Dcom104 Financial Accounting II
Dcom104 Financial Accounting II
Dcom104 Financial Accounting II
DCOM104
FINANCIAL ACCOUNTING - II
Copyright © 2012 KK Verma
All rights reserved
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.
CONTENTS
Objectives
Introduction
1.1 Meaning
1.4 Summary
1.5 Keywords
Objectives
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.
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.
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.
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.
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
5. Under partnership law, a partnership firm is not a legal entity, but only consists of individual
partners for the time being.
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.
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.
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.
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.
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.
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:
= 7100
= 9600
Solution:
100000 12 1200000
30000 6 180000
20000 2 40000
6 1
Interest on Capital = 1420000 × 7100
100 12
= 1,60,000 × 12 = 19,20,000
6 1
1920000 × 9600
100 12
2. Product 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:
= 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:
24,000 66 months
= 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 ( )
The interest on drawings is calculated @ 8%. Compute the interest on drawings of Mr. X.
Solution:
= 2,000
Self Assessment
7. No interest will be charged on drawings made by the partners in absence of the ......................
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.
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:
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.
Notes
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:
Dr. Cr.
Share of Profit Net Profit as per profit and loss account 76,000
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.
12. ................. is an assurance that a partner will not get as his share of profit less than the
guaranteed amount.
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.
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.
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.
1. False 2. False
3. True 4. False
Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.
Prasanna Chandra, Financial Management - Theory and Practice, Tata McGraw Hill,
New Delhi (1994).
CONTENTS
Objectives
Introduction
2.4 Summary
2.5 Keywords
Objectives
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.
Notes
(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.
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:
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:
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:
!
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.
(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:
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:
(b) Commission paid to a partner is charged to Profit and Loss Appropriation account
by recording the following entry:
To Reserve A/c
If Profit:
If Loss:
Figure 2.1 shows the proforma of profit and loss appropriation account.
Notes
Figure 2.1: Profit and Loss Appropriation A/c
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.
Notes Solution:
Books of Ajit, Chaudhary and Vishal
Journal
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)
Dr. Cr.
Particulars Amount Particulars Amount
( ) ( )
To Ajit's Salary 12,000 By Net profit as per profit and 35,660
loss 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
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
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
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.
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.
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.
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.
Notes Solution:
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
Dr. Cr.
Dr. Cr.
Date Particulars J.F. Asha’s Bony’s Date Particulars J.F. Asha’s Bony’s
2000 ( ) ( ) 2000 ( ) ( )
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.
Notes
Bony’s Capital A/c Dr. 1,835
Asha’s Capital A/c 1,835
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
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
R B
(`) (`)
Notes Net profit before charging interest on capital and partners salary was 25,600. They agree
on the following:
Prepare Profit and Loss Appropriation Account and partners capital accounts.
(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.
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.
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?
Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.
Prasanna Chandra, Financial Management - Theory and Practice, Tata McGraw Hill,
New Delhi (1994).
CONTENTS
Objectives
Introduction
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
3.4 Summary
3.5 Keywords
Objectives
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.
Notes
Notes A newly admitted partner acquires two main rights in the firm:
1. Right to share in the assets of the partnership firm
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:
= 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.
Notes Following cases may arise for the calculation of new profit sharing ratio and sacrificing ratio:
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:
The new profit sharing ratio of Rohit, Mohit and Sumit is:
= 12 : 8 : 5
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:
=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:
Therefore, the new profit sharing ratio of Him, Raj and Jolly will be 27 : 16 : 17
Self Assessment
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 ......................
5. The share sacrificed by the existing partners should be deducted from his ......................
share.
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 new partner does not bring his/her share of goodwill in cash.
3. Capitalisation 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:
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
2003 4,00,000
Total 21,93,000
= 2,19,3000/5 = 4,38,600
= 4,38,600 × 4 = 17,54,400
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:
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.
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:
= 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:
Notes
10
= 5,00,000
100
= 50,000
= 60,000
Capitalization Method
(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:
3. Computation of goodwill
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:
= 40,000 × 100/10
= 4,00,000
= 4,00,000 – 3,10,000
= 90,000
(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:
= 25,000 – 22,000
= 3,000
= 3,000 × 100/15
= 20,000
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.
