Goodwill brought by a new partner is distributed among the existing partners in their:
Sacrificing Ratio
Understanding Goodwill Distribution on Partner Admission
When a new partner is admitted into an existing partnership, they often bring in capital and sometimes an additional amount as goodwill. Goodwill represents the value of the firm's reputation and future earning capacity built up by the existing partners. The new partner acquires a share in the future profits of the firm, which was previously shared only among the old partners.
The share of profit that the new partner gets is surrendered by the old partners. The ratio in which the old partners give up their share of profit is known as the sacrificing ratio. The goodwill brought in by the new partner is essentially compensation to the old partners for the share of future profits they are giving up.
What is Sacrificing Ratio?
The sacrificing ratio is the ratio in which the old partners agree to surrender a portion of their share of profits in favour of the new partner. It is calculated as:
\(\text{Sacrificing Ratio} = \text{Old Profit Sharing Ratio} - \text{New Profit Sharing Ratio}\)
Only partners whose share decreases will have a sacrificing ratio. Some partners might not sacrifice any share, or they might even gain a share (though gaining is less common when a new partner is simply admitted without other changes).
Why Distribute Goodwill in Sacrificing Ratio?
The fundamental principle behind distributing the goodwill brought by the new partner is to compensate the old partners for the sacrifice they make in their future profit-sharing ratio. The partners who sacrifice a larger portion of their share should receive a proportionally larger share of the goodwill brought in.
- The new partner pays for the right to share in future profits.
- This right comes from the share previously belonging to the old partners.
- The old partners who reduce their share (sacrifice) are compensated for this reduction.
- The compensation (goodwill) is distributed in the ratio of their sacrifice.
Example Scenario
Suppose partners A and B share profits in a 3:2 ratio. They admit C for a 1/5th share. The new ratio becomes 4:4:2 (simplified 2:2:1). Let's calculate the sacrificing ratio:
- A's Sacrifice: Old share (3/5) - New share (2/5) = 1/5
- B's Sacrifice: Old share (2/5) - New share (2/5) = 0
In this case, only A sacrifices a share (1/5). B does not sacrifice any share. Therefore, if C brings in goodwill, the entire amount of goodwill would be distributed only to A. The sacrificing ratio here is effectively 1:0 (for A and B respectively).
If the new ratio led to both A and B sacrificing, the goodwill would be shared between them in proportion to their sacrifice.
| Ratio Type | Calculation/Purpose |
|---|---|
| Old Ratio | Original profit-sharing ratio before partner admission/retirement. |
| New Ratio | Profit-sharing ratio after partner admission/retirement. |
| Sacrificing Ratio | Ratio in which old partners surrender their profit share to the new partner. Calculated as Old Ratio > New Ratio. Used for distributing goodwill brought by the new partner. |
| Gaining Ratio | Ratio in which remaining partners gain a share of profit from a retiring/deceased partner. Calculated as New Ratio > Old Ratio. Used for adjusting goodwill on retirement/death. |
Based on the principles of partnership accounting, goodwill brought by a new partner is distributed among the existing partners as compensation for the portion of their profit share that they give up to the new partner. This distribution happens in the sacrificing ratio.
Revision Table: Partnership Ratios
| Ratio Name | Significance | Use Case (Common) |
|---|---|---|
| Old Profit Sharing Ratio | Original ratio before change in partnership constitution. | Calculating sacrifice/gain; distributing accumulated profits/reserves. |
| New Profit Sharing Ratio | Ratio after change in partnership constitution. | Distributing future profits/losses. |
| Sacrificing Ratio | Ratio of decrease in old partners' profit share. | Distributing goodwill brought by a new partner. |
| Gaining Ratio | Ratio of increase in remaining partners' profit share. | Adjusting goodwill on retirement/death of a partner. |
Additional Information: Accounting for Goodwill
The accounting treatment of goodwill when a new partner is admitted can vary depending on the situation. The goodwill can be brought in by the new partner in cash or kind, or it might be adjusted through the partners' capital accounts if the new partner does not bring goodwill in cash (often called 'premium for goodwill').
When the new partner brings their share of goodwill in cash, this amount is credited to the Sacrificing Partners' Capital Accounts in their Sacrificing Ratio. The journal entry typically involves debiting Cash/Bank and crediting Goodwill Premium Account (or directly crediting Sacrificing Partners' Capital Accounts). Then, the Goodwill Premium Account is debited and Sacrificing Partners' Capital Accounts are credited in the sacrificing ratio.
The key takeaway is that regardless of the specific accounting entries used (like the premium method or revaluation method in older practices, though premium method is common now), the benefit of the goodwill brought by the new partner always goes to the partners who sacrifice their share of profit, and in proportion to that sacrifice, i.e., in the sacrificing ratio.
Important Questions from Accounting for Partnership : Goodwill
Consider the following facts about valuation of Goodwill of a partnership firm:
A. Goodwill valuation is done on change in profit sharing ratio among the existing partners.
B. Goodwill is valued on admission of a partner, to know the amount to be paid by him to compensate sacrificing partner(s).
C. Goodwill valuation is done on the retirement of a partner to know the amount to be paid to him as compensation for his sacrifice.
D. Goodwill valuation is done at the time of dissolution of a firm which involves sale of business as a going concern.
E. Goodwill valuation is done during the distribution of profits of the partnership firm.
Choose the correct answer from the options given below:
In the context of a partnership firm, the need for valuation of goodwill arises in the following circumstances.
According to AS-26 on Intangible Assets:
(A) Internally generated goodwill should not be recognised as an asset
(B) Self-generated goodwill is accounted for in the books and shown as an asset
(C) Intangible assets should be written off as early as possible but not exceeding its estimated life
(D) Purchased goodwill is not recognised as an asset
(E) Can be written off even beyond 10 years depending upon the nature of the asset
Choose the correct answer:
Match List I with List II.
List - I List - II (A) Normal Rate of Return (I) Total Assets – Outside Liabilities (B) Number of years purchase (II) Usual return on capital employed (C) Capital Employed (III) Return over and above usual return in similar business (D) Super Profit (IV) Expected period for which returns are anticipated to accrue Choose the correct answer:
Under the capitalisation method of calculating goodwill, the term capital refers to:
