to pay, the same is also recorded. For revaluation of assets and recording of
unrecorded assets and for the reassessment of liabilities and recording of unrecorded liabilities
the firm prepares an account in its book called Revaluation Account. Any gain or loss on
revaluation of assets and reassessment of liabilities is transferred to the capital accounts of the
old partners in their old profit sharing ratio. The revaluation account is credited with increase in
the value of assets and decrease in the value of liabilities because it is a gain. Similarly, decrease
of assets and increase in the value of liabilities is debited to revaluation account because it is a
loss. Unrecorded assets are credited and unrecorded liabilities are debited in the revaluation
account. If the revaluation account shows a credit balance then it indicates gain and if there is a
debit balance then it indicates loss. Gain on revaluation or loss on revaluation will be transferred
to the capital accounts of the old partners in old ratio.

The following journal entries are recorded on revaluation of assets and reassessment of liabilities.
(i) For increase in the value of Assets
Asset A/c Dr.
To Revaluation A/c
(Increase in the value of Assets)
(ii) For decrease in the value of Asset
Revaluation A/c Dr.
To Asset A/c
(Decrease in the value of Assets)
(iii) For increase in the value of Liabilities
Revaluation A/c Dr.
To Liabilities A/c
(Increase in the value of Liabilities)

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(iv) For decrease in the value of Liabilities Notes

Liabilities A/c Dr.

To Revaluation A/c

(Decrease in the value of Liabilities)

(v) For unrecorded Assets

Asset A/c [unrecorded] Dr.

To Revaluation A/c

(Unrecorded asset recorded at actual value)

(vi) For unrecorded Liability

Revaluation A/c Dr.

To Liability A/c [unrecorded]

(Unrecorded Liability recorded at actual value)

(vii) For transfer of gain on revaluation

Revaluation A/c Dr.

To Existing Partner’s Capital/Current A/c

(Profit on revaluation transferred to capital account in existing ratio)

(viii) For transfer of loss on revaluation

Existing Partner’s Capital/Current A/c Dr.

To Revaluation A/c

(Loss on revaluation transferred to capital account in existing ratio)

Notes
Proforma of Revaluation A/c
Dr. Revaluation A/c Cr.

( ) ( )

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Notes
Example: Given below is the Balance Sheet of A and B, who are carrying on partnership
business as on March 31, 2003. A and B share profits in the ratio of 2 : 1
Balance Sheet of A and B as at March 31, 2003

( ) ( )

C is admitted as a partner on the date of the balance sheet on the following terms:

1. C will bring in 1,00,000 as his capital and 60,000 as his share of goodwill for 1/4th share
in profits.

2. Plant is to be appreciated to 1,20,000 and the value of buildings is to be appreciated by

10%.

3. Stock is found overvalued by 4,000.

4. A provision for bad and doubtful debts is to be created at 5% of debtors.

5. Creditors were unrecorded to the extent of 1,000.

Record the necessary journal entries and prepare the revaluation account.

Solution:
Books of A, B and C
Journal
Date Particulars L.F. Debit Amount Credit Amount
( ) ( )
Cash A/c Dr. 1,60,000
To C’s capital A/c 1,00,000
To Goodwill A/c 60,000
(cash brought by C for capital and goodwill)

Goodwill A/c Dr. 60,000

To A’s capital A/c 40,000
To B’s capital A/c 20,000
(Goodwill brought by C transferred to the
capital accounts of A and B in their sacrificing
ratio)

Revaluation A/c Dr. 7,000

To Stock 4,000
To provision for bad and doubtful debts 3,000
(Stock depreciated and provision for bad and
doubtful debts created on sundry debtors)

Revaluation A/c Dr. 1,000

To Creditors A/c 1,000
(Increase in the value of creditors)

Plant and Machinery A/c Dr. 20,000 Contd...

Buildings A/c Dr. 15,000
To Revaluation A/c 35,000
(Increase in the value of assets on revaluation)
40 LOVELY PROFESSIONAL UNIVERSITY
Revaluation A/c Dr. 27,000
To A's Capital A/c 18,000
To B's Capital A/c 9,000
(Transfer of gain on revaluation to old partners'
capital accounts)
 ratio)

Revaluation A/c Dr. 7,000

To Stock 4,000
To provision for bad and doubtful debts 3,000
(Stock depreciated and provision for bad and
doubtful debts created on sundry debtors)
Unit 3: Admission of Partner
Revaluation A/c Dr. 1,000
To Creditors A/c 1,000
(Increase in the value of creditors)
Notes
Plant and Machinery A/c Dr. 20,000
Buildings A/c Dr. 15,000
To Revaluation A/c 35,000
(Increase in the value of assets on revaluation)

Revaluation A/c Dr. 27,000

To A's Capital A/c 18,000
To B's Capital A/c 9,000
(Transfer of gain on revaluation to old partners'
capital accounts)

Revaluation Account

( ) ( )

Example: (Preparation of balance sheet of reconstituted firm)

Himani and Harsha are partners in a firm. Their Balance Sheet on March 31, 2006 was as follows:
Balance Sheet of Himani and Harsha
as on March 31, 2006

( ) ( )

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Financial Accounting - II

Notes On April 1, 2006 they admitted Charu as a Partner on the following terms:

1. Charu brings 90,000 as her share of capital and she is unable to bring any amount for
goodwill.

2. Goodwill is valued at 2 Years purchase of the average profit of last 4 years. The Profit of
last 4 years amounted to 20,000; 30,000; 30,000; 40,000 Respectively.

3. New Profit sharing ratio between Himani’s, Harsha’s and Charu are 3 : 2 : 1.

4. Outstanding Expenses to be brought down to 500.

5. The provision for doubtful debts is to be increased up to 5% on Debtors.

6. Machinery is depreciated by 10% and Stock is valued at 47,000.

Prepare Revaluation Account, Partners Capital account and opening Balance sheet of the new
firm.

Solution:

Revaluation Account

Dr. Cr.

( ) ( )

Capital Account

Dr. Cr.

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Balance Sheet of Himani, Harsha and Charu Notes

as on March 31, 2007

( ) ( )

3,37,900

Working Note:

(i) Valuation of Goodwill:

Total Profit = 20,000 + 30,000 + 30,000 + 40,000

Average Profit = 1,20,000/4

= 30,000

Goodwill = 30,000 × 2 = 60,000

Charu’s Share of Goodwill = 60,000 × 1/6 = 10,000

(ii) Computation of sacrificing ratio:

Sacrificing Ratio = Existing Ratio – New Ratio

1 3
Himani’s =  0
2 6

1 2 1
Harsha’s =  
2 6 6

Memorandum Revaluation A/c

At the time of admission of a partner after revaluation of assets and liabilities, if all the partners
do not want to show the revised value of assets and liabilities in their new balance sheet, then
under such circumstances the revaluation A/c is reopened, which is known as Memorandum
revaluation A/c. In such case, all entries passed through revaluation account are reversed. For
example, if revaluation A/c was debited and plant A/c was credited earlier now the plant A/c
would be debited and revaluation A/c would be credited. Subsequently, a new revaluation
A/c comes into existence which is known as Memorandum Revaluation A/c. The memorandum
revaluation A/c is closed by transferring the balance to all the partners including new one in
new profit sharing ratio.

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Financial Accounting - II

Notes The given below is the proforma of Memorandum Revaluation A/c:

Proforma of Memorandum Revaluation Account

Decrease in Assets Increase in Assets

Increase in Liabilities Decrease in Liabilities
Unrecorded Liabilities Unrecorded Assets
Outstanding Expenses Accrued Incomes
Profit : A’s Capital A/c Loss: A’s Capital A/c
B’s Capital A/c XXX B’s Capital A/c XXX
Decrease in Assets Increase in Assets
Increase in Liabilities Decrease in Liabilities
Unrecorded Liabilities Unrecorded Assets
Outstanding Expenses Accrued Incomes
Profit : A’s Capital A/c Loss: A’s Capital A/c
B’s Capital A/c B’s Capital A/c
C’s Capital A/c C’s Capital A/c

Example: A and B are partners in a firm sharing profits in the ratio 2 : 1. C is admitted
into the firm with 1/4th share in profits. He will bring in 30,000 as capital and capitals of A and
B are to be adjusted in the profit sharing ratio. The Balance sheet of A and B as on March 31, 2002
(before C’s admission) was as under:

Balance Sheet of A and B as at March 31, 2002

( ) ( )

Other terms of agreement are as under:

(i) C will bring in 12,000 as his share of goodwill.

(ii) Building was valued at 45,000 and Machinery at 23,000.

(iii) A provision for bad debts is to be created @ 6% on debtors.

The partners decide to keep the value of the assets and liabilities the same and hence their book
values will not change due to the above adjustments. Show the necessary ledger accounts and
prepare the balance sheet after C’s admission.

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Solution: Notes

Memorandum Revaluation A/c

Particulars Amount Particulars Amount

( ) ( )
To Machinery ( 25,000 – 23,000) 2,000 By building ( 45,000 – 40,000)
To provision for bad and doubtful 5,000
debts (6% of 8,000) 480
To Profit on revaluation A/c
A 1,680
B 840 2,520
5,000 5,000

To machinery 2,000 By Building 5,000

To Provision for bad and doubtful
debts 480
To Partners Capital A/c – Loss on
Revaluation
A – 2/4 of 2520 = 1260
B – ¼ of 2520 = 630
C – ¼ of 2520 = 630
2,520 2,520
5,000 5,000

Partner’s Capital A/c

Particulars A( ) B( ) C( ) Particulars A( ) B( ) C( )
To Revaluation By balance b/d 50,000 32,000
A/c – loss 1,260 630 630 By cash A/c ------- ------- 30,000
By Premium 8,000 4,000 ------
To balance c/d 62,420 3,8210 29,370 By profit on
revaluation 1,680 840
By general
reserve
4,000 2,000
63,680 38,840 30,000 63,680 38,840 30,000

Balance Sheet of A, B and C as at March 31, 2002

(After Admission)

Liabilities Amount ( ) Liabilities Amount ( )

Creditors 8,000 Building 40,000
Bills Payable 4,000 Machinery 25,000
Capitals Furniture 5,000
A 62,420 Stock in Hand 10,000
B 38,210 Sundry Debtors 8,000
C 29,370 13,0000 Cash at Bank
( 10,000 + 30,000 + 12,000)
Cash in Hand 52,000
2,000
14,2000 14,2000

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Notes Working Note:

1. Computation of New Profit Sharing Ratio

C’s share of profit = 1/4

Remaining share = 3/4

A’s new share = 2/3 of 3/4 = 1/2

B’s new share = 1/3 of 3/4 = 1/4

Thus new profit sharing ratio of A, B and C

=2:1:1

2. General reserves should be distributed between the old partners in their old profit sharing
ratios.

Self Assessment

Fill in the blanks:

11. At the time of admission of a new partner, it is always desirable to ascertain whether the
assets of the firm are shown in books at their ..................... values.

12. For revaluation of assets and recording of unrecorded assets and for the reassessment of
liabilities and recording of unrecorded liabilities the firm prepares an account in its book
called .....................

13. The revaluation account is ..................... with increase in the value of assets.

14. Gain on revaluation or loss on revaluation will be transferred to the ..................... of the old
partners in old ratio.

15. Decrease of assets and increase in the value of liabilities is ..................... to revaluation
account.

3.4 Summary

 When a business enterprise requires additional capital or managerial help or both for
expansion of the business it may admit a new partner to supplement its existing resources.

 According to the Partnership Act 1932, no new partner can be introduced into a firm
without the consent of all the existing partners.

 The new partner acquires his share in profits from the old partners.

 The ratio in which the old partners agree to sacrifice their share of profit in favour of the
incoming partner is called sacrificing ratio.

 The term goodwill means the value of the reputation of a firm in respect of the profit
earned in future over and above the normal profit.

 On the eve of the admission, the new partner who is going to acquire the right to share
future profits must compensate the existing partners by making payment to them.

 For revaluation of assets and recording of unrecorded assets and for the reassessment of
liabilities and recording of unrecorded liabilities the firm prepares an account in its book
called Revaluation Account.

 Gain on revaluation or loss on revaluation will be transferred to the capital accounts of the
old partners in old ratio.

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3.5 Keywords Notes

Goodwill: The term goodwill means the value of the reputation of a firm in respect of the profit
earned in future over and above the normal profit.

Revaluation a/c: For revaluation of assets and recording of unrecorded assets and for the
reassessment of liabilities and recording of unrecorded liabilities the firm prepares an account
in its book called Revaluation Account.

Sacrificing ratio: The ratio in which the old partners agree to sacrifice their share of profit in
favour of the incoming partner is called sacrificing ratio.

3.6 Review Questions

1. X and Y are partners sharing profits and losses in proportion of 3 : 1. They admit a new
partner Z whom they give 1/4 th share in profits. Calculate new profit sharing ratio.

2. A and B share profits in the ratio of 7 : 3. C was admitted as a partner. A surrendered 1/7th
of his share and B 1/3rd of his share in favour of C. Calculate new profit sharing ratio.

3. A and B are in partnership sharing-profits in the ratio of 3 : 2 respectively. C is admitted

into the partnership. The new profit sharing ratio will be A 5, B 3 and C 2. Calculate
sacrificing ratio.

4. Explain ‘Revaluation Account’. Why assets are liabilities are revalued at the time of
admission of a new partner?

5. Rohit and Meena are partners sharing and losses in the ratio of 7 : 3. Rohit surrenders 1/7
of his share and Meena surrenders 1/3 of his share in favour of Teena, a new partner.
Calculate the new profit sharing ratio.

6. John and Mike were partners in a firm sharing profits in 3:1 ratio. They admitted Wahid as
a new partner for 1/6th share in the profits of the firm. Wahid acquired his share from
John and Mike in the ratio 2 : 1. Calculate the new profit sharing ratio of John, Mike and
Wahid.

7. A and B are partners sharing profits as 2 : 1. Following is their Balance Sheet as on December
31, 2001:
Balance Sheet of A and B as on Dec 31, 2001

( ) ( )

On January 1, 2002, C is admitted into partnership for 1/4th share on the following terms:

(a) That he should bring in 15,000 as his capital and 6,000 as premium for his share
of goodwill.

(b) That land and building be revalued at 25,000 and stock at 18,500.

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Financial Accounting - II

Notes (c) That 500 be provided for doubtful debts.

(d) That after the above adjustments, the capital of the old partners be adjusted on the
basis of the new partner’s capital, having regard to profit sharing ratio. Excess or
shortage will be adjusted through actual cash.
Record the necessary journal entries.

8. The following is the Balance Sheet of Tarun and Ashima sharing profit and losses in the
ratio of 2 : 1.

( ) ( )

20,000

They agreed to admit Sunita into partnership on the following terms:

(i) Sunita to pay 9,000 as Goodwill.
(ii) Sunita bring 11,000 as her Capital for 1/4 share of profit in the business.
(iii) Building and furniture to be depreciated at 5%. Stock is reduced by 1,600 and Bad
Debt Reserve 1,300 to be provided for.
Prepare necessary ledge account and balance sheet after admission.
9. George and Henry are partners sharing profits in the ratio of 3 : 2. They decided to admit
David as a new partner and to share future profits and losses equally. David brings in
50,000 as his capital. Goodwill of the firm is valued at 60,000. Record the necessary
journal entries—
(a) When no goodwill appears in books.
(b) When goodwill appears at 50,000, and
(c) When goodwill appears at 1,00,000.
10. Explain the methods of valuation of goodwill.

Answers: Self Assessment

1. consent 2. old partners

3. sacrificing ratio 4. Existing Ratio

5. existing 6. true

7. false 8. true
9. false 10. true

11. current 12. Revaluation Account

13. credited 14. capital accounts

15. debited

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3.7 Further Readings Notes

Books I.M. Pandey, Financial Management, Vikas Publishing, New Delhi.

Khan and Jain, Management Accounting.

Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.

Prasanna Chandra, Financial Management - Theory and Practice, Tata McGraw Hill,
New Delhi (1994).

R.L. Gupta and Radhaswamy, Advanced Accountancy.

S. Bhat, Financial Management, Excel Books, New Delhi.

S.N. Maheswari, Management Accounting.

V.K. Goyal, Financial Accounting, Excel Books, New Delhi.

Online link www.futureaccountant.com

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Notes Unit 4: Adjustment of Capitals

CONTENTS

Objectives

Introduction

4.1 Adjustment of Partner’s Capital

4.1.1 On the Basis of new Partner’s Capital and his Profit Sharing Ratio

4.1.2 On the Basis of the Existing Partner’s Capital Account Balances

4.2 Preparation of Balance Sheet of New Firm

4.3 Summary

4.4 Keywords

4.5 Review Questions

4.6 Further Readings

Objectives

After studying this unit, you will be able to:

 Compute partner’s capital

 Prepare balance sheet of new firms

Introduction

Sometimes, it is possible that the partners decide to adjust their capital so as to be proportionate
to their profit sharing ratio. If the capital of the new partner is given, the same can be used as a
base for calculating the new capitals of the old partners. After making the necessary adjustments
the partners can compare their new capital with the old capital and the partner whose capital
falls short, will bring in the necessary amount and the partner who has a surplus, will withdraw
excess amount of capital.

4.1 Adjustment of Partner’s Capital

The partners can decide to maintain their new capital on the following basis:

 On the basis of new Partner’s Capital and his profit sharing ratio

 On the basis of the existing partner’s capital account balances

4.1.1 On the Basis of new Partner’s Capital and his Profit Sharing Ratio

If the capital of the new partner is given, the entire capital of the new firm will be determined on
the basis of the new partner’s capital and his profit sharing ratio. Therefore the capital of other
partners is ascertained by dividing the total capital as per his profit sharing ratio.

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Notes
!
Caution If the existing capital of the partner after adjustment is in excess of his new capital,
the excess amount is withdrawn by partner or transferred to the credit of his current
account. If the existing capital of the partner is less than his new capital, the partner brings
the short amount or makes transfer to the debit of his current account.

The journal entries are made as under:

(i) When excess amount is withdrawn by the partner or transferred to current account.

Existing Partner’s Capital A/c Dr.

To Bank A/c or Partner Current A/c

(Excess amount is withdrawn by the partner or transferred to current account)

(ii) For bringing in the Deficit amount or Balance transferred to current account.

Bank A/c or Partner Current A/c Dr.

To Existing Partner’s Capital A/c

(Bringing the Deficit amount or Balance transferred to current account)

Example: A and B are partners sharing profit in the ratio of 5:3 with capital of 80,000
and 70,000 respectively. They admit a new partner C. The new profit sharing ratio of A, B and
C is 5:3:2 respectively. C brings 40,000 as capital. The profit on revaluation of assets and
reassessment of liabilities is 6,400. It is agreed that capitals of the partner’s should be in the
new profit sharing ratio. Calculate new capital of each partner.

Solution:

Actual Capital of A and B

A B

( ) ( )

Balance in Capital A/c 80,000 70,000

Add Profit on Revaluation (5 : 3) 4,000 2,400

Capital after Adjustment 84,000 72,400

Calculation of new capital of the firm and existing partner’s capital

C’s Share in the firm = 2/10

C’s brings 40,000 for 2/10 Share

Total capital of the new firm in terms of C’s capital

= 40,000 × 10/2

= 2,00,000

A’s share in New Capital = 2,00,000 × 5/10 = 1,00,000

B’s share in New Capital = 2,00,000 × 3/10 = 60,000

On comparing A’s adjusted capital with the new capital we find that the A brings 16,000
[ 1,00,000 – 84,000] or the amount may be debited to his current account.

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Notes On comparing the B’s adjusted capital with the new capital, we find that the B is to withdraw
12,400 [ 72,400 – 60,000] or the amount may be credited to his current account.

4.1.2 On the Basis of the Existing Partner’s Capital Account Balances

Sometimes the capital of the new partner is calculated on the basis of existing partners. The
partner is required to bring an amount proportionate to his/her share of profit. In such a case,
new partner’s capital will be calculated on the basis of adjusted capital of the existing partners.

Example: The capital account of X and Y show the balance after all adjustments and
revaluation are 100,000 and 50,000, respectively.

They admit Z as a new partner for 1/4 share in the profits. Z’s capital is calculated as follows:

Total share = 1

Z’s share in the profit = 1/4

Remaining share = 1 – 1/4 = 3/4

3/4 share of profit combined capital of X and Y = 100,000 + 50,000 = 1,50,000

Total Capital of the firm = 1,50,000 × 4/3 = 2,00,000

Z’s capital for 1/4 share of profits = 2,00,000 × 1/4 = 50,000

Z brings in 50,000 as his Capital

Task X, Y and Z are partners in a firm sharing profits the ratio of 3:2:1. D is admitted
into the firm for 1/4 share in profits, which he gets as 1/8 from X and 1/8 from Y. The total
capital of the firm is agreed upon as 1,20,000 and D is to bring in cash equivalent to 1/4
of this amount as his capital. The capitals of other partners are also to be adjusted in the
ratio of their respective shares in profits and losses. The respective capitals of X, Y and Z
after all adjustments have been made, works out at 40,000, 35,000 and 30,000,
respectively. Calculate the final capitals of X, Y and Z.

Self Assessment

Fill in the blanks:

1. If the capital of the new partner is given, the entire capital of the new firm will be
determined on the basis of the new partner’s capital and his ........................

2. If the existing capital of the partner after adjustment is in excess of his new capital, the
excess amount is ........................ by partner or transferred to the credit of his current account.

3. If the existing capital of the partner is less than his new capital, the partner brings the short
amount or makes transfer to the debit of his ........................

4. Sometimes the capital of the new partner is calculated on the basis of ........................

5. New partner’s capital will be calculated on the basis of ........................ of the existing partners.

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4.2 Preparation of Balance Sheet of New Firm Notes

After making all the necessary adjustments and assets revaluation the next step is to prepare the
balance sheet of new firm. To know the true position of the new firm it is necessary to make the
assets revaluation and capital adjustments. The following examples illustrate the preparation of
new firm’s balance sheet.

Example: A and B are partners in a firm sharing profits in the ratio 2:1. C is admitted into
the firm with 1/4th share in profits. He will bring in 30,000 as capital and capitals of A and B
are to be adjusted in the profit sharing ratio. The Balance sheet of A and B as on March 31, 2002
(before C’s admission) was as under:
Balance Sheet of A and B as at March 31, 2002

Liabilities Amount Assets Amount

( ) ( )
Creditors 8,000 Cash in hand 2,000
Bills Payable 4,000 Cash at bank 10,000
General Reserve 6,000 Sundry debtors 8,000
Stock on Hand 10,000
Capitals: 50,000 Furniture 5,000
32,000 82,000 Machinery 25,000
Building 40,000
10,0000 1,00,000

Other terms of agreement are as under:

(i) C will bring in 12,000 as his share of goodwill.
(ii) Building was valued at 45,000 and Machinery at 23,000.
(iii) A provision for bad debts is to be created @ 6% on debtors.
(iv) The Capital accounts of A and B are to be adjusted by opening current accounts.
Record necessary journal entries, show necessary ledger accounts and prepare the balance sheet
after C’s admission.

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Notes Solution:
Books of A, B and C
Journal

Date Particulars L.F. Debit Amount Credit Amount

( ) ( )
Mar 1 Cash A/c Dr. 42,000
To C’s capital A/c 30,000
To Goodwill (Premium) A/c 12,000
(Cash brought by C for capital and
goodwill)

Goodwill (Premium) A/c Dr. 12,000

To A’s capital A/c 8,000
To B’s capital A/c 4,000
(Goodwill brought by C transferred
to the capital accounts of A and B in
their sacrificing ratio)

Revaluation A/c Dr. 2,480

To Machinery A/c 2,000
To provision for bad and 480
doubtful debts A/c
(Decrease in the value of machinery
and creation of provision for bad
debts)

Building A/c Dr.

To Revaluation A/c 5,000
5,000
(Increase in the value of building)

Revaluation A/c Dr.

To A's Capital A/c 2,520
To B's Capital A/c 1,680
(Transfer of gain on revaluation to 840
old partners' capital accounts)

General Reserve A/c Dr.

To A's Capital A/c 6,000
To B's Capital A/c 4,000
(Undistributed profit transferred to 2,000
A and B)

A's Capital A/c Dr.

B's Capital A/c Dr. 3,680
To A's Current A/c 8,840
To B's Current A/c 3,680
(The excess of capitals transferred 8,840
to partner's current accounts)

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Revaluation Account Notes

Dr. Cr.

( ) ( )

Partners’ Capital Accounts

Dr. Cr.

( ) ( ) ( ) ( ) ( ) ( )

Partners’ Current Accounts

Dr. Cr.

( ) ( ) ( ) ( ) ( ) ( )

Balance Sheet of A, B and C as at March 31, 2002

(After Admission)

( ) ( )

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Notes Working Notes:

1. New Profit Sharing Ratio: Since nothing is given as to how C acquired his share from A
and B. It is assumed that A and B, between themselves continue to share the profits in the
old ratio of 2:1

C’s share of profits = 1/4

Remaining Share = 1 – 1/4 = 3/4

A’s new share = 2/3 of 3/4 = 6/12 = 1/2

B’s new share = 1/3 of 3/4 = 3/12 = 1/4

Thus, new profit sharing ratio between A, B and C is 2:1:1

2. New Capitals of A and B: C’s capital is 30,000 and his share of profits is 1/4. Based on C’s
capital the total capital of the firm will work out at 1,20,000 (4/1 × 30,000). Hence, based
on their respective shares of profits, the capitals of A and B will be as follows:

A’s Capital = 2/4 of 120000 = 60000

B’s Capital = 1/4 of 120000 = 30000

Self Assessment

State whether the following statements are true or false:

6. Balance sheet of new firm records the assets and liabilities at the value before revaluation.

7. Balance sheet records the partner’s capital after adjustment.

4.3 Summary

 Sometimes, it is possible that the partners decide to adjust their capital so as to be

proportionate to their profit sharing ratio.

 If the capital of the new partner is given, the entire capital of the new firm will be
determined on the basis of the new partner’s capital and his profit sharing ratio.

 If the existing capital of the partner after adjustment is in excess of his new capital, the
excess amount is withdrawn by partner or transferred to the credit of his current account.

 If the existing capital of the partner is less than his new capital, the partner brings the short
amount or makes transfer to the debit of his current account.

 Sometimes the capital of the new partner is calculated on the basis of existing partners.

 The partner is required to bring an amount proportionate to his/her share of profit.

 To know the true position of the new firm it is necessary to make the assets revaluation
and capital adjustments.

4.4 Keywords

Revaluation A/c: For revaluation of assets and recording of unrecorded assets and for the
reassessment of liabilities and recording of unrecorded liabilities the firm prepares an account
in its book called Revaluation Account.

Revaluation of Assets and Liabilities: On admission of a new partner, the firm is reconstituted
and the assets are revalued and liabilities are reassessed.

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Sacrificing Ratio: The ratio in which the old partners agree to sacrifice their share of profit in Notes
favour of the incoming partner is called sacrificing ratio.

4.5 Review Questions

1. Explain the calculation of the proportionate capital of the new partner in case of admission
of a partner.

2. Ram and Shyam were partners in a firm sharing profits and losses in the ratio of 2 : 1 with
capitals of 40,000 and 30,000 respectively. They decided to admit Mohan into partnership
on conditions that he would bring in 20,000 as his capital and 6,000 for his share of
goodwill for 1/4 th share of profits. Half of the amount of goodwill was withdrawn by the
existing partners. The capital of the partners in the New firm were to be arranged in profit
sharing ratio on the basis of Mohan’s Capital and excess or deficit capital to be adjusted in
cash.
Give the necessary journal entries to record the transactions and show the capital accounts
of the partners and the cash account.

3. A and B are partners sharing profits in the ratio of 4 : 1. They admit C as a new partner who
brings 15,000 as his share of goodwill (premium). C is entitled to 1/3rd share in profits.
As between themselves, A and B agree to share future profits and losses equally.
You are required to:
(a) Calculate the new profit sharing ratio
(b) Record journal entries showing the appropriation of premium.
4. Swadesh and Swaraj were partners sharing profits equally. Their Balance Sheet as on
March 31, 2002 was as follows:

( ) ( )

On that date, they agreed to admit Sambhav as a partner on the following terms:
(a) Sambhav shall get 1/5th share in profits and he will bring 20,000 as his capital and
5,000 as his share of goodwill.

(b) Goodwill brought by Sambhav shall be withdrawn by Swadesh and Swaraj.

(c) Provision for bad and doubtful debts should be brought up to 5% on debtors.

(d) Machinery be depreciated by 2,000 and furniture by 12.5%.

(e) Stock be valued at 23,000.

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Notes (f) Land & Building be appreciated by 20%, and

(g) Investments of 2,000 which did not appears in books should be duly recorded.

Record necessary journal entries and prepare the Balance Sheet of the new firm.

5. A and B are partners sharing profits as 2 : 1. Following is their Balance Sheet as on December
31, 2001:
Balance Sheet of A and B as on Dec 31, 2001

( ) ( )

On January 1, 2002, C is admitted into partnership for 1/4th share on the following terms:

(a) That he should bring in 15,000 as his capital and 6,000 as premium for his share
of goodwill.

(b) That land and building be revalued at 25,000 and stock at 18,500.

(c) That 500 be provided for doubtful debts.

(d) That after the above adjustments, the capital of the old partners be adjusted on the
basis of the new partner’s capital, having regard to profit sharing ratio. Excess or
shortage will be adjusted through actual cash.

Record necessary journal entries and prepare Capital Accounts and new Balance Sheet of
the partners.

6. The Balance Sheet of Alka and Bandana carrying on business in partnership and sharing
profits in proportion of 2/3rd and 1/3rd respectively, stood as follows:
Balance Sheet of Alka and Bandana as at March 31, 2003

( ) ( )

They admitted Chandana into partnership giving her 1/5th share of profits on the following
terms:

(a) The goodwill of the firm is to be valued at two year’s profits calculated on the
average of the 1st three-year’s profits, which amounted to 20,000, 15,000 and
22,000.

(b) Chandana is to bring in cash for the amount of her share of goodwill

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(c) Chandana is to bring in capital in proportion to her profit sharing arrangements Notes
with other partners.

Give journal entries and opening Balance Sheet of the firm and also state their future profit
sharing ratio.

7. Illustrate the adjustment of partner’s capital on the basis of new Partner’s Capital and his
profit sharing ratio.

Answers: Self Assessment

1. Profit sharing ratio 2. Withdrawn

3. Current account 4. Existing partners

5. Adjusted capital 6. False

7. True

4.6 Further Readings

Books I.M. Pandey, Financial Management, Vikas Publishing, New Delhi.

Khan and Jain, Management Accounting.

Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.

Prasanna Chandra, Financial Management - Theory and Practice, Tata McGraw Hill,
New Delhi (1994).

R.L. Gupta and Radhaswamy, Advanced Accountancy.

S. Bhat, Financial Management, Excel Books, New Delhi.

S.N. Maheswari, Management Accounting.

V.K. Goyal, Financial Accounting, Excel Books, New Delhi.

Online link www.futureaccountant.com

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Notes Unit 5: Retirement of Partner

CONTENTS

Objectives

Introduction

5.1 Computation of New Profit Sharing Ratio and Gaining Ratio

5.2 Adjustment Regarding Goodwill

5.3 Revaluation of Assets and Liabilities

5.4 Accounting Treatment of Undistributed Profit

5.5 Summary

5.6 Keywords

5.7 Review Questions

5.8 Further Readings

Objectives

After studying this unit, you will be able to:

 Compute gaining ratio

 Make adjustments regarding goodwill

 Construct revaluation A/c

 Illustrate accounting treatment of undistributed profit

Introduction

An outgoing partner means a partner who has retired from a firm. The firm is reconstituted by
the remaining partners. Section 32 contemplates three ways in which a partner may retire from
the firm, viz., (i) he may retire at any time with the consent of all other partners; (ii) where there
is an agreement between the partners about retirement, a partner may retire in accordance with
the terms of that agreement; (iii) where the partnership is at will, a partner may retire by giving
to his partners a notice of his intention to retire. Section 32 clearly comprehends a situation
where a partner may retire without dissolving the firm.

5.1 Computation of New Profit Sharing Ratio and Gaining Ratio

As soon as a partner retires the profit sharing ratio of the continuing partners get changed. At the
time of retirement or death of a partner, the share of retiring/deceased partner is acquired by
existing partners, on the basis of agreement among them. In the absence of information, the
continuing partners take the retiring partner’s share in their profit sharing ratio or in an agreed
ratio. The ratio in which retiring partner’s share is distributed amongst continuing partners’ is
known as “gaining ratio”.

Gain of continuing partner = New share – Old share

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Notes
Example: Sita, Rita and Raj are partners sharing profits in the ratio of 5:3:2. Due to some
personal reasons Sita retires from the partnership. Calculate the new profit sharing ration and
gaining ratio of remaining partners.

Solution:

1. Calculation of new profit sharing ratio: In order to calculate new ratio of Rita and Raj, it
5
is assumed that Sita’s share of will be taken up by Rita and Raj in their old profit
10
sharing ratio

3 5 3 3 15 30
Rita’s new share = (  )  
10 10 5 10 50 50

2 5 2 2 10 20
Raj’s new share = (  )  
10 10 5 10 50 50
Therefore, the new profit sharing ration id 3:2

2. Calculation of gaining ratio: Gaining ratio = New share – Old share

3 3 3
(i) Rita’s gain =  
5 10 10

2 2 2
(ii) Raj’s gain =  
5 10 10

Task Ajay, Vijay and Veena are partners sharing profits in the ratio of 3:2:1. Ajay
retires and his share is taken up by Vijay and Veena: (i) equally, (ii) in the ratio of 3 : 2.
Calculate the new profit sharing ratio.

Self Assessment

Fill in the blanks:

1. ................... clearly comprehends a situation where a partner may retire without dissolving
the firm.

2. At the time of retirement or death of a partner, the share of retiring/deceased partner is

acquired by ................... partners.

3. The ratio in which retiring partner’s share is distributed amongst continuing partners’ is
known as ...................

4. In the absence of information, the continuing partners take the retiring partner’s share in
their ................... or in an agreed ratio.

5. Gain of continuing partner = New share – ...................

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Notes 5.2 Adjustment Regarding Goodwill

At the time of retirement or death of a partner the retiring partner is entitled to his share of
goodwill because the goodwill has been earned by the firm with the efforts of all the existing
partners. The valuation of goodwill will be done as per the agreement among the partners. It is
possible that company will earn some profit in near future because of the existing goodwill of
the company. Therefore, the retiring/deceased partner should be compensated for the same by
the continuing partners in their gaining ratio. For this purpose, the retiring/deceased partner’s
capital will be credited. In this case the following journal entry is recorded:

Remaining partner’s capital A/c (in the gaining ratio) Dr

To Retiring/deceased partner’s capital A/c

(Retiring partner’s share of goodwill adjusted to remaining partners in the gaining ratio)

Did u know? What is hidden goodwill?