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:
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
However, instead of these two entries one can record only one entry given below:
Cash/Bank A/c Dr
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
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
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
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.
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.
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)
To Revaluation A/c
To Revaluation A/c
To Revaluation A/c
Notes
Proforma of Revaluation A/c
Dr. Revaluation A/c Cr.
( ) ( )
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.
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)
Revaluation Account
( ) ( )
( ) ( )
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.
Prepare Revaluation Account, Partners Capital account and opening Balance sheet of the new
firm.
Solution:
Revaluation Account
Dr. Cr.
( ) ( )
Capital Account
Dr. Cr.
( ) ( )
3,37,900
Working Note:
= 30,000
1 3
Himani’s = 0
2 6
1 2 1
Harsha’s =
2 6 6
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.
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:
( ) ( )
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.
Solution: Notes
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
=2:1:1
2. General reserves should be distributed between the old partners in their old profit sharing
ratios.
Self Assessment
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.
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.
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.
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.
8. The following is the Balance Sheet of Tarun and Ashima sharing profit and losses in the
ratio of 2 : 1.
( ) ( )
20,000
7. false 8. true
9. false 10. true
15. debited
Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.
Prasanna Chandra, Financial Management - Theory and Practice, Tata McGraw Hill,
New Delhi (1994).
CONTENTS
Objectives
Introduction
4.1.1 On the Basis of new Partner’s Capital and his Profit Sharing Ratio
4.3 Summary
4.4 Keywords
Objectives
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.
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
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.
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.
(i) When 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.
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:
A B
( ) ( )
= 40,000 × 10/2
= 2,00,000
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.
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.
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
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
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.
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
Notes Solution:
Books of A, B and C
Journal
( ) ( )
( ) ( ) ( ) ( ) ( ) ( )
( ) ( ) ( ) ( ) ( ) ( )
( ) ( )
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
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:
Self Assessment
6. Balance sheet of new firm records the assets and liabilities at the value before revaluation.
4.3 Summary
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.
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.
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.
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.
(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.
(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
(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.
7. True
Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.
Prasanna Chandra, Financial Management - Theory and Practice, Tata McGraw Hill,
New Delhi (1994).
CONTENTS
Objectives
Introduction
5.5 Summary
5.6 Keywords
Objectives
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.
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”.
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
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
1. ................... clearly comprehends a situation where a partner may retire without dissolving
the firm.
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.
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:
(Retiring partner’s share of goodwill adjusted to remaining partners in the gaining ratio)
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
Working Notes:
3
B’s Old share =
10
1
B’s new share =
2
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
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
6. Retiring partner’s share of goodwill is debited to his/her capital account at the time of
retirement.
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.
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:
To Revaluation A/c
To Asset A/c
To Liabilities A/c
To Revaluation A/c
To Revaluation A/c
To Revaluation A/c
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:
(iii) A provision for outstanding bill standing in the books at 1,000 is now not required.
Solution:
Self Assessment
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 .................
(Surplus available on workmen’s compensation fund and investment fluctuation fund transferred Notes
to partner’s capital A/c in old profit sharing ratio)
20,000 20,000
Solution:
Books of X, Y and Z
Self Assessment
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.
The ratio in which retiring partner’s share is distributed amongst continuing partners’ is
known as “gaining ratio”.
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.
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.
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
( ) ( )
(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:
(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.
10. Why do firms revalue assets and reassess their liabilities on retirement or on the event of
death of a partner?
1. Section 32 2. Existing
7. True 8. False
15. Surplus
Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.
Prasanna Chandra, Financial Management - Theory and Practice, Tata McGraw Hill,
New Delhi (1994).
CONTENTS
Objectives
Introduction
6.3 Summary
6.4 Keywords
Objectives
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.
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:
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:
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:
(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
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
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.
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 ...................
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.
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:
To Cash/Bank A/c
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
(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.
Solution:
= 3/4 : 1/4
= 3 : 1.
28,000 28,000
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.
