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ACT 3121 Intermediate Financial Accounting 1

Changes in Partnership Structures. ACT 3121 Intermediate Financial Accounting 1. Changes in partnership’s structures. Typical events that requires special treatment and may change the partnership structures: Change in profit sharing ratio Admission of new partners

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ACT 3121 Intermediate Financial Accounting 1

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  1. Changes in Partnership Structures ACT 3121Intermediate Financial Accounting 1

  2. Changes in partnership’s 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 3:2:1. 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

  5. Under 3 possibilities: Change the profit sharing ratio to 3:3:1 as Sim will manage the new outlet Admit a new partner Shum 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)?

  6. Discussion No changes in the value of business The only thing that change is the profit sharing ratio Assets – Liabilities = Equity (capital a/c + current a/c)  RM65800 Thus; No special entries needed. Shum contribute RM5000  dt. Bank, cr. Shum’s capital (current a/c 0 balance). Sam’s balance will be withdrawn from the business  closed a/c, give cash!

  7. When does it need 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

  8. 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

  9. 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 (C was not yet a member when the value increase).

  10. 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

  11. Factors that may bring about the existence of goodwill Personal characteristics of the owner (charm, relationship with customers 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

  12. 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, 3:2:1.

  13. 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 concerned about future prospect , assume past result would affect future result trend of the past result may foretell future expected profits

  14. 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 )

  15. 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 Illustration for Future Profits

  16. 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

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