If the firm has agreed to settle the account of retiring/deceased partner by paying him a
lump-sum amount, then amount paid to him in excess of his capital and share in reserves/
revaluation account etc. shall be treated as his share of goodwill. For example, A, B and C
are partners. C retires, his capital account, after making adjustments for reserves and
profit on revaluation exists at 80,000. A and B have agreed to pay him 100,000 in full
settlement of his claim. It implies that 20,000 is C’s share in the goodwill of the firm. This
will be treated by debiting 20000 in A & B’s capital account in their gaining ratio and
crediting C’s capital account.

Example: A, B and C are partners sharing profits in the ratio 5 : 3 : 2. A retires and
goodwill is valued at 54,000. New profit sharing ratio of continuing partners will be equal.
Pass the necessary journal entry.

Solution:
Journal

Date Particulars L.F. Debit Credit

Amount ( ) Amount ( )
B's Capital A/c Dr. 10800
C's Capital A/c Dr. 16200
To A's Capital A/c 27000
(Share of A’s goodwill credited to his
capital A/c)

Working Notes:

Calculation of Gaining Ratios

Gain of partner = New share – Old share

3
B’s Old share =
10

1
B’s new share =
2

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1 3 2 Notes
B’s gain =  
2 10 10

2
C’s Old share =
10

1
C’s new share =
2

1 2 3
C’s gain =  
2 10 10
Therefore, gaining ration is 2 : 3

Example: S, U and R are partners sharing profits in the ratio of 3 : 2 : 1. U wants to retire
due to personal problems. For this purpose goodwill is valued at two years purchase of average
super profits of last three years, the profit for the last three years are as under:
1st year : 36,600
2nd year : 43,600
3rd year : 48,800
The normal profits for similar firms are 34,000.
Record necessary entry for goodwill on retirement of U.

Solution:
Books of S, U and R
Journal

Date Particulars L.F. Debit Amount Credit

( ) Amount ( )
S's Capital A/c Dr. 4,500
R's Capital A/c Dr. 1,500
To U's Capital A/c 6,000
(Share of U’s goodwill credited to his
capital A/c)

Working Notes:

2
U’s share of goodwill = 18,000 × = 6,000
6
Average profits = (36,600 + 43,600 + 48,800)/3 = 43,000
Super profits = Average profits – Normal profits
= 43,000 – 34,000= 9,000
Goodwill = Super profits × No. of years purchase
= 9,000 × 2= 18,000

Task S, M, U and R are partners sharing profits in ratio of 3 : 2 : 3 : 2. On the retirement

of U, goodwill was valued at 1,20,000. U’s share of goodwill will be given to her by
adjusting it into the capital accounts of S, M and R. Record necessary entry for the treatment
of goodwill when new profit sharing ratio decided is 3 : 1 : 6.

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Notes Self Assessment

State whether the following statements are true or false:

6. Retiring partner’s share of goodwill is debited to his/her capital account at the time of
retirement.

7. Goodwill is recorded in the books only when it is purchased.

8. The retiring partner’s capital account is debited with his/her share of goodwill and
remaining partner’s capital account is credited in their gaining ratio.

9. In case goodwill account is written off the capital account of all partners is credited.

5.3 Revaluation of Assets and Liabilities

In case of retirement or death of a partner the assets and liabilities of the firm should be revalued
in the same way as at the time of admission of a partner. At the time of retirement/death some
of the assets or liabilities may not have been shown at their current values. To ascertain the net
profit and loss on revaluation of assets and liabilities Revaluation A/c is prepared.

The following journal entries are passed for the revaluation of assets and liabilities:

(i) For increase in the value of Assets

Asset A/c Dr.

To Revaluation A/c

(Increase in the value of assets)

(ii) For decrease in the value of Asset

Revaluation A/c Dr.

To Asset A/c

(Decrease in the value of assets)

(iii) For increase in the value of Liabilities

Revaluation A/c Dr.

To Liabilities A/c

(Increase in the value of Liabilities)

(iv) For decrease in the value of Liabilities

Liabilities A/c Dr.

To Revaluation A/c

(Decrease in the value of Liabilities)

(v) For unrecorded Assets

Asset A/c [unrecorded] Dr.

To Revaluation A/c

(Unrecorded asset recorded at actual value)

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(vi) For unrecorded Liability Notes

Revaluation A/c Dr.

To Liability A/c [unrecorded]

(Unrecorded Liability recorded at actual value)

(vii) For transfer of gain on revaluation:

Revaluation A/c Dr.

To All Partner’s Capital A/c (Old ratio)

(Profit on revaluation transferred to capital account in old profit sharing ratio)

(viii) For transfer of loss on revaluation:

All Partner’s Capital Dr.

To Revaluation A/c

(Loss on revaluation transferred to capital account in existing ratio)

Example: X, Y and Z are partners sharing profit in the ratio 1 : 2 : 3. X retires from the
partnership. In order to settle his claim, the following revaluation of assets and liabilities was
agreed upon:

(i) The value of Machinery is increased by 15,000.

(ii) The value of Investment is increased by 2,000.

(iii) A provision for outstanding bill standing in the books at 1,000 is now not required.

(iv) The value of Land and Building is decreased by 12,000.

Give journal entries and prepare Revaluation account.

Solution:

Date Particulars L.F. Debit Credit

Amount Amount
( ) ( )
Machinery A/c Dr. 15,000
Investments A/c Dr. 2,000
Provision for Outstanding Bill Dr. 1,000
To Revaluation A/c 18,000
(Increase in value of Assets and
reduction in provision)

Revaluation A/c Dr. 12,000

To Land and Building A/c 12,000
(Decrease in value of assets)

Revaluation A/c Dr. 6,000

To X’s Capital A/c 1,000
To Y’s Capital A/c 2,000
To Z’s Capital A/c 3,000
(Profit on revaluation credited to all
partners capital A/c in old profit
sharing ratio i.e. 1 : 2 : 3)

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Notes Revaluation A/C

Dr. Cr.

Particulars Amount Particulars Amount

( ) ( )
Land and Building 12000 Machinery 15000
Profit transferred to: Investments 2000
X’s capital 1000 Provision for Outstanding Bill 1000
Y’s capital 2000
Z’s capital 3000 6000
18000 18000

Self Assessment

Fill in the blanks:

10. In case of retirement or death of a partner the ................. of the firm should be revalued.

11. To ascertain the net profit and loss on revaluation of assets and liabilities ................. is
prepared.

12. At the time of retirement/death some of the assets or liabilities may not have been shown
at their .................

13. The credit balance of Revaluation account shows .................

5.4 Accounting Treatment of Undistributed Profit

At the time of retirement or death of a partner the amount of undistributed profits (losses), funds
and reserves as shown in the Balance Sheet of the firm belongs to all the partners and is transferred
to their capital accounts in old profit sharing ratio.
For the purpose, the following journal entries are recorded:
(i) For distribution of undistributed profit and reserve.
Reserves A/c Dr.
Profit and loss A/c (Profits i.e. credit balance) Dr.
To All partners’ capital A/c (individually)
(Reserves and undistributed profit transferred to partner’s capital A/c in old profit sharing
ratio)
(ii) For distributing losses among all partners in the old ratio
All Partners, Capital A/c Dr.
To P&L A/c (accumulated losses, i.e. debit balance)
To Deferred Revenue Expenditure A/c
The surplus available on some specific funds like workmen’s compensation fund or investment
fluctuation fund to meet certain obligations in future will be transferred to capital accounts of all
the partners in their old ratio. For the purpose, the following journal entries are recorded:
Workman’s Compensation Fund A/c Dr.
Investment Fluctuation fund A/c Dr.
To All Partners’ capital A/c

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 Unit 5: Retirement of Partner

(Surplus available on workmen’s compensation fund and investment fluctuation fund transferred Notes
to partner’s capital A/c in old profit sharing ratio)

Example: X, Y and Z are partners sharing profits in proportion of 3 : 2 : 1. X decides to

retire form the partnership. On the date of her retirement, firm’s abstract Balance Sheet was as
under. Pass the necessary entry to treat the profit and loss A/c in balance sheet.

Balance Sheet……… as at …………

Liabilities Amount ( ) Assets Amount ( )

Capitals : Cash 14,000
X 10,000 Profits and Loss 6,000
Y 6,000
Z 4,000 20,000

20,000 20,000

Solution:
Books of X, Y and Z

Date Particulars L.F. Debit Credit

Amount ( ) Amount ( )
X's Capital A/c Dr. 3000
Y's Capital A/c Dr. 2000
Z’s capital A/c Dr. 1000
To profit and loss A/c 6000

(Loss of 6,000 divided among all

partners in their profit sharing ratio
i.e. 3 : 2 : 1)

Self Assessment

Fill in the blanks:

14. At the time of retirement or death of a partner the amount of undistributed profits (losses),
funds and reserves as shown in the Balance Sheet of the firm belongs to all the partners and
is transferred to their capital accounts in ................... profit sharing ratio.

15. The ................... available on some specific funds will be transferred to capital accounts of
all the partners in their old ratio.

5.5 Summary

 Section 32 clearly comprehends a situation where a partner may retire without dissolving
the firm.

 As soon as a partner retires the profit sharing ratio of the continuing partners get changed.

 At the time of retirement or death of a partner, the share of retiring/deceased partner is

acquired by existing partners, on the basis of agreement among them.

 The ratio in which retiring partner’s share is distributed amongst continuing partners’ is
known as “gaining ratio”.

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Notes  At the time of retirement or death of a partner the retiring partner is entitled to his share
of goodwill.

 If the firm has agreed to settle the account of retiring/deceased partner by paying him a
lump-sum amount, then amount paid to him in excess of his capital and share in reserves/
revaluation account etc. shall be treated as his share of goodwill.

 In case of retirement or death of a partner the assets and liabilities of the firm should be
revalued in the same way as at the time of admission of a partner.

 At the time of retirement or death of a partner the amount of undistributed profits (losses),
funds and reserves as shown in the Balance Sheet of the firm belongs to all the partners and
is transferred to their capital accounts in old profit sharing ratio.

5.6 Keywords

Gaining Ratio: The ratio in which retiring partner’s share is distributed amongst continuing
partners’ is known as “gaining ratio”.

Hidden Goodwill: If the firm has agreed to settle the account of retiring/deceased partner by
paying him a lump-sum amount, then amount paid to him in excess of his capital and share in
reserves/revaluation account etc. shall be treated as his share of goodwill.

Revaluation A/c: For revaluation of assets and recording of unrecorded assets and for the
reassessment of liabilities and recording of unrecorded liabilities the firm prepares an account
in its book called Revaluation Account.

5.7 Review Questions

1. Define gaining ratio.

2. Explain the accounting treatment of goodwill on retirement of a partner.

3. A, B and C were partners in a firm sharing profit in the ratio of 7 : 6 : 7. B retired and his
share was divided equally between A and C. Calculate the new profit sharing ratio of
A and C.

4. Madhu, Surabhi and Nikhil are partners without any partnership deed. Madhu retire,
calculate future ratio of continuing partners if they agreed to acquire her share (i) in the
ratio 5 : 3 (ii) equally. Also mention their gaining ratio.

5. A, B and C are partners in a firm sharing profits in the ratio of 2 : 1 : 1. They took out a
policy in 2002 of 1,40,000. On 21st March, 2003 B die. The surrender value of the policy
appearing in the books on that date was 20,000. Record necessary journal entries to close
the joint life policy in the year of death of B, if premium paid was treated (i) as business
expenses and (ii) as an asset.

6. Rita, Puneeta and Gita are partners sharing profits in the ratio of 1 : 2 : 3. Rita retires on the
date of balance sheet on the following terms:

(a) A computer costing 40,000 which was not recorded earlier, to be recorded now.

(b) A liability of compensation towards an employee for 16,000 has also been finalised
for payment.

Record necessary entries to record the above arrangement.

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 Unit 5: Retirement of Partner

7. R, S and M were carrying on business in partnership sharing profits in the ratio of 3 : 2 : 1, Notes
respectively. On March 31, 1999, Balance Sheet of the firm stood as follows:
Balance Sheet as at March 31, 1999

( ) ( )

Shyam retired on the above mentioned date on the following terms:

(i) Buildings to be appreciated by 8,800.

(ii) Provision for bad debts be made @ 5% on debtors.

(iii) Goodwill of the firm be valued at 9,000.

(iv) 5,000 be paid to S immediately and the balance due to him treated as a loan
carrying interest @ 6% per annum.

Record necessary journal entries and prepare the balance sheet of the reconstituted firm.

8. The Balance Sheet of A, B and C who were sharing the profits in proportion to their
capitals stood as on March 31, 2003.
Balance Sheet as at March 31, 1999

( ) ( )

B retired on the date of balance sheet and the following adjustments were made:

(a) Stock was depreciated by 10%.

(b) Factory building were appreciated by 12%.

(c) Reserve for doubtful debts be created up to 5%

(d) Reserve for legal charges to be made at 265.

(e) The goodwill of the firm fixed at 10,000.

(f) The capital of the new firm be fixed at 30,000. The continuing partners decide to
keep their capitals in the new profit sharing ratio of 3 : 2.

Record journal entries and prepare the initial balance sheet of reconstituted firm after
transferring the balance in B’s capital account to his loan account.

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Notes 9. Distinguish between sacrificing and gaining ratio.

10. Why do firms revalue assets and reassess their liabilities on retirement or on the event of
death of a partner?

Answers: Self Assessment

1. Section 32 2. Existing

3. “Gaining ratio” 4. Profit sharing ratio

5. Old share 6. False

7. True 8. False

9. False 10. Assets and liabilities

11. Revaluation a/c 12. Current values

13. Profit 14. Old

15. Surplus

5.8 Further Readings

Books I.M. Pandey, Financial Management, Vikas Publishing, New Delhi.

Khan and Jain, Management Accounting.

Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.

Prasanna Chandra, Financial Management - Theory and Practice, Tata McGraw Hill,
New Delhi (1994).

R.L. Gupta and Radhaswamy, Advanced Accountancy.

S. Bhat, Financial Management, Excel Books, New Delhi.

S.N. Maheswari, Management Accounting.

V.K. Goyal, Financial Accounting, Excel Books, New Delhi.

Online link www.futureaccountant.com

70 LOVELY PROFESSIONAL UNIVERSITY

 Unit 6: Settlement of Retiring Partner’s Claim

Unit 6: Settlement of Retiring Partner’s Claim Notes

CONTENTS

Objectives

Introduction

6.1 Computation of Partner’s Interest

6.2 Mode of Payment

6.2.1 Payment in Lump Sum

6.2.2 Payment in Installments

6.3 Summary

6.4 Keywords

6.5 Review Questions

6.6 Further Readings

Objectives

After studying this unit, you will be able to:

 Compute retiring partner’s interest

 Illustrate the lump sum and instalment methods of claim settlement

Introduction

In the last unit you learnt about the key adjustments required at the time of retirement of a
partner. The current unit discussed about the computation of retiring partner’s claim for settlement
of his/her account. The key methods used for claim settlement are lump sum and instalment
method. The claim of the retiring or deceased partner usually consists of his capital as on the
date of retirement or death less drawings (if any) plus his share of goodwill in the firm plus his
share in the accumulated profits of the firm (if any) less his share of accumulated loss (if any)
plus (minus) his share in the profit (loss) and revaluation of assets and liabilities of the firm and
such other things. The outgoing partner’s account is settled as per terms of partnership deed, i.e.
in lump sum immediately or in various installments with/without interest as agreed or partly
cash immediately and partly in installments at the agreed intervals.

6.1 Computation of Partner’s Interest

When a partner retires from business, his claim against the firm is determined by preparing his
capital account incorporating therein all the adjustments in respect of his share of goodwill,
accumulated profits or losses, profit/loss on revaluation of assets and liabilities, etc. Now the
settlement of the claim depends on the provisions of the partnership deed. If nothing is given in
the problem to be solved in respect of settlement of claim, the amount of claim is usually
transferred to the Retiring partner’s Loan Account for which the following entry is passed:

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Notes Retiring Partner’s Capital A/c Dr

To Retiring Partner’s Loan A/c

Notes The retiring partners’ claim consists of:

Particulars
(A) Items to added
 The credit balance of Capital Account --------
 His/her share in the Goodwill of the firm --------
 His/her share in the Revaluation Profit --------
 His/her share in General Reserve and Accumulated Profit --------
 Interest on Capital --------
Total
(B) Items to be Deducted
 His/her share in the Revaluation loss --------
 His/her Drawings and Interest on Drawings up to the date of
retirement
 His/her share of any accumulated losses --------
 Loan taken from the firm --------
--------
Total
Retiring Partner’s Interest (A – B) --------

Example:
X, Y and Z are partners sharing profits in the ratio of 2 : 2 : 1 respectively. Their balance sheet as
on December 2010 was as follows:

Liabilities Amount ( ) Assets Amount ( )

Bills Payable 16,000 Cash at Bank 68,000
Sundry Creditors 42,000 Bills Receivable 10,000
Loan from X 1,00,000 Sundry Debtors 30,000
Reserve Fund 20,000 Stock 45,000
Capitals : Furniture 10,000
X 60,000 Machinery 60,000
Y 50,000 Buildings 80,000
Z 27,000 Goodwill 12,000

3,15,000 3,15,000

Z retires from business as on January 1, 2010. For the purpose of retirement of Z, the assets and
liabilities of the firm are revalued as follows:

(i) Stock 20% less; Furniture at 6,000

(ii) Machinery at 75% of book value

(iii) Building at 1,60,000

(iv) A provision of 10% is to be made for doubtful debts

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 Unit 6: Settlement of Retiring Partner’s Claim

(v) The goodwill of the firm is estimated to be worth 60,000 Notes

(vi) A bill for repairs of building 8,000 was unpaid and was not recorded in the books.

Ascertain the claim of Z against the firm by preparing his Capital Account.

Solution:
1. Preparation of Revaluation A/c
Revaluation A/c

Particulars Amount Particulars Amount

( ) ( )

To Stock 9,000 By Building 80,000

To Furniture 4,000
To Machinery 15,000
To Provision for, Doubtful
Debts 3,000
To Outstanding Repair 8,000
To Capital a/c (Share of
profit)
X - 2/5 16,400
Y - 2/5 16,400
Z - 1/5 8,200 41,000

80,000 80,000

2. Calculation of Z’s share of Goodwill: Goodwill of the firm is estimated to be 60,000. But
in the Balance Sheet of the firm is already showing the goodwill at 12,000. Hence, it
should be increased by 48,000 and the amount should be credited to all the three partners
in their profit’ sharing ratios. Hence Z’s share of goodwill is 48,000 x 1/5 = 9,600.
3. Z’s share of Reserve Fund: There is a Reserve Fund of 20,000 in the Balance Sheet which
represents accumulated profits. Z’s share is 20,000 × 1/5 = 4,000.
4. Preparation of Z’s capital A/c

Particulars Amount Particulars Amount

( ) ( )

T o Z's Loan A/c 48,000 By Revaluation A/c 8,200

By Goodwill A/c 9,600
By Reserve Fund 4,000

By Balance 27,000
48,000 48,000

Notes As nothing is given in the questions as regards the settlement of the claim, the
amount due to Z on his retirement is transferred to his Loan Account.

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Financial Accounting - II

Notes Self Assessment

Fill in the blanks:

1. The settlement of the claim depends on the provisions of the ...................

2. If nothing is given in the problem to be solved in respect of settlement of claim, the

amount of claim is usually transferred to the Retiring partner’s ...................

3. The retiring partners’ claim consists the ................... balance of Capital Account.

4. The retiring partner’s share of accumulated losses should be ................... in settling his/her
claim.

5. While computing the retiring partners’ claim the amount of drawings should be ...................

6.2 Mode of Payment

The outgoing partner’s account is settled as per terms of partnership deed, i.e. in lump sum
immediately or in various installments with/without interest as agreed or partly cash
immediately and partly in installments at the agreed intervals.

6.2.1 Payment in Lump Sum

If the full amount of claim is payable to the retiring partner on the date of retirement as per
agreement, the amount will not be transferred to Loan Account but will be paid in cash or by
cheque.

The following journal entry is made for disposal of-the amount payable to the retiring partner:

Retiring Partner’s Capital A/c Dr.

To Cash/Bank A/c

(Amount paid to the retiring partner)

Example: Ram, Shyam and Mohan are partners sharing profit in the ratio of 3 : 2 : l. Their
balance sheet as on December 31st 2006 is as under:
Balance sheet as on December 31st, 2006

Liabilities Amount ( ) Assets Amount ( )

Creditors 80,000 Building 1,80,000

Bills Payable 26,000 Plant 1,40,000
General reserve 24,000 Motor Car 40,000
Capital : Stock 1,00,000
Ram 1,60,000 Debtors 63,000
Shyam 1,20,000 Less Provision for Bad debts 3,000
Mohan 1,20,000 4,00,000 Cash at Bank 60,000
10,000
5,30,000 5,30,000

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 Unit 6: Settlement of Retiring Partner’s Claim

Shyam retires on that date on the following terms: Notes

(a) The Goodwill of the firm is valued at 60,000.

(b) Stock and Building to be appreciated by 10%.

(c) Plant is depreciated by 10%.

(d) Provision for Bad debts is increased up to 5,000.

(e) Shyam’s share of goodwill adjusted through remaining partners capital account.

The amount due to Shyam is paid out of the fund brought in by Ram and Mohan for that purpose
in their new profit sharing ratio. Shyam is paid full amount.

Prepare Revaluation Account and Partner’s Capital account.

Solution:

Suppose the gaining ratio of Ram and Mohan will remains 3 : l.

(a) Gaining ratio = 3 : 1.

Ram gets = 2/6 × 3/4 = 1/4

Ram’s new share = 3/6 + 1/4 = 3/4

Mohan gets 2/6 × 1/4 = 1/12

Mohan’s new share = 1/6 + 1/12 = 3/12 = 1/4

New profit sharing ratio between Ram and Mohan is

= 3/4 : 1/4

= 3 : 1.

(b) Shyam’ Share of goodwill

60,000 × 2/6 = 20,000

The following journal entry will be passed for goodwill:

Ram’s Capital A/c Dr. 15,000

Mohan’s Capital A/c Dr. 5,000

To Shyam’s Capital A/c 20,000

(Shyam’s share of goodwill debited to remaining partners’ capital A/c)

Revaluation A/c

Particulars Amount Particulars Amount

( ) ( )
Provision for Bad debts 2,000 Stock 10,000
Plant 14,000 Building 18,000
Profit transferred to
Capital Accounts:
Ram 6,000
Shyam 4,000
Mohan 2,000 12,000

28,000 28,000

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Financial Accounting - II

Notes Capital A/c

Dr. Cr.

Particulars Ram Shyam Mohan Particulars Ram Shyam Mohan

( ) ( ) ( ) ( ) ( ) ( )
Capital 15,000 ------ 5,000 Balance b/d 1,60,000 1,20,000 1,20,000
Bank 1,52,000 General
Balance c/d 2,77,000 ------ 1,59,000 Reserve 12,000 8,000 4,000
Revaluation
(Profit) 6,000 4,000 2,000
Ram Capital ----- 15,000 -----
Mohan
Capital ----- 5,000 -----
Bank 1,14,000 38,000
2,92,000 1,52,000 1,64,000 2,92,000 1,52,000 1,64,000

6.2.2 Payment in Installments

In this case the amount due to retiring partner is paid in installments. In the absence of any
agreement, section 37 of the Indian Partnership Act, 1932 is applicable.

!
Caution As per the Sec 37 of Indian Partnership Act, 1932, outgoing partner is at liberty
to receive either interest @ 6% p.a. till the date of payment or the share of profits which has
been earned with his money.

An instalment consists of two parts:

(i) Principal Amount of instalment due to retiring partner.

(ii) Interest at an agreed rate.

Interest due on loan amount is credited to retiring partners’ loan account. Instalment inclusive
of interest then is paid to the retiring partner as per schedule agreed upon.

(i) On part payment in cash and balance transferred to his/her loan account.
Retiring Partner’s Capital A/c Dr.

To Cash/Bank A/c

To Retiring Partner’s Loan A/c

(Part payment made and balance transferred to loan A/c)

(ii) Total amount due transferred to loan A/c

Retiring Partner’s Capital A/c Dr.

To Retiring Partner’s Loan A/c

(Total amount due transferred to loan A/c)

(iii) For interest due

Interest on loan A/c Dr.

To Retiring Partners’ Loan A/c

(Interest due on loan)

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 Unit 6: Settlement of Retiring Partner’s Claim

(iv) For payment of instalment Notes

Retiring Partners’ Loan A/c Dr.

To Cash/Bank A/c

(Instalment inclusive of interest paid)

Example: Taking the figures of the pervious example, assuming that he is paid 40% of
the amount due immediately and the balance in three equal yearly installments. The interest
payable is 12% p.a.

Solution:

The amount due to Mohan = 1,52,000

Amount paid immediately = 1,52,000 × 40/100

= 60,800

Amount of three equal installments = 1,52,000 – 60,800 × 3

= 91,200 ÷ 3 = 30,400

1st Instalment at the end of 1st Year = 30,400 + 10,944

= 41,344

Interest @ 12% pa. = 91,200 × 12/100

= 10,944

2nd Instalment at the end of 2nd Year = 30,400 + 7,296

= 37,344

Interest @ 12% pa. = 60,800 x 1.2/ 100

= 7,296

3rd Instalment at the end of 3rd Year = 30,400 + 3,648

= 34,048

Interest @ 12% pa. = 30,400 × 12/100

= 3,648

Self Assessment

Fill in the blanks:

6. If the full amount of claim is payable to the retiring partner on the date of retirement as
per agreement, the amount will not be transferred to Loan Account but will be paid in
....................

7. In the absence of any agreement, ……… of the Indian Partnership Act, 1932 is applicable.

8. Section 37 of the Indian Partnership Act says that outgoing partner is at liberty to receive
either interest @ ……….. p.a. till the date of payment or the share of profits which has been
earned with his money.

9. An ………. consists of two parts, Principal Amount of instalment due to retiring partner
and Interest at an agreed rate.

10. Interest due on loan amount is credited to retiring partners’ …………..

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Financial Accounting - II

Notes

Task Prepare the Proforma of capital account with a suitable example.

6.3 Summary

 The outgoing partner’s account is settled as per terms of partnership deed, i.e. in lump sum
immediately or in various installments with/without interest as agreed or partly cash
immediately and partly in installments at the agreed intervals.

 When a partner retires from business, his claim against the firm is determined by preparing
his capital account incorporating therein all the adjustments in respect of his share of
goodwill, accumulated profits or losses, profit/loss on revaluation of assets and liabilities,
etc.

 If nothing is given in the problem to be solved in respect of settlement of claim, the

amount of claim is usually transferred to the Retiring partner’s Loan Account.

 If the full amount of claim is payable to the retiring partner on the date of retirement as
per agreement, the amount will not be transferred to Loan Account but will be paid in
cash or by cheque.

 In the absence of any agreement, section 37 of the Indian Partnership Act, 1932 is applicable,
which says that outgoing partner is at liberty to receive either interest @ 6% p.a. till the
date of payment or the share of profits which has been earned with his money.

 An instalment consists of two parts:

(i) Principal Amount of instalment due to retiring partner.

(ii) Interest at an agreed rate.

 Interest due on loan amount is credited to retiring partners’ loan account.

 Instalment inclusive of interest then is paid to the retiring partner as per schedule agreed
upon.

6.4 Keywords

Annuity: Annual Payment of the claim of a retiring or deceased partner.

Executors: The representatives of the deceased partner who are entitled to claim a his share.

Gaining Ratio: The ratio of the continuing partners inter se which has been purchased by them
from the retiring or deceased partner.

6.5 Review Questions

1. List the various claims of retiring partner.

2. Illustrate the methods of settling the claims of retiring partner.

3. A retires from business on 1st January, 2004. His total claim against the firm works out to
91,000 on that date. The partners have agreed to allow 20% interest on the unpaid balance
per annum and settle his claim in three equal annual installments including interest.
Prepare A’s Loan Account.

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 Unit 6: Settlement of Retiring Partner’s Claim

4. Calculate the total amount due to X, who is retiring from the partnership: Notes
 Credit balance in X capital account 50,000.
 X’s share of goodwill 5,000
 General reserve balance shown in Balance sheet 10,000
 Profit on Revaluation of Assets/liabilities 3,000
 Interest on drawings 500.
 X share in the profit of the firm 2/3
5. Illustrate the lump sum payment method for settling the claims of retiring partner.
6. A, B and C were partners in a firm. A retired from business on 31st December; 2004 His
total claim against the firm on his retirement works out to be 59,500. It is agreed
amongst the partners that the total amount payable to the retired partner should be
transferred to his loan account carrying interest @ 12.5% p.a. It is also agreed that a sum of
9,500 be paid to the retiring partner immediately on 1 st January, 2005 and balance in five
equal annual installments payable at the end of each of the next five years on 31st December,
plus interest !he first of such payment to be made on 31st December, 2005. Show the
Retired Partner’s Loan Account for the five years from 2005 to 2009.
7. Ashu, Ashmita and Metu are partners sharing profits in the ratio of 4 : 3 : 2. Ashu retires,
assuming Ashmita and Metu will share profits in future in the ratio 5 : 3, determine the
gaining ratio.

Answers: Self Assessment

1. Partnership deed 2. Loan Account

3. Credit 4. Deducted

5. Deducted 6. Cash or by cheque

7. Section 37 8. 6%

9. Instalment 10. Loan account

6.6 Further Readings

Books I.M. Pandey, Financial Management, Vikas Publishing, New Delhi.

Khan and Jain, Management Accounting.

Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.

Prasanna Chandra, Financial Management - Theory and Practice, Tata McGraw Hill,
New Delhi (1994).

R.L. Gupta and Radhaswamy, Advanced Accountancy.

S. Bhat, Financial Management, Excel Books, New Delhi.

S.N. Maheswari, Management Accounting.

V.K. Goyal, Financial Accounting, Excel Books, New Delhi.

Online link www.futureaccountant.com

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Financial Accounting - II

Notes Unit 7: Death of Partner

CONTENTS

Objectives

Introduction

7.1 Accounting Treatment on Death of a Partner

7.2 Ascertainment of Share of Profit Up to the Death of Partner

7.2.1 On the Basis of Time

7.2.2 On the Basis of Turnover

7.3 Settlement of Executor’s Account

7.4 Summary

7.5 Keywords

7.6 Review Questions

7.7 Further Readings

Objectives

After studying this unit, you will be able to:

 Illustrate the accounting treatment on death of a partner

 Compute the share of profit up to the death of the partner

 Record the transactions for settlement of executor’s A/c

Introduction

Partnership stands dissolved on the death of a partner. The rights of the legal representatives of
the deceased partner depend on the provisions of the partnership deed. The claim of the deceased
partner is determined as per the provisions of the partnership deed which is normally purchased
by the surviving partners and they continue to carry on the business as usual. The claim of the
deceased partner is either paid immediately or transferred to Loan Account in the name of his
legal representatives. The claim is usually determined on the same basis as that of a retired
partner taking into account his share in the accumulated profits of the firm, goodwill, profit/
loss on revaluation of assets/liabilities and so on.

7.1 Accounting Treatment on Death of a Partner

The key difference between the retirement and death of partner is that normally the retirement
takes place at the end of an accounting period whereas death can occur at any time. Hence, in the
case of death of a partner his claim shall include:

 share in the profits of the firm up to the date of death

 interest on his capital up to the date of death

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 Unit 7: Death of Partner

 share in the proceeds of joint life policy (if any) in addition to his share in the accumulated Notes
profits

 goodwill, etc.

!
Caution Section 37 of the Partnership Act provides that if the amount is not paid
immediately, the executors of the deceased partner would be entitled, at their choice, to
receive interest @ 6% p.a. from the date of death to the date of actual payment or a share in
the profits of the firm earned during that period in the proportion in which the amount
due to the deceased partner bears to the total capital employed. This section is also applicable
in the case of retirement of a partner.
On the death of a partner, the accounting treatment regarding goodwill, revaluation of assets
and reassessment of liabilities, accumulated reserves and undistributed profit are similar to that
of the retirement of a partner.

Notes The deceased partners’ claim consists of:

Particulars
(A) Items to be credited
 The amount standing to the credit to the capital account of the deceased
partner ---------
 Interest on capital, if provided in the partnership deed
upto the date of death ---------
 Share of goodwill of the firm ---------
 Share of undistributed profit or reserves ---------
 Share of profit on the revaluation of assets and liabilities ---------
 Share of profit upto the date of death ---------
 Share of Joint Life Policy ______ -------
Total
(B) Items to be Deducted
 His/her share in the Revaluation loss ---------
 His/her Drawings and Interest on Drawings
up to the date of retirement ---------
 His/her share of any accumulated losses ---------
 Loan taken from the firm ______ -------

Total

Deceased Partner’s Claim (A – B) -------

Self Assessment

Fill in the blanks:

1. The claim of the deceased partner is either paid immediately or transferred to Loan Account
in the name of his ...................

2. The rights of the legal representatives of the deceased partner depend on the provisions of
the ...................

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Notes 3. The key difference between the retirement and death of partner is that normally the
................... takes place at the end of an accounting period whereas ................... can occur at
any time.

4. Share of Joint Life Policy should be ................... in deceased partner’s capital A/c.

7.2 Ascertainment of Share of Profit Up to the Death of Partner

If the death of a partner occurs during the year, the representatives of the deceased partner are
entitled to his/her share of profits earned till the date of his/her death. Such profit is ascertained
by any of the following methods:

 Time Basis

 Turnover or Sales Basis

7.2.1 On the Basis of Time

There are two methods used in ascertainment of profit on the basis of tome:

1. On the basis of average profit of certain years: Under this method the calculation of profit
is based on the average annual profit for the past few years say, 3 to 5 years. Then, the
profit for the proportionate period is found out.

Example: X, Y and Z are partners sharing profits equally. Z dies on April 30, 2004. The
accounts of the firm are closed on Dec. 31. The profits for the past 3 years are: 2001 - 35,000;
2002 - 40,000 and 2003 - 60,000. Calculate the Z’s share of profit from 1 st April to 30th April
2004.

Solution:

The average profit for the past three years:

35,000  40,000  60,000

 45,000
3

Profit for 4 months up to April 30, 2004 = 4/12 × 45,000 = 15,000

Z’s share of Profit = 15,000 × 1/3 = 5,000

2. On the basis of last year’s profit: Calculation of profit is based on the last year’s profit.

Example: The total profit of previous year is 360000 and a partner dies three months
after the close of previous year, the profit of three months is;

= 360000 × 3/12 = 90000

If the deceased partner took 2/10 share of profit, his/her share of profit till the date of death is
90000 × 2/10 = 18000.

7.2.2 On the Basis of Turnover

Under this method, the share of profit is calculated on the basis of the profit and the total sales
of the last year. Thereafter, the profit up to the date of death is estimated on the basis of the sale
of the last year.

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Notes
!
Caution Profit is assumed to be earned uniformly at the same rate.

Example: A, B and C are partners sharing profits and losses in the ratio of 2 : 1 : l. B dies
on March 1, 2004. Sales for the year 2004 amount to 80,000, out of which 25,000 are for a
period from January 1, 2004 to March 1, 2004. The profit for the year are 40,000.

Calculate the B’s share of profit.

Solution:

The Profit up to the date of B’s death

25,000
= × 40,000= 12,500
80,000

B’s share = 12,500 × 1/4 = 3,125

Task X, Y and Z are partners sharing profits in the ratio of 3 : 2 : 1. Z dies on 31st May
2006. Sales for the year 2005-2006 amounted to 4,00,000 and the profit on sales is 60,000.
Accounts are closed on 31 March every year. Sales from lst April 2006 to 31st May 2006 is
1,00,000.

Calculate the deceased partner’s share in the profit up to the date of death.

Self Assessment

Fill in the blanks:

5. The Executor is entitled to all the right of a ......................

6. Share of goodwill of the deceased partner is ...................... to his capital account.

7. In case of death of a partner, the profit may be estimated on the basis of ...................... and
......................

8. The balance in the capital account of the deceased partner is transferred to his ......................
account.

9. Interest on drawing due from deceased partner till the date of the death is ...................... to
his capital account.

10. Under ...................... method the calculation of profit is based on the average annual profit
for the past few years say, 3 to 5 years.

11. The profit can be calculated on the basis of ......................

12. Under ......................, the share of profit is calculated on the basis of the profit and the total
sales of the last year.

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Notes 7.3 Settlement of Executor’s Account

After the death of a partner the total amount due to him is transferred to his, executor’s account
and paid off as per the provisions of the partnership deed immediately or in installments
together with interest on the unpaid balance. As explained earlier the amount due to the deceased
partner should include the amount standing to the credit of his Capital Account, a share in the
accumulated profits, goodwill, joint life policy (if any), profit on revaluation of assets/liabilities,
etc.

The following entries should be passed for disposal of amount due to the deceased partner:

(a) The amount standing to the credit of deceased partner’s capital is transferred to his
executor’s account, by recording the following entry:

Deceased partner’s capital A/c Dr

To Deceased partner’s executor’s A/c

Deceased partner’s executor’s account will be settled as per the agreement between the
firm and executor’s of the deceased partner.

(b) When the full amount is paid in cash, following entry is recorded:

Executor’s A/c Dr

To Cash/Bank A/c

(c) When the settlement is made in installments, the following entries are made:

(i) For interest due:

Interest on executor’s A/c Dr

To Executor’s A/c

(ii) For payment of instalment on loan account

Executor’s A/c Dr

To Cash/Bank A/c

Example: Nutan, Sumit and Shiba are partners in a firm sharing profits in the ratio
5 : 3 : 2. On 31st December 2006 their Balance Sheet was as under:

( ) ( )

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 Unit 7: Death of Partner

Nutan died on 1 July 2007. It was agreed between her executor and the remaining partners that: Notes

(i) Goodwill to be valued at 2½ years purchase of the average profits of the last Four years,
which were: 2003 25,000; 2004 20,000; 2005 40,000 and 2006 35,000.

(ii) Building is valued at 70,000; Plant at 46,000 and Stock at 32,000.

(iii) Profit for the year 2006 be taken as having accrued at the same rate as that of the previous
year.

(iv) Interest on capital is provided at 9% p.a.

(v) On 1 July 2007 her drawings account showed a balance of 20,000.

(vi) 25,950 are to be paid immediately to her executor and the balance is transferred to her
Executors Loan Account.

Prepare Nutan’s Capital Account and Nutan’s Executor’s Account as on 1st July 2007.

Solution:

(i) Valuation of Goodwill:

Total Profit = 25,000 + 20,000 + 40,000 + 35,000

= 1,20,000

Average Profit = 1,20,000/4 = 30,000

Hence, Goodwill at 2½ year’s purchase = 30,000 × 2½ = 75,000

Nutan’s share of goodwill = 75,000 × 5/10 = 37,500

It is adjusted into the Capital Accounts of Sumit and Shiba in the gaining ratio of 3 : 2 i.e.
22,500 and 15000 respectively.

(ii) Share of Profit payable to Nutan [up to the date of death]

= 35,000 × 6/12 × 5/10

= 8,750

(iii) Nutan’s Share of Reserve Fund = 15,000 × 5/10

= 7,500

(iv) Interest on Nutan’s Capital = 60,000 × 9/100 × 6/12

= 2,700
Revaluation Account
Dr Cr

( ) ( )

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Notes Nutan’s Capital Account

Dr Cr

( ) ( )

Nutan’s Executor’s Accounts

Dr Cr

( ) ( )

Self Assessment

State whether the following statements are true or false

13. After the death of a partner the total amount due to him is transferred to his, executor’s
account.

14. Deceased partner’s executor’s account will be settled as per the agreement between the
firm and executor’s of the deceased partner.

15. The amount due to the deceased partner will always be settled in cash.

7.4 Summary

 The rights of the legal representatives of the deceased partner depend on the provisions of
the partnership deed.

 The claim of the deceased partner is either paid immediately or transferred to Loan Account
in the name of his legal representatives.

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 Unit 7: Death of Partner

 The claim is usually determined on the same basis as that of a retired partner taking into Notes
account his share in the accumulated profits of the firm, goodwill, profit/loss on revaluation
of assets/liabilities and so on.

 The key difference between the retirement and death of partner is that normally the
retirement takes place at the end of an accounting period whereas death can occur at any
time.

 If the death of a partner occurs during the year, the representatives of the deceased partner
are entitled to his/her share of profits earned till the date of his/her death.

 Under this average profit method the calculation of profit is based on the average annual
profit for the past few years say, 3 to 5 years.

 The profit can be calculated on the basis of last year’s profit.

 Under turnover method, the share of profit is calculated on the basis of the profit and the
total sales of the last year.

 After the death of a partner the total amount due to him is transferred to his, executor’s
account and paid off as per the provisions of the partnership deed immediately or in
installments together with interest on the unpaid balance.

7.5 Keywords

Executors: The representatives of the deceased partner who are entitled to claim his share.

Gaining Ratio: The ratio of the continuing partners inter se which has been purchased by them
from the retiring or deceased partner.

7.6 Review Questions

1. Accounting treatment in the event of death of the partner is on the same lines as that of the
retirement of a partner except a few. What are those exceptions?

2. A, B and C are partners sharing in the ratio of 5 : 3 : 2. B dies on June 30, 2002 i.e. three
months after closing of the books Profits for three years:

2000 : 25,000

2001 : 20,000

2002 : 15,000

Find out B’s share of profit on the date of death if as per terms of the agreement he was
entitled to profit (i) on the basis of immediately preceding year’s profits to the date of
death (ii) on the basis of average profit of the preceding three years to the date of death.

3. X, Y and Z are partners sharing profit in the ratio of 2 : 2 : 1. X dies on July 1, 2002 whereas
books of accounts are closed on March 31st every year. Sales for the year 2001 amounts to
4,00,000 and that from April 1 to June 30, 2002 to 1,50,000. The profit for the year 2001
were calculated as 40,000 calculate X’s share of profits in the firm for 2002 on the basis of
sales.

4. Following is the Balance Sheet of the Pon, Kon and Bon as on March 31, 2003. They shared
profits in the ratio of their capital.

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Notes Balance Sheet as at March 31, 2003

( ) ( )

Pon died on June 30, 2003. Under the terms of partnership the executors of a deceased
partner were entitled to:

(a) Amount standing to the credit of the Partner’s Capital Account.

(b) Interest on Capital at 12% per annum.

(c) Share of goodwill on the basis of four year’s purchase of three year’s average profits.

(d) Share of Profit from the closing of the last financial year to the date of death on the
basis of the last year’s profit. Profit for the years 2001, 2002 and 2003 were respectively
8,000, 12,000 and 7,000.

Record the necessary journal entries and draw up Pon’s account to be rendered to his
executors and his executor’s account, presuming that they are paid by raising bank loan.

5. M, N and C are in partnership, sharing profit in the proportion of 2/3, 1/6 and 1/6
respectively. To clear the dues of deceased’s partner an assurance was effected on their
lives jointly for 10,000 without profit, at an annual premium of 650 to provide liquidity
to the firm. C died on June 30, 2002, three months after the annual accounts had been
prepared. In accordance with the partnership agreement, his share of the profits to the date
of death was estimated on the basis of the profits for the preceding year. The agreement
also provided for interest on capital at 10% per annum and also for goodwill, which was
to be brought into account at two years’ purchase of the average profits for the last three
years, prior to charging the abovementioned insurance premiums, but after charging
interest on capital. C’ capital on March 31, 2002, stood at 10,000 and drawings from then
to the date of death amounted to 2,000. The net profits of the business for the three
preceding years amounted 3,350, 4,150 and 4,050, respectively, after charging interest
on capital and insurance premiums. The premiums paid on policy are written off to Profit
and Loss Account. You are instructed to prepare C’s capital account as at the date of death
and also prepare C’s Executor’s account.

6. Mansi and Puneet are in partnership sharing profits and losses 3 : 2. They insure their lives
jointly for 75,000 at an annual premium of 4,400 charged to the business. Puneet dies
three months after the date of the last Balance Sheet. According to the partnership deed,
the legal representatives of Puneet are entitled to the following payments:

(a) His capital as per the last Balance Sheet.

(b) Interest on above capital at 8% per cent per annum to date of death.

(c) His share of profit to date of death calculated on the basis of last three year’s profits.

His drawings are to bear interest at an average rate of 1 per cent on the amount irrespective
of the period.

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 Unit 7: Death of Partner

The net profits for the last three years, after charging insurance premium, were 20,000, Notes
25,000 and 30,000 respectively. Puneet’s capital as per balance sheet was 40,000 and
his drawing to date of death were 2,000.

Draw Puneet account to be rendered to his representatives.

7. Pass the necessary journal entries for the settlement of executor’s A/c.

8. Prepare the Proforma of capital A/c and explain the key elements.

9. Following is the balance sheet of Tony, Sony and Romy as on March 31, 2003

( ) ( )

Sony died on June 30, 2003. Under the terms of the partnership deed, the executors of a
deceased partner were entitled to:

(a) Amount standing to the credit of the partner’s capital account.

(b) Interest on capital at 5% per annum.

(c) Share of goodwill on the basis of twice the average of the past three years’ profit,
and

(d) Share of profit from the closing of the last financial year to the date of death on the
basis of the last three year’s profit.

Profits for 2001, 2002 and 2003 were 12,000, 16,000 and 14,000 respectively. Profits
were shared in the ratio of capitals. Record the necessary journal entries and draw up the
Sony’s Account to be rendered to his executors.

10. List the key items that should be debited and credited to calculate the claim of deceased
partner.

Answers: Self Assessment

1. Legal representatives 2. Partnership deed

3. Retirement, death 4. Credited

5. Deceased partner 6. Credited

7. Time, Sales 8. Executor’s

9. Debited 10. Average profit

11. Last year’s profit 12. Turnover method

13. True 14. True

15. False

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Notes 7.7 Further Readings

Books I.M. Pandey, Financial Management, Vikas Publishing, New Delhi.

Khan and Jain, Management Accounting.

Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.

Prasanna Chandra, Financial Management - Theory and Practice, Tata McGraw Hill,
New Delhi (1994).

R.L. Gupta and Radhaswamy, Advanced Accountancy.

S. Bhat, Financial Management, Excel Books, New Delhi.

S.N. Maheswari, Management Accounting.

V.K. Goyal, Financial Accounting, Excel Books, New Delhi.

Online link www.futureaccountant.com

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 Unit 8: Joint Life Policy

Unit 8: Joint Life Policy Notes

CONTENTS

Objectives

Introduction

8.1 Accounting Treatment for Joint Life Policy

8.2 Individual Life Policies

8.3 Summary

8.4 Keywords

8.5 Review Questions

8.6 Further Readings

Objectives

After studying this unit, you will be able to:

 Define joint life policy

 Illustrate the accounting treatment for joint life policy

 Prepare the accounts for individual life policies

Introduction

The term Joint Life Policy means an insurance policy taken out by the partnership firm on the
joint lives of all the partners. The amount of such a policy is payable by the Insurance Company
either on death of any partner or on maturity whichever is earlier. The main objective behind
taking out such a policy by the partnership firm is to mobilise funds to settle the claims of the
deceased partner in case of death of a partner without affecting the Working Capital of the
business. If any one of the partners covered by such a policy expires, the policy gets matured
immediately and with the amount recovered from Insurance Company, the claim of the deceased
partner is settled. However, it is important to note here that the profit arising out of such a
policy should always be distributed to all the partners including the deceased partner in their
profit-sharing ratio.

Did u know? What is surrender value?

Surrender Value (SV) is the amount payable by an insurance company on the surrender/
discontinuation of joint life policy before the date of maturity. However, the surrender
value keeps on increasing with the successive payment of premium.

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Notes 8.1 Accounting Treatment for Joint Life Policy

There are two ways to record the Joint Life Policy transactions by the firm:

1. Treated as an expense of firm: Under this method the premium paid is treated as a business
expense. The premium is chargeable to the profit and loss account.

Accounting entries in the books of the firm will be as follows:

(a) For payment of premium:

Joint life policy premium Dr.

To Bank A/c

(b) For transfer of premium paid to profit and loss account at the end of the year:

Profit and loss A/c Dr.

To Joint life policy premium

On the maturity of the policy, if the death takes place before the due date of the premium,
the premium will not be paid in the year of death. This would imply that entry for
payment of premium would not be recorded. On maturity, the insurance policy will be
surrendered to register the claim with the insurance company and sum assured will be
collected.

For this following entries are to be recorded:

(i) On the death of partner, for making claim with the insurance company

Insurance Company/Insurance claim receivable A/c Dr.

To Joint Life Policy

(ii) For Claim duly received from Insurance Co. on the date of receipt

Bank A/c Dr.

To Insurance Co./Insurance claim receivable A/c

(iii) Claim due will be distributed among existing partners (including outgoing)

Joint life policy Dr.

To All partner’s capital A/c (individually)

2. When premium paid is treated as an asset at an amount equal to the surrender value of
joint life policy

In such a case, Joint Life Policy Account will appear in the books of the firm which must be
shown as an asset in the Balance Sheet at its present value i.e. surrender value.

Following accounting entries are to be recorded in this case:

(i) 1st Year: On the date when policy is taken and premium is paid.

Joint Life Policy Dr.

To Bank A/c

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 Unit 8: Joint Life Policy

(ii) At the end of first year, the joint life policy account will show the balance which is Notes
equal to its surrender value. The difference between the premium paid and surrender
value will be transferred to profit and loss account.

Profit and loss A/c Dr.

To Joint Life Policy

Notes Amount = surrender value in the previous year + premium paid during the
current year – surrender value in the current year.

Second year and onwards, the entries (i) and (ii) shall be repeated until the last year.
In the last year, i.e., the year of death, entry no. (i) will be recorded only if death takes place
after the due date of premium and entry no. (ii) will not be recorded at all.

(iii) On maturity of policy or in the event of death, entry for making the insurance claim
will be:
Insurance company A/c Dr.
To Joint Life Policy
(iv) On the date of receipt when insurance company pays the insurance claim due:
Bank A/c Dr.
To Insurance Company

(v) Balance standing in Joint Life Policy account is distributed among all partners in
profit sharing ratio.
Balance in Joint Life Policy account = Total claim due – (Surrender value of the policy in the
previous year + premium paid during the current year).

Example: Jatin, Gagan and Kiran are equal partners have taken a Joint Life Policy of
60,000 on June 30, 1999 paying annual premium of 6,000. Surrender values for : 1999 - NIL;
2000 - 3,000; 2001 - 6,000 ; 2002 - 10,000: Gagan die on July 3, 2002.

Record necessary entries for the year 2002:

(i) If premium paid is transferred to profit and loss account every year.
(ii) If premium paid is treated as an asset. Also prepare Joint Life Policy account for 2002.

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Notes Solution:
(i) If premium paid is transferred to profit and loss account every year.
Books of Jatin, Gagan and Kiran
Journal

( ) ( )

A/c

A/c

A/c
A/c
A/c

A/c

Note: It is assumed that the claim registered with insurance company will be received in due
course of time.
(ii) If premium paid is treated as an asset. Also prepare Joint Life Policy account for 2002.
Books of Jatin, Gagan and Kiran
Journal

( ) ( )

A/c

A/c

A/c
A/c
A/c

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 Unit 8: Joint Life Policy

Joint Life Policy Account Notes

Dr. Cr.

( ) ( )

* This amount is the balance of Joint Life policy account on the date of death, which is the surrender value of Joint Life
Policy of previous year to the death, i.e. year 2001.

Task Nita and Rita are partners in a business sharing profits in the ratio of 7 : 3. The
firm has taken a joint life insurance policy on the lives of partners for a sum of 1,00,000
with effect from 30-06-99. The annual premium is 10,000. On Jan 2, 2002, Nita died and
amount of 1,20,000 (including bonus) was received from the Life Insurance Company.
The firm has charged the premium to Profit and Loss Account each year on financial year
basis. You are required to make necessary journal entries assuming that the amount was
received on Feb.1, 2002.

Joint Life Policy Reserve A/c

When premium paid on joint life policy is treated as capital expenditure then a reserve may also
be created equal to the surrender value. Then the joint life policy will be shown at its surrender
value on the asset side of the Balance Sheet and Joint Life Policy Reserve account will be shown
at the same amount on the liability side of the balance sheet. If on the admission of a partner it
is decided not to show these two accounts in the books of accounts in future then these accounts
will be closed by debiting joint life policy reserve account and crediting joint life policy account.
The following journal entry will be recorded.
Joint Life Policy Reserve A/c Dr.

Joint Life Policy

Example: On the admission of Rohit on April 1, 2003 in the firm of Ram and Shyam there
existed a balance of 40,000 each in the joint life policy account and joint life policy reserve
account. It was decided that these accounts will not be shown in the books of the new firm.
Record the necessary journal entry for the same.

Solution:
Books of Ram, Shyam and Rohit
Journal

Date Particulars L.F. Dr ( ) Cr. ( )

April 1 Joint Life Policy Reserve A/c Dr. 40,000
Joint Life Policy 40,000
(Joint life policy and joint life policy reserve accounts
closed on Rohit's admission)

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Financial Accounting - II

Notes
Example: A,B, and C sharing profits and losses in the ratio 2 : 1 : 1 have taken a joint life
policy for 100,000 with an annual premium of 1,000 on 1 st January 2000. The surrender values
estimated for the policy were:

31st Dec. 2000 - Nil;

31st Dec. 2001 - 300;

31st Dec. 2002 - 750

31st Dec. 2003 - 1,250

C died on 10 February 2003. The Insurance Company settled the claim on 15 th Feb, 2003. Pass
th

necessary journal entries and related ledger accounts keeping treating the surrender value of the
insurance policy as asset and maintaining a reserve against the policy.

Solution:

First Year
Jan 1, 2000
Joint life policy account Dr. 1,000
To Cash 1,000
(Premium paid on the joint life policy)
31 Dec., 2000
P&L Appropriation Account Dr. 1000
To Joint Life Policy Reserve Account 1,000
(Reserve created for the premium payment)
31st Dec, 200
Joint Life Policy Reserve Account Dr. 1,000
To Joint Life Policy Account 1,000
(Balances in reserve and policy accounts eliminated by mutual transfer)
Note: There is no surrender value in the first year in the above example.

Second Year
Jan 1, 2001
Joint Life Policy account Dr. 1,000
To Cash 1,000
(Premium paid on the policy)
31 Dec. 2001
P&L Appropriation Account Dr 1,000
To Joint Life Policy Reserve Account 1,000
(Reserve created for the premium payment)
31st Dec. 2001
Joint Life Policy Reserve Account Dr. 700
Joint Life Policy Account 700
(Both JLP and Reserve reduced to the surrender value by mutual elimination)
(Note: Here the premium payment is 1,000, but Joint life policy and JLP reserve accounts
will appear at 300 on the either side of the Balance Sheet.)

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 Unit 8: Joint Life Policy

Third Year Notes

Jan 1, 2002
Joint Life Policy account Dr. 1,000
To Cash 1,000
(Premium paid on the policy)
31 Dec., 2002
P&L Appropriation account Dr. 1,000
To Joint Life policy Reserve Account 1,000
(The reserve created against premium payment)
31st Dec., 2001
Joint Life Policy Reserve Account Dr. 550
Joint Life Policy Account 550
(Both JLP and Reserve reduced to the surrender value by mutual elimination)

Fourth Year

1st January 2003

Joint Life Policy account Dr. 1,000
To Cash 1,000
(Premium paid on the policy
10 Feb 2003
Insurance Claim Account Dr. 100,000
To Joint Life Policy 100,000
(Insurance Claim credited to policy account)

10 Feb 2003
Joint Life Policy Reserve Account Dr. 750
To Joint Life Policy Account 750
(Reserve account closed by transfer to policy account)
Note: You can transfer the reserve directly to the capital accounts of partners.

10 Feb 2003
Joint Life Policy Account Dr. 100,000
To A’s Capital 39,600
To B’s Capital 39,600
To C’s Capital 19,800
(Joint Life policy closed by transfer to capital accounts)

15 Feb 2003
Bank Account Dr. 100,000
To Insurance Claim 100,000
(Insurance claim settled)

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Notes Joint Life Policy Account

Date Particulars Amount Date Particulars Amount

1 Jan, 2000 To Cash 1,000 31 Dec 2000 By JLP Reserve A/c 1,000
1,000 1,000
1 Jan 2001 To Cash 1,000 31 Dec, 2001 By JLP Reserve A/c 700
By Balance c/d 300
1,000 1,000
1 Jan 2002 To balance b/d 300 31 Dec, 2002 By JLP Reserve A/c 550
31 Dec 2002 To Cash 1,000 By Balance c/d 750
1,300 1,300
1 Jan 2003 To balance b/d 750 10 Feb 2003 By JLP Reserve 750
To Cash 1,000 By Insurance Claim 100,000
10 Feb 2003 To A’s Capital 39,600
To B’s Capital 39,600
To C’s Capital 19,800 99,000
100,750 100,750

Joint Life Policy Reserve Account

Date Particulars Amount Date Particulars Amount

31 Dec 2000 To JLP Account 1,000 31 Dec, 2000 By P&L Appropriation 1,000
1,000 1,000
31 Dec 2001 To JLP Account 700 31 Dec, 2001 By P&L Appropriation 1,000
To Balance c/d 300
1,000 1,000
31 Dec 2002 To JLP Account 550 1 Jan, 2002 By Balance b/d 300
To Balance c/d 750 31 Dec, 2002 By P&L Appropriation 1,000
1,300 1,300
10 Feb 2003 To JLP Account 750 1 Jan, 2003 By Balance b/d 750

750 750

Self Assessment

Fill in the blanks:

1. The amount of joint life policy is payable by the Insurance Company either on death of
any partner or on ................... whichever is earlier.

2. The main objective behind taking out such a policy by the partnership firm is to mobilise
funds to settle the claims of the deceased partner in case of death of a partner without
affecting the ................... of the business.

3. ................... is the amount payable by an insurance company on the surrender/

discontinuation of joint life policy before the date of maturity.

4. The surrender value keeps on increasing with the successive payment of ...................

5. Amount = surrender value in the previous year + ................... – surrender value in the
current year.

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8.2 Individual Life Policies Notes

The firm may decide to take the insurance policy separately for each of the partners on their
lives. For such insurance policies, if premium is paid by the firm, being a transaction of business,
it becomes an asset of the firm. Whenever death of any partner occurs, policy matures, the firm
makes a claim to the insurance company and claim so received is distributed among all the
partners in the profit sharing ratio. The heir of deceased partner will be entitled to the
proportionate share in the policy of deceased. Further, surrender values of the policies of other
partners will be distributed among all the partners (including heir of deceased) in their profit
sharing ratio. The Joint Life Policy will be shown in the Balance Sheet at its surrender value.

Example: X, Y and Z are partners in the ratio of 5 : 3 : 2. X died on 14 th Aug. 2002. The firm
had taken insurance policies on the lives of the partners, premium being charged to profit and
loss account every year.

The Policy amount and surrender value (on 14.08.2002)

Particulars Policy Amount Surrender Value

( ) ( )
Life Insurance Policies:
X 60,000 25,000
Y 90,000 35,000
Z 60,000 15,000

Work out the amount payable to X’s legal representatives regarding insurance policies. Record
necessary journal entries.

Solution:
Books of X, Y and Z

Date Particulars L.F. Debit Credit

2002 Amount Amount
( ) ( )
Aug.14 Insurance Company A/c Dr 60,000
To life policy 60,000
(claim for the policy registered)

Aug.14 Bank A/c Dr 60,000

To insurance company A/c 60,000
(policy amount received on X’s death)

Aug.14 Life policy A/c Dr 60,000

To X’s A/c 30,000
To Y’s A/c 18,000
To Z’s A/c 12,000
(Amount of life policy transferred to
capital A/c)

Aug.14 Y’s capital A/c Dr 15,000

Z’s capital A/c Dr 10,000
To X’s capital A/c 25,000
(X’s share credited to him in gaining
ratio of 3 : 2)

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Notes Working Notes:

1. Surrender value of policies of Y and Z = 35,000 + 15,000 = 50,000

5
2. X’s share = 50000× = 25000
10

Self Assessment

Fill in the blanks:

6. In case of individual insurance policies, if premium is paid by the firm, being a transaction
of business, it becomes an ................... of the firm.

7. The heir of deceased partner will be entitled to the ................... share in the policy of
deceased.

8. Surrender values of the policies of other partners will be distributed among all the partners
in their ................... ratio.

9. The Joint Life Policy will be shown in the ................... at its surrender value.

10. Claim received under individual life policy is distributed among all the partners in the
................... ratio.

8.3 Summary

 For the purpose of ensuring liquidity in the firm to settle the claim of the retiring/
deceased partner an assurance policy is taken up by the partners on their lives collectively.

 The insurance company agrees to pay the sum assured (i.e., the amount for which the
policy has been taken) to the firm on the maturity date.

 Maturity date is the date of death of any of the partners or the date on which the term of the
policy expires, whichever is earlier.

 The firm in turn agrees to pay to the insurance company the amount of premium
periodically.

 The amount of premium payable will be same in each of the years.

 Surrender Value (SV) is the amount payable by an insurance company on the surrender/
discontinuation of joint life policy before the date of maturity.

 However, the surrender value keeps on increasing with the successive payment of premium.

 The firm may decide to take the insurance policy separately for each of the partners on
their lives.

 Under individual life policy the heir of deceased partner will be entitled to the proportionate
share in the policy of deceased.

 Further, surrender values of the policies of other partners will be distributed among all
the partners (including heir of deceased) in their profit sharing ratio.

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8.4 Keywords Notes

Joint Life Policy: An insurance policy taken by the partnership firm on the joint lives of all the
partners.

Surrender Value: Amount receivable from the insurance company on surrendering the policy
before maturity.

8.5 Review Questions

1. Why the Joint Life Policy is needed? What are the different ways of treating Joint Life
Policy in accounts?

2. What is the objective of taking a joint life policy by the partners?

3. What is the accounting treatment of the claim received on account of joint life policy from
insurance company on the event of death of a partner?

4. What is surrender value?

5. Madhu and Shyam who shared profits in the ratio of 3 : 2 took out a Joint Life Policy on
May 14, 1999 for 60,000. The annual premium was 8,500. The surrender value of the
policy was: 1999 - NIL ; 2000 - 4,500 ; 2001- 8,000; and 2002 - 12,000.

Madhu died on Nov 14, 2002 and the amount of the policy was received on Dec.1, 2002. The
books are closed on December 31 each year. Give journal entries assuming that the firm
treats premium paid as asset and maintains a Joint Life Policy Account at its surrender
value. Also prepare Joint Life Policy account.

6. Mahesh and Raj sharing profit in the ratio of 2 : 3, took out a joint life policy on July 1, 1999
of 80,000 for paying annual premium of 8,000. The surrender values were 1999 - NIL;
2000 - 4,200; 2001 - 7,500; 2002 - 12,000. Raj died on March 18, 2002 and claim was
received. Books are closed on calendar year basis. Prepare Joint Life Policy Account.

7. Illustrate the different ways for accounting treatment of joint life policy.

8. State the difference between joint life policy and individual life policy with a suitable
example.

9. Pass necessary entries on maturity of the policy.

10. Prepare the proforma of Joint Life Policy A/c.

Answers: Self Assessment

1. Maturity 2. Working Capital

3. Surrender Value (SV) 4. Premium

5. Premium paid during the current year 6. Asset

7. Proportionate 8. Profit sharing

9. Balance Sheet 10. Profit sharing

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Notes 8.6 Further Readings

Books I.M. Pandey, Financial Management, Vikas Publishing, New Delhi.

Khan and Jain, Management Accounting.

Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.

Prasanna Chandra, Financial Management - Theory and Practice, Tata McGraw Hill,
New Delhi (1994).

R.L. Gupta and Radhaswamy, Advanced Accountancy.

S. Bhat, Financial Management, Excel Books, New Delhi.

S.N. Maheswari, Management Accounting.

V.K. Goyal, Financial Accounting, Excel Books, New Delhi.

Online link www.futureaccountant.com

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 Unit 9: Dissolution of Partnership

Unit 9: Dissolution of Partnership Notes

CONTENTS

Objectives

Introduction

9.1 Dissolution of Partnership and Firm

9.1.1 Dissolution of Partnership

9.1.2 Dissolution of Firm

9.2 Settlement of Accounts

9.2.1 Treatment of Firm’s Debts and Private Debts

9.2.2 Accounting Treatment of Assets and Liabilities

9.2.3 Treatment of Goodwill

9.2.4 Treatment of unrecorded Assets or Liabilities

9.3 Garner v/s Murray Rule Including Insolvency of Firm

9.4 Piecemeal Distribution

9.5 Summary

9.6 Keywords

9.7 Review Questions

9.8 Further Readings

Objectives

After studying this unit, you will be able to:

 Distinguish between the dissolution of partnership and firm

 Illustrate the settlement of accounts

 Discuss Garner v/s Murray rule including insolvency of firm

 Define piecemeal distribution

Introduction

In the present unit, you will study about the dissolution of partnership and firms. The unit
discussed about the dissolution of partnership and firm, settlement of accounts and accounting
treatment. Section 39 provides that the dissolution of partnership between all the partners of a
firm is called the “dissolution of the firm”. It follows that if the dissolution of partnership is not
between all the partners, it would not amount to “dissolution of firm”, but it would nevertheless
be “dissolution of partnership”. Thus, dissolution of firm always implies dissolution of
partnership, but dissolution of partnership need not lead to dissolution of firm. Dissolution of
partnership may involve merely a change in the relation of the partners and not the dissolution
of the firm.

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Notes For example, where A, B and C were partners in a firm and C died or was adjudged insolvent, the
partnership firm would come to an end; but if the partners had agreed that the death, retirement,
insolvency of the partner would not dissolve the firm on the happening of these contingencies,
the ‘partnership’ would certainly come to an end although the ‘firm’ or as the Act calls it, a
‘reconstituted firm’, might continue under the same name.

Thus, a reconstitution of a firm involves a change in the relation of partners whereas in the case
of dissolution of firm, there is complete severance of relationship between all partners.

9.1 Dissolution of Partnership and Firm

Dissolution of partnership is different from the dissolution of a firm. As we discussed earlier

that dissolution of partnership does not demand dissolution of the firm but dissolution of the
firm means the dissolution of partnership.

9.1.1 Dissolution of Partnership

Dissolution of the partnership (owing to retirement, death or bankruptcy of a partner), merely

involves change in the relation of the partners but it does not end the firm. The dissolution of
partnership can be understood from the following points:

1. Dissolution of partnership means a contract among the partners to dissolve the partnership.
This is because of the changes in the constitution of the partnership.

2. Partnership is created at will; similarly it can be wound up voluntarily.

3. If partnership is dissolved, the firm will not dissolve if the other partners desire to continue.

4. Dissolution of partnership require the revaluation of assets and liabilities.

5. In dissolution of partnership the final settlement of accounts is not required.

9.1.2 Dissolution of Firm

On dissolution of the firm, the business of the firm stops its affairs and wind up by selling the
assets and by paying the liabilities and discharging the claims of the partners. The dissolution of
partnership among all partners of a firm is called dissolution of the firm.

The different methods of dissolution are as follows:

(i) By mutual consent: Section 40 provides that a firm may, at any time, be dissolved with the
consent of all the partners. This applies to all cases whether the firm is for a fixed period or
otherwise.

(ii) By agreement: Section 40 also provides for the dissolution of a firm in accordance with a
contract between the partners. The contract providing for dissolution may have been
incorporated in the partnership deed itself or in a separate agreement.

(iii) By the insolvency of all the partners but one: If all the partners or all the partners but one
become insolvent, there is a dissolution of the firm. Section 41 calls this as compulsory
dissolution.

(iv) By business becoming illegal: Section 41 provides that a firm is dissolved by the happening
of any event which makes it unlawful for the business of the firm to be carried on or for the
partners to carry it on in partnership. But, if the partnership relates to more than one
adventure, the illegality of one or more of them does not prevent the lawful adventure
from being carried on by the firm.

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(v) Partners becoming alien enemies: Section 41 also covers cases of partnership between Notes
persons some of whom become alien enemies by a subsequent declaration of war. In such
a case partnership is dissolved, because trading with an alien enemy is against public
policy.

Section 41 covers cases of compulsory dissolution of firm by operation of law.

(vi) By notice of dissolution of partnership at will: Section 43 provides that where the
partnership is at will, a partner may give a notice in writing to the other partners of his
intention to dissolve the firm. The notice must state the intention to dissolve the firm and
be in writing. The firm is dissolved as from the date mentioned in the notice as the date of
dissolution, or if no date is mentioned then from the date of communication of the notice.

!
Caution Filing a suit for dissolution is not a notice as required by this section. In such a
case, the date of dissolution will be the date of passing of the preliminary decree for
dissolution [Banarsi Das v. Kanshi Ram , A I R (1983) S.C. 1165].

(vii) Dissolution by Court (s.44): At the suit of a partner, the court may dissolve a firm on any
of the following grounds:

(a) If a partner has become of unsound mind: The application in this case may be made by
any of the partners or by the next friend of the insane partner. In the case of insanity
of a dormant partner, the court will not order dissolution, unless a very special case
is made out for dissolution.

(b) Permanent incapacity of a partner: The court may order for dissolution of partnership,
if a partner becomes permanently incapable of performing his duties as a partner.
The application for dissolution, in such a case, may be made by any of the partners
and not by the incapacitated partner. However, where a partner is attacked with
paralysis which, on evidence, is found to be curable, dissolution may not be granted.

(c) Misconduct of a partner affecting the business: If a partner is guilty of conduct which is
likely to affect prejudicially the carrying on of the business of the firm, the court
may order dissolution. For example, A partner of a mercantile firm is engaged in
speculation in cotton. This act may be regarded a sufficient ground for dissolution of
the firm.