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 Cash/Bank A/c
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:
= 60,800
= 91,200 ÷ 3 = 30,400
= 41,344
= 10,944
= 37,344
= 7,296
= 34,048
= 3,648
Self Assessment
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.
Notes
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 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.
Instalment inclusive of interest then is paid to the retiring partner as per schedule agreed
upon.
6.4 Keywords
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.
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.
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.
3. Credit 4. Deducted
7. Section 37 8. 6%
Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.
Prasanna Chandra, Financial Management - Theory and Practice, Tata McGraw Hill,
New Delhi (1994).
CONTENTS
Objectives
Introduction
7.4 Summary
7.5 Keywords
Objectives
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.
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 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.
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
Self Assessment
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 ...................
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.
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
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:
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;
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.
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.
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.
Solution:
25,000
= × 40,000= 12,500
80,000
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
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.
12. Under ......................, 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. 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 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:
To Executor’s A/c
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:
( ) ( )
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.
(iii) Profit for the year 2006 be taken as having accrued at the same rate as that of the previous
year.
(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:
= 1,20,000
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.
= 8,750
= 7,500
= 2,700
Revaluation Account
Dr Cr
( ) ( )
( ) ( )
( ) ( )
Self Assessment
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.
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.
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.
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.
( ) ( )
Pon died on June 30, 2003. Under the terms of partnership the executors of a deceased
partner were entitled to:
(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:
(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.
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.
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:
(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.
15. False
Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.
Prasanna Chandra, Financial Management - Theory and Practice, Tata McGraw Hill,
New Delhi (1994).
CONTENTS
Objectives
Introduction
8.3 Summary
8.4 Keywords
Objectives
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.
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.
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.
To Bank A/c
(b) For transfer of premium paid to profit and loss account at the end of the year:
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.
(i) On the death of partner, for making claim with the insurance company
(ii) For Claim duly received from Insurance Co. on the date of receipt
(iii) Claim due will be distributed among existing partners (including outgoing)
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.
(i) 1st Year: On the date when policy is taken and premium is paid.
To Bank A/c
(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.
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.
(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.
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
( ) ( )
* 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.
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.
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
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:
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.)
Fourth Year
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)
750 750
Self Assessment
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.
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.
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.
Work out the amount payable to X’s legal representatives regarding insurance policies. Record
necessary journal entries.
Solution:
Books of X, Y and Z
5
2. X’s share = 50000× = 25000
10
Self Assessment
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.
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.
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.
1. Why the Joint Life Policy is needed? What are the different ways of treating Joint Life
Policy in accounts?
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?
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.
Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.
Prasanna Chandra, Financial Management - Theory and Practice, Tata McGraw Hill,
New Delhi (1994).
CONTENTS
Objectives
Introduction
9.5 Summary
9.6 Keywords
Objectives
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.
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.
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.
3. If partnership is dissolved, the firm will not dissolve if the other partners desire to continue.
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.
(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.
(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.
(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].
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.
Self Assessment
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.
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.
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.
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.
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.
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:
Dr. Cr.
S. No. Particulars L.F.
Realization A/c Dr.
To Sundry Assets A/c
(Transfer of assets)
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:
(b) When realisation expenses are paid by partner on behalf of the firm:
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.
Notes
( ) ( )
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:
4. A typewriter, completely written off in the books of accounts, was sold for 400.
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.
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.
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.
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:
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
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
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
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
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
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.
7. Which account is debited at the time of dissolution of a firm when assets are transferred?
(c) Creditors
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.
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.
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.
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
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:
( )
Stock 16,000
Give accounts to close the books of the firm taking the capitals as fixed.
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
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 -
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
9. If a partner is insane, partnership firm is dissolved, explain which is the mode of dissolution:
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.
Solution: Notes
A B C
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.
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
Loan-B 7,500
1,60,500 1,60,500
Notes (1) The partners share profit and losses in the ratio of 5 : 3 : 2.
July 2005
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).
September 2005
Prepare a schedule of cash payments as of September 30, showing how the cash was distributed.
Solution:
Creditors Capitals
A( ) B( ) C( )
July
August
Contd...
