ACT 3121 Intermediate Financial Accounting 1 G 2

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ACT 3121Intermediate Financial Accounting 1G
2

• Lecture 3 (21st Nov)
• 1 hr

2
Changes in partnerships structures

• Typical events that requires special treatment
  and may change the partnership structures
• Change in profit sharing ratio
• Admission of new partners
• Death or retirement of existing partner
• Eventually 2 and 3 will lead to 1

3
Basic

• If partners decided that the value of the
  partnership is equal to the book value, thus
  simple accounting treatment
• The only thing that changes is the profit and
  loss ratio, which affect the allocation of future
  profits or losses
• Therefore changes will only appear at the end of
  the next accounting period (the amount of profits
  shared).

4
Example

• Sam, Sim and Soon are partners with profit
  sharing ratio of 321. The capital and current
  a/c as at 31 Dec 20-X shows
• Capital Sam RM30000
• Sim RM20000
• Soon RM15000
• Total RM65000
• Current Sam RM1500 (dt.)
• Sim RM2000 (cr.)
• Soon RM300 (cr.)
• Total RM800 (cr.) RM65800

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• At that date, there are 3 possibilities
• Change the profit sharing ratio to 331 as Sim
  will manage the new outlet
• Admit a new partner Shak who will contribute
  RM5000
• Sam died of heart attack
• What would the treatment be for all of the above
  possibilities if they value the partnership as
  what is in the book (B/S)?

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Discussion

• No changes in the value of business
• The only thing that changes is the profit sharing
  ratio
• Assets Liabilities Equity (capital a/c
  current a/c) ? RM65800
• Thus
• No special entries needed.
• Shak contribute RM5000 ? dt. Bank, cr. Shaks
  capital (current a/c 0 balance).
• Sams balance will be withdrawn from the business
  ? closed a/c, give cash!

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When does it needs special treatment?

• Only when the partners believe that the value of
  the business is greater than what is in the book.
• Previous example Sam, Sim and Soon partnership
  valued at RM65800 but current value / market
  value of the business is RM70000 (could be sold
  RM70000).
• The treatment of the extra value goodwill and
  revaluation

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Revaluation

• Why do we revalue
• Amount charged as depreciation every year can
  only be an approximation
• If no changes in composition of partnership, this
  basis of revaluing assets is satisfactory
• When changes occur, it becomes necessary to
  revalue the assets
• Circumstances that necessitates revaluation
• Admission of new partner
• Death or retirement of existing partner

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Illustration

• Consider A and B as partners and has been since
  10 years ago. Bought a building when they first
  started at the cost of RM4000, but its present
  value is RM10000 (diff. RM6000).
• Say they agree to admit C, thus necessary to
  revalue the building to RM10000.
• ? Dt Buildings RM6000, profit credited to A and
  B a/cs, NOT C since C does not deserve it (he was
  not yet a member when the value increase).

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Goodwill

• What is
• Ability to earn profits in the future
• Difference between the value of the business as a
  whole and the sum of the values of the
  identifiable assets less the sum of its
  liabilities
• Value of business 50000
• Assets 34000
• Liabilities 12000 (Net assets) 22000
• Goodwill 28000
• ? Usually when the business is sold, partnership
  same circumstances for revaluation

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• Factors that may bring about the existence of
  goodwill
• Personal characteristics of the owner (charm,
  relationship with customers, tact etc.)
• Quality of goods
• Location of premises
• The possession of near-monopoly rights
• Value of labour force, management skills
• Cost of the research and development that make it
  more efficient to run the business
• Badwill negative goodwill

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Valuation of Goodwill

• Average profits
• Base calculation on past profits with weight
  given to more recent years (practically 5 yrs)
• Goodwill X times the weighted average of the
  last Y years.
• 19x1 RM600, 19x2 RM900, 19x3 RM1200 and
  Goodwill should be taken as 2 (x) years purchase
  of the weighted average of the last 3 years.
  Weighting, 321.

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• 1 x 500 600
• 2 x 900 1800
• 3 x 1200 3600
• 6 6000
• Weighted average RM6000 / 6 RM1000
• Goodwill 2 x RM1000 RM2000
• Note
• it uses past result while goodwill is concern
  about future prospect , assume past result would
  affect future result
• trend of the past result may foretell future
  expected profits

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• 2. Average revenue
• just substitute profits with revenue
• 3. Future profits
• - estimate future cash flows generated
• - value the stream of cash (value of the PS)
• - goodwill value of the PS ( A L )
• -

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Illustration for Future Profits

• Expected profits RM25000 per annum
• Fair charge for service of partners RM11000
• 10 return expected from investment in such
  business
• Net assets (A L) is RM23000
• Estimated annual return 25000
• Less Charge for partners services 11000
• Return 14000

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• Say V is the value of the partnership, thus
• V 14000 140000
• 0.10
• Value of P/S 140000
• Less Net assets 23000
• Goodwill 127000