(d) Wilful and persistent disregard of partnership agreement by a partner: If a partner wilfully
and persistently commits a breach of the partnership agreement regarding
management, or otherwise conducts himself in such a way that is not reasonably
practicable for the other partners to carry on business in partnership with him, the
court may order dissolution.

(e) Transfer of interest or share by a partner: If a partner transfers, in any way (e.g., by sale,
mortgage or charge), his whole interest in the partnership to a third party (outsider)
or allows his share to be charged in execution of a decree against him or allows the
same to be sold for arrears of land revenue or for charges recoverable as land
revenue, the court may dissolve the partnership.

(f) The court can also dissolve partnership where the business of the firm cannot be carried
on save at a loss. The court can order dissolution even though the partnership is for
a fixed period [Rehmat-un-nisa-v. Price, 42 Bom. 380].

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Notes (g) Just and equitable: The court can order dissolution on any other ground which in the
opinion of the court is a fit ground for dissolution of partnership. Dissolution on
this ground has been granted in case of deadlock in the management, disappearance
of the substratum of the business, partners not on speaking terms, etc.

Notes Distinction Between Dissolution of Partnership and Dissolution of Firm

Self Assessment

Fill in the blanks:

1. Dissolution of partnership does not demand dissolution of the .....................

2. Dissolution of partnership requires the ..................... of assets and liabilities.

3. The dissolution of partnership among all partners of a firm is called dissolution of the
.....................

4. In case when the business becomes illegal there will be ..................... of the firm.

5. ..................... is created at will.

6. Dissolution of ..................... requires revaluation of assets and liabilities.

9.2 Settlement of Accounts

Usually the Deed of Partnership contains an accounting clause according to which the final
accounts between partners are settled. In the absence of such an agreement, s.48 provides as
follows:

 The losses, including losses on capital, must be paid, first from profits, next out of capital
and lastly, if necessary, by contribution of each partner in proportion to his share in
profits.

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 The assets of the firm, including sums contributed by partners to make up deficiency of Notes
capital, shall be applied as follows: (a) in paying debts of the firm to outsiders; (b) in
paying each partner rateably for advances made by him to the firm as distinct from
capital; (c) in paying each partner, rateably, amount due for capital contribution, and
(d) the residue in paying each partner in accordance with his share in the profits of the
firm.

 If a partner becomes insolvent or otherwise cannot pay his share of the contribution, the
solvent partners must share rateably the available assets (including their own contribution
to the capital deficiency), i.e., the available assets will be distributed in proportion to their
original capital. This is called the rule in Garner v. Murray (1904)1 Ch. 57.

9.2.1 Treatment of Firm’s Debts and Private Debts

Under section 49 of the Indian Partnership Act, the following provisions shall apply in case a of
firm’s debts and private debts:

 The creditors of the firm (third party liabilities) should be paid out of the assets of the
firm. If there is any surplus, it will be divided among the partners as per their claims
which can be utilised for paying the private liabilities of the partners.

 Similarly, the private creditors of partners should be first paid out of the private assets
of partners and if there is any surplus, it can be utilised for paying off the partnership
debts.

9.2.2 Accounting Treatment of Assets and Liabilities

As we discussed earlier that in case of dissolution of a partnership firm the business activities of
a firm comes to an end and the firm get dissolved. As soon as the partners decide to discontinue
the business of the firm, it becomes necessary to settle its accounts. For this purpose, all the
assets have to be sold and the liabilities are to be paid off. For this purpose a separate account
called ‘Realisation Account’ is opened.

Did u know? How to prepare Realisation A/c?

Realisation is an account in which assets excluding cash in hand and bank are transferred
at their book value and all external liabilities are transferred at their book.

The following entries are passed in the books to record the disposal of assets and discharge of
liabilities:

1. For Transfer of assets:

Dr. Cr.
S. No. Particulars L.F.
Realization A/c Dr.
To Sundry Assets A/c
(Transfer of assets)

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Notes
!
Caution It is to be noted that the following items on the assets side of the Balance Sheet are
not transferred to the Realisation Account:

(a) (i) Undistributed loss (i.e. Debit Balance of Profits and Loss account)
(ii) Fictitious assets or deferred revenue expenditures such as preliminary expenses;

(b) Cash in hand, and Cash at Bank, will be the opening balance of the Cash/Bank
account.

(c) Provisions and reserves against assets should be closed by crediting the Realisation
Account.
2. For Transfer of Liabilities:

External Liabilities A/c Dr.

To Realization A/c
(Transfer of external liabilities)

3. Treatment of Accumulated Reserves and Profit/loss

All the balance of Reserve or Undistributed Profit, Reserve fund or other reserves are transferred
to partner’s capital account in their profit sharing ratio. The following entries are to be passed:

Reserve A/c Dr.

Profit and Loss A/c Dr.
Any Other fund A/c Dr.
To Partner’s Capital A/c
(Transfer of profit and reserves)

4. For Sale of Assets

Cash/Bank A/c Dr.

To Realization A/c
(sale of assets)

5. For assets taken over by the partner

Partner’s Capital A/c Dr.

To Realization A/c
(Assets taken over by partner)

6. Payment of liabilities in cash

If any liabilities is paid off in cash:

Realization A/c Dr.

To Cash/Bank A/c
(payment of liabilities)

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7. Payment of liabilities by the partners Notes

Realization A/c Dr.

To Partner’s Capital A/c
(liabilities taken over by partner)

8. Settlement of loan given by the partner

Partner’s Loan A/c Dr.

To Bank A/c
Partner’s loan paid off.

9. Payment of realization expenses:

(a) When realisation expenses are paid by firm:

Realization A/c Dr.

To cash A/c
(expenses paid off)

(b) When realisation expenses are paid by partner on behalf of the firm:

Realization A/c Dr.

To Partner’s capital A/c
(payment of realisation expenses by partner on behalf
of the firm)

10. Closing of realisation A/c

The balance in the realisation account would show either profit or loss on dissolution. If it
is a profit, it is transferred to Partner’s capital accounts in their profit sharing ratio.

(a) In case of profit, the following entries are to be passed:

Realization A/c Dr.

To Partner’s Capital A/c
Profit on realization transferred.

(b) In case of loss, Reserve entry is to be passed.

Partner’s Capital A/c Dr.

To Realization A/c
Loss on realization transferred.

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Notes

Notes Proforma of Realisation A/C

( ) ( )

Example: Pass the necessary journal entries on the dissolution of a firm, after various
assets (other than cash) and third party liabilities have been transferred to Realization Account:

1. Bank Loan 10,000 is paid.

2. Stock worth 5,000 is taken over by partner A.

3. Expenses on dissolution amounted to 1,200 and were paid by partner B.

4. A typewriter, completely written off in the books of accounts, was sold for 400.

5. Loss on Realization 7,000 was to be distributed between A and B in the ratio of 5 : 2.

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Solution: Notes
Journal Entries

Dr. Cr.
Sr. No. Particulars L.F.
1. Realization A/c Dr. 10,000
To Cash/Bank A/c 10,000
(Payment of bank loan)
2. B’s Capital A/c Dr. 5,000
To Realization A/c 5,000
Stock taken over by partner A
3. Realization A/c Dr. 1,200
To A’s Capital A/c 1,200
Expenses on dissolution paid by partner B
4. Cash A/c Dr. 400
To Realization A/c 400
Typewriter completely written off was sold for Rs. 400.
5. A’s Capital A/c Dr. 5,000
B’s Capital A/c Dr. 2,000
To Realization A/c 7,000
Loss on realization was distributed between A and B.

9.2.3 Treatment of Goodwill

Section 55 provides that in settling the accounts of a firm after dissolution, goodwill shall,
subject to contract between the partners, be included in the assets and it may be sold either
separately or along with other property of the firm.
Where the goodwill of a firm is sold after dissolution, a partner may carry on a business
competing with that of the buyer and he may advertise such business but subject to agreement
between him and the buyer, he may not (a) use the firm’s name; (b) represent himself as carrying
on business of the firm; or (c) solicit the custom of persons who were dealing with the firm
before its dissolution.

Any partner may, upon the sale of goodwill of a firm, make an agreement with the buyer that
such partner will not carry on any business similar to that of the firm within a specified period
or within specified local limits. Such an agreement shall be void if the restrictions imposed are
unreasonable.
There is nothing special in treatment of goodwill on dissolution of a firm. On dissolution of a
firm:
 If goodwill appears in the Balance Sheet, it is treated like any other asset and is transferred
to realization account.

 If goodwill does not appear in the balance sheet, no entry is passed for this.

 If something is realized or Goodwill is purchased by any one of the partners, then either
Cash Account is debited or Partner’s Capital A/c is debited and Realization Account is
credited.

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Notes 9.2.4 Treatment of unrecorded Assets or Liabilities

Unrecorded assets and liabilities are those assets/liabilities that have been written-off form the
books of accounts but physically still exist in the operation. For example, there is an old typewriter,
which is still in working condition though its book value is zero. Similarly, there may be some
liabilities, which do not appear in the Balance Sheet, but actually they are still there. For example,
a bill discounted with bank, on dissolution it was dishonored and had to be taken up by the firm
for payment purposes.

The following journal entries will be passed to record such transactions:

1. For sale of unrecorded assets for cash:

Cash/Bank A/c Dr.

To Realization A/c
(sale of unrecorded assets)

2. For unrecorded assets taken over by the partner

If any unrecorded assets is taken over by partner/s, then:

Partner’s Capital A/c Dr.

To Realization A/c
(Unrecorded assets taken over by partner)

3. Payment of unrecorded liabilities in cash

If any unrecorded liabilities is paid off in cash:

Realization A/c Dr.

To Cash/Bank A/c
(payment of unrecorded liabilities)

4. Payment of unrecorded liabilities by the partner on behalf of the firm

If any unrecorded liabilities is paid off in cash:

Realization A/c Dr.

To Partner’s Capital A/c
(payment of unrecorded liabilities by partner on
behalf of the firm)

Example: X and Y are equal partners in a firm. They decided to dissolve the partnership
on December 31, 2006 when the balance sheet stood as under:

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Balance Sheet as on Dec 31, 2006 Notes

Liabilities Assets
Creditors 54,000 Cash at bank 22,000
Reserve for Dep. on Plant 20,000 Sundry debtors 24,000
Loan 80,000 Stock 84,000
Capital Account Furniture 50,000
Plants 94,000
X 1,20,000 Leasehold lands 1,20,000
Y 1,20,000 2,40,000

3,94,000 3,94,000

Assets were realised as follows:

Leasehold land 1,44,000

Furniture 45,000
Stock 81,000
Plant 96,000
Sundry debtors 21,000
The creditors were paid 51,000 in full settlement. Expenses of realisation amounted to 6,000.
Show the ledger accounts to record the dissolution measures.
Solution:
Books of X and Y

Particulars Particulars
To Sundry Assets: By Creditors 54,000
S Debtors 24,000 By Loan 80,000
Plants 94,000 By Bank
Stock 84,000 S Debtors 21,000
Leasehold land 1,20,000 Plants 96,000
Furniture 50,000 3,72,000 Stock 81,000
To Bank a/c Leasehold land 144,000
Creditors 51,000 Furniture 45,000 3,87,000
Loan 80,000
Realisation Exp. 6,000 1,37,000
To Profit on Realization:
X 6,000
Y 6,000 12,000

5,21,000 5,21,000

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Notes Partner’s Capital Account

Particulars X( ) Y ( ) Particulars X( ) Y( )
To Bank A/c 1,36,000 1,36,000 By Balance b/d 1,20,000 1,20,000
By Reserve fund 10,000 10,000
By Profit on realisation A/c 6,000 6,000
1,36,000 1,36,000 1,36,000 1,36,000

Bank Account

Particulars Particulars
To balance b/d 22,000 By Realization A/c 1,37,000
To Realization A/c 3,87,000 By X’s Capital A/c 1,36,000
By Y’s Capital A/c 1,36,000
4,09,000 4,09,000

Example: The following is the Balance Sheet of Ram and Gopal as on 31 st March, 2006.

Liabilities Assets
Creditors 38,000 Bank 11,500
Mrs. Ram’s Loan 10,000 Stock 6,000
Mrs. Gopal’s Loan 15,000 Debtors 19,000
Reserve 5,000 Furniture 4,000
Capital Plant 28,000
A 10,000 Investment 10,000
B 8,000 18,000 Profit and Loss A/c 7,500
86,000 86,000

The firm was dissolved on 31 st March, 2006 on the following terms:

1. A agreed to take the Investments at 8,000 and to pay off Mrs. Ram’s Loan.
2. Other Assets were realized as follows:

Stock 5,000

Debtors 18,500
Furniture 4,500
Plant 25,000

3. Expenses on realization amounted to 1,600.

4. Creditors agreed to accept 37,000.

The profits and losses were shared in the ratio of 2:1. You are required to prepare realization
A/c, Partner’s capital A/c and Bank A/c.

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Solution: Notes
Realization Account

Particulars Particulars
To Stock 6,000 By Creditors 38,000
To Debtors 19,000 By Mrs. Ram’s Loan 10,000
To Furniture 4,000 By Mrs. Gopal’s Loan 15,000
To Plant 28,000 By Ram’s Capital A/c 8,000
To Investment 10,000 (Investment)
To Ram’s Capital A/c By Bank
(Mrs. Ram’s Loan) 10,000 (Stock) 5,000
To Bank (Expenses) 1,600 (Debtors) 18,500
To Bank (Creditors) 37,000 (Furniture) 4,500
To Bank (Mrs. Gopal’s Loan) 15,000 (Plant) 25,000
By Loss on realization A/c 6,600
Ram’s Capital 4400
Gopal’s Capital 2200
1,30,600 1,30,600

Partner’s Capital Account

Particulars Ram Gopal Particulars Ram Gopal

( ) ( ) ( ) ( )
To Realization A/c 8,000 – By Balance b/d 10,000 8,000
To Profit & Loss A/c 5,000 2,500 By Mrs. Ram’s Loan A/c 10,000 –
To Loss on realization A/c 4,400 2,200 By Reserve A/c 3,333 1,667
To Bank A/c 5,933 4,967
23,333 9,667 23,333 9,667

Bank Account

Particulars Particulars
To balance b/d 11,500 By Creditors A/c 37,000
To Realization A/c 53,000 By Mrs. Gopal’s Loan 15,000
By Realization A/c (Cash Exp.) 1,600
By Ram’s Capital A/c 5,933
By Gopal’s Capital A/c 4,967
64,500 64,500

Task Take any practical example of a firm dissolution from the market and analyse it.

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Notes Self Assessment

Multiple Choice Questions:

7. Which account is debited at the time of dissolution of a firm when assets are transferred?

(a) Revaluation Account

(b) Realisation Account

(c) Profit and Loss Adjustment A/c

(d) None of the above.

8. When assets are realised who is paid first?

(a) Partners Capital A/c

(b) Partners Loan A/c

(c) Creditors

(d) Expenses relating to dissolution

9.3 Garner v/s Murray Rule Including Insolvency of Firm

In case one partner or more than one partners are insolvent and the remaining (solvent) are
required to compensate the loss (deficiency) of insolvent partner/s, the problem arises as how
to compensate that deficiency or in what ratio the solvent partners are required to compensate.

This deficiency is to be compensated in two ways: (1) This deficiency is to be shared by solvent
partners in their profit sharing ratio like other business losses, or (2) to be shared according to
Garner Vs. Murray rule. According to this rule, the loss is to be shared among the solvent
partners in the ratio of their opening capitals.

Examples illustrating the ruling in Garner v. Murray:

1. A, B and C were partners, sharing profits and losses equally, with capital contribution of
30,000, 15,000 and 3,000, respectively. On dissolution it is found that, after paying the
debts of the firm and advances made by the partners, the assets are 21,000. Thus, the
deficiency comes to 27,000 (i.e., total capital – assets), which is to be met by the partners
equally. Now the total assets available are 48,000. This amount will be distributed
rateably among the partners. However, in actual practice it will not be necessary for A and
B to pay 9,000 each in cash but notional adjustment may be made so that C, whose capital
contribution was only 3,000 will have to pay 6,000. Now the total assets available for
distribution between A and B would be 21,000 + 6,000 = 27,000,
A getting 21,000 and B 6,000.

2. Sometimes it so happens that one or more of the partners is insolvent and so cannot
contribute anything towards the deficiency. Thus, in the above case if C is insolvent and
nothing can be recovered from him, the assets will be distributed as follows: A and B will
bring in their share of deficiency, increasing the assets from 21,000 to 39,000. The total
assets would be distributed between A and B in their capital ratio, i.e., 2:1. A will get
26,000 and B 13,000. Thus, A on the whole will lose 13,000 and B 11,000. This
settlement of accounts is in accordance with the rule laid down in Garner v. Murray. From
the calculations it is obvious that the remaining partners are suffering loss in accordance
with the amount of capital contributed. Thus, A suffers more loss than B even though they
are sharing profits and losses equally.

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3. The principle enunciated above will also apply if C in the case mentioned in illustration Notes
above, though not insolvent, fails to contribute his share of the deficiency. Out of the total
amount of 21,000, A will get 17,000 and B 4,000. The court will pass a decree for
4,000 in favour of A against C and for 2,000 in favour of B against C.

Example: Long, Short and Thin were carrying on business in partnership sharing profits
and losses in the ratio of 3 : 2 : 1 respectively. They decided to dissolve the firm on 31st December,
2006 on which date their Balance Sheet stood as follows:

Liabilities Assets
Creditors 47,000 Land & Buildings 57,000
Long’s Loan A/c 10,000 Stock 50,000
Capital Accounts: Debtors 50,000
Long 90,000 Cash 3,000
Short 10,000 Profit & Loss A/c 1,500
Thin 10,000 1,10,000 Short’s Current A/c 2,000
Long’s Current A/c 1,500 Thin’s Current A/c 5,000
1,68,500 1,68,500

Land and Buildings were sold for 40,000 and Stock and Debtors realized 30,000 and
42,000 respectively. The Goodwill was sold for 600, the expenses of realization amounted to
1,200. Thin is insolvent and a final dividend of 50 paise a rupee is received from his estate in full
settlement.

Prepare the necessary accounts closing the books of the firm applying the ruling given in Garner
Vs. Murray.

Delhi B. Com. 2009 [Figure 10 times]

Solution:

Realization Account

Particulars Particulars
To Sundry Assets: By Sundry Creditors: 47,000
Land & Buildings 57,000 By Cash A/c
Stock 50,000 Sale of Land & Building 40,000
Debtors 50,000 Stock 30,000
To Cash (Expenses) 1,200 Debtors 42,000
To Cash (Sundry creditors) 47,000 Goodwill 600
By Loss on Realization:
Long 22,800
Short 15,200
Thin 7,600 45,600
2,05,200 2,05,200

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Notes Partner’s Capital Accounts

Particulars Long Short Thin Particulars Long Short Thin

( ) ( ) ( ) ( ) ( ) ( )
To Profit & Loss A/c 750 500 250 By Balance b/d 90,000 10,000 10,000
To Short’s Current - 2,000 - By Long’s Current A/c 1,500 - -
A/c - - 5,000 By Cash A/c - 7,842 1,425
To Thin’s Current A/c 22,800 15,200 7,600 By Long’s Capital A/c - - 1,283
To Loss on Realization 1,283 142 - By Short’s Capital A/c - - 142
To Thin’s Capital 66,667 - -
To Cash A/c
91,500 17,842 12,850 91,500 17,842 12,850

Cash Account

Particulars Particulars
To Balance 3,000 By Realization ( Expenses) 1,200
To Realization (Sale of assets) 1,12,600 By Sundry Creditors 47,000
To Shorts’ Capital 7,842 By Long’s Loan A/c 10,000
To Thin’s Capital 1,425 By Long’s Capital A/c 66,667
1,24,867 1,24,867

Example: The following is the Balance sheet of A, B and C on December 31, 2007:

Liabilities Assets
Creditors 20,000 Cash 6,000
Reserve Fund 15,000 Stock 20,000
A’s Capital 25,000 Plants & Tools 20,000
B’s Capital 15,000 Sundry Debtors 10,000
Bills Receivable 10,000
C’s Capital Overdrawn 9,000
75,000 75,000

C is insolvent but his estate pays 2,000. It is decided to wind up the partnership. The assets
realized as follows:

( )

Sundry Debtors 7,500

Bills Receivable 7,000

Stock 16,000

and Plant & Tools 14,000

The cost of winding up came to 2,500

Give accounts to close the books of the firm taking the capitals as fixed.

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Solution: Notes
Dissolution A/c

Particulars Particulars
To Stock 20,000 By Sundry Debtors 7,500
“ Plant & Tools 20,000 “ Bills Receivable 7,000
“ Sundry Debtors 10,000 “ Stock 16,000
“ Bills Receivables 10,000 “ Plant & Tools 14,000
“ Cash (cost of winding up) 2,500 “ Loss on Dissolution
A 6,000
B 6,000
C 6,000 18,000
62,500 62,500

Partner’s Current A/c

Particulars A B C Particulars A B C
( ) ( ) ( ) ( ) ( ) ( )

To Loss on Dissolution 6,000 6,000 6,000 By Reserve Fund 5,000 5,000 5,000
To C’s Capital A/c - - 9,000 By Cash A/c - - 2,000
To C’s Current A/c(1) 5,000 3,000 - By A’s Current A/c - - 5,000
By B’s Current A/c - - 3,000
By Cash A/c 6,000 4,000 -

11,000 9,000 15,000 11,000 9,000 15,000

Cash A/c

Particulars Particulars
To Balance b/d 6,000 By Expenses of winding up
To C’s Current A/c 2,000 By Creditors A/c 2,500
To A’s Current A/c 6,000 By A’s Capital A/c 20,000
To B’s Current A/c 4,000 By B’s Capital A/c 25,000
To Realization A/c 15,000
(Dissolution A/c)
Sundry Debtors A/c 7,500
Bills Receivable A/c 7,000
Stock A/c 16,000
Plants & Tools A/c 14,000
62,500 62,500

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Notes Self Assessment

Multiple Choice Questions:

9. If a partner is insane, partnership firm is dissolved, explain which is the mode of dissolution:

(a) Dissolution by Agreement

(b) Compulsory Dissolution

(c) Dissolution by Court

(d) Dissolution by Notice.

10. The Partnership firm is dissolved if number of its partners exceeds

(a) 5 (b) 10 (c) 20 (d) 50

11. The firm is dissolved if it deals is:

(a) Unlawful business

(b) Lawful business

(c) Lawful in the beginning but subsequently becomes illegal.

(d) None of the above.

9.4 Piecemeal Distribution

As we discussed in the previous section it was assumed that all the assets were realised on the
date of dissolution and accounts settled on the same date. However the process of realizing the
assets takes a long time and cash is distributed as and when it is realized. Such a process of
gradual distribution of money is known as “Piecemeal Distribution”.

The following are the key methods for distribution of cash under piecemeal distribution:

1. Proportionate Capital Method: If the capitals of the partners are in the ratio of their profit
sharing arrangement, then each of them is paid out according to his capital ratio at each
distribution. If the capitals of the partners are not in the profit sharing ratio then the first
cash available (after making payment of outside liabilities and loans due to the partners)
for distribution amongst the partners should be paid to those partners whose capitals are
more than their profit sharing ratio so as to bring their capitals to their profit sharing
levels. After this the cash available is distributed amongst all partners according to their
profit sharing ratio.

The unpaid balance of capital accounts will represent loss on realisation and this loss will
be exactly in their profit sharing ratio.

Example: A, B and C are partners having capital of 20,000; 10,000 and 5,000. The
profit sharing ratio of A, B and C is 2:2:1 respectively. Calculate the surplus capital.

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Solution: Notes

Statement Showing Surplus Capital

A B C

Profit sharing ratio 2 2 1

20,000 20,000 5,000
Actual Capital

Capital’s of partner’s on the basis of C’s

10,000 10,000 10,000
capital (C is having the least capital)

Surplus Capital 10,000 ------------ ---------

Note: After paying the surplus capital to A, the remaining capital should be distributed among
all the partners among their capital sharing ratio of 2 : 2 : 1.

2. Maximum Loss Method: An alternative method of piecemeal distribution amongst partner

is to calculate the maximum possible loss on every realisation after the outside liabilities
and the partners loan has been paid. The amount available for distribution amongst
partners is compared with the total amount of capital payable to the partners and the
maximum loss is ascertained on the assumption that in future assets will not realize any
amount. The maximum possible loss so ascertained is deducted from the capital balances
of the partners in their profit and loss sharing ratio and the balance left in the capital
account after deducting the maximum possible loss will be the amount payable to the
partner.

If a partner’s share of maximum possible loss is more than the amount standing to the
credit of his capital account, he should be treated as insolvent and his deficiency should be
debited to the capital accounts of the solvent partners in the proportion of their capitals
which stood on the dissolution date as stated under the Garner V/s. Murray Rule. The
amount standing to the credit of the partners after debiting their share of maximum loss
and their share of insolvent partners deficiency will be equal to the cash available for the
distribution amongst the partners.

This process of maximum possible loss is repeated on each realisation till all the assets are
disposed.

Example: The partners A, B and C have called you to assist them in winding up the affairs
of their partnership on 30th June, 2005. Their Balance Sheet as on that date is given below:

Liabilities Assets

Sundry Creditors 17,000 Cash at Bank 6,000

Capital Accounts: Sundry Debtors 22,000

A 67,000 Stock in trade 14,000

B 45,000 Plant and Equipment 99,000

C 31,500 1,43,500 Loan-A 12,000

Loan-B 7,500

1,60,500 1,60,500

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Notes (1) The partners share profit and losses in the ratio of 5 : 3 : 2.

(2) Cash is distributed to the partners at the end of each month.

(3) A summary of liquidation transactions are as follows:

July 2005

16,500 - collected from Debtors; balance is uncollectable.

10,000 - received from sale of entire stock.

1,000 - liquidation expenses paid.

8,000 - cash retained in the business at the end of the month.

August 2005

1,500 – liquidation expenses paid. As part payment of his Capital, C accepted apiece of
equipment for 10,000 (book value 4,000).

2,500 – cash retained in the business at the end of the month.

September 2005

75,000 – received on sale of remaining plant and equipment.

1,000 – liquidation expenses paid. No cash retained in the business.

Prepare a schedule of cash payments as of September 30, showing how the cash was distributed.

Solution:

Statement showing Distribution of Cash

Creditors Capitals

A( ) B( ) C( )

Balance Due 17,000 55,000 37,500 31,500

July

Balance available 6,000

Realisation less expenses

and cash retained 17,500

Amount available and paid 23,500 17,000 6,500

Balance due — 55,000 37,500 25,000

August

Opening balance 8,000

Expenses paid and balance

carried forward 4,000

Available for distribution 4,000

Cash paid to ‘B’ and

Equipment given to C. — 4,000 10,000

Contd...

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(Excess paid to ‘C’ 7,333) Notes

55,000 33,500 15,000

September

Opening balance 2,500

Amount realised less
expenses 74,000

Amount paid to partners 76,500 41,500 25,400 9,600

13,500 8,100 5,400

Working Note:
(i) Highest Relative Capital Basis

A B C

Scheme of payment for July

Balance of Capital Accounts 67,000 45,000 31,500
Less: Loans 12,000 7,500
55,000 37,500 31,500
Profit sharing ratio 5 3 2
Capital Profit sharing ratio 11,000 12,500 15,750
Capital in profit sharing ratio taking
A’s Capital as base 55,000 33,000 22,000

Excess of C’s Capital and B’s Capital 4,500 9,500

Excess of C’s Capital over B (9,500 – 3,000) 6,500
(ii) Scheme of distribution of available cash:
A B C
Scheme of payment for September

Balance of Capital Accounts 55,000 33,500 15,000

Profit Sharing Ratio 5 3 2

Capital/Profit sharing Ratio 11,000 11,167 7,500
Capital in profit sharing ratio taking

C’s Capital as base 37,500 22,500 15,000

Excess of A’s Capital and B’s Capital 17,500 11,000

Excess in Profit Sharing Ratio 3,500 3,667

Excess in profit sharing Ratio taking

A’s excess as base 17,500 10,500

Excess – 500 –

Payment 500 (500)

Contd...

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Notes Balance of Excess 17,500 10,500

Payment 28,000 (17,500) (10,500)

Balance 37,500 22,500 15,000

Payment ( 76,500 – 28,500) 48,000 (24,000) (14,400) (9,600)

Loss 13,500 8,100 5,400

Total Payment 76,500 41,500 25,400 9,600

Example: The following is the Balance Sheet of A, B, C on 31st December, 2005 when they
decided to dissolve the partnership:

Liabilities Assets

Creditors 2,000 Sundry Assets 48,500

A’s Loan 5,000 Cash 500

Capital Accounts :

A 15,000

B 18,000

C 9,000

49,000 49,000

The assets realised the following sums in installments:

I 1,000

II 3,000

III 3,900

IV 6,000

V 20,100

34,000

The expenses of realisation were expected to be 500 but ultimately amounted to 400 only.

Show how at each stage the cash received should be distributed between partners. They share
profits in the ratio of 2 : 2 : 1.

Solution:

First of all, the following table will be constructed to show the amounts available for distribution
among the various interests:
Statement showing Realisation and Distribution of Cash Payments
Realisation Creditors Partners’ Loan Partners’ Capitals

1. After taking into account 1,000 1,000 - -

cash balance and amount
set aside for expenses

2. 3,000 1,000 2,000 –

Contd...

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3. 3,900 - 3,000 900 Notes

4. 6,000 - - 6,000

5. Including saving
in expenses 20,100 - - 20,100

34,000 2,000 5,000 27,000

To ascertain the amount distributable out of each instalment realised among the partners, the
following table will be constructed:

Statement of Distribution on Capital Account

Total A B C

(1) Calculation to determine the

mode of distribution of 900

Balance 42,000 15,000 18,000 9,000

Less: Possible loss, should

remaining assets
prove to be worthless 41,100 16,440 16,440 8,220

+ 900 – 1,440 + 1,560 + 780

Deficiency of A’s capital

written off against those of
B and C in the ratio of their
capital, 18,000 : 9,000
(Garner vs. Murray) 960 480

Manner in which the first

900 should be distributed + 600 + 300

(2) Distribution of 6,000

Balance after making payment

of amount shown in step (1) 41,100 15,000 17,400 8,700

Less:

Possible Loss assuming

remaining asset to be valueless 35,100 14,040 14,040 7,020

Balance available and

to be distributed 6,000 960 3,360 1,680

(3) Distribution of 20,100

Balance after making

payment of amount
shown in step (2) 35,100 14,040 14,040 7,020

Less: Possible loss,

assuming remaining
assets to be valueless 15,000 6,000 6,000 3,000
Contd...

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Notes Manner of distribution

of 20,100 20,100 8,040 8,040 4,020

Summary:

Balance 42,000 15,000 18,000 9,000

Total amounts paid 27,000 9,000 12,000 6,000

Loss 15,000 6,000 6,000 3,000

Self Assessment

Fill in the blanks:

12. A process of gradual distribution of money is known as .............................

13. The unpaid balance of ............................. will represent loss on realisation and this loss will
be exactly in their profit sharing ratio.

14. The amount standing to the credit of the partners after debiting their share of
............................. and their share of insolvent partners deficiency will be equal to the cash
available for the distribution amongst the partners.

15. If a partner’s share of maximum possible loss is more than the amount standing to the
credit of his capital account, he should be treated as .............................

9.5 Summary
 The dissolution of a firm implies the discontinuance of the partnership business and
separation of economic relation between the partners.
 In the case of a dissolution of a firm, the firm closes its business altogether and realizes all
its assets and settles all liabilities.
 The payment is made to the creditors, first out of profits and assets realized, next out of the
contributions made by the partners in their profit sharing ratio.
 When the final payment is made to the partners for their due share, the books of the firm
are closed.
 The Realization Account is prepared to record the transactions relating to sale and
realization of assets and settlement of creditors.
 Any profit or loss arising out of this process is shared by the partners in their profit
sharing ratio.
 Partners are paid off in the final settlement, if any sum is due to them. At the end Cash/
Bank Account is closed by making payment to partners.
 The process of realizing the assets takes a long time and cash is distributed as and when it
is realized.
 Such a process of gradual distribution of money is known as “Piecemeal Distribution”.
 If the capitals of the partners are in the ratio of their profit sharing arrangement, then each
of them is paid out according to his capital ratio at each distribution.
 Maximum Loss Method is an alternative method of piecemeal distribution amongst partner
is to calculate the maximum possible loss on every realisation after the outside liabilities
and the partners loan has been paid.

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9.6 Keywords Notes

Dissolution: Dissolution means the undoing or breaking of a bond tie.

Realization A/c: The account in which all the assets and liabilities of the dissolved firm are
transferred.
Revaluation A/c: Revaluation account is prepared when the firm is constituted.

9.7 Review Questions

1. Dissolution of partnership does not demand dissolution of the firm but dissolution of the
firm means the dissolution of partnership. Discuss.
2. A, B, C and D are partners sharing 4 : 3 : 2 : 1. Their position statement was as follows:

Liabilities Assets
Bank Loan 20,000 Cash 1,500
Creditors 40,000 Building 44,000
A’s Capital 30,000 Stock 60,000
B’s Capital 20,000 C’s Capital 3,500
D’s Capital 1,000
1,10,000 1,10,000

The firm is dissolved. All assets realized 82,000. All outside liabilities paid
58,500 in full satisfaction. Outstanding creditors are also paid 500. The expenses of
dissolution are 600. D becomes insolvent and C paid only 3,000. Prepare ledger accounts
to close the books of the firm.

3. D, E and F were partners. Their profit sharing ratio was 3 : 2 : 1. They dissolved their firm.
The Balance Sheet on that date was as follows:

Liabilities Assets
D’s Capital 34,000 Plant 30,000
E’s Capital 23,000 Machine 13,850
F’s Capital 1,500 Stock and Debtors 25,200
E’s Loan 1,000 Cash 6,550
Bills Payable 7,550
Profit & Loss Account 8,550
75,600 75,600

Assets were sold for 50,100. Realization expenses were 300. F became insolvent and
only 512 were received from him.

Prepare necessary ledger accounts following the rule of Garner vs. Murray’s Case.

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Notes 4. A, B and C sharing profit as 6:2:2 decided to dissolve their firm on 31-12-2007 when their
position was as follows:

Liabilities Assets

Capital:
A 8,250 Sundry 5,100
B 3,000 Stock 2,340
C 2,100 13,350 Furniture 300
Sundry creditors 1,800 Debtors 7,260
Loan 450 Less provision for doubtful debts 360 6,900

Cash in hand 960

15,600 15,600

It was agreed that:

(i) A is to take furniture at 240 debtors amounting to 6,000 at 5,160 and also the
creditors at their book value.
(ii) B agreed to take over stock at 2,100 and a part of the sundry assets at 2,160 (being
book value less 10%).
(iii) C agreed to take remaining sundry assets at 90% if their book value less 30 as
allowance. He also assumed the responsibility for the payment of loan together
with accrued interest of 9 (not recorded in the books).
(iv) Dissolution expenses amounted to 181.
(v) The remaining debtors were sold to a Debt collecting Agency at 50% of the book
value. Close the books of the firm with the help of ledger account.