September
Working Note:
(i) Highest Relative Capital Basis
A B C
Example: The following is the Balance Sheet of A, B, C on 31st December, 2005 when they
decided to dissolve the partnership:
Liabilities Assets
Capital Accounts :
A 15,000
B 18,000
C 9,000
49,000 49,000
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
Contd...
4. 6,000 - - 6,000
5. Including saving
in expenses 20,100 - - 20,100
To ascertain the amount distributable out of each instalment realised among the partners, the
following table will be constructed:
Total A B C
Less:
Summary:
Self Assessment
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.
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.
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
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
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.
Stock 40,000
You are required to prepare realization account, bank account and capital of the partners.
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:
Notes 9. A, B & C sharing profits and losses in the proportion of 3:2:1. Their Balance Sheet was as
follows:
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:
1. firm 2. revaluation
5. Partnership 6. Partnership
15. insolvent
Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi
Prasanna Chandra, Financial Management - Theory and Practice, Tata McGraw Hill,
New Delhi (1994)
CONTENTS
Objectives
Introduction
10.5 Summary
10.6 Keywords
Objectives
Introduction
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.
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
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.
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.
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.
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.
Self Assessment
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
.................
Dependant Departments
Independent Departments
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.
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.
Self Assessment
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.
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.
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
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.
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.
6. Stock on 31st March, 1998 in X Department was worth 33,48, 000 and in Y Department
24,111,000.
Solution:
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
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:
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.
Solution Notes
8,00,000
100 16%
50,00,000
16
Unrealised Profit = 90,000 = 14,400
100
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...
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
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
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
Notes
Self Assessment
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
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.
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.
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.
3. Departments 4. Equitable
5. Sales 6. Wages
Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.
Prasanna Chandra, Financial Management - Theory and Practice, Tata McGraw Hill,
New Delhi (1994).
CONTENTS
Objectives
Introduction
11.7 Summary
11.8 Keywords
Objectives
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.
Dependent Branches
Independent Branches
Foreign Branches
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.
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
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.
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:
Notes
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
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.
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.
In case of goods are sent at cost the following journal entries are passed in the books of
head office:
S. No Particulars L.F.
Branch A/c Dr.
To Goods Sent to Branch A/c
(Goods sent to branch)
S. No Particulars L.F.
Branch A/c Dr.
To Cash A/c
S. No Particulars L.F.
Goods Sent to Branch A/c Dr.
To Branch A/c
S. No Particulars L.F.
Cash/bank A/c Dr.
To Branch A/c
(Cash received from branch)
S. No Particulars L.F.
Goods sent to branch A/c Dr.
To Purchases A/c
(balance stock transferred to purchase/trading A/c)
S. No Particulars L.F.
Branch A/c Dr.
To Profit and Loss A/c
(balance stock transferred to purchase/trading A/c)
S. No Particulars L.F.
Profit and Loss A/c Dr.
To Branch A/c
(balance stock transferred to purchase/trading A/c)
Notes
Notes
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.
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
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.
Loading is the difference between the invoice price and cost price.
The following additional journal entries are passed in the books of head office:
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
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.
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.
1
(a) 25% (b) 20% (c) 33 %
3
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:
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.
(2) When goods are retuned by the branch to head office (at invoice price)
(14) Transfer of balance of branch adjustment account to general profit and loss account, then
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 spoiled 50
Solution:
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
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
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
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
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
Particulars ` Particulars `
To branch adjustment a/c 600 By Balance b/d 600
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.
13. Goods sent by the H.O. is not received by the branch, it is debited to goods in transit A/c.
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:
Prepare the Memorandum Branch Trading and Profit and Loss A/c and Madras branch A/c for
the year ending Dec 31, 2008.
Solution: Notes
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
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.
(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
( ) ( )
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.
Solution: Notes
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
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
4,90,000
Self Assessment
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.
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.
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?
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.
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.
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:
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:
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.
Particulars Particulars
Notes
3. Dependent 4. Independent
7. False 8. True
Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.
Prasanna Chandra, Financial Management - Theory and Practice, Tata McGraw Hill,
New Delhi (1994).
CONTENTS
Objectives
Introduction
12.5 Summary
12.6 Keywords
Objectives
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.
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:
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.