5. P, Q and R Were partners in a firm sharing profits in the ratio of 1 : 2 : 2. Their Balance Sheet
on 31st December 2006 was as follows:
Balance Sheet of P, Q and R
as on 31st December 2006

Liabilities Amount Assets Amount

( ) ( )
Accounts payable A/c 15,000 Land & building A/c 47,000
Bank overdraft A/c 12,000 Office equipment A/c 8,000
Q’s loan A/c 18,000 Stock A/c 56,000
Joint life insurance Accounts receivable A/c 18,000
Policy reserve 15,000 Joint life insurance policy A/c 15,000
Capitals: Bank A/c 16,000
P 20,000
Q 40,000
R 40,000 1,00,000
1,60,000 1,60,000

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Partners agreed to dissolve the firm on that date. You are given the following information Notes
about dissolution

(i) The Joint Life Insurance Policy was surrendered for 9,000

(ii) Office equipments was accepted by a creditor for 7,000 in full settlement. The
remaining creditors were paid in full by cheques.

(iii) Assets realized as follows:

Land and Buildings 1,20,000

Stock 40,000

Accounts Receivable 15,000

(iv) Other liabilities were paid in full.

(v) Dissolution expenses amounted to 3,000

You are required to prepare realization account, bank account and capital of the partners.

6. The following Balance Sheet of A, B, C and D as on 31.3.2006 is presented to you.

Liabilities Assets
Creditors 20,000 Sundry Assets 30,000
B’s Loan 5,000 Cash at Bank 1,000
Capitals P & L A/c 15,000
A’s 10,000 Drawings:
B’s 6,000 B 2,000
C’s 6,000 C 2,000
D’s 3,000
50,000 50,000

They shared profits and losses in the ratio of 2 : 3 : 3 : 2 respectively. The position of
partners on the date of dissolution was as follows:

Particulars Private Estate Private Liabilities

A 10,000 15,000
B 20,000 6,000
C 5,000 4,000
D 8,000 9,000

The assets realized 26,000 and expenses of dissolution came to 1,000.

Prepare ledger accounts giving effect to the dissolution.

7. Explain Garner vs. Murray rule.

8. Write a short note on accounting treatment of goodwill.

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Notes 9. A, B & C sharing profits and losses in the proportion of 3:2:1. Their Balance Sheet was as
follows:

Liabilities Amount Assets Amount

Creditors 50,000 Land and Buildings 70,000
A’s Loan A/c 10,000 Plant & Machinery 40,000
A’s Capital A/c 50,000 Stock 25,000
B’s Capital A/c 10,000 Debtors 20,000
C’s Capital A/c 40,000 Cash 5,000
Total 1,60,000 1,60,000

The partnership is dissolved & the Assets are realized as follows

1st Realisation 40000

2nd Realisation 30000
3rd Realisation 54000
4th Realisation 7000

Prepare a statement showing how the distribution should be made by using proportionate
capital method

10. M, N & O were partners in a firm sharing profits and losses in the ratio of 2:1:1 respectively
on the date of dissolution their balance sheet was as follows:

Liabilities Amount Assets Amount

Creditors 28,000 Sundry Assets 80,000
L’s Capital A/c 20,000
M’s Capital A/c 20,000
O’s Capital A/c 12,000
Total 80,000 80,000
,
The assets realized 68,000 & it was received in installments of 28,000, 20,000 & 20,000.
Prepare a statement showing distribution of cash by using proportionate capital method.

Answers: Self Assessment

1. firm 2. revaluation

3. firm 4. compulsory dissolution

5. Partnership 6. Partnership

7. Realisation Account 8. Expenses relating to dissolution

9. Dissolution by Court 10. 20

11. Unlawful business 12. “Piecemeal Distribution”

13. capital accounts 14. maximum loss

15. insolvent

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9.8 Further Readings Notes

Books I.M. Pandey, Financial Management, Vikas Publishing, New Delhi

Khan and Jain, Management Accounting.

Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi

Prasanna Chandra, Financial Management - Theory and Practice, Tata McGraw Hill,
New Delhi (1994)

R.L. Gupta and Radhaswamy, Advanced Accountancy

S. Bhat, Financial Management, Excel Books, New Delhi

S.N. Maheswari, Management Accounting

V.K. Goyal, Financial Accounting, Excel Books, New Delhi

Online link www.futureaccountant.com

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Notes Unit 10: Departmental Accounts

CONTENTS

Objectives

Introduction

10.1 Basics for Preparing Inter-department Accounts

10.2 Allocation of Expenses between Different Departments

10.3 Types of Departments

10.4 Inter-departmental Transfer at Cost and Invoice Price

10.4.1 Transfer of Goods at Cost price

10.4.2 Transfer of Goods at Invoice Price

10.5 Summary

10.6 Keywords

10.7 Review Questions

10.8 Further Readings

Objectives

After studying this unit, you will be able to:

 Prepare departmental accounting

 Record interdepartmental transfer at cost and invoice price

Introduction

There may be a number of departments in a business organisation dealing in a different type of

goods. For example, one department may be dealing in medicines, the other may be dealing in
textiles, still another may be dealing in provisions, etc. To ascertain the profitability of each
department it will be advisable to prepare separately Trading and Profit & Loss Account of each
Department at the end of the accounting year. The following are the key advantages of preparing
the departmental accounts:

 Departmental accounts are helpful to compare the performance of one Department with
that of another.

 It helps the business in formulating proper policies relating to the expansion of the business.
New profitable lines of production of trading can be taken up while the existing lines of
production or trading which are giving a loss can be closed down.

 It helps in appropriate rewarding or penalizing the Department employees on the basis of

the results shown by them.

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10.1 Basics for Preparing Inter-department Accounts Notes

The preparation of Departmental Trading and Profit & Loss Account requires maintenance of
proper subsidiary books having appropriate columns for different departments. This may be
done by having columnar subsidiary books and a columnar ledger. Alternatively, a separate set
of books may be kept for each department, including complete stock accounts of goods received
from or transferred to other departments or as also sales.

For example, if a business has three departments A, B & C, the subsidiary books such as Purchases
Book, Purchases Returns Book, Sales Book, Sales Returns Books, etc., should have separate
columns for each of the departments. Cash Book may also have columns for recording cash sales
of each of the departments separately in case the volume of cash sales is quite large.

Notes

Date Particulars L.F Dep.A Dep.B Dep.C Date Particulars L.F Dep.A Dep.B Dep.C

Self Assessment

Fill in the blanks:

1. ................. are helpful to compare the performance of one Department with that of another.

2. The preparation of Departmental Trading and Profit & Loss Account requires maintenance
of proper .................

3. A separate set of books may be kept for each department, including complete stock accounts
of goods received from or transferred to other ................. or as also sales.

10.2 Allocation of Expenses between Different Departments

In order to compute the profit or loss made by each department, it is necessary that each
department is charged with a proper share of the various business expenses. The following basis
may be adopted for departmentalization of such expenses:

1. Expenses incurred specially for a particular department are charged directly to the concerned
department.

For example, salary paid to each of the department manager.

2. Common expenses, which are charged as a whole should be distributed among the
departments on some equitable basis.

For example, Rent is charged to different departments according to the floor area occupied
by each department, having regard to any favourable location specially allocated to a
department. Lighting and heating expenses are distributed on the basis of consumption of
energy by each department and so on.

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Notes 3. Expenses which are not easy to measure separately should be categorised on the basis of
sales;

For example, selling expenses like discount, bad debts, selling commission, etc. are charged
on the basis of sales; Administrative and other expenses, e.g., salaries of managers, directors,
common advertisement expenses, depreciation on assets, etc. are allocated equally among
all the departments that have benefited thereby.

Notes Common Basis for Allocation of Expenses

Expenditure Basis of Allocation

1. Selling Commission Sales 1. Sales
2. Bad Debts Sales 2. sales
3. Carriage Outwards 3. Sales
4. Rent and Rates 4. Floor Area Covered
5. Building Insurance 5. Floor Area Covered
6. Building Repairs 6. Floor Area Covered
7. Lighting 7. Number of Lighting Points or Floor Area Covered
8. Depreciation 8. Value of Assets or wages
9. Power 9. Horse power of Machinery Installed
10. Insurance 10. Average Stock, Value of Assets
11. Workmen's 11. Wages
Compensation
12. Labour Welfare Expenses 12. Number of Employees
13. Advertising 13. Sales or Space Allocated to each Department

Self Assessment

Fill in the blanks:

4. Common expenses, which are charged as a whole should be distributed among the
departments on some ................. basis.

5. Expenses which are not easy to measure separately should be categorised on the basis of
.................

6. Depreciation should be charged on the basis of value of Assets or .................

7. Building Insurance should be charged on .................

8. Labour Welfare Expenses should be charged on the basis of .................

10.3 Types of Departments

There are two types of departments:

 Dependant Departments

 Independent Departments

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1. Dependant Departments: Dependent departments are those departments where the output Notes
of one department becomes the input for another department. Dependant departments
transfer goods from one department to another department for further processing. These
transfers may be done at cost or some pre-decided selling price.

Did u know? What is Transfer Price?

The price at which interdepartmental transfer is recorded which may be the cost or cost
plus the margin of profit is known as transfer price.

2. Independent Department: Independent departments are the departments which work

independently of each other and have negligible inter department transfer.

Notes Advantages of Departmental Accounting

The main advantages of departmental accounting are as follows:

 Departmental accounting is helpful in measuring the performance of individual

departments.

 The performance and growth potential of a department as compared to others can

be evaluated.

 It helps the management to determine the justification of capital outlay in each

department.

 Departmental accounting helps to calculate stock turnover ratio of each department

separately, and thus the efficiency of each department can be revealed.

Self Assessment

Fill in the blanks:

9. Dependent departments are those departments where the output of one department
becomes the ....................... for another department.

10. The price at which interdepartmental transfer is recorded which may be the cost or cost
plus the margin of profit is known as .......................

11. ....................... departments are the departments which work independently of each other
and have negligible inter department transfer.

12. Departmental accounting helps to calculate ....................... ratio of each department

separately, and thus the efficiency of each department can be revealed.

10.4 Inter-departmental Transfer at Cost and Invoice Price

In case of dependant departments the product of one department may be used as a raw material
in another department. For example, a firm may have two departments, cloth and ready-made
garments. The garments are made out of the cloth supplied by cloth department. Such supply of
cloth is called interdepartmental transfer. The accounting entry in such cases involves debiting
the department which receives goods or services, and crediting the department which supplies
them.

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Notes The interdepartmental transfer of goods or services may be done either:

(a) Cost Price

(b) Invoice Price

10.4.1 Transfer of Goods at Cost price

When goods or services are supplied from one department to another at cost price, the
corresponding entries to record the transfer will be made at cost price. This does not involve any
adjustment at any stage.

Example: From the following Trial Balance of Ram and Shyam, prepare Departmental
Trading and Profit and Loss Account for the year ending 31st March, 1998 and the Balance Sheet
as at that date:
in 000
Stock (1st April, 1997)
Department X 3400
Department Y 2900
Purchases
Department X 7,180
Department Y 6,040
Sales
Department X 13,160
Department Y 10,250
Wages
Department X 1640
Department Y 540
Rent, Rates & taxes 1878
Sundry Expenses 720
Salaries 600
Lighting & Heating 420
Discount Allowed 444
Discount Received 130
Advertising 736
Carriage Inwards 468
Furniture & Fittings 600
Machinery 4200
Sundry Debtors 1212
Sundry Creditors 3720
Capital 9532
Drawings 900
Cash at Bank 2014

The following additional information is available:

1. Inter-transfer of goods from X to Y department 84,000.

2. Rent, rates and taxes, sundry expenses, lighting and heating, Salaries and carriage are to be
apportioned in the ration of 2 : 3 between department X and Department Y.

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3. Discount allowed and received are to be apportioned on the basis of departmental sales Notes
and purchases (excluding transfers)

4. Depreciation at 10% per annum on Furniture and Fittings and on Machinery is to charged
in the ration of 3:1 between the department X and Y.

5. Services rendered by department Y to department X are included in wages as 1,00,000.

6. Stock on 31st March, 1998 in X Department was worth 33,48, 000 and in Y Department
24,111,000.

Solution:

Particulars Dep. Dep. Y Particulars Dep. Dep. Y

X( ) ( ) X( ) ( )
To Opening Stock 3,400 2,900 By sales 12,160 10,250
To Purchases 7,080 6,040 By transfer of goods 84 100
To wages 1,640 540 By closing stock 3,348 2,410
To transfer of goods 100 84
To carriage Inward 312 156
To gross profit c/d 3,060
3,040
15,592 12,760 15,592 12,760

To salary 400 200 By gross profit b/d 3,060 3,040

To rent, rates and taxes 1,252 626 By discount received 70 60
To sundry expenses 480 240 By Net loss 252 __
To lighting and heating 280 140
To advertising 368 368
To Depreciation:
On Machinery 315 105
On Furniture 45 15
To Discount allowed 242 202
To net profit __ 1,204

3,382 3,100 3,382 3,100

Balance Sheet
as on 31st March 1998
( 000)
Liabilities Amount Assets Amount
( ) ( )
Capital 9,532 Machinery 4,200
Add: Profit Less: Dep. 420 3,780
952
Less: 10,484 Furniture and fittings
Drawings Less: Dep. 600
Sundry 900 9,584 Stock in trade 60 540
Creditors Sundry debtors 5,758
3,720 Cash at bank 1,212
2,014
13,304 13,304

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Notes 10.4.2 Transfer of Goods at Invoice Price

When goods or services are supplied to another department at invoice price, the transfer has to
be recorded at a invoice (selling) price is called transfer price. This obviously includes cost as
well as profit, In such a situation, if the department to whom goods or services are transferred at
selling price has an unsold on unused stock at the end of the accounting period, this involves an
element of unrealised profit. This needs an adjustment which will be made by creating a stock
reserve with the help of the following journal entry:

General Profit & Loss A/c Dr.

To Stock Reserve

It may be noted that the unrealised profit is equal to the amount of difference between the
selling price and the cost price of the unsold/unused stock.

Example: A firm has two departments, cloth and ready-made garments. The garments
were made by the firm itself out of cloth supplied by the cloth department at its selling price.
From the following figures prepare Departmental Trading and Profit & Loss Account for the
year 1997.

Cloth Ready-made
Department Garments
( ) ( )
Opening Stock on 1.1.1997 6,00,000 1,00,000
Purchases 40,00,000 30,000
Sales 44,00,000 9,00,000
Transfer to Ready-made Garments Department 6,00,000 -
Expenses - Manufacturing - 1,20,000
- Selling 40,000 12,000
Stock on 31.12.1997 4,00,000 1,20,000

The stock in the ready-made garments department may be considered as consisting of 75% cloth
and 25% other expenses. The cloth department earns profit at the rate of 15% in 1996. General
expenses of business as a whole came to 2,20,000.

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Solution Notes

Departmental Trading and Profit and Loss A/c

for the year ending Dec 31, 1997

Cloth Ready- Total Cloth Ready- Total

( ) made ( ) made
Garments Garments
( ) ( )

To Opening Stock 6,00,000 1,00,000 7,00,000 By Sales 44,00,000 9,00,000 53,00,000

To Purchases 40,00,000 30,000 40,30,000 By Transfer to
Ready-made
Garments Dept. 6,00,000 6,00,000
To Transfer from By Closing Stock 4,00,000 1,20,000 5,20,000
Cloth Dept. 6,00,000 6,00,000
To Mfg. Exp. 1,20,000 1,20,000
To Gross Profit c/d 8,00,000 1,70,000 9,70,000
54,00,000 10,20,000 64,20,000 54,00,000 10,20,000 64,20,000
To Selling Exp. 40,000 12,000 52,000 By Gross Profit b/d 8,00,000 1,70,000 9,70,000
To Net Profit c/d 7,60,000 1,58,000 9,18,000
8,00,000 1,70,000 9,70,000 8,00,000 1,70,000 9,70,000
To Gen. Exp. 2,20,000 By Net Profit b/d 9,18,000
To Stock Reserve 14,400 By Stock Reserve 11,250
(cl. stock) (op. stock)
To Net Profit 6,94,850
9,29,250 9,29,250

Note: Stock Reserve has been calculated as follows:

Rate of Gross Profit on Sales in Cloth Debt.

8,00,000
 100  16%
50,00,000

Element of cloth in closing stock of Garments

75% of 1,20,000 = 90,000

16
Unrealised Profit =  90,000 = 14,400
100

Unrealised Profit in opening stock of Garments

15 75
  1,00,000  11, 250
100 100

Example: The following figures relate to the business of Singla Associates for the year
ended 31st December, 2007:
Department
X( ) Y( )
Stock (lst Jan, 2007) 80,000 --
Purchases from outside 4,00,000 40,000
Contd...

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Notes Wages 20,000 2,000

Transfer of Goods from Dept. X -- 1,00,000
Stock at Cost (31st December, 2007) 60,000 20,000
Sales 4,00,000 1,42,000

Y’s entire stock represents goods from Department X which transfers them at 25% above the
cost, Administrative and Selling Expenses mount to 30,000 which are to be allocated between
Departments X and Y in the ratio of 4 : 1 respectively.
Prepare Departmental ‘Trading and Profit and Loss Account’ and a Combined Income Account
of the business for the year ended 31st December, 2007.

Solution:
Departmental Trading and Profit and Loss A/c
for the year ending Dec 31st 2007

Particulars X( ) Y( ) Particulars X( ) Y( )
TO Opening Stock 80,000 ------ By Transfer of
To Purchases 4,00,000 40,000 Goods to Y 1,00,000 ------
To Wages 20,000 2,000 By Sales 4,00,000 1,42,000
TO Goods from X ------ 1,00,000 By Closing Stock 60,000 20,000
To Gross Profit c/d 60,000 20,000

5,60,000 1,62,000 5,60,000 1,62,000

To Adm. & Selling 24,000 6,000 By Gross profit b/d 60,000 20,000
Expenses
* To Net Profit 36,000 14,000
60,000 20,000 60,000 20,000

Profit and Loss A/c

for the year ending Dec 31, 2007
Dr. Cr.

Particulars Particulars
To Stack Reserve 4,000 By Net Profit as per
To Net Profit 46,000 Dept. Trading and profit and
(to Capital A/c) loss A/c
X Dept. 36,000
Y Dept. 14,000
50,000 50,000

Notes The stock Reserve relates to the unrealised profit on unsold stock of 20,000
with Department Y out of the goods supplied by X. The amount has been calculated as
25
under: 20000   4000
125

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Notes

Task Department A transferred 4,000 units of material X at 10 per unit to Department

B, The actual cost of materials of Department A is 8 per unit: Find out the Stock Reserve
on 1,000 units of material X which could not be consumed by Department B during the
year.

Self Assessment

Fill in the blanks:

13. When goods or services are supplied from one department to another at cost price, the
corresponding entries to record the transfer will be made at ..................
14. If the department to whom goods or services are transferred at selling price has an unsold
on unused stock at the end of the accounting period, this involves an element of ..................

15. The unrealised profit is equal to the amount of difference between the selling price and the
cost price of the ..................

10.5 Summary

 There may be a number of departments in a business organisation dealing in a different

type of goods.

 To ascertain the profitability of each department it will be advisable to prepare separately

Trading and Profit & Loss Account of each Department at the end of the accounting year.

 The preparation of Departmental Trading and Profit & Loss Account requires maintenance
of proper subsidiary books having appropriate columns for different departments.

 In order to compute the profit or loss made by each department, it is necessary that each
department is charged with a proper share of the various business expenses.

 Expenses incurred specially for a particular department are charged directly to the concerned
department.

 Common expenses, which are charged as a whole should be distributed among the
departments on some equitable basis.

 Expenses which are not easy to measure separately should be categorised on the basis of
sales.

 Dependent departments are those departments where the output of one department
becomes the input for another department.

 Independent departments are the departments which work independently of each other
and have negligible inter department transfer.

 When goods or services are supplied from one department to another at cost price, the
corresponding entries to record the transfer will be made at cost price.

 When goods or services are supplied to another department at invoice (selling) price, the
transfer has to be recorded at a selling price called transfer price.

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Notes 10.6 Keywords

Allocation: Apportionment of expenses between the different departments on some rational

basis.

Interdepartmental Transfers: Transfer of business and services by one department to another

department.

Transfer Price: The price at which interdepartmental transfer is recorded which may be the cost
or cost plus the margin of profit is known as transfer price.

10.7 Review Questions

1. What do you mean by departmental accounts? Why are they considered necessary?
2. Discuss the basis for allocation of common expenses among different departments.
3. Prepare the proforma of departmental subsidiary books.
4. Illustrate the accounting treatment of interdepartmental transfer of goods.
5. What is unrealised profit? How it is worked out and accounted for?
6. Alpha Ltd., has a factory with two manufacturing departments ‘X’ and ‘Y’. Part of the
output of department X is transferred to department Y for further processing and the
balance is directly transferred to selling department. The entire production of department
Y is directly transferred to the selling department. Interdepartmental stock transfers are
made as follows:
X department to Y department at 33-1/3% over departmental cost.
X department to selling department at 50% over departmental cost.
Y department to selling department at 25% over departmental cost.
The following information is given for the year ending 31 st March 2011.

Department X Department Y Selling

Department
Units Units Units
Opening stock
Finished Goods 60 60,000 20 40,000 50 1,28,000
Raw materials - - - - - -
Raw materials consumed - 1,82,000 - 20,000 - -
Labour charges - 70,000 - 32,000 - -
Sales - - - - 120 4,80,000
Closing stock
Finished Goods 40 - 50 - 60 -

Out of the total transfer by X department 30 units were transferred to selling department,
while the remaining to department Y. Per unit material and labour consumption of X
department on production to be transferred directly to the selling department is 300 per
cent of the labour and material consumption on units transferred to Y department. General
Administration expenses are 1,80,000.

Prepare Departmental Profit and Loss Account and General Profit and Loss Account.

7. Illustrate the transfer of goods at invoice with a suitable example.

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Answers: Self Assessment Notes

1. Departmental accounts 2. Subsidiary books

3. Departments 4. Equitable

5. Sales 6. Wages

7. Floor area covered 8. Number of employees

9. Input 10. Transfer price

11. Independent 12. Stock turnover

13. Cost price 14. Unrealised profit

15. Unsold/unused stock

10.8 Further Readings

Books I.M. Pandey, Financial Management, Vikas Publishing, New Delhi.

Khan and Jain, Management Accounting.

Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.

Prasanna Chandra, Financial Management - Theory and Practice, Tata McGraw Hill,
New Delhi (1994).

R.L. Gupta and Radhaswamy, Advanced Accountancy.

S. Bhat, Financial Management, Excel Books, New Delhi.

S.N. Maheswari, Management Accounting.

V.K. Goyal, Financial Accounting, Excel Books, New Delhi.

Online link www.futureaccountant.com

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Notes Unit 11: Branch Accounting

CONTENTS

Objectives

Introduction

11.1 Types of Branches

11.2 Preparation of Books of Accounts

11.3 Debtor System

11.4 Stock and Debtors System

11.5 Final Accounts System

11.6 Wholesale Branch System

11.7 Summary

11.8 Keywords

11.9 Review Questions

11.10 Further Readings

Objectives

After studying this unit, you will be able to:

 Describe the importance of branch accounts

 Know the types of branches

 Prepare the books of accounts

Introduction

A branch means any subordinate subdivision of a business. As per the sec 29 of Companies Act,
1956, a branch is any establishment carrying on either the same or substantially the same
activity as that carried on by the head office of the company. For example Bata has its branches
all over the country. Each branch is treated as a separate profit centre and hence the profit or loss
of each branch is computed separately. The head office of the firm has to keep strict control over
various activities of each branch and ensure its smooth functioning.

11.1 Types of Branches

The branches can be divided into the following categories:

 Dependent Branches

 Independent Branches

 Foreign Branches

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1. Dependent Branches: Dependent branches are those branches which are not keeping the Notes
full system of accounting. The following are the key features of branch accounting:

 The dependent branches are not allowed to make any purchases and they sell goods
received form the head office.

 Goods are supplied by the head office to such branches either at cost price or at
invoice price.

 All the major expenses are paid by the head office.

 Normally the goods are sold for both the cash and credit.

2. Independent Branches: Independent branches are those branches which are keeping the
full system of accounting. They are allowed to purchase goods from the open market and
also supply to the head office, if necessary. They can pay their expenses from the cash
realised and can have the bank account on their own name.

3. Foreign Branches: When a branch is located out of the home country, it is called foreign
branch. Foreign branches keep their accounts in the foreign currency.

In this unit we will discuss about the accounting treatment of dependent branches.

Self Assessment

Fill in the blanks:

1. As per the .................. of Companies Act, 1956, a branch is any establishment carrying on
either the same or substantially the same activity as that carried on by the head office of
the company.

2. Each branch is treated as a separate .................. and hence the profit or loss of each branch
is computed separately.

3. .................. branches are those branches which are not keeping the full system of accounting.

4. .................. branches are those branches which are keeping the full system of accounting.

5. Foreign branches keep their accounts in the ..................

11.2 Preparation of Books of Accounts

As we discussed earlier dependent branches do not keep a complete set of books. The head office
is responsible to keep the books of accounts for dependent branches. The following are the key
methods which are adopted by head office to keep the branch accounts:

1. Debtors System: This system of accounting is used for those branches which are small in
size. Under this system, the head office simply opens a Branch Account for each branch in
which it records all transactions relating to the branch.

2. Stock and Debtor System: Under this system, the head office does not open any Branch
Account. Under this system, the following ledger accounts are opened:

 Branch Stock Account

 Branch Debtors Account

 Branch Expenses Account

 Branch Adjustment Account

 Branch Profit and Loss Account

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Notes

Notes Purpose of Preparing Branch Accounts

 To find out the profit or loss of each branch.

 To know the financial position of each branch.

 To make estimation of cash and stock for each branch.

 To know the performance of each branch.

 To make business expansion strategies.

 To fulfill the statutory requirements.

3. Final Accounts System: Under this system, the head office prepares Trading and Profit and
Loss Account 'in order to find out profit or loss of each branch and a Branch Account to find
out the amount due to, or due from, that branch, In this case, the Branch. Account simply
acts as a personal account.

4. Whole Sale Branch System: Manufacturers may sell goods to the consumers either through
the wholesalers and approved stock brokers or through their branches. In order to know
whether self-retailing through branch is more profitable than wholesaling, it is necessary
to make distinction between profit due to wholesale and profit due to retail business of
the branch. Wholesale price is always less than retail price.

Self Assessment

State whether the following statements are true or false:

6. The head office is not responsible to keep the books of accounts for dependent branches.

7. Stock and debtor system of accounting is used for those branches which are small in size.

8. Under debtor system, the head office simply opens a Branch Account for each branch in
which it records all transactions relating to the branch.

11.3 Debtor System

As stated earlier under this system the head office simply opens a branch account which records
all the transactions relating to a particular branch. Branches are also not required to ascertain
profit or loss as no information relating to the cost of sales is given to them. Under debtor
system the goods may be invoiced to branch at cost or invoice price.

1. In Case of Goods are sent at cost price

In case of goods are sent at cost the following journal entries are passed in the books of
head office:

(a) When Goods are sent to Branch

S. No Particulars L.F.
Branch A/c Dr.
To Goods Sent to Branch A/c
(Goods sent to branch)

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(b) Cash sent to Branch Notes

S. No Particulars L.F.
Branch A/c Dr.
To Cash A/c

(Cash sent to branch)

(c) When goods are returned to head office by branch

S. No Particulars L.F.
Goods Sent to Branch A/c Dr.
To Branch A/c

(Goods returned by branch)

(d) When amount received from branch

S. No Particulars L.F.
Cash/bank A/c Dr.
To Branch A/c
(Cash received from branch)

(e) For closing goods sent to branch A/c

S. No Particulars L.F.
Goods sent to branch A/c Dr.
To Purchases A/c
(balance stock transferred to purchase/trading A/c)

(f) For transferring profit/loss to Profit and loss A/c

(i) In case of profit

S. No Particulars L.F.
Branch A/c Dr.
To Profit and Loss A/c
(balance stock transferred to purchase/trading A/c)

(ii) In case of loss

S. No Particulars L.F.
Profit and Loss A/c Dr.
To Branch A/c
(balance stock transferred to purchase/trading A/c)

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Notes

Notes

Proforma of Branch A/c

Particular Amount Particular Amount

( ) ( )
To Opening Balance By opening balances
Stock O. S. expenses
Debtors Creditors
Petty Cash By bank A/c
Furniture Cash sales
Prepaid expenses Collections from debtors
To goods sent to branch A/c By goods sent to branch A/c
To Bank A/c (for expenses) (for goods returned by branch)
To closing balances By closing balances
O. S. expenses Stock
Creditors Debtors
To profit transferred to profit Petty Cash
and loss A/c Furniture (less depreciation)
Prepaid expenses
By loss transferred to profit
and loss A/c

Example: The GM Ltd. Delhi has a sales branch in Karnal. From the following figures,
prepare Karnal Branch Account and also ascertain the profit or loss of the branch.

Goods sent to branch 50,000

Cash sent to branch for expense 3,500
Cash received from the branch 52,000

Stock at branch on 31st December 5,500

Petty cash in hand at branch 500

Solution:

In the books of Head Office

Karnal Branch Account

Particulars Particulars
To Goods Sent to Branch A/c 50,000 By Cash 52,000
To bank A/c 3500 By Stock at Branch A/c 5,500
To Profit transferred to P & L A/c 4,500 By Cash at Branch A/c 500

58,000 58,000

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2. In case of Goods are sent at Invoice Price Notes

When goods are sent at invoice price (which is higher than the cost price) it is necessary to
make adjustment for the amount of difference between the cost price and invoice price.

Did u know? What is loading?

Loading is the difference between the invoice price and cost price.

The following additional journal entries are passed in the books of head office:

(a) For adjustment of loading in opening stock

S. No. Particulars L.F.

Adjustment for Goods Sent to Branches A/c Dr.
Or
Stock Reserve A/c
To Branch Account
Adjustment for difference between invoice & cost price

(b) For adjustment of loading in closing stock

S.No. Particulars L.F.

Branch A/c
To Adjustment for Stock with Branch A/c
Or
To Stock Reserve A/c
Adjustment for difference in value (Invoice & cost price)

Example: ABC & Co. of Delhi have a branch at Mumbai. Goods are sent by the head office
at invoice price which is at a profit of 20% on invoice price. All expenses of the branch are paid
by the head office. From the following particulars, prepare branch account in the head office
books when, goods are shown at an invoice price.

Opening balances: ( )
Stock at invoice price 11,000
Debtors 1,700
Petty cash 100
Goods sent to branch at invoice price 20,000
Expenses made by head office:
Rent 600
Wages 200
Salary, etc. 900
Remittances made to head office:
Cash sales 2,650
Cash collected from debtors 21,000
Goods returned by branch at invoice price 400
Balances at the end:
Stock at invoice price 13,000
Debtors at the end 2,000
Petty cash 25

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Notes Solution:
As profit is 20% on invoice price. So profit is 20/100 or 1/5 of invoice price. Adjusting entries are
to be passed on the above basis.
Mumbai Branch Account

Particulars Particulars
To Balance b/d: By Cash Sales 2,650
Stock 11,000 By Cash Collected from Debtors 21,000
Debtors 1,700 By Goods Returned by Branch 400
Petty Cash 100 12,800 By Adjustment for Goods sent
To Goods Sent to Branch A/c 20,000 to Branch A/c 4,000
To Bank A/c (Expenses): By Stock Reserve A/c 2,200
Rent 600 By Closing Balance
Wages 200 Stock 13,000
Salary, etc. 900 1,700 Debtors 2,000
To Adjustment for Goods Returned 80 Petty Cash 25 15,025
To Stock Reserve A/c 2,600
To Net Profit transferred to
General Profit & Loss A/c 8,095
45,275 45,275

Task The Shraddha Gas Co., Kanpur has a sales branch at Ghaziabad and invoiced
goods to the branch at cost price plus 25 per cent. It is arranged that all cash received by the
branch is to be paid daily to the Head Office Account with the SBI. From the following
particulars, prepare Branch Account and Goods sent to Branch Account in the Head
Office ledger showing the actual profit or loss of the branch for the year ending -December
31, 2004.

Stock on 1-1-2004 (at invoice price) 12,000

Goods Sent to Branch (at invoice price) 96,000

Debtors on 1-1-2004 1,500

Cash Sent to Head Office 77,100
Sales 77,000

Rent, Rates and Taxes 3,200

Salaries and Wages 4,800

Debtors on 31-12-2004 1,600

Goods Returned to Head Office (at invoice price) 16,000

Shortage of stock (at invoice price) 200

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Self Assessment Notes

Multiple Choice Questions:

9. Goods sent by the H.O. to the branch but not received by the branch are termed as:

(a) Branch account (b) Goods in Transit A/c (c) None of the above.

10. If profit on cost is 25% then profit on sales will be

(a) 25% (b) 20% (c) 30%

11. If profit on sales is 25% then profit on cost will be

1
(a) 25% (b) 20% (c) 33 %
3

11.4 Stock and Debtors System

Under Stock and Debtors System, the head office does not open a Branch Account in its books. It
maintains a few control accounts for recording the various branch transactions. These accounts
usually are:

 Branch Stock Account

 Branch Debtors Account

 Branch Expenses Account

 Branch Cash Account

 Goods sent to Branch Account

 Branch Fixed Assets Account

At the end of the accounting year, head office prepares the Branch Adjustment Account and the
Branch Profit & loss Account. This system is used only when goods are invoiced at selling price
which the branch is not allowed to vary.

The following journal entries are made by the head office:

(1) When goods are sent to branch (at Invoice price)

S.No Particulars L.F.

Branch Stock A/c Dr.
To Goods Sent to Branch A/c
(Goods sent to branch at an invoice price)

(2) When goods are retuned by the branch to head office (at invoice price)

Goods Sent to Branch A/c Dr.

To Branch Stock A/c
(Goods returned by the branch)

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Notes (3) Sales of goods by branch

(a) For cash sale

Cash A/c Dr.

To Branch Stock A/c
(Cash sales at branch)

(b) For credit sale

Branch Debtors A/c Dr.

To Branch Stock A/c
(Cash sales at branch)

(4) Cash receipts from branch debtors

Cash A/c Dr.

To Branch debtors A/c
(Cash received form branch debtors)

(5) For sales return

Branch stock A/c Dr.

To Branch debtors A/c
(Cash received form branch debtors)

(6) For discount allowed, bad debts, etc.

Branch Expenses A/c Dr.

To Branch Debtors A/c

(Expenses on branch debtors)

(7) For payment of branch expenses

Branch Expenses A/c Dr.

To Cash A/c
(Branch expenses paid by head office)

(8) If there is shortage/loss of stock, then

Branch Adjustment A/c (with amount of loading) Dr.

Branch profit and loss A/c (with cost of storage) Dr.
To Branch Stock A/c
(Loss in Stock at branch)

(9) For surplus of stock at branch

Branch stock A/c Dr.

To Branch adjustment A/c (with amount of loading)
To Branch profit and loss A/c (with cost of storage)
(surplus in stock at branch)

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(10) For adjustment of loading in opening stock Notes

Stock reserve A/c Dr.

To Branch adjustment A/c

(Difference in value passed)

(11) For adjustment of loading in closing stock

Branch Adjustment A/c Dr.

To Stock Reserve A/c

(Difference in value passed)

(12) For adjustment of loading on net goods sent to branch

Goods sent to Branch A/c Dr.

To Branch Adjustment A/c
(Difference in value passed)

(13) Branch expenses are transferred to branch adjustment account i.e.

Branch Adjustment A/c Dr.

To Branch Expenses A/c
(Branch expenses transferred)

(14) Transfer of balance of branch adjustment account to general profit and loss account, then

Branch Adjustment A/c Dr.

To General Profit & Loss A/c
(Balance being profit transferred)

Note: In case of loss at branch, reverse entry to be passed.

(15) For closing of goods sent to branch A/c

Goods sent to Branch A/c Dr.

To Trading A/c
(closing of goods sent to branch)

Example: ABC Co. has its branch at Jaipur. Goods are invoiced to the branch at selling
price, being cost plus 25% (on cost). From the following details prepare Branch stock A/c, Branch
Expenses A/c, Branch Debtors A/c, Branch Adjustments A/c, Reserve A/c, Goods supplied to
Branch A/c, Stock Reserve A/c and also Branch A/c:

Goods supplied to branch (at cost to head office) 15,200

Cash sales 17,400

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Notes Credit sales 5,600

Cash received from Debtors 5,000

Rent and rates (paid by head office) 900

Wages (paid by head office) 760

Sundry Expenses (paid by head office) 100

Discount allowed to customers 200

Goods returned by customers 100

Goods spoiled 50

Opening stock (at invoice price) 3,000

Opening debtors 2,000

Solution:

In the books of the head office

(A) Branch Stock Account

Particulars Particulars
To Balance b/d 3,000 By Cash (sales ) 17,400
To Supplies from Head office (125% of 15,200) 19,000 By Branch Debtors A/c (Credit sales) 5,600
Branch Debtors (Returns by debtors) 100 By Branch Adjustment A/c
To Net profit transferred to General (Spoilage of goods) 50
Profit & Loss A/c 950
23,050 23,050

(B) Branch Expenses Account

Particulars Particulars
To Cash: Rent & Rates 900 By Branch Adjustment A/c (Transfer) 1,960
Wages 760
Sundry expenses 100
To Branch debtors A/c: Discount allowed 200
1,960 1,960

(C) Branch Debtors Account

Particulars Particulars
To Balance b/d 2,000 By Cash 5,000
To Branch Stock A/c (credit sales) 5,600 By Discount (Branch expenses) A/c 200
By Branch stock A/c (Returns) 100
By Balance c/d 2,300
7,600 7,600

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(D) Branch Adjustment Account Notes

Particulars ` Particulars `
To branch stock A/c (spoilage of goods) 50 By good supplied to branch A/c 3,800
To branch expenses A/c 1,960 By stock reserve A/c 600
To net profit transferred to general Profit & 2,390
Loss A/c
4,400 4,400

(E) Goods Supplied to Branch Account

Particulars ` Particulars `
To Branch Adjustment A/c 3,800 By Branch stock A/c 19,000
To purchases A/c 15,200
19,000 19,000

(F) Stock Reserve Account

Particulars ` Particulars `
To branch adjustment a/c 600 By Balance b/d 600

(G) Jaipur Branch Account

Particulars ` Particulars `
To opening stock 3,000 By Cash (cash sales) 17,400
To opening debtors 2,000 By Received from branch debtors 5,000
To goods sent to branch 19,000 By Closing debtors a/c (3) 2,300
To cash : Rent & Rates 900 By Adjustment for opening stock 600
Wages 760 By Adjustment for goods sent 3,800
Sundry expenses 100
To net profit transferred to general
Profit & Loss a/c (1) 3,340
29,100 29,100

Working Notes:

(1) According to branch stock and debtors system, total net profit transferred to General
profit & Loss A/c is ` 3,340 i.e. ` 950 from Branch stock A/c and ` 2,390 from Branch
adjustment A/c.

(2) Profit is separated by using 25% on cost or 20% on sale basis i.e., 1/5 of selling price.

(3) For closing debtors balance, see Branch Debtors A/c.

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Notes Self Assessment

State whether the following statements are true or false:

12. Branch A/c under independent branch is a personal A/c.

13. Goods sent by the H.O. is not received by the branch, it is debited to goods in transit A/c.

14. If profit on cost is 25% then it is 20% on sales.

15. If profit on sales is 25% then it is 20% on costs.

11.5 Final Accounts System

The profit or loss of a dependent branch can also be worked out by preparing a Memorandum
Branch Trading and Profit & Loss Account. This account is prepared on the basis of cost of goods
sent to the branch (not the invoice price). Apart from the Branch Trading and Profit & Loss
Account, the head office also maintains the Branch Account. But, under this system, the Branch
Account is in the nature of a personal account which shows only the mutual transactions between
the head office and the branch, the balance of Branch Account, therefore, represents the net assets
of the branch.

Example: A-one Ltd., Bhopal has a branch at Madras to which the goods are sent at cost
plus 25%. The Madras branch keeps its own Sales Ledger and remits all cash received to the head
office every day. All expenses are paid by the head office. The transactions for Madras Branch
during the year ending December 31, 2008 were as follows:

Stock (1-1-2008) 11,000 Return inwards 500

Debtors (1-1-2008) 100 Cheques sent to branch:
Petty cash 100 Rent 600
Cash sale 2,650 Wages 200
Credit sales 23,950 Salary and other expenses 900
Goods sent to branch 20,000 Stock (31-12-2008) 13,000
Collection on ledger account 21,000 Debtors (31-12-2008) 2,000
Goods returned to H. O. 300 Petty cash (31-12-2008)
Bad debts 300 (including misc. income 25 not
Allowance to customers 250 remitted) 125

Prepare the Memorandum Branch Trading and Profit and Loss A/c and Madras branch A/c for
the year ending Dec 31, 2008.

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Solution: Notes

Memorandum Branch Trading and Profit and Loss A/c

for the year ending 31-12-2008
Dr. Cr.

Particulars Particulars
To O. S. By sales
( 11,000 – 2,200) 8,800 Cash 2,650
To goods sent to branch Credit 23,950
(20,000 – 4,000) 16,000 26,600
To wages 200 Less: Returns 500 26,100
To gross profit c/d 11,740 By goods sent to HO 240
( 300 – 60)
By closing stock 10,400
( 13,000 – 2,600)
36,740 36,740
To bad debts 300 By gross profit b/d 11,740
To allowance 250 By Misc. income 25
To rent 600
To salaries and other 900
expenses
To profit transferred to 9,715
general profit and loss A/c

11,765 11,765

Madras Branch A/c

To balance b/d By bank A/c

Stock 8,800 Cash received form debtors 21,000
Debtors 100 Cash sales 2,650
Petty cash 100 By goods sent to branch
To goods sent to branch A/c 16,000 (returns to HO) 240
To bank A/c By balance c/d
Rent 600 Stock 10,400
Wages 200 Debtors 2,000
Salaries and other exp. 900 Petty cash 125
To profit as per Branch Trading
and Profit and Loss A/c 9,715
36,415 36,415

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Notes 11.6 Wholesale Branch System

Sometimes the manufacturing organisations (head office) sell their products through wholesalers
as well as through own branches. In case the head office decides two prices (i) Wholesale price;
and (ii) retail price. Goods are supplied to the whole-seller and branches at wholesale price, that
is, cost plus profit. The branches are supposed to sell these goods at retail price which is greater
than the wholesale price. It means the branches earn more profit than the head office. But the
total profit (Retail price-cost) cannot be considered as branch profit. The real profit of the branch
shall be the difference between the wholesale price and retail price.

The wholesale price means cost plus profit. Therefore in the books of head office Branch Stock
Account shall be maintained at wholesale price. At the end of the accounting period, the problem
arises only when the goods received from head office remains unsold at branch, because it
includes a part of profit which has been charged by the head office. To calculate the proportion
of profit, the value of unsold goods shall be reduced from wholesale price to cost price.

At the end of accounting year the following entry shall be made:

Profit & Loss A/c (H.O.) Dr

To Stock Reserve A/c

(Reserve created for the difference in the wholesale price and cost price of Branch closing stock)

Example: M/s Gaba and co. of Delhi submits the following particulars regarding the
branch transactions of its Mumbai branch for the year ended March 31, 2006:

H.O Branch

( ) ( )

Stock on 1-4-2005 72,000 28,800

Goods purchased during the year 4,18,000 -----

Indirect expenses 21,800 3,900

Goods sent to branch at invoice price 1,29,600 -----

Sales 3,78,000 1,45,800

Goods received by branch ------ 1,29,600

Goods sold to regional stockists 79,200 -----

Generally goods are invoiced to branch and regional stockists at 20% below the list price. The
list price is calculated at 80% above the cost. Goods are sold to the customers at the list price by
the HO and the branch both.

You are required to prepare the Trading and Profit and Loss A/c of the head office and the
branch for the year ended on March 31, 2006.

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Solution: Notes

In the books of Head Office

Trading and Profit and Loss A/c

for the year ended on March 31, 2006

Dr Cr
Particulars Particulars
To O.S. 72,000 By sales 3,78,000
To Purchases 4,18,000 By goods sent to the branch 1,29,600
To GP c/d 2,31,800 By regional stockists 79,200
By closing stock 1,35,000
7,21,800 7,21,800
To Indirect exp. 21,800 By gross profit b/d 2,31,800
To stock reserves By stock reserve (OS) 8,800
( 41760 * 44/144) 12,760 ( 28800 * 44/144)
To Net Profit 2,06,040
2,40,600 2,40,600

Branch Trading and Profit and Loss A/c

for the year ended on March 31, 2006

Dr Cr
Particulars Particulars
To OS 28,800 By sales 1,45,800
To goods from head office 1,29,600 By closing stock 41,760
To GP c/d 29,160
1,87,560 1,87,560
To indirect exp. 3,900 By GP b/d 29,160
To general profit and loss a/c 25,260
29,160 29,160

Working notes:
1. Calculation of list price and invoice price
Let cost price is = 100
List price = 100 + 80% of 100 = 180
Thus invoice price = 180 – 20% of 180 = 144
2. Calculation of closing stock at the branch

OS at the branch 28,800

Goods sent by the HO 1,29,600
1,58,400
less: cost of goods sold to customers
(1,45,800 * 144/180) 1,16,640
Closing stock at the branch 41,760

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Notes 3. Calculation of closing stock at HO

Opening Stock 72,000

Add: Goods purchased 4,18,000

4,90,000

Less: Cost of goods sold

Sold to customers (3,78,000 * 100/180) = 2,10,000

Goods sent to branch (1,29,600 * 100/144) = 90,000

Goods sent to stockists (79,200 * 100/144) = 55,000 3,55,000

Closing stock at the HO 1,35,000

Self Assessment

Fill in the blanks:

16. The Branch Account is in the nature of a ……………. account which shows only the mutual
transactions between the head office and the branch.

17. Goods are supplied to the whole-seller and branches at wholesale price, that is, ………….

11.7 Summary

 The extent of business expansion is responsible for opening of the new branches.

 The branches are of three types: Dependent Branches, Independent Branches and Foreign
Branches.

 Dependent branches are such which are not free either to buy or sell without the head
office directives.

 Independent branches are such which are free to buy and sell the goods, i.e., Branches
which buy goods according to its requirements and sell goods for cash as well as on credit.

 In case of dependent branches, complete set of books is not required because dependent
branches are required to remit cash daily to the head office or deposit it in a bank account
as per instructions of the head office.

 Stock at branch and cash at branch are to be shown in the balance sheet of the head office
as an asset & the goods sent to branch is shown in the trading account.

 Complete set of accounts connected with the branch are kept in the head office whereas
office branch maintains the cash records only which is sent to the head office by the
branch.

 When goods are sent by the head office to branch/es at an invoice price which is more than
the cost price, then the object of the head office is to exercise (1) more control on stock by
preparing branch stock register, and (2) to keep the amount of profit as secret.

 When goods are sent by head office to branch at an invoice price, then stock and debtor
system can be used to ascertain profit or loss of the branch.

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11.8 Keywords Notes

Dependent Branches: Dependent branches are such which are not free either to buy or sell
without the head office directives.

Debtors System: This system of accounting is used for those branches which are small in size.
Under this system, the head office simply opens a Branch Account for each branch in which it
records all transactions relating to the branch.

Independent Branches: Independent branches are such which are free to buy and sell the goods,
i.e., Branches which buy goods according to its requirements and sell goods for cash as well as
on credit.

Loading: Loading is the difference between the invoice price and cost price.

Stock and Debtor System: Under this system, the head office does not open any Branch Account.

11.9 Review Questions

1. How many types of branches are there? What entries are made in the books of company to
incorporate branch’s trial balance?

2. Explain the causes of difference in the balances shown by the H.O. and the Branch.

3. How are normal and abnormal losses are treated in the branch account?

4. What are the different systems of accounting of dependent branches?

5. How to compute the profit of dependent branches?

6. Illustrate the branch stock account with a suitable example.

7. Delhi Traders, Delhi opened a branch at Baroda on 1st January 2006. The following
information is available in respect of the branch for the year 2006.

Goods sent to the branch 70,000

Cash sales at the branch 40,000

Credit sales at the branch 60,000

Salaries of the branch paid by the Head Office 25,000

Office Expenses of the branch paid by the Head Office 10,000

Cash remittances to branch towards petty cash 6,000

Petty cash at branch on 31.12.2006 500

Debtors at branch as on 31.12.2006 5,000

Stock at branch on 31.12.2006 27,000

Prepare Branch Account to show the profit/loss from the branch for the year 2006.

8. A Head Office at Mumbai has branch at Chennai in charge of a manager. The ratio of gross
profit on turnover at the branch was 25% constant throughout the year.

The Branch manager is entitled to a commission of 10% of the profit earned by the branch
calculated before charging his commission, but subject to a deduction from such commission
a sum equal to 50% of any ascertained deficiency of Branch Stock. All goods were supplied
to the branch by the Head Office.

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Notes From the following figures extracted from the branch books, calculate the commission
due to the manager for the year ended 31st December, 2006

Particulars Particulars
Stock as on 1.1.06 at Cost 31,210 Establishment Expenses 22,550
Goods received from Head Office at Cost 1,08,700 Drawings by Manager against Commission 1,000
Sales 1,46,400 Stock on 31.12.06 at Selling Price 39,880

9. From the following details prepare Branch Account in the books of Head Office:

Goods sent to branch at cost 40,000

Goods returned by branch at cost 2,000
Branch credit sales 51,000
Cash sales at branch 3,500
Cash remitted to head office by branch 40,000
Expenses paid by head office 10,000
Discount allowed to customers by branch 1,800
Closing Stock with Branch at Cost 14,000
Branch Debtors (Closing balance) 7,700

10. Kapur Brothers has branch at Lucknow, Goods are invoiced to his branch at 20% profit on
invoice price. From the following details, prepare ‘Branch Account’ in the books of Head
Office showing branch profit:

Credit sales 1,12,000

Goods supplied to branch at invoice price 3,80,000
Cash sales 2,48,000
Cash received from debtors 1,00,000
Wages (Paid by head office) 15,200
Rent (Paid by head office) 18,000
Discount allowed to customers 4,000
Sundry expenses (Paid by head office) 1,000
Goods returned by customers 2,000
Depreciation on furniture 1,000
Goods spoiled 1,000

11. X Ltd. operates a retail branch at Mumbai. All purchases are made by the head office in
Calcutta, goods being charged out to the Branch at selling price which is cost plus 25%. All
the expenses of branch are paid through head office cheques. Cash collected from customers
as also the ready money sales are daily banked to the credit of the head office. From the
following particulars of the branch write up the necessary accounts to arrive at the branch
profit or loss in the head office books by using stock and debtors system.

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Particulars Particulars
Notes

Debtors at start 15,000 Invoiced Inventory at beginning 30,000

Debtors at end 19,000 Invoiced Inventory at end 28,000
Ready money sales during the year 1,30,000 Salaries 12,000
Cash Received on Ledger Account 1,20,000 Rent etc. 10,000
Return to H.O. at Invoiced Amount 5,000 Bad debts 4,000
Normal Leakage and Spoilage 4,000 Discount and Allowances 6,000

Answers: Self Assessment

1. sec 29 2. profit centre

3. Dependent 4. Independent

5. foreign currency 6. False

7. False 8. True

9. (b) 10. (b)

11. (c) 12. True

13. True 14. True

15. False 16. personal

17. cost plus profit

11.10 Further Readings

Books I.M. Pandey, Financial Management, Vikas Publishing, New Delhi.

Khan and Jain, Management Accounting.

Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.

Prasanna Chandra, Financial Management - Theory and Practice, Tata McGraw Hill,
New Delhi (1994).

R.L. Gupta and Radhaswamy, Advanced Accountancy.

S. Bhat, Financial Management, Excel Books, New Delhi.

S.N. Maheswari, Management Accounting.

V.K. Goyal, Financial Accounting, Excel Books, New Delhi.

Online link www.futureaccountant.com

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Notes Unit 12: Hire Purchase

CONTENTS

Objectives

Introduction

12.1 Meaning and Nature of Hire Purchase

12.1.1 Features of Hire Purchase Agreement

12.1.2 Hire Purchase vs Installment Sale

12.2 Accounting Treatment of Hire Purchase Transactions

12.2.1 Accounting Treatment in the Books of Hire Purchaser

12.2.2 Accounting Treatment in the Books of Vendor

12.3 Computation of Cash Price

12.3.1 Without using Annuity Table

12.3.2 Calculation of Cash Price with the Help of Annuity Tables

12.4 Forfeiture of Goods by the Vendor or Repossession of Goods

12.5 Summary

12.6 Keywords

12.7 Review Questions

12.8 Further Readings

Objectives

After studying this unit, you will be able to:

 Explain the meaning and nature of hire purchase

 Summarize the recording of transactions

 Create the different accounts

Introduction

Mr. Rohit wants to buy a car but he is not able to pay the full amount in one time. He went into
a contract with the dealer that he will pay 50000 as down payment and the rest of amount in
equal installments. The dealer agreed with the contract but he said that he will transfer the
ownership of the car only after receiving the last installment. These types of purchase agreements
are called hire purchase agreements.

In the present unit, you will study about the meaning and nature of hire purchase. The unit
covers the aspects like recording transactions and maintaining accounts. In the modern age of
science and technology several methods are used to sell goods, products or services. There are
two systems of deferred payments, namely, (i) Hire Purchase System, and (ii) Instalment Payment
System. In this unit we will learn in detail about the Hire Purchase System.

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12.1 Meaning and Nature of Hire Purchase Notes

A hire purchase agreement is defined in the Hire Purchase Act, 1972 as a peculiar kind of
transaction in which the goods are let on hire with an option to the hirer to purchase them, with
the following stipulations:

1. Payments to be made in installments over a specified period.

2. The possession is delivered to the hirer at the time of entering into the contract.

3. The property in goods passes to the hirer on payment of the last installment.

4. Each installment is treated as hire charges so that if default is made in payment of any
installment, the seller becomes entitled to take away the goods.

5. The hirer/purchase is free to return the goods without being required to pay any further
installments falling due after the return.

12.1.1 Features of Hire Purchase Agreement

The following are the key features of hire purchase agreement:

 Under hire purchase system, the buyer takes possession of goods immediately and agrees
to pay the total hire purchase price in installments.

 Each installment is treated as hire charges.

 The ownership of the goods passes from the seller to the buyer on the payment of the last
installment.

 In case the buyer makes any default in the payment of any installment the seller has the
right to repossess the goods from the buyer and forfeit the amount already received
treating it as hire charges.

 The hirer has the right to terminate the agreement any time before the property passes.
That is, he has the option to return the goods in case he need not pay installments falling
due thereafter. However, he cannot recover the sums already paid as such sums legally
represent hire charges on the goods in question.

12.1.2 Hire Purchase vs Installment Sale

Though both the system of consumer credit are very popular in financing and look similar,
there is clear distinction between the two. In an installment sale, the contract of sale is entered
into the goods are delivered and the ownership is transferred to the buyer but the price is paid
in specified installments over a period of time. In hire purchase, the hirer can purchase the goods
at any time during the term of the agreement and he has the option to return the goods at any
time without having to pay the rest of the installments. But in installment payment financing
there is no such option to the buyer.

!
Caution In installment payment, the owner ship of the goods is transferred immediately
at the time of entering into the contract. Whereas in hire purchase the ownership is
transferred after the payment of last installment or when the hirer exercises his option to
buy goods.

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Notes Self Assessment

State whether the following statements are true or false:

1. Under hire purchase system, the buyer takes possession of goods immediately and agrees
to pay the total hire purchase price in installments.

2. Under hire purchase the interest is calculated on the purchase price.

3. Each installment is treated as hire charges.

4. In case of default, the hire vendor is allowed to repossess the goods immediately.

5. In installment payment, the owner ship of the goods is transferred immediately at the
time of entering into the contract.
6. In an installment sale, the contract of sale is entered into the goods are delivered and the
ownership is transferred to the buyer but the price is paid in specified installments over a
period of time.

7. The hirer has no right to terminate the agreement before the property passes.

8. A hire purchase agreement is defined in the Hire Purchase Act, 1872.

12.2 Accounting Treatment of Hire Purchase Transactions

In case of a hire purchase transaction the accounts are prepared by both the hire purchaser and
vendor. The accounting treatment of hire purchase transactions in the books of hire purchaser
and vendor are discussed below:

12.2.1 Accounting Treatment in the Books of Hire Purchaser

There are two methods by which the purchaser can record the transactions in the books of
accounts.

1. When assets are recorded at full cash price

2. When assets are recorded at actual cash price paid

When assets are recorded at full cash price

The following entries are passed in the books of hire purchaser:

1. When Asset is purchased on Hire Purchase

S. No. Particulars L.F. Dr. Cr.

Assets A/c Dr.
To Hire Vendor A/c
(Asset purchased under hire purchase system)

2. For cash down payment

Hire Vendor A/c Dr.

To Cash A/c
(Cash down payment)

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3. For interest accrued Notes

Interest A/c Dr.

To Hire Vendor A/c
(Interest account debited)

4. When the first installment is paid

Hire Vendor A/c Dr.

To Bank A/c
(payment of 1st instalment)

5. For Depreciation charges

Depreciation A/c Dr.

To Asset A/c
(Depreciation charged on asset)

6. For transfer of interest and depreciation to profit and loss A/c

Profit and Loss A/c Dr.

To Interest A/c
To Depreciation A/c
(Interest and depreciation are transferred to profit and loss A/c)

Note: Entries 3 and 4 will be repeated for all subsequent installments.

Example: Ram Ltd. bought on 1.1.04 a machine from Shyam Ltd. Under a hire purchase
system of payment under which three annual installments of 2,412 would be paid. There is no
down payment and the cash price is 6,000, the rate of interest would be 10% and depreciation
@ 10% p.a. would be charged on straight line basis.

Prepare machinery A/c and vendor A/c in the books of Ram ltd.

Solution:

In the books of Ram Ltd.

Shyam Ltd Account

Date Particulars Amount Date Particulars Amount

( ) ( )
By Machine A/c 6,000
31.12.04 To Cash A/c 2,412 31.12.04 By Interest A/c 600
” To Balance c/d 4,188
6,600 6,600
31.12.05 To Cash A/c 2,412 01.01.05 By Balance b/d 4,188
” To Balance c/d 2,194 31.12.05 By Interest A/c 418
4,606 4,606
31.12.06 To Cash A/c 2,412 01.01.06 By Balance c/d 2,194
By Interest (Balancing figure) 218
2,412 2,412

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Notes Machine Account

Date Particulars Amount ( ) Date Particulars Amount ( )

01.01.04 To Shyam ltd 6,000 31.12.04 By Depreciation A/c 600
” By Balance c/d 5,400
6,000 6,000
1.1.05 To Balance b/d 5,400 31.12.05 By Depreciation A/c 600
” By Balance c/d 4,800
54,00 5,400
1.1.06 To Balance b/d 4,800 31.12.06 By Depreciation A/c 600
” By Balance c/d 4,200
4,800 4,800

Working Note:

1. Computation of interest on instalment

Cash price 6,000

Add: Interest on 1st Instalment (10% of 6,000) 600

6,600

Less: 1st Instalment 2,412

4,188

Add: Int. on 2nd Instalment (10% of 4,188) 418

4,606

Less: 2nd Instalment 2,412

2,194

Add: Int. on 3rd instalment 218

2,412

Example: (When Rate of Interest is not given)

On 1st January, 2004 ABC ltd. purchased a printing machine on hire purchase system from XYZ
ltd. The payment was to be made at 30,000 down and the balance in three equal annual
installments of 20,000 each, payable on 31 st December. The Vendor Company charged interest
@ 8% p.a. ABC ltd provided depreciation @ 10% p.a. on the diminishing balance and paid all the
installments.

It closed its books on 31st December, every year. The cash down value of the machine was
81,543.

Show the (a) XYZ ltd A/c and (b) Printing Machinery A/c in the books of ABC ltd for 3 years to
31st December, 2006.

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Solution: Notes

In the books of ABC ltd.

XYZ ltd Account

Date Particulars Amount ( ) Date Particulars Amount

( )
01.01.04 To Cash A/c 30,000 01.01.04 By Machine A/c 81,543
31.12.04 To Cash A/c 20,000 31.12.04 By Interest A/c 4,123
” To Balance c/d 35,666
85,666 85,666
31.12.05 To Cash A/c 20,000 01.01.05 By Balance b/d 35,666
” To Balance c/d 18,519 31.12.05 By Interest A/c 2,853
38,519 38,519
31.12.06 To Cash A/c 20,000 01.01.06 By Balance c/d 18,519
By Interest (Balancing figure) 1,481
20,000 20,000

Printing Machine Account

Date Particulars Amount Date Particulars Amount

( ) ( )
01.01.04 To Cash A/c 30,000 31.12.04 By Depreciation A/c 8,154
31.12.04 To Cash A/c 15,877 ” By Balance c/d 37,723
45,877 45,877
1.1.05 To Balance b/d 37,723 31.12.05 By Depreciation A/c 7,339
31.12.05 To Cash A/c 17,147 ” By Balance c/d 47,531
54,870 54,870
1.1.06 To Balance b/d 47,531 31.12.06 By Depreciation A/c 6,605
31.12.06 To Cash A/c 18,519 ” By Balance c/d 59,445
66,050 66,050

Calculation of Interest

If rate of interest is not given it is calculated as follows:

Cash Price 15980, Hire Purchase Price 17,000.
Hire Purchase Price due:

At the end of 1st year 17,000 – 4,000 = 13,000

At the end of 2nd year 13,000 – 6,000 = 7,000
rd
At the end of 3 year 7,000 – 5,000 = 2,000

Total Interest = 17,000 – 15,980 = 1,020

Divisible in the ratio of 13000 : 7000 : 2000

i.e., 13 : 7 : 2

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Notes

1,020 6,630
I Year Interest =  13  603
22 11
1,020 3, 570
II Year Interest = 7  325
22 11
1,020
III Year Interest =  2 = (Balancing Figure) 92
22

1,020

Note: Interest for the final year is not to be calculated but the balancing figure is to be taken as
an interest for that year.

When assets are recorded at cash price actually paid

Under this method the entries are passed as and when the installments become due and the
amount is paid towards the price of the article. The following journal entries are passed to
record the hire purchase transactions:

1. No entry will be passed at the time of purchase of asset.

2. When down payment is made

Asset A/c Dr.

To Cash A/c
(Cash down payment)

3. When instalment become due

Asset A/c (cash price) Dr.

Interest A/c (interest on instalment) Dr.
To Hire Vendor A/c
(Instalment due including the interest on instalment)

4. When the first installment is paid

Hire Vendor A/c Dr.

To Bank A/c
(payment of 1st instalment)

5. For Depreciation charges

Depreciation A/c Dr.

To Asset A/c
(Depreciation charged on asset)

!
Caution It should be noted that though the asset account is debited with the amount
of the cash price paid (not full cash price), the depreciation is charged on the full cash price.

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Notes
Example: Ram Ltd. bought on 1.1.04 a machine from Shyam Ltd. Under a hire purchase
system of payment under which three annual installments of 2,412 would be paid. There is no
down payment and the cash price is 6,000. The rate of interest would be 10% and depreciation
@ 10% p.a. would be charged on straight line basis.

Pass the necessary journal entries in the books of hire purchaser when the asset is recorded at
cash price actually paid.

Solution:

Journal Entries in the Books of Ram Ltd

Date Particulars Amount Amount
(Dr.) (Cr.)
2004 Machinery A/c Dr. 1812
Dec Interest A/c Dr. 600
31 To Shyam ltd 2412
(being 1st instalment due)

Shyam ltd A/c Dr. 2412

To Bank A/c 2412
(payment of 1st instalment)

Depreciation A/c Dr. 600

To Asset A/c 600
(Depreciation charged on asset at the rate of 10%)

Profit and loss A/c Dr. 1200

To Depreciation A/c 600
To Interest A/c 600
(Interest and depreciation charges transferred to P&L A/c)

2005 Machinery A/c Dr. 1994

Dec Interest A/c Dr. 418
31 To Shyam ltd 2412
(being 2nd instalment due)

Shyam ltd A/c Dr. 2412

To Bank A/c 2412
(payment of 2nd instalment)

Depreciation A/c Dr. 600

To Asset A/c 600
(Depreciation charged on asset at the rate of 10%)

Profit and loss A/c Dr. 1018

To Depreciation A/c 600
To Interest A/c 418
(Interest and depreciation charges transferred to P&L A/c)

2006 Machinery A/c Dr. 2194

Dec Interest A/c Dr. 218
31 To Shyam ltd 2412
(being 3rd instalment due)

Shyam ltd A/c Dr. 2412

To Bank A/c 2412
(payment of 3rd instalment)

Depreciation A/c Dr. 600

To Asset A/c 600
(Depreciation charged on asset at the rate of 10%)

Profit and loss A/c Dr. 818

To Depreciation A/c 600
To Interest A/c 218
(Interest and depreciation charges transferred to P&L A/c)

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Notes Working Notes:

1. Depreciation should be charged on straight line method at the rate of 10% on full cost price
of 6000.

2. Computation of interest on instalment

Cash price 6000

Add: Interest on 1st Instalment (10% of 6000) 600

6600

Less: 1st Instalment 2412

4188

Add: Int. on 2nd Instalment (10% of 4188) 418

4606

Less: 2nd Instalment 2412

2194

Add: Int. on 3rd instalment 218

2412

12.2.2 Accounting Treatment in the Books of Vendor

The following entries are passed by the vendor in their books of accounts to record the hire
purchase transactions:

1. When goods are sold on Hire Purchase

S. No. Particulars L.F. Dr. Cr.

Hire Purchaser A/c Dr.
To Sales A/c
(Goods sold under hire purchase system)

2. For cash down payment

Cash A/c Dr.

To Hire Purchaser A/c
(Cash down payment received)

3. On instalment becoming due

Hire Purchaser A/c Dr.

To Interest A/c
(Instalment due)

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4. When instalment received Notes

Bank A/c Dr.

To Hire Purchaser A/c
(amount received for instalment)

12.3 Computation of Cash Price

Sometimes, the total cash price is not given. In such a situation we can not proceed with the
accounting for hire purchase transaction because in the books of the buyer, the amount to be
capitalised cannot be more than the cash price. The different methods of calculation of cash price
are as below:

(i) Without using annuity table

(ii) With the help of annuity table

12.3.1 Without using Annuity Table

Under this method the interest is calculated starting form the last instalment to first instalment.
The interest is calculated on the outstanding amount of cash price. In order to compute the
amount of cash price it is important to calculate the amount of interest included in instalment
and then it is subtracted from the instalment amount. The following formula is used to compute
the amount of interest:

Rate of Interest
Interest  Amount Due at the time of Instalment 
100  Rate of Interest

Example: X purchased a machine for manufacturing steel utensils on hire purchase

system from Y. Payment was to be made as 18,000 at contract and three annual installments of
18,000 each. Interest charged @ 20% p.a. which was included in the annual payments of 18,000.
Depreciation charged by X was 10% on straight-line method.

Calculate the Cash Price of the Machine and prepare Machine Account and Y’s Account in the
books of X. [Delhi, B.Com. (Pass), 1991 (B)]

Solution:

In The books of X

Calculation of Cash Price

Hire purchase price of machine = 18000 + 3 x 18000 = 72,000

20 1
Interest at the end of each year = or
120 6

1
Hence Interest for the third year = 18,000  = 3,000
6

Amount at the beginning of third year = 15,000 + 18,000 = 33,000

1
Interest for second year = 33,000  = 5,500
6

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Notes Amount outstanding at the beginning of second year = 27,500 + 18,000 = 45,500

1
Interest for first year = 45,500  = 7,583
6

Amount outstanding at beginning of first year = 37,917 + 18,000

= 55,917 or 55,920
Machine Account

Date Particulars Date Particulars

1 st Year 1s Year
At the At the
Beginning To Hire Vendor A/c 55,920 End of By depreciation A/c 5,592
The Year (P & L A/c)
” Balance c/d 50,328
55,920 55,920
2 nd Year To Balance b/d 50,328 2 nd year By Depreciation A/c 5,592
At the At the (P & L A/c)
Beginning End of ” Balance c/d 44,736
The year
50,328 50,328
3 rd Year 3 rd Year
At the At the
Beginning To Balance c/d 44,736 End of By depreciation A/c 5,592
The year ( P & L A/c )
” Balance c/d 39,144
44,736 44,736

Y’s Account

Date Particulars Date Particulars

1 st Year To Cash 1 st year
At the To Cash A/c 18,000 At the By Machine A/c 55,920
Beginning To Cash A/c 18,000 Beginning By Interest A/c 7,580
At the end To Balance c/d 27,500 At the end
63,500 63,500
2 nd Year 2 nd year
At the end To Cash A/c 18,000 At the By balance b/d 27,500
To Balance c/d 15,000 Beginning By Interest A/c 5,500
At the end
33,000 33,000
3 rd year 3 rd year
At the end To Cash A/c 18,000 At the By Balance b/d 15,000
Beginning By Interest A/c 3,000
At the end
18,000 18,000

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12.3.2 Calculation of Cash Price with the Help of Annuity Tables Notes

It is easy to compute the amount of interest using the annuity table. With the help of annuity
table the present value of each instalment can be calculated. Cash price is calculated by adding
all these present value and cash down payment.