Under hire purchase system, the buyer takes possession of goods immediately and agrees
to pay the total hire purchase price in installments.
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.
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.
1. Under hire purchase system, the buyer takes possession of goods immediately and agrees
to pay the total hire purchase price in installments.
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.
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:
There are two methods by which the purchaser can record the transactions in the books of
accounts.
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:
Working Note:
6,600
4,188
4,606
2,194
2,412
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.
Solution: Notes
Calculation of Interest
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.
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:
!
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.
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:
1. Depreciation should be charged on straight line method at the rate of 10% on full cost price
of 6000.
6600
4188
4606
2194
2412
The following entries are passed by the vendor in their books of accounts to record the hire
purchase transactions:
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:
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
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
20 1
Interest at the end of each year = or
120 6
1
Hence Interest for the third year = 18,000 = 3,000
6
1
Interest for second year = 33,000 = 5,500
6
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
= 55,917 or 55,920
Machine Account
Y’s Account
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:
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:
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
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.
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:
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,
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
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:
The following example explains the accounting treatment of complete and partial repossession: Notes
Show the necessary ledger account in the books of both the parties.
Solution:
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.
Solution: Notes
Working Notes:
on W.D.V. 8,400
on W.D.V. 6,720
9,450
(-) Depreciation for II year 945
Self Assessment
13. In case of default of payment of installment. What is the right of the vendor?
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.
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.
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.
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.
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.
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.
1. True 2. False
3. False 4. True
5. True 6. True
7. False 8. False
15. interest
Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.
Prasanna Chandra, Financial Management - Theory and Practice, Tata McGraw Hill,
New Delhi (1994).
CONTENTS
Objectives
Introduction
13.2.1 Definition
13.2.2 Features
13.6 Summary
13.7 Keywords
Objectives
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.
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.
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.
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.
Self Assessment
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.
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.
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
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.
(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
T = Lessor’s tax-rate
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.
Where K = required post-tax rate of return duration of the primary lease period 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?
Notes Solution:
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
Difference between the instalment amount and opening balance of 4th year
Notes
End of the Lease Tax shield After tax cash PV factors Present value of
year payment outflows at 9% cash out flows
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.
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.
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
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.
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
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.
0 1 2 3 4 5
Self Assessment
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 .......................
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.
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.
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?
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
(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.’
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
(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
(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.
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:
(a) Inflow
I II III IV V
(b) Outflow
Notes
Computation of Annual Tax
(a) Income
Lease Rentals 35,000 35,000 35,000 35,000 35,000
(b) Expenditure
0 98,000
100,240 95,380
D S
Ko = Kd (1 – t) + Ke
DS DS
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.
14. If this IRR is higher than the ................ average cost of capital (of the lessor), the lease plan
is accepted.
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:
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:
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.
The accounting of finance lease as recommended by ICAI guidelines are as follows: Notes
(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.
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
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
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.
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.
Unearned Finance Income: It is the sum of finance charges over the lease period.
2. Briefly discuss the various aspects of appraisal considered by a banker while financing to
a leasing and hire purchase company.
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?
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.
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.
CONTENTS
Objectives
Introduction
14.4 Summary
14.5 Keywords
Objectives
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.
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.
Notes
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.
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:
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:
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)
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:
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.
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
Self Assessment
2. Sometimes it is not possible to compute the value of stock destroyed by fire form the
....................
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 ....................
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.
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.
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.
Solution:
2. Amount of Claim
Sum Insured
NetClaim Lossof Stock
InsurableAmount(Total Cost)
Notes
60,000
Amount of Claim 66,000 45,154
87,700
Self Assessment
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.
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:
Standing charges
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.
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.
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.
Notes
Example: From the following information, calculate the claim made on a ‘loss of profit’
policy.
(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.
(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.
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
20
11,70,000 ×
= 30,000 × 100 = 24,718.
20
11,70,000 × 50,000
100
20
= 1,60,000 × = 32,000
100
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
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.
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.
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.
1. Illustrate the key methods to compute the claim for loss of stock.
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.
Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi
Prasanna Chandra, Financial Management - Theory and Practice, Tata McGraw Hill,
New Delhi (1994)