!
Caution Cash Price = PV of all the Installments + Cash Down Payment

Example: X Ltd. purchased a machine on hire purchase system. The payment is made as
follows:

Down Payment 1500

1st Instalment 2000

2nd instalment 2500

3rd Instalment 1500

The payments are made at the end of 1st year, 2nd year and 3rd year respectively.

The rate of interest is 5% p.a, The annuity table shows that the present value of.

Re. 1 for one, two and three years is .9524, .9070 and .8639, respectively. Calculate the cash price
of the machine.

Solution:

Instalment PV Factor PV of Instalment

(1) (2) (1) * (2)
Cash Down 1500 1 1500
1st Instalment 2000 .9524 1904.8
2nd Instalment 2500 .9070 2267.5
3rd Instalment 1500 .8639 1295.85
Total Cash Price 6968.15

Task A purchased a truck on hire purchases system. The cash price of the truck
was 74,500. He paid 20,000 on signing of agreement and rest in three installments of
20,000 each. Calculate interest for each Year.
Hint: Total interest: 5500 divisible in the ratio of 3 : 2 : 1

Self Assessment

State whether the following statements are true or false:

9. In case, the price is not given, it is calculated with the help of 1 st installment.

10. If the rate of interest not given, total interest is divisible equally.

11. Hire purchase and installment system are synonymous.

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Notes 12.4 Forfeiture of Goods by the Vendor or Repossession of Goods

Possession of goods means physical holding of goods. You know that under hire purchase
agreement the vendor transfers the possession of goods. He does not transfer the ownership,
and if the hirer fails to pay even the last instalment he has 'the legal right to recover the
possession of the goods. This act of recovery of possession is termed as 'repossession'.

The legal position of the hire vendor and hire purchaser (hirer) in case of default is complicated.
The Hire Purchase Act of 1972 did codify this issue first, but as this Act was not put to operation,
the legal position is not very clear. However, the relevant provisions of the said Act are discussed
below:

Rights of the Hire Vendor

1. Rights of hire vendor to terminate hire purchase agreement: Where the hirer makes
more than one default in payment of instalment as provided in the agreement, the hire
vendor (the owner) shall be entitled to terminate the agreement by giving the notice of
termination in writing.

2. Rights of the hire vendor on termination: Where a hire purchase agreement is terminated,
the hire vendor (the owner) shall be entitled:

(i) to enter the premises of the hirer and seize the goods,

(ii) to retain the hire charges already paid and to recover the arrears of hire charges
due,

(iii) to claim damages for non-delivery of the goods.

Restrictions on the Owner

The above rights of the owner are, however, subject to the following restrictions:

1. Rights of hirer in case of seizure of goods by the owner: where the owner seizes the goods
lent under a hire purchase agreement, the hirer may recover from the owner the amount,
if any, by which the hire purchase price falls short of the aggregate of two amounts:

(i) the amounts paid in respect of the hire purchase price up to the date of seizure; and

(ii) the value of the goods on the date of seizure.

2. Restrictions on owner's right to repossess: Where goods have been let under a hire purchase
agreement, and the statutory amount of the hire purchase price has been paid, the
owner shall not enforce any right to recover possession of the goods from the hirer
otherwise than by 'verdict of any competent court.

In case the purchaser fails to pay any of the installments, the hire vendor can take back the
possession of the goods, The amount already paid to the vendor as a part of the payment for
the asset is treated as the hire charge. So, far as the repossession of goods is concerned the
vendor can either take back the whole of the asset or a part of it. Let us now discuss what entries
will be passed in base of:

(i) Complete repossession

(ii) Partial repossession.

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The following example explains the accounting treatment of complete and partial repossession: Notes

Example: (Full Repossession)

X purchased from Y three cars costing 1,00,000 each on hire purchase system. Payment was to
be made; 60,000 down and balance in three equal installments together with interest at 15% per
annum. X provides depreciation at 20% per annum on diminishing balance method. X paid the
first installment at the end of the first year but could not pay the second installment, Y took
possession of all the three cars. He spent 18,000 on repairs and sold them for 1,50,000.

Show the necessary ledger account in the books of both the parties.

[Delhi, B.Com. (Pass), 1995 (Supple.)]

Solution:

In the books of Hire Purchaser

Cars Account

Date Particulars Date Particulars

I yr. 1.1 To Hire Vendor A/c 3,00,000 I yr 31.12 By Depreciation 60,000
By Balance c/d 2,40,000
3,00,000 3,00,000
II yr. 1.1 To Balance b/d 2,40,000 II yr 31.12 By Depreciation 48,000
By Hire Vendor A/c 1,84,000
By P & L A/c (Loss on sale) 8,000
2,40,000 2,40,000

Hire Vendor Account

Date Particulars Date Particulars

I yr. I yr.
1.1 To Cash A/c 60,000 1.1 By Cars A/c 3,00,000
31.12 To Cash A/c (80,000 + 36,000) 1,16,000 31.12 By Interest A/c 36,000
” To Balance c/d 1,60,000
3,36,000 3,36,000
II yr. II yr.
1.1 To Cars A/c 1,84,000 31.12 By Balance b/d 1,60,000
31.12 By Interest A/c 24,000
1,84,000 1,84,000

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Notes In the books of Hire Vendor

Hire Purchaser Account

Year Particulars Year Particulars

I yr. I yr.
1.1 To Cars A/c 3,00,000 1.1 By Cash A/c 60,000
31.12 To Interest A/c 36,000 31.12 By Cash A/c 1,16,000
” By Balance c/d 1,60,000
3,36,000 3,36,000
II yr. II yr.
1.1 To Balance b/d 1,60,000 31.12 By Goods Repossessed A/c 1,84,000
31.12 To Interest 24,000
1,84,000 1,84,000

Goods Repossessed Account

Date Particulars Date Particulars

II Yr. II yr.
31.12 To Hire Purchase A/c 1,84,000 31.12 By Cash (Sale) 1,50,000
” To Cash (Repairs) 18,000 ” By Profit & Loss A/c (Loss) 52,000
2,02,000 2,02,000

Example: (Partial Repossession)

A Company purchased two machines of 10,500 each on hire purchase system, paying
6,000 down and remainder in three equal installments of 5,000 each together with interest at
5% p.a. The company writes off depreciation at 10% p.a. according to Diminishing Balance
Method.

The company could not pay the second installment. The vendor left one machine with the
company adjusting the value of the other against amount due taking the machine at 20%
depreciation at Diminishing Balance Method.

Prepare Ledger Account in the company’s books.

[Delhi, B.Com. (Pass), 1990]

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Solution: Notes

In the books of Hire Purchaser

Machines Account

Year Particulars Year Particulars

1st year 1st year
At the To Hire Vendor A/c 21,000 At the end By Depreciation A/c 2,100
Beginning ” By Balance c/d 18,900
21,000 21,000
2nd year To Balance b/d 18,900 2nd year By Depreciation A/c 1,890
At the At the end By Hire Vendor A/c 6,720
Beginning (P & L A/c ) 1,785
(Loss on A/c of seizure)
By Balance c/d (2) 8,505
18,900 18,900

Hire Vendor Account

Year Particulars Year Particulars

1st year 1st year
At the To Cash A/c 6,000 At the
Beginning To Cash A/c 5,750 Beginning By Machinery A/c 21,000
At the end To Balance c/d 10,000 At the By Interest A/c 5% on Rs. 750
end 15,000
21,750 21,750
2nd year 2nd year
At the end To Machine A/c 6,720 At the By Balance A/c 10,000
(1)
” To Balance c/d 3,780 Beginning
At the By Interest A/c 500
end
10,500 10,500

Working Notes:

1. Revised price of 1 Machine seized

Cash Price of each Machine 10,500

(–) Depreciation for I year @ 20% 2,100

on W.D.V. 8,400

(–) Depreciation for II year @ 20% 1,680

on W.D.V. 6,720

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Notes 2. Value of 1 Machine retained

Cash Price of Machine 10,500
(-) Depreciation for I year 1,050

9,450
(-) Depreciation for II year 945

Value of Machine I retained 8,505

Self Assessment

A. Multiple Choice Questions:

12. In case of hire purchases which account is debited?

(i) Hire Vendor A/c

(ii) Assets A/c

(iii) None of the above

13. In case of default of payment of installment. What is the right of the vendor?

(i) Filing a suit in the court for recovery

(ii) Repossess the goods immediately

(iii) Filing of suit as well as repossession of goods

B. Fill in the blanks:

14. If the hire purchaser fails to pay the installment due, the hire vendor’s right is to
....................... the goods.

15. The last installment is deducted from the preceding installment, difference is termed as
.......................

12.5 Summary

 Hire purchase is a mode of financing the price of the goods to be sold on a future date.

 In a hire purchase transaction, the goods are let on hire, the purchase price is to be paid in
installments and hirer is allowed an option to purchase the goods by paying all the
installments.

 Hire purchase is a method of selling goods. In a hire purchase transaction, the goods are
let out on hire by a finance company (creditor) to the hire purchase customer (hirer).

 The buyer is required to pay an agreed amount in periodical installments during a given
period.

 The ownership of the property remains with creditor and passes on to hirer on the payment
of the last installment.

 A hire purchase agreement is defined in the Hire Purchase Act, 1972 as peculiar kind of
transaction in which the goods are let on hire with an option to the hirer to purchase them.

 In an installment sale, the contract of sale is entered into the goods are delivered and the
ownership is transferred to the buyer but the price is paid in specified installments over a
period of time.

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12.6 Keywords Notes

Accounting: Process of recording, measuring, interpreting, and communicating financial data

for the purpose of decision-making.

Hire Purchase: Hire purchase is a mode of financing the price of the goods to be sold on a future
date.

Installment Sale: In an installment sale, the contract of sale is entered when the goods are
delivered and the ownership is transferred to the buyer but the price is paid in specified
installments over a period of time.

12.7 Review Questions

1. What journal entries are to be made in the books of the buyer and seller, When the goods
are sold on hire purchase system? And the seller takes the possession of the goods on
default of payment of installments by the hire buyer.

2. Distinguish between Hire Purchase and Instalment System of accounting.

3. Hire Purchases Ltd. purchased motor car on hire purchase system 12,000 was payable on
delivery i.e., on 1.1.2005 and the rest in four, equal installments of 12,000 each payable at
the end of each year. The seller, Hire Vendors Ltd. agreed to charge interest @ 5% on-the
yearly balances, the cash price of the car was 54,551. Depreciation @ 25% on written down
values was to be written-off in each year.

Prepare the necessary journal entries and ledger accounts in the books of Hire Purchasers
Ltd.

4. Dinesh Ltd., on April 1, 2003, purchased a machine from Rajesh Ltd., on hire purchase
basis. The cash price of the machine was 25,000. The payment was to be made 5,000 on
the date of the contract and the balance in four annual installments of 5,000 each plus
interest at 5% per annum payable on December 31 each year, and the first such instalment
being payable on 31.12.2005. Depreciation is to be charged @ 10% on original cost, Show
the journal entries and ledger accounts in the books of both the parties.

5. An engineering company purchased machine on Hire Purchase System over a period of

three years paying 846 as initial payment on 1.1.2002 and further annual payments of
2,000 due on 31.12.2002, 31.12.2003 and 31.12.2004. The cash price of the machine was
6,000 and the vendor company was to charge interest at 8% p.a. on outstanding balances.

Show the appropriate ledger accounts in the books of the hire purchaser assuming
depreciation @, 10% p.a, was to be charged on the machine. Assume that capitalisation was
to be done at the time of payment of each instalment.

6. A purchased four cars of 14,000 each on hire purchase system. The hire purchase price for
all the four cars was 60,000 to be paid 15,000 down, and three installments of 15,000
each at the end of each year. Interest is charged at 5% per annum and the buyer is
depreciating cars at 10% per annum on Straight Line Method.

After having paid down payment and first instalment, the buyer could not pay second
instalment and the seller took possession of three cars at an agreed value to be calculated
after depreciating cars at 20% per annum on written down value method. One car was left
with the buyer. The seller after spending 1,200 on repairing sold away all the three cars
to A for 35,000.

Open Ledger Account in the books of both the parties.

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Notes 7. X Ltd. purchased three cars from Y Ltd. costing 75,000 each on hire purchase system.
Payment was to be made for each car @ 45,000 down and the balance in three equal
installments together with interest at 12% p.a. X Ltd. writes off depreciation @ 20% p.a. on
diminishing balance. It paid the first instalment at the end of first year but could not pay
the next. Y Ltd. left one car with the purchaser adjusting the value of the other two cars
against the amount due. The cars were valued on the basis of 30% depreciation annually
on written down value.

Show the Car A/c and Seller’s A/c in the books of X Ltd. Show your calculations clearly.

8. X purchased seven trucks on hire purchase on 1.7.2006. The cash price of each truck was
50,000. He was to pay 20% of the cash purchase price at the time of delivery and the
balance in five half- yearly installments starting from 31.12.2006 with interest @ 5% per
annum.

On X’s failure to pay the instalment due on 30.06.2007 it was agreed that X would return
three trucks to the vendor and the remaining four would be retained by him., The vendor
agreed to allow him a credit for the amount paid against these three trucks less 25%. Show
the relevant ledger accounts in the books of X assuming that his books are closed in June
every year and deprecation @ 20% is charged on Trucks.

9. Aman purchased machinery under the Hire Purchase Agreement from Rahul. The cash
price of the machine was 15,000. The payment for the purchase was to be made as
follows: 3,000 on signing the agreement and 5,000 each at the end of first year, second
year third year respectively. Calculate the amount of interest included in each instalment.

10. Make a distinguish between hire purchase and lease transactions.

Answers: Self Assessment

1. True 2. False

3. False 4. True

5. True 6. True

7. False 8. False

9. False 10. False

11. False 12. Assets A/c

13. Repossess the goods immediately 14. forfeit

15. interest

12.8 Further Readings

Books I.M. Pandey, Financial Management, Vikas Publishing, New Delhi.

Khan and Jain, Management Accounting.

Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.

Prasanna Chandra, Financial Management - Theory and Practice, Tata McGraw Hill,
New Delhi (1994).

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 Unit 12: Hire Purchase

R.L. Gupta and Radhaswamy, Advanced Accountancy. Notes

S. Bhat, Financial Management, Excel Books, New Delhi.

S.N. Maheswari, Management Accounting.

V.K. Goyal, Financial Accounting, Excel Books, New Delhi.

Online link www.futureaccountant.com

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Notes Unit 13: Lease Purchase Accounts

CONTENTS

Objectives

Introduction

13.1 Types of Lease

13.2 Legal Framework of Leasing

13.2.1 Definition

13.2.2 Features

13.2.3 Modus Operandi

13.3 Computation of Lease Rental

13.4 Lease Evaluation

13.4.1 Lessee’s Perspective

13.4.2 Lessor’s Perspective

13.5 Accounting Treatment of Lease Purchase Transactions

13.6 Summary

13.7 Keywords

13.8 Review Questions

13.9 Further Readings

Objectives

After studying this unit, you will be able to:

 Define lease

 Explain the types and legal framework of leasing

 Make lease evaluation

 Illustrate the accounting treatment of lease transactions

Introduction

Leasing has become a timely and flexible source of term financing for industries, especially
when not everyone could have access to all types of projects and classes of assets. The practice of
leasing is an age-old one. The leasing of lands and buildings were common. Leasing of equipments,
plants and machineries are comparatively of recent development in India. Business communities
facing tight money conditions have developed leasing as a method of funding. The use of
leasing as a financing device runs as far back as the 1940s, though it emerged in India in an
organized manner only in the early seventies.

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 Unit 13: Lease Purchase Accounts

The credit for inventing lease financing in its present form goes to the USA. There, it developed Notes
from the sale and lease back techniques utilized by the large departmental stores and
supermarkets. Even before 1940s the idea was prevalent in chain grocery stores and in 1936 itself
this type of financial leasing was used by Safeway Stores Inc. However, till the 1960s, leasing
was looked at with suspicion as it was mostly identified with lack of commercial means to
obtain financing. Only in 1963, did leasing begin to gain importance when permission was
granted by the controller of currency of the US to the banks to engage in leasing of moveable
properties? This afforded respectability to leasing as a financing method.

Did u know? Why Leasing?

Acquisition of new plants and equipments are often required by business organizations.
While it is necessary to see the profitability in investing on new equipment, one must
equally be aware of the necessity to conserve cash resources to maintain liquidity. Under
such circumstances, leasing arrangements may come in handy for various reasons.

13.1 Types of Lease

Leasing is a unique type of commercial contract. Lease financing is often termed as equipment
leasing and it is broadly classified into:

John J. Hampton classifies leases into three basic types; they are:

(a) Operating Lease: In operating lease, the lease is usually for a shorter term and is generally
cancellable. As the asset is leasable repeatedly to several persons, the operating lease is
usually said to be a non-payout lease.

(b) Service Lease: It is an equipment leasing under which the lessor provides financing as well
as servicing of the assets during the lease period. The lessor will covenant with the lessee
to provide maintenance and servicing of the leased asset during the existence of the lease.

(c) Financial Lease: Financial lease is a long-term lease usually coinciding with the economic
life of the asset and is non-cancellable. It operates as a long-term debt financing and is
usually full-payout as in contrast to operating lease, it is usually a single lease repaying
the cost of the asset. They play a major role in financing of building of buildings and
equipments to industries.

Notes Finance vs Operating Lease

Financial Lease Operating Lease

1. The leased asset is use-specific. 1. The leased asset is of common-use
Usually the lessor buys the asset activity. The lessor already owns the
identified by the lessee and leases out asset and leases it out to several users
to him. successively.
2. The risks and rewards incidental to 2. The lessee is given the use of the asset for
ownership are passed on to the lessee. certain period. Ownership and benefits
The lessor only remains the legal and risks associated with it remain with
owner of the asset. the lessor.
3. Therefore, the lessee bears the risk of 3. Therefore, the lessor bears the risk of
Contd...
obsolescence. He is responsible for obsolescence. He is responsible for
maintenance, insurance, taxes, etc. maintenance, insurance, tax, etc.
4. It is an intermediate to long-term lease 4. It is a short-term lease, the lease period
essentially covering the expected being significantlyUNIVERSITY
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useful life of the asset. life of the asset.
5. During the primary lease period, 5. The lease is usually cancellable at short
usually the initial 3 or 5 or 8 years, the notice.
lease cannot be cancelled.
6. The lessors' capital outlay is fully 6. The lessors' capital outlay is not fully
 Financial Lease Operating Lease
1. The leased asset is use-specific. 1. The leased asset is of common-use
Usually the lessor buys the asset activity. The lessor already owns the
identified by the lessee and leases out asset and leases it out to several users
to him. successively.
Financial Accounting - II 2. The risks and rewards incidental to 2. The lessee is given the use of the asset for
ownership are passed on to the lessee. certain period. Ownership and benefits
The lessor only remains the legal and risks associated with it remain with
owner of the asset. the lessor.
Notes 3. Therefore, the lessee bears the risk of 3. Therefore, the lessor bears the risk of
obsolescence. He is responsible for obsolescence. He is responsible for
maintenance, insurance, taxes, etc. maintenance, insurance, tax, etc.
4. It is an intermediate to long-term lease 4. It is a short-term lease, the lease period
essentially covering the expected being significantly less than the useful
useful life of the asset. life of the asset.
5. During the primary lease period, 5. The lease is usually cancellable at short
usually the initial 3 or 5 or 8 years, the notice.
lease cannot be cancelled.
6. The lessors' capital outlay is fully 6. The lessors' capital outlay is not fully
amortized during the primary lease amortized during the period of a single
period. During a single lease, the lease. The lease rentals recovered during
lessor recovers through the lease a lease-period are not sufficient to cover
rentals his investment on the leased fully the cost of leased asset along with
asset along with interest and profit. an acceptable return thereon. Hence, it is
Hence, it is called full-pay-out lease. called a non-payout lease.
7. A financial lease is basically a debt 7. An operating lease is basically a rental
equivalent i.e. it is a form of agreement. Since it is an investment
borrowing in disguise. Since, it is a decision, the lessee has to decide
financing decision, the lessee has to whether to lease or buy the asset.
decide whether to lease or borrow and
buy the asset.
8. The lessor takes the role of a financier. 8. The lessor is specialized in handling and
Usually, the lessor is a financial operating the particular asset and
institution and cannot render usually provides in specialized services.
specialized service connection with
the asset.
9. This type of lease is generally suitable 9. This type of lease is suitable for
for equipment that is tailor-made and equipment that has longer economic life
does not have ready resale or release and ready resale or re-lease market i.e.,
market, e.g. heavy machines, etc. automobiles, computers and office
equipments.

Self Assessment

Fill the blanks:

1. In operating lease, the lease is usually for a shorter term and is generally .....................
2. ..................... is an equipment leasing under which the lessor provides financing as well as
servicing of the assets during the lease period.

3. Financial lease is a ..................... lease usually coinciding with the economic life of the asset
and is non-cancellable.
4. In ..................... the risks and rewards incidental to ownership are passed on to the lessee.

5. An ..................... lease is basically a rental agreement.

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13.2 Legal Framework of Leasing Notes

The legal provisioning of lease financing covers the following:

13.2.1 Definition

Leasing is a contractual transaction in which the owner of an asset (called lessor) gives the same
to another party (called lessee) the right to use it for a specified period of time (called lease
period) in consideration of certain payments (called lease rentals). The International Accounting
Standard No.17 (IAS - No.17) defines Leasing as “an agreement whereby the Lessor conveys, to
the lessee in return for rent, the right to use an asset for an agreed period of time.”

13.2.2 Features

(i) The Parties: There are mainly two parties – lessor and lessee. In a type of lease called
‘Leveraged Lease’, there is a third party, the financier, who provides the whole or part of
the finance needed for acquiring the asset. A lessor may be a leasing company,
a manufacturer, a banker or a subsidiary or an associate. A lessee may be a company,
a co-operative society, a firm, an individual, the government or its agencies.

(ii) The Asset: The subject of lease transactions is a tangible asset, which can be anything
ranging from a plant to an aircraft, land, building or an industry, etc.

(iii) The Agreement: Written lease agreement is not a legal necessity. It is desirable to execute
a written lease agreement when the period is large and considerations complex. Such
written agreements attract stamp duty according to the rates prescribed in respective
statutes.

(iv) The Period: The term of a lease is the period for which the lease agreement will be in
operation. When the lease period expires the asset reverts back to the lessor.

(v) The Rent: The lease rentals are the regular fixed payments made by the lessee over a
period of time at the beginning or at the end of say a month, a quarter, a half-year or year.
The same may be based on the cost of lessor’s investment, depreciation in the asset other
service charges if any. Although generally fixed, the amount and timing of lease rentals
can be tailored to the lessee’s cash flows. In up-fronted leases, more rentals are charged in
the initial years and less in the later years of the contract. The opposite happens in back-
ended leases. Sometimes, the lease contract is divided into two parts – primary lease and
secondary lease – for the purpose of lease rentals. Primary lease provides for the recovery
of the cost of the asset and profit through lease rentals during a period of about five years.
It may be followed by a perpetual secondary lease on nominal lease rentals. Various other
combinations are also possible.

(vi) The use: In a lease transaction, the lessee (user) acquires only the usage or custody of the
asset and is not the owner thereof. Legal ownership vests with the lessor. As the legal
owner, it is the lessor not the lessee, who is entitled to claim depreciation of leased asset.
Although, the lessor is the legal owner of a leased asset, the lessee bears the risk and
enjoys the return. Leasing separates ownership and use as two economic activities and
facilitates asset use without ownership.

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Notes 13.2.3 Modus Operandi

Lease financing normally goes through the following stages:

 The lessee selects the asset. This involves specification of the asset item, supplier, price,
terms of warranties, delivery period, installation and service, etc. The lessor normally
does not involve himself at this stage.

 The lessee approaches the lessor (s) and submits the formal application.

 Terms of lessee are negotiated and finalised with the lessor offering the best.

 The lessor and lessee sign the lease agreement giving details such as length of the lease
period, the distribution of rentals, mechanism of collection of rentals, etc. The lessee
assigns purchase rights to the lessor.
 The lessor purchases the asset from the manufacturer/dealer.

 The asset is delivered to the lessee who issues a certificate to the lessor for having inspected
the asset and conforming to the specifications.

 The assignable guarantees and service terms are passed on to the lessee. The lessee insures
the equipment and endorses the insurance policy in favour of the lessor.

 During the lease period, the lessee pays the rental regularly as agreed upon and enjoys the
use of the asset.

 At the end of the lease period, the asset is transferred back to the lessor. However, in long-
term lease contracts, the lessee may be given an option to buy or renew the lease.

Self Assessment

State whether the following statements are true or false:

6. Under a lease contract lessee is the owner of the asset.

7. In a lease transaction, the user acquires only the usage or custody of the asset and is not the
owner thereof.

8. The lease rentals are the regular fixed payments made by the lessee over a period of time.

9. The subject of lease transactions is an intangible asset.

13.3 Computation of Lease Rental

While pricing, the lessor has to consider the following:

(i) The rates should be competitive;

(ii) The rates should be adequate to earn a reasonable (risk adjusted) rate of return on
investment.

The lessor calculates as follows the present value of cash inflows arising from his ownership of
the asset.

n Dt(T) (SV)n
 (1  K)
t 1
t

(1  K)n

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D = Depreciation charge for year ‘t’ which varies from 1 to n Notes

T = Lessor’s tax-rate

K = Lessors’ post-tax required rate of return

n = Duration of the primary lease period

SVn = Net Salvage/residual value after the primary lease period.

The net recovery through lease rentals should be equal to cost of leased asset (net of initial
deposit) minus the present value of ownership benefits.

The Post-Tax Lease Rental (PTLR) can be worked out as:

Net recovery of lease rentals

PTLR =
PVIFA

Where K = required post-tax rate of return duration of the primary lease period Present Value
Interest Factor for Annuity.

n = duration of the primary lease period

PVIFA = Present Value Interest Factor for Annuity

The actual return of the lessor will also depend upon the timing of rental payments. So the cash
inflows by way of lease rentals may be discounted at appropriate post-tax rate of return. The
present value of all these lease rentals should be equal to the net recovery through lease rentals.

Post tax lease rentals is adjusted for the tax factor to get the lease rentals (LR) as follows:

PTLR
LR =
1  tax rate

Example: Mysore Limited is faced with a decision to purchase or acquire on lease a mini
car. The cost of the mini car is 1,26,965. It has a life of 5 years. The mini car can be obtained on
lease by paying equal lease rentals annually. The leasing company desires a return of 10% on the
gross value of the asset. Mysore Limited can also obtain 100% finance from its regular banking
channel. The rate of interest will be 15% p.a. and the loan will be paid in five annual equal
installments, inclusive of interest. The effective tax rate of the company is 40%. For the purpose
of taxation it is to be assumed that the asset will be written off over a period of 5 years on a
straight-line basis.

(a) Advise Mysore Limited about the method of acquiring the car.

(b) What should be the annual lease rental to be charged by the leasing company to match the
loan option?

For your exercise, use the following discount factors:

Discount rate Year 1 Year 2 Year 3 Year 4 Year 5

10% 0.91 0.83 0.75 0.68 0.62

15% 0.87 0.76 0.66 0.57 0.49

9% 0.92 0.84 0.77 0.71 0.65

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Notes Solution:

Loan amount 1,26,965

(a) Annual loan repayment = = = 32,892
Annuity factor of 15% 3.86

Note: Annuity factor is based on the assumption that loan instalment is repaid at the
beginning of the year to be at par with lease rentals. Such annuity factor at 15% works out
to be 3.86.

Year 0 1 2 3 4

Opening balance of principal 1,26,965 94,073 75,292 53,694 28,856

Interest @ 15% Nil 14,111 11,294 8,054 4,036

Total 1,26,965 1,08,184 86,586 61,748 32,892

Repayment of instalment 32,892 32,892 32,892 32,892 32,892

Closing balance 94,073 75,292 53,694 28,556 Nil

Difference between the instalment amount and opening balance of 4th year

Schedule of Cash Outflows in Debt Financing

End of Loan Interest @ Depreciation Tax Net cash PV factor P.V. of

year repayment 15% shield outflows @ 9% cash
outflows
(1)-(4)

0 32,892 - - - 32,892 1.00 32,892

1 32,892 14,111 25,393 15,802 17,090 0.92 15,723

2 32,892 11,294 25,393 14,675 18,217 0.84 15,302

3 32,892 8,054 25,393 13,379 19,513 0.77 15,025

4 32,892 4.036 25,393 11,772 21,120 0.71 14,995

5 32,892 - 25,393 10,157 (10,157) 0.65 (6,602)

Total present value of cash outflows: 87,335

Cost of assets 1,26,965

(a) Annual lease rentals = = = 30,447
Annuity factor of 10% 4.17

Schedule of Cash Outflows – Leasing Alternative

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Notes
End of the Lease Tax shield After tax cash PV factors Present value of
year payment outflows at 9% cash out flows

0 30,447 - 30,447 1.00 30,447

1-4 30,447 12,179 18,268 3.24 59,188

5 - 12,179 (12,179) 0.65 (7,916)

Total present value of cash outflows = 81,719

Decision: The present value of cash outflow under lease financing is 81,719 while that of debt
financing (i.e., owning the asset) is 87,335. Thus leasing has an advantage over ownership in
this case.

(b) Let the Annual Rental be ‘x’

Therefore the after tax cost of lease rentals will be 0.60x

Present value will be 0.60 ? X4.17 = 2,502x

Equating 2,502x = 87,335

The value of x is obtained at 34,906

Therefore, the lease rentals should be 34,906 to match the loan option

Example: Zonal garment factory needs an equipment for use. It has the option of outright
purchase or leasing the equipment. The data are given below. Recommend the best option that
the factory should choose.

Option 1

Purchase outright for a cost of 80 lakhs. It is to be entirely financed by a term loan @ 18% p.a.
interest and outstanding payable on a yearly basis. The term loan is to be repaid in eight equal
installments of 10 lakhs each, beginning from second year-end. The economic life of the
equipment is assessed to be ten years. The equipment will be depreciated @ 10% p.a. on a
straight-line basis, with insignificant salvage value at the end of the economic life.

The estimated maintenance expenses would be as detailed below:

Year 1 2 3 4 5 6 7 8 9 10

MC 4.00 4.40 4.88 5.47 6.18 7.05 8.11 9.41 11.01 13.00

(*) MC - Maintenance cost in lakhs

Option 2

The equipment may be leased for a ten-year period. The lessor will do the maintenance of the
equipment. The lessee has to pay 18 lakhs annual rental at the beginning of each year over the
lease period.

Note: Assume that the lessee is in a tax bracket of 50% and average cost of capital of the lessee
firm as 14% p.a.

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Notes Present value factors for discounting at 14% p.a. given below may be used for ready reference:

1 2 3 4 5 6 7 8 9 10

.877 .769 .675 .592 .519 .465 .400 .351 .308 .270

Solution:

Option 1: Purchase

Year Loan Amount Interest Mainte- Interest + Tax saved Outflow Total
balance on nance Maintenance 50% Interest + outflow
repaid
balance + Maintenance
Cost
Depreciation

1 . 26.40 13.20 5.20 5.20

2 10 26.80 13.40 5.40 15.40

3 10 4.88 25.48 12.74 4.74 14.74

4 10 5.47 24.27 12.13 4.14 14.14

5 10 6.18 23.18 11.59 3.59 13.59

6 10 7.05 22.25 22.25 11.13 13.13

7 10 8.11 21.51 10.76 2.76 12.76

8 10 9.41 21.01 10.50 2.50 12.50

9 10 11.01 20.81 10.41 2.41 12.41

10 - - 13.00 21.00 10.50 2.50 2.50

Calculation of Present Value

Year Total cash outflow DCF @ 14% Present value

1 5.20 0..877 4.56
2 15.40 0.769 11.84
3 14.74 0.675 9.95
4 14.14 0.592 8.37
5 13.59 0.519 7.05
6 13.13 0.465 6.11
7 12.76 0.400 5.10
8 12.50 0.351 4.39
9 12.41 0.308 3.82
10 2.50 0.270 0.67
Total present value of cash outflows =61.86

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Option 2: Lease Notes

Year Lease rent Lease rent after tax shield DCF @ 14% Present value
1 18 9 1.000 9.00
2 18 9 0..877 7.89
3 18 9 0.769 6.92
4 18 9 0.675 6.07
5 18 9 0.592 5.33
6 18 9 0.519 4.67
7 18 9 0.465 4.19
8 18 9 0.400 3.60
9 18 9 0.351 3.16
10 18 9 0.308 2.77
Total present value of cash outflows = 53.60

Analysis: The present value of net cash flows is lowest for lease option. Hence it is suggested to
take equipment on lease basis.

Task RKV Ltd. is considering the possibility of purchasing a multipurpose machine

which cost 10 lakhs. The machine has an expected life of 5 years. The machine generates
6 lakhs per year before depreciation and tax and the management wishes to dispose the
machine at the end of 5 years, which will fetch 1 lakh. The depreciation allowable for the
machine is 25% on written down value and the company’s tax rate is 50%. The company
approached a NBFC for a five-year lease for financing the asset, which quoted a rate of 28
per thousand per month. The company wants you to evaluate the proposal with purchase
option. The cost of capital of the company is 12% and for lease option it wants you to
consider a discount rate of 16%.

0 1 2 3 4 5

PV@ 12% 1,000 0.893 .797 0.712 0.636 0.567

PV@ 16% 1,000 0.862 0.743 0.641 0.552 0.476

Self Assessment

Fill in the blanks:

10. The net recovery through lease rentals should be equal to cost of leased asset (net of initial
deposit) minus the ....................... of ownership benefits.

11. The actual return of the lessor will also depend upon the timing of ....................... payments.

12. The cash inflows by way of lease rentals may be discounted at appropriate .......................

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Notes 13.4 Lease Evaluation

A leasing transaction has to be beneficial to both the lessee and lessor. Each party evaluates the
transaction from his points of view and arrives at the cost-benefit analysis. Let us understand
their viewpoints and techniques used to evaluate a lease transaction.

13.4.1 Lessee’s Perspective

There are many models to evaluate a lease from lessee’s angle. Some treat leasing as a finance
decision and compare the advantages of buying and leasing according to discounted cash flow
technique, using either Net Present Value (NPV) or Internal Rate of Return (IRR) method. Some
treat leasing as an investment decision while some others treat leasing as financial-cum-
investment decision.

After establishing the economic viability of acquiring an asset, a lessee has to weigh the various
options to finance such acquisition. The cost of alternative sources of finance – through cash
accrual, hire-purchase, leasing, public deposits, share capital, debentures, term loans, deferred
credit, etc. – has to be kept is mind. Broadly the decision variables boil down to ‘buy’ or lease’.

Buy or Lease

The following features of ‘buying’ and ‘leasing’ are noted for comparing both the options.

Features Buying Leasing

Initial cost/Deposit Incurred (cash outflows) Not incurred
Depreciation charges Available (cash inflows) Not available
Residual value Available (cash inflows) Not available
Management fees and lease rentals. Not payable. Payable (cash outflows).

Once the lessee accepts leasing as a financing proposition, for the sake of comparison, we limit
ourselves to after-tax cash flows. Let us evaluate separately under NPV and IRR method.

Once the lessee accepts leasing as a financing proposition, for the sake of comparison, we limit
ourselves to after-tax cash flows. Let us evaluate separately under NPV and IRR method.

NPV Method

Under this method, the present value of cash flows associated with the buying and leasing
alternatives are independently ascertained and compared. The alternative that shows higher
NPV is preferred. But the basic question is to decide the rate at which the cash flows will be
discounted to arrive at the Net Present Values. However, we can evaluate a ‘Buy or Lease’
preposition by assuming certain discount rate as worked out in the following cases.

Example: A firm wishes to acquire a machine costing 12000. It has two options. It can
acquire the machine by borrowing 10000 and meeting the balance as margin from own sources.
The loan is repayable in 5 year-end installments at an interest rate of 15% p.a. Alternatively, it
can lease-in the asset at yearly rental of 3200 payable at year-end. The firm can claim 25%
depreciation on WDV method. It also has an effective tax rate of 50% and expects a discounting
rate of 18%. Let us assume that at the end of 5th year, the machine is sold for 4000 and the excess
realization, if any over the written down value is subject to tax. Which option is advisable for the
firm?

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Solution: Notes

Since there is no cash inflow, the net post-tax discounted cash flow under lease ’ option is
5003.47 which is lesser than the net post-tax discounted cash outflow of 5191.91 under ‘Borrow
and Buy’ option. Hence, leasing should be advisable for the firm in the above example.

IRR Method

Under this method, a lessee’s evaluation will proceed as follows:

(i) IRR under the ‘buying’ alternative is computed.

(ii) IRR under the ‘leasing’ alternative is computed. IRR computation is made based upon the
post-tax net cash outflows.

(iii) A choice between buying and leasing is taken by comparing the IRR under the two
alternatives. The alternative having a higher IRR is preferred.

!
Caution In the IRR analysis, the lessee’s evaluation is based on cash flows associated
with various options. But the effect of other variables like lease management fee, sales tax
on lease rental, lessee’s tax position, issues relating to flexibility of lease agreement in the
event of contingencies, alternative sources and cost of capital, lessee’s capital structure,
urgency of finance, etc., will influence the decision to ‘buy or lease.’

13.4.2 Lessor’s Perspective

While evaluating a lease, a lessor faces a problem of whether to accept a lease plan or not, or
which plan among the various alternatives to accept, or how to quote lease rates. In answering
these questions, lessors commonly adopt the technique of Internal Rate of Return (IRR). This
simple analytical technique of capital budgeting is used since a lessor’s expected cash inflows
and outflows are known with near certainty. IRR is the rate which discounts these cash flows to
zero. If this IRR is higher than the weighted after-tax average cost of capital (of the lessor), the
lease plan is accepted.

Cash Inflows

The lessors’ inflows from a financial lease are:

(i) Initial/security deposit, (ii) Lease rentals, (iii) Management fees, (iv) Tax benefit on account
of depreciation, etc. (v) Salvage/residual value at the termination of agreement.

Cash Outflows

The following outflows are most perceptible in a lease deal.

(i) Purchase cost of the asset, (ii) Financing cost, (iii) Administrative charges, (iv) Tax outflows,
including sales tax.

Cost of Capital

The cost of leasing relates directly to the cost of the lease to the lessor. Lessor view investing in
a lease the same way the lenders evaluate the loans or investment judge investments. At the
time of a lease deal the lessor receives some initial deposit from the lessee. Rent is a function of
the lessor's investment risk and cost. The cost of capital includes both the debt and equity fund.

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Notes Risk Factor

Apart from considering the cash inflows arising from leasing out the assets, the lessor also
makes an assessment of the risk involved in the transaction. A lease is similar to a term loan in
the form of an asset. Hence, while appraising a lessee, a lessor will apply the sound principles of
lending as a banker does. Depending upon his risk perception on the lessee, the lessor may
demand higher rentals, increased initial/security deposit, personal guarantees, shorter lease
term, additional collateral security, etc.

Example: Let us take an example to evaluate a lease plan from lessors’ perspective using
IRR technique.

A firm wishes to let on lease a machine costing 1 lakh financed 75% through debt and the
balance through equity. Pre-tax explicit cost of debt is 18% and that of equity is 15% per annum.

The firm has an effective tax rate of 45% and can claim 25% on WDV method. The residual value
of the machine is 15,000 at the end of 5th year. The lessor has to spend 2000 per year towards
maintenance of machine and administration. The lessee agrees to pay annual year-end rent of
35,000 for 5 years; security deposit of 1000 and one-time management fee of 1000 at the
beginning of the lease. Is the above plan beneficial to the lessor?

Solution:

The lessor’s cash flow profile:

(i) Cash outflow at year 0

Cost of Machine 1,00,000.00

Less: Security Deposit 1000.00
Management Fee 1000.00 2,000.00
Net Cash Outflow 98,000.00

(ii) Annual Net Cash Inflow

(a) Inflow

I II III IV V

Lease Rentals 35,000 35,000 35,000 35,000 35,000

Residual Value of Machine - - - - 15,000

35,000 35,000 35,000 35,000 50,000

(b) Outflow

Maintenance /Admn. cost 2,000 2,000 2,000 2,000 2,000

Tax (see working below) 3,600 6,413 8,522 10,104 11,290

C. Net Cash Inflow 29,400 26,587 24,478 22,896 36,710

(A-B)

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Notes
Computation of Annual Tax

(a) Income
Lease Rentals 35,000 35,000 35,000 35,000 35,000

(b) Expenditure

Maintenance & Admn 2,000 2,000 2,000 2,000 2,000

Depreciation 25,000 18,750 14,063 10,547 7,910

27,000 20,750 16,063 12,547 9,910

(c) Taxable Income (a-b) 8,000 14,250 18,937 22,453 25,090

(d) Tax @ 45% 3,600 6,413 8,522 10,104 11,290

Post Tax Profit 4,400 7,837 10,415 12,349 13,800

(iii) Computation of Internal Rate of Return (IRR)

Year Cash Cash Discount Present Discount Present

Outflow Inflow Factor at 12% Value Factor at 14% Value

0 98,000

1 - 29,400 0.8928 26,248 0.8771 25,787

2 - 26,587 0.7971 21,192 0.7694 20,456

3 - 24,478 0.7117 17,421 0.6749 16,520

4 - 22,896 0.6355 14,550 0.5920 13,554

5 - 36,710 0.5674 20,829 0.5193 19,063

100,240 95,380

NPV +2,240 -2,620

IRR = 12 + (2240/2240 + 2620) × 2 = 12 + 0.92 = 12.92%

(iv) Weighted Average Cost of Capital

D S
Ko = Kd (1 – t) + Ke
DS DS

= (18(1 – 45/100) × 75,000/100,000) + (15 × 25,000/100,000)

= 7.425 + 3.75 = 11.175%

Since, the tax-adjusted weighted average cost of capital works out to 11.175%, which is less than
the IRR of 12.92%. The lessor can take up this beneficial lease plan.

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Notes Self Assessment

Fill in the blanks:

13. The alternative that shows ................ NPV is preferred.

14. If this IRR is higher than the ................ average cost of capital (of the lessor), the lease plan
is accepted.

13.5 Accounting Treatment of Lease Purchase Transactions

The accounting treatment of lease transactions in the books of lessee and lessor are as follows:

1. Accounting Treatment in the books of lessee: The assets acquired on lease do not appear in
the balance sheet of the lessee. In order to give a true and fair view of the financial
statements, the lessee should be required to disclose the amount of leased assets and
financial obligations as a footnote to the balance sheet. Total lease rentals, however,
appear as chargeable expenses in the Profit & Loss Account.

2. Accounting Treatment in the books of Lessor: In case of lease transactions the following
journal entries are passed by the lessor in their books of accounts:

(a) When Asset is leased out

S. No. Particulars L.F. Dr. Cr.

Lease Receivables A/c Dr.
To Fixed Asset A/c
(Fixed asset leased out)

(b) When lease rent received

Bank A/c Dr.

To Lease Rental A/c
(Rent received for leased asset)

The lessors show in their balance sheets, leased assets at cost less depreciation as fixed assets.
Lease rentals earned are taken as income in the Profit & Loss Account.

The lending banker should ensure that the asset is depreciated within the primary lease period.
Even in respect of the companies, which depreciate the leased assets over the primary lease
period different depreciation methods, are followed. These methods include:

(a) Equal depreciation over the primary lease period

(b) Depreciation based on lease rentals ratio

(c) Sum of year digit method

(d) ICAI method and its variations

It can be seen that the same leasing transaction reflects difference operational results based on
the depreciation policy adopted by the lessor. It makes inter-firm comparison difficult.

The Institute of Chartered Accountants of India (ICAI) has published guidance note for lease
accounting in line with International Accounting Standard – IAS 17.

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The accounting of finance lease as recommended by ICAI guidelines are as follows: Notes

(a) Calculate the IRR built in the lease rental structure.

(b) Apply the IRR on the principal sum that is outstanding at the beginning of the period. This
would be the net income earned during the period.

(c) Net-off from the lease rental receipt the amount received as in (b) above. This would be
the principal component built into the lease rental.

(d) Depreciate the asset as required under company law. If the depreciation as per company
law is less than the principal recovery calculated as per (c) above then debit the difference
to the Profit & Loss Account as a “Lease Equalisation Account” debit. On the other hand, if
the depreciation as per company law is more than the principal recovery calculated as per
(c) above, then credit the difference to the P & L A/c as a “Lease Equalisation Account”
credit.

(e) Corresponding to the “Lease Equalisation Account” credit/debit there would be a “Lease
Terminal Adjustment” debit/credit shown under the head “current Asset/Liability” in
the balance sheet.

The essence of the ICAI guidelines is to bring leases at par with loans and hire purchase finance.
This is because the net income recognized as per the guidelines for leases would be lease rentals
minus the principal recovery, which in effect is the interest component, built into the lease
transaction. Thus, ICAI’s guidelines should be followed.

It may be noted that ICAI’s guidelines are different from IAS-17 as follows:

(i) ICAI’s guidelines aim to show the leased asset as a fixed asset in the balance sheet of a
lessor. IAS-17 shows the discounted value of the future lease rentals as an asset. ICAI’s
logic is to emphasize ownership status and claim depreciation allowance under Section 32
of Income Tax Act.

(ii) Amortization of the principal sum is directly charged to asset under IAS-17 whereas as per
ICAI’s guidelines it is shown as two items i.e. statutory depreciation and lease equalization
credit/debit.

The requirement of charging the principal recovery as statutory depreciation and lease
equalization charge has arisen because our Companies Act, 1956 does not look at a leasing
transaction in the right perspective. This calls for suitable changes in company law. Thereafter
ICAI’s guidelines can be amended in line with IAS-17.

Sale and Leaseback Transactions

Under this arrangement, a firm sells an asset to a leasing company, which in turn leases the asset
back to the firm. The asset is generally sold at market price. The firm receives the sale price in
cash. Through this transaction, the firm unlocks its investment in the existing asset by its sale,
improves its liquidity, but still retains the right to possess and use the asset during the basic
lease period.

This arrangement is beneficial to both the lessor and lessee. The lessor gets periodic lease rentals
and gets the benefit of tax credits due to depreciation. The lessor, as the legal owner of the asset,
is also entitled to any residual value the asset might have at the end of the lease period. Besides,
retaining the use of the asset the lessee gets immediate cash, which improves his cash flow
position. It also improves ratio of return on investment and increases the borrowing power of
the unit. Where the asset has been fully depreciated, the seller (lessee) is also in a position to
improve the bottom line. For this purpose the block concept of depreciation under Income Tax

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Notes Act has come very handy to these sellers (lessees). The RBI has, however, not permitted banks to
finance sale and leaseback transaction.

The sale and leaseback arrangement can be an operating lease or financial lease, depending
upon the intentions of the parties in the agreement. It is widely prevalent in the retail market in
Western countries. Companies facing short-term liquidity problem also favour it.

Self Assessment

State whether the following statements are true or false:

15. The assets acquired on lease appear in the balance sheet of the lessee.

16. Lease rentals earned are taken as income in the Profit & Loss Account in lessor’s books of
accounts.
17. Under sale and leaseback arrangement, a firm sells an asset to a leasing company, which
in turn leases the asset back to the firm.

13.6 Summary

 Leasing is a contractual transaction in which the owner of an asset (called lessor) gives the
same to another party (called lessee) the right to use it for a specified period of time (called
lease period) in consideration of certain payments (called lease rentals).

 In operating lease, the lease is usually for a shorter term and is generally cancellable.

 Financial lease is a long-term lease usually coinciding with the economic life of the asset
and is non-cancellable.

 The cash inflows by way of lease rentals may be discounted at appropriate post-tax rate of
return.

 The key methods of lease evaluation are Net Present Value (NPV) or Internal Rate of
Return (IRR) method.

 Under NPV method, the present value of cash flows associated with the buying and
leasing alternatives are independently ascertained and compared.

 In the IRR analysis, the lessee’s evaluation is based on cash flows associated with various
options.

 The assets acquired on lease do not appear in the balance sheet of the lessee.

 The lessors show in their balance sheets, leased assets at cost less depreciation as fixed
assets. Lease rentals earned are taken as income in the Profit & Loss Account.

 Under sale and leaseback arrangement, a firm sells an asset to a leasing company, which
in turn leases the asset back to the firm.

13.7 Keywords

Finance Lease: A lease that transfers substantially the entire risks and rewards incident to
ownership of an asset.

Gross Investment in the Lease: Aggregate of minimum lease payments under a finance lease
plus any unguaranteed residual value accruing to the lessor.

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Minimum Lease Payments: Payments over the lease term that the lessee makes to the lessor Notes
(other than contingent rent, cost of services and taxes) including guaranteed residual value of
the leased asset or promised purchase price at the expiry of the lease period.

Net Investment in the Lease: Gross investment in the lease less unearned finance income.

Operating Lease: A lease other than the finance lease.

Unearned Finance Income: It is the sum of finance charges over the lease period.

13.8 Review Questions

1. Define leasing. How does it differ from hire purchase?

2. Briefly discuss the various aspects of appraisal considered by a banker while financing to
a leasing and hire purchase company.

3. Finance lease operates as a long-term debt financing and is usually full-payout as in

contrast to operating lease. Identify the other differences between the operating lease and
finance lease.

4. A finance company leases out machinery costing 50,00,000. The finance company has
asked for a 20% down payment and the balance in twenty equal quarterly installments.
Each installment is payable at the end of every quarter. The lessor requires a pre-tax return
of 16% per annum from the deal. How much should be the quarterly lease rental? What is
the total amount of interest earned by the lessor from the deal?

5. Distinguish between a lease and hire purchase transactions.

6. Illustrate the accounting treatment of lease transactions in the books of lessor and lessee.

7. DLF Ltd. is engaged in the business of leasing and hire purchase. The company also
functions as a merchant banker equity researcher, corporate financier, portfolio manager,
etc. The company provides fund based as well as non-fund based financial solutions to
both wholesale and retail segments.

DLF Ltd. has been approached by A Ltd., Mumbai, for financial help. A Ltd. manufacturers
process system for food processing, pharmaceuticals, engineering, dairy and chemical
industries. A wide range of centrifugal separators, plate, spray drudgers, custom fabricated
equipment for exotic metals, refrigeration compressors, are also manufactured by the
company. One of the major strengths of the company is project management.

A Ltd. has a well-equipped R&D centre. It has pilot plant facilities and a modern laboratory
for chemical, metallurgical and mechanical analyser. The company has also set up a
technology centre with advanced testing facilities. Recently, the manager of the technology
centre has requisitioned for the acquisition of computerised sophisticated equipment for
conducting important tests.

The equipment is likely to have the useful life of three years. The cost of the equipment is
10 crore. The scrap value of the equipment at the end of its useful life will be zero for the
company. The finance manager of A Ltd. has suggested that the company should take a
loan for three years from a commercial bank. Repayment of the loan would be made at the
end of each year in three equal installments. The repayments would comprise of the
(i) principal, and (ii) interest at 10% p.a. (on the outstanding amount in the beginning of
the year). A Ltd. uses a cost of capital of 15% to evaluate the investments of this type. The
equipment will be depreciated @ 33.3% p.a. (WDV).

P. Securities Ltd. has agreed to give the equipment to the company on a three-year lease.
The annual rental for the lease, payable in the beginning of each year, would be 4 crore.

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Notes P. Securities Ltd. discounts its cash flows @ 14%. The equipment is depreciable at 33.3% p.a.
(straight line method). The lessee may exercise its option to purchase the equipment for
4 crore at the termination of the lease.
A Ltd. would bear all maintenance, insurance and other charges in both the alternatives.
Both the companies pay tax @ 35%.
You are a practicing Company Secretary. You are approached by the Managing Director of
A Ltd. to help the company in evaluating the proposal.
Prepare a report for the Managing Director of A Ltd. showing the effect of the lease
alternative on the wealth of its shareholders. Support your answer with appropriate
calculations.
8. Discuss the lease evaluation from both the lessor and lessee perspective.
9. The Institute of Chartered Accountants of India (ICAI) has published guidance note for
lease accounting in line with International Accounting Standard – IAS 17. What are those
guidelines?
10. Illustrate the key methods of lease evaluation.

Answers: Self Assessment

1. cancellable 2. Service lease

3. long-term 4. finance leasing
5. operating 6. False
7. True 8. True
9. False 10. present value
11. rental 12. post-tax rate of return
13. higher 14. weighted after-tax
15. False 16. True
17. True

13.9 Further Readings

Books I.M. Pandey, Financial Management, Vikas Publishing, New Delhi.

Khan and Jain, Management Accounting.
Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.
Prasanna Chandra, Financial Management - Theory and Practice, Tata McGraw Hill,
New Delhi (1994).
R.L. Gupta and Radhaswamy, Advanced Accountancy.
S. Bhat, Financial Management, Excel Books, New Delhi.
S.N. Maheswari, Management Accounting.
V.K. Goyal, Financial Accounting, Excel Books, New Delhi.

Online link www.futureaccountant.com

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 Unit 14: Insurance Claim

Unit 14: Insurance Claim Notes

CONTENTS

Objectives

Introduction

14.1 Loss of Stock Policy

14.1.1 Computation of the Value of Stock on the Date of Fire

14.1.2 Computation of Actual Amount of Claim

14.2 Average Clause

14.3 Loss of Profit Policy

14.4 Summary

14.5 Keywords

14.6 Review Questions

14.7 Further Readings

Objectives

After studying this unit, you will be able to:

 Prepare loss of stock policy

 Illustrate insolvency accounts

Introduction

A business may suffer abnormal losses due to different reasons such as fire, theft, strike, etc.
Among all the most common is loss by fire. When a fire takes place the business naturally incurs
heavy losses and in turn the normal business operation disrupted. To cover the loss from such
events a business may take on an insurance policy. Insurance being a contract of indemnity, the
claim for loss is restricted to the actual loss of assets.

14.1 Loss of Stock Policy

A business takes fire insurance policy to cover the loss of assets including stocks and loss of
profit (consequential loss). In case of loss of a fixed asset, the computation of loss is simple. The
value of the assets can be ascertained form the books of accounts. When stock is destroyed by
fire, the computation of loss is not simple because the prices of stock are changing according to
the varying rates.

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Notes

Notes Consequential Loss Policy

This policy is suitable for business establishments and corporates for whom business
interruption would mean heavy monetary loss in view of huge fixed costs.

Fire consequential loss policy provides cover for:

 Expenses and increased cost of working as a result of business interruption following

a loss covered by the fire policy.

 This cover can be taken for the maximum period of the anticipated interruption in
the event of loss. In addition, the supplier’s and the customer’s premises on which
the business is dependent, cost of auditors fee (required to submit the monetary
claim) can also be insured.

 It covers reduction in gross profit due to a reduction in turnover followed by

interruption of business.

 The additional expenditure necessarily incurred for avoiding or reducing the fall in
turnover during the interruption period is covered under this policy.

 Also, there are overhead expenses of running the business such as salaries, wages,
taxes, interest, etc. which continue to be incurred in spite of the interruption of the
production.

The following are the key methods to compute the claim for loss of stock:

 Computation of the value of stock on the date of fire.

 Computation of actual amount of claim.

14.1.1 Computation of the Value of Stock on the Date of Fire

Sometimes it is not possible to compute the value of stock destroyed by fire form the stock
register. In such case the value of stock on the date of fire can be ascertained by constructing a
Memorandum Trading A/c up to the date of fire.
The given below is the proforma of Memorandum Trading A/c:

Memorandum Trading Account (up to the date of fire)

Particulars Particulars
To Opening Stock By Sales
To Purchases Less: Return Inwards
Less: Return Outward By Closing Stock (Balance)
To Direct Expenses A/c
To carriage Inward A/c
To Wages A/c
To Gross Profit (% of sale)

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14.1.2 Computation of Actual Amount of Claim Notes

The Memorandum of Trading A/c shows the value of stock which is supposed to exit at the time
of fire. In order to compute the actual amount of claim to be lodged, the value of salvaged stock
should be deducted from the estimated value of the closing stock. The actual amount of claim to
be lodged is as follows:

Book value of stock (Balance as per Memorandum Trading A/c) ———

less: Salvaged ———

Loss of stock ———

Example: On 12th June, 2010 fire occurred in the premises Mr. X. Most of the stocks were
destroyed, cost of stock salvaged being 11,200. From the books of account, the following
particulars were available:

(i) His stock at the close of account on December 31st, 2009 was valued at 83,500.

(ii) His purchases from 1-1-2010 to 12-6-2010 amounted to 1,12,000 and his sales during that
period amounted to 1,54,000.

On the basis of his accounts for the past three years it appears that he earns on an average a gross
profit of 30% of sales.

Compute the amount of the claim.

Solution:

Books of Mr. X
Memorandum Trading Account for the period 1-1-2010 to 12-6-2010

Particulars Particulars
To Opening Stock 83,500 By Sales 1,54,000
To Purchases 1,12,000 By Closing Stock (Balance) 87,700
To Gross Profit (30 % of sale)
46,200
2,41,700 2,41,700

Amount of claim for the loss of stock as on 12-6-2010

Book value of stock 87,700

Less: salvaged 11,200

Claim to be lodged 76,500

Self Assessment

Fill in the blanks:

1. The value of the assets can be ascertained form the ....................

2. Sometimes it is not possible to compute the value of stock destroyed by fire form the
....................

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Notes 3. In order to compute the actual amount of claim to be lodged, the value of salvaged stock
should be deducted from the .................... of the closing stock.

4. The value of stock on the date of fire can be ascertained by constructing a .................... up to
the date of fire.

5. When stock is destroyed by fire, the computation of loss is not simple because the prices
of stock are changing according to the ....................

14.2 Average Clause

The amount of insurance premium is paid at regular intervals depends on the value of stock
insured. More the value of stock insured more is the amount of premium to be paid. In order to
reduce the burden of insurance premium the average stock of a business may no be adequately
insured with the assumption that fire may not destroy the whole stock.

Did u know? What is under-insurance?

When the value of an insurance policy taken by a business is less than the value of average
stock lying in the godown is known as under-insurance.

Generally the insurance policies contain an average clause to discourage under-insurance.

In case of partial loss of stock, the amount of claim for loss of stock is proportionately reduced,
considering the ratio of policy amount to the value of stock as on the date of fire. The amount of
Net Claim is calculated as:

Sum Insured
Net Claim  Loss of Stock 
Insurable Amount (Total Cost)

Example: Continuing with the above example, compute the value of claim by considering
the following additional information:

(i) Some stock was salvaged in the damaged condition and its value in that condition was
agreed at 10,500.

(ii) Mr. X has insured his stock for 60,000.

Solution:

1. Computation of value of claim to be lodged for the loss of stock as on 12-6-2010

Book value of stock 87,700

Less: salvaged 11,200

Agreed value of damaged stock 10,500 21,700

Claim to be lodged 66,000

2. Amount of Claim

The formula to compute the amount of claim is:

Sum Insured
NetClaim  Lossof Stock 
InsurableAmount(Total Cost)

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Notes
60,000
Amount of Claim   66,000  45,154
87,700

Self Assessment

Fill in the blanks:

6. The amount of insurance premium is paid at regular intervals depends on the value of
...................

7. When the value of an insurance policy taken by a business is less than the value of ...................
lying in the godown is known as under-insurance.

8. In order to reduce the burden of ................... the average stock of a business may no be
adequately insured with the assumption that fire may not destroy the whole stock.

9. Generally the insurance policies contain an average clause to discourage ...................

10. Net claim = ...................* Sum assured/Insurable amount.

14.3 Loss of Profit Policy

In case of a fire the business has to incur some consequential losses apart from the direct loss on
account of stock and other assets destroyed. The consequential losses occurred because for some
time the business is disorganised or has to discontinued and during that period the fixed expenses
of the business like salaries, rent, etc., continue. Moreover there is the loss of profit which the
business would have earned during that period. This types of losses can be insured against the
"Loss of Profit" policy. This type of policy covers the following items:

 Loss of net profit

 Standing charges

 Any increased cost of working.

To measure the loss suffered by the firm due to fire it is necessary to set up some standards
expressed in such units to represent the volume of work. There should be a direct relation
between the amount of standard and the amount of profit raised. The most satisfactory unit of
measuring the prosperity is usually the turnover.

The following are the essential conditions for establishing a claim for loss of profit:

 the insured's premises or the property are destroyed or damaged by the peril defined in
the policy,

 the insured's business carried on the premises is interrupted or interfered with as a result
of such damages.

Conditions included in a Loss of Profit Insurance Policy

Insurance policies covering loss of profit contain the following conditions usually:

Rate of Gross Profit: The rate of Gross Profit earned on turnover during the financial year
immediately before the date of damage.

Annual Turnover: The turnover during the twelve months immediately before the damage.

Standard Turnover: The turnover during that period in the twelve months immediately before
the date of damage which corresponds with the Indemnity Period.

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Notes To which such adjustment shall be made as may be necessary to provide for the trend of the
business and for variations in or special circumstances affecting the business either before or
after the damage or which would have affected the business had the damage not occurred, so
that the figures thus adjusted shall represent, as nearly as may be reasonably practicable the
results which but for the damage would have been obtained during the relative period after
damage.

Indemnity Period: The period beginning with the occurrence of the damage and ending not later
than twelve months thereafter during which the results of the business shall be affected in
consequences of the damage.

Memo 1: If during the indemnity period goods shall be sold or services shall be rendered
elsewhere than at the premises for the benefit of the business either by the insured or by others
on the insured’s behalf, the money paid or payable in respect of such sales or services shall be
brought into account in arriving at the turnover during the indemnity period.

Memo 2: If any standing charges of the business be not insured by this policy then in computing
the amount recoverable hereunder as increase in cost of workings that proportion only of the
additional expenditure shall be brought into account which the sum of the Net Profit and the
insured Standing Charges bear to the sum of the Net Profit and all standing charges.

Memo 3: This insurance does not cover loss occasioned by or happening through or in consequence
of destruction of or damage to a dynamo motor, transformer, rectifier or any part of an electrical
installation resulting from electric currents however arising.

The amount payable as indemnity is the sum of (a) and (b) below:

(a) In respect of reduction in turnover: The sum produced by applying the rate of gross profit to
the amount by which the turnover during the indemnity period shall, in consequence of
the damage, falls short of the standard turnover.

(b) In respect of increase in cost of working: The additional expenditure [subject to the provisions
of Memo (2) given above] necessarily and reasonably incurred for the sole purpose of
avoiding or diminishing the reduction in turnover which, but for that expenditure, would
have taken place during the indemnity period in consequence of the damage: the amount
allowable under this provision cannot exceed the sum produced by applying the rate of
gross profit to the amount of reduction avoided by the additional expenditure.

The amount payable arrived at as above is reduced by any sum saved during the indemnity
period in respect of such of the insured standard charges as may cease or be reduced in consequence
of the damage.

Insurance policies provide that if the sum insured in respect of loss of profit is less than the sum
produced by applying the rate of gross profit to the annual turnover (as adjusted by the trend of
the business or variation in special circumstances affecting the business either before or after the
damage or which would have affected the business had the damage not occurred), the amount
payable by the insurer shall be proportionately reduced. This is nothing but application of the
average clause.

The turnover of a business rarely remains constant and where there has been an upward or
downward trend since the date of the last accounts and up to the date of the fire, the “standard
turnover” should be appropriately adjusted, as per definition given above.

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 Unit 14: Insurance Claim

Notes
Example: From the following information, calculate the claim made on a ‘loss of profit’
policy.

(i) Indemnity period 13 months

(ii) Sum insured 2,00,000

(iii) Turnover, last financial year ended Dec. 31, 2010 12,00,000.

(iv) Gross Profit i.e., Net profit plus insured standing charges, 2,00,000 giving a gross profit
rate of 20%.

(v) Net profit plus all standing charges, 2,50,000 i.e., 50,000 of the standing charges are not
insured.

(vi) Fire occurs on 31st March 2011, and affects business for 6 months.

(vii) Turnover for 12 months ended 31st March, 2011, 11,70,000.

(viii) Turnover: 1-4-2000 to 30-9-2010 5,00,000

1-4-2011 to 30-9-2011 3,00,000

Reduction in turnover 2,00,000

(ix) Increase in cost of working, 30,000 otherwise of which turnover during 1-4-2011 to
30-9-2011 would reduce hereinafter by 1,60,000.

(x) Saving in insured charges in the indemnity period 10,000.

The claim in respect of profit will be calculated as follows:

(a) Short Sales: 5,00,000

Reduction in Turnover 1-4-2010 to 30-9-2010 3,00,000

2,00,000

Down-trend:

 12,00,000 
Quarterly sales in 2010   3 3,00,000
 12 

12,00,000
Sales of first quarter in 2011: 11,70,000 –  
 9 2,70,000
 12 

Adjusted Annual Turnover:

Sales for the period 1-4-2010 to 31-12-2010 (11,70,000 – 2,70,000) 9,00,000
Add: Sales from 1-1-2011 to 31-3-2011 2,70,000
11,70,000
(b) Gross Claim: Gross Profit @ 20% on (a) 40,000
Add: Claim for increase in cost of working 24,718
64,718
Less: Saving in insured standing charges 10,000
54,718

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Notes Claim for increased cost of working is subject to two tests

G.P. on Annual Turnover

(i) Increased cost of working 
G.P. as above + Uninsured Standing Charges

20
11,70,000 ×
= 30,000 × 100 = 24,718.
20
11,70,000 ×  50,000
100

(ii) Gross Profit on sales generated by increased cost of workings

20
= 1,60,000 × = 32,000
100

Lower of the two, i.e., 24,718 is allowable

(c) Application of average clause:

Gross Profit of annual turnover, 20% on 11,70,000 2,34,000

Sum insured 2,00,000

2,00,000
Hence claim limited to 54,718  46,768
2, 34,000

Task Discuss the key provisions for preparing the statement of affairs under
Insolvency Act in India.

Self Assessment

Fill in the blanks:

11. To measure the loss suffered by the firm due to fire it is necessary to set up some standards
expressed in such units to represent the …………...

12. There should be a direct relation between the amount of standard and the amount of
………raised.

13. The most satisfactory unit of measuring the prosperity is usually the ………..

14.4 Summary

 A business may suffer abnormal losses due to different reasons such as fire, theft, strike,
etc.

 Among all the most common is loss by fire.

 When a fire takes place the business naturally incurs heavy losses and in turn the normal
business operation disrupted.

 A business takes fire insurance policy to cover the loss of assets including stocks and loss
of profit (consequential loss).

 Sometimes it is not possible to compute the value of stock destroyed by fire form the stock
register.

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 Unit 14: Insurance Claim

 In such case the value of stock on the date of fire can be ascertained by constructing a Notes
Memorandum Trading A/c up to the date of fire.

 The Memorandum of Trading A/c shows the value of stock which is supposed to exit at the
time of fire.

 In order to compute the actual amount of claim to be lodged, the value of salvaged stock
should be deducted from the estimated value of the closing stock.

 The amount of insurance premium is paid at regular intervals depends on the value of
stock insured.

 In case of partial loss of stock, the amount of claim for loss of stock is proportionately
reduced, considering the ratio of policy amount to the value of stock as on the date of fire.

14.5 Keywords

Annual Turnover: The turnover during the twelve months immediately before the damage.

Indemnity Period: The period beginning with the occurrence of damage and ending not later
than the twelve months thereafter during which the results of the business shall be affected in
consequence of the damages.

Standard Turnover: The turnover during that period in twelve months immediately before the
date of damage which corresponds with the indemnity period.

Under-insurance: When the value of an insurance policy taken by a business is less than the
value of average stock lying in the godown is known as under-insurance.

14.6 Review Questions

1. Illustrate the key methods to compute the claim for loss of stock.

2. Prepare the proforma of Memorandum trading A/c.

3. Generally the insurance policies contain an average clause to discourage under-insurance.

Discuss.

4. On 1st Oct 2004 fire occurred in the premises Mr. Ram. Most of the stocks were destroyed,
cost of stock salvaged being 15,000. From the books of account, the following particulars
were available.

(i) His stock at the close of account on December 31st, 2009 was valued at 90,500.

(ii) His purchases from 1-1-2004 to 1-10-2004 amounted to 120,000 and his sales during
that period amounted to 1,70,000.

On the basis of his accounts for the past three years it appears that he earns on an average
a gross profit of 25% of sales.

Compute the amount of the claim.

5. Why there is need for loss of profit policy in the business?

6. Identify the key conditions included in loss of profit insurance poicy.

7. Why loss of profit is limited to loss of gross profit?

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Notes Answers: Self Assessment

1. Books of accounts 2. Stock register

3. Estimated value 4. Memorandum Trading A/c
5. Varying rates 6. Stock insured
7. Average stock 8. Insurance premium
9. Under-insurance 10. Loss of stock
11. volume of work 12. profit
13. turnover

14.7 Further Readings

Books I.M. Pandey, Financial Management, Vikas Publishing, New Delhi

Khan and Jain, Management Accounting.

Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi

Prasanna Chandra, Financial Management - Theory and Practice, Tata McGraw Hill,
New Delhi (1994)

R.L. Gupta and Radhaswamy, Advanced Accountancy

S. Bhat, Financial Management, Excel Books, New Delhi

S.N. Maheswari, Management Accounting

V.K. Goyal, Financial Accounting, Excel Books, New Delhi

Online link www.futureaccountant.com

212 LOVELY PROFESSIONAL UNIVERSITY

LOVELY PROFESSIONAL UNIVERSITY
Jalandhar-Delhi G.T. Road (NH-1)
Phagwara, Punjab (India)-144411
For Enquiry: +91-1824-300360
Fax.: +91-1824-506111
Email: odl@lpu.co.in