Take a breath. If the word goodwill has been floating around your Accountancy class making you feel like everyone else got a memo you missed, you are in exactly the right place, and you are not behind. Goodwill is one of those topics that sounds abstract and philosophical until somebody sits down next to you and shows you that it is really just one simple idea dressed up in accounting language: some businesses are worth more than the sum of their furniture. That is it. That is the whole secret. Everything else in this chapter is bookkeeping built on top of that one sentence.
By the time you reach the bottom of this page you will be able to explain what goodwill is in your own words, value it three different ways without panicking, work out who is sacrificing and who is gaining when partners rearrange their profit shares, and pass the whole set of adjustments — goodwill, reserves, revaluation — through the capital accounts cleanly enough to close a balance sheet that actually balances. We will go slowly, we will do twenty worked examples together, and then you will get a worksheet to prove to yourself that it stuck.
- 1. What Goodwill Really Means
- 2. Factors That Affect the Value of Goodwill
- 3. Why and When a Firm Values Goodwill
- 4. Valuation Method 1: Average Profit
- 5. Valuation Method 2: Super Profit
- 6. Valuation Method 3: Capitalisation
- 7. Change in Profit-Sharing Ratio Among Existing Partners
- 8. Sacrificing Ratio and Gaining Ratio
- 9. Treatment of Goodwill on Change in Ratio
- 10. Reserves, Accumulated Profits and Losses
- 11. Revaluation of Assets and Reassessment of Liabilities
- 12. Putting It All Together
- Practice Worksheet — 10 Questions with Full Solutions
Your Game Plan for This Chapter
Do not try to swallow this chapter whole. Partnership questions are long, and long questions punish people who skip the foundations. Here is the order I would use if I were sitting beside you with a cup of tea and a rough notebook.
- Get the idea before the arithmetic. Spend ten minutes on sections 1 to 3 until you can explain goodwill to a friend who has never studied commerce. If you cannot explain it, no formula will save you.
- Learn the three valuation methods one at a time. Average profit, then super profit, then capitalisation. Do not mix them on day one. Each has its own small habit of adjustment, and mixing them is how marks leak away.
- Master the sacrifice and gain arithmetic separately. Old share minus new share. Practise fifteen of these on a single page until they take you twenty seconds each. This single skill carries roughly half the marks in reconstitution questions.
- Then learn the four adjustments. Goodwill, reserves and accumulated profits or losses, revaluation, and finally the redrawn balance sheet. Always in that order, so your capital accounts never get tangled.
- Attempt one full question from start to finish without looking. Section 12 gives you a complete board-style problem with every line shown. Cover the solution, try it, then compare.
- Finish with the worksheet. Ten questions, answers hidden until you click. Write your answer on paper first — reading a solution feels like learning but it is not.
Study Notes
1. What Goodwill Really Means
Imagine two tea stalls standing side by side on the same street. Both have the same steel counter, the same two gas burners, the same battered kettle. If you added up the furniture and utensils of each, you would get roughly the same figure — say sixty thousand rupees. Yet one of them has a queue every morning at seven, and the other is empty. The owner of the busy stall has been there twenty-two years, remembers how you take your tea, and never once served a stale samosa. If both owners decided to sell tomorrow, would a buyer pay the same for both? Obviously not.
That extra amount a buyer is willing to pay — over and above the value of the identifiable net assets — is goodwill. It is the money value of reputation, of habit, of trust, of a location people already know how to find. In formal words: goodwill is the value of the advantage a firm enjoys because of its established name, connections and reputation, which enables it to earn more than the normal rate of return on the capital it employs.
Notice the two halves of that definition, because both matter in the exam. Goodwill exists (a) because of an advantage that is real but not physical, and (b) it shows up as extra earnings. Those extra earnings are the reason we can put a number on something as soft as reputation.
The nature of goodwill. Goodwill is an intangible asset — you cannot touch it, weigh it or lock it in a cupboard. But be careful: intangible does not mean fictitious. A fictitious asset (such as an advertisement suspense account or a debit balance of Profit and Loss) has no value at all and is simply a loss waiting to be written off. Goodwill, by contrast, has genuine value; a real buyer will really hand over real money for it. That distinction is a favourite one-mark question.
| Point of difference | Goodwill (intangible asset) | Advertisement Suspense (fictitious asset) |
|---|---|---|
| Does it have value? | Yes — a purchaser will pay for it | No — it is an unwritten-off loss |
| Can it be sold separately? | Only along with the business as a whole | Cannot be sold at all |
| Where does it sit? | Assets side, under intangible assets | Assets side, but only until written off |
| Treatment on reconstitution | Valued and adjusted through capital accounts | Written off among partners in the old ratio |
Purchased goodwill versus self-generated goodwill. This is where Accounting Standard 26 (Intangible Assets) walks in and lays down the law. Goodwill may be recorded in the books only when it has been purchased — that is, only when money or money’s worth was actually paid for it. Goodwill that a firm builds up on its own over the years, however genuine, is never brought into the books as an asset. It is simply too subjective to measure reliably.
Step 1 — find the net assets taken over.
Net assets = Assets − Liabilities = 9,60,000 − 2,40,000 = ₹7,20,000.
Step 2 — compare with what he actually paid.
Purchase price 9,00,000 − Net assets 7,20,000 = ₹1,80,000.
Ravi handed over ₹1,80,000 more than the things he could point at. That surplus is purchased goodwill, and because real money changed hands it may be recorded as an asset.
Why it works: a rational buyer never pays extra for nothing. The extra ₹1,80,000 is his own estimate of the future extra profits that the existing name and customer list will bring him.
2. Factors That Affect the Value of Goodwill
Goodwill is not a lucky accident. It is built, and it can be destroyed. When an examiner asks you to “state any four factors affecting the value of goodwill”, they want you to show that you understand what makes customers come back. Here are the factors that matter, each with the reason attached — because a bare list earns fewer marks than a list with reasons.
| Factor | Why it pushes goodwill up or down |
|---|---|
| Quality of the product or service | Consistent quality creates repeat customers. Repeat customers mean predictable profits, and predictable profits are exactly what a buyer pays extra for. |
| Location of the business | A shop on a busy main road or near a station enjoys footfall that a back-lane shop can never buy. Favourable location raises goodwill. |
| Efficiency and honesty of management | Well-run firms control costs and keep staff. A firm that earns high profits under a skilled team is worth more than one limping along. |
| Nature of the business | A business with stable demand, few competitors and no risk of sudden obsolescence commands higher goodwill than a fashion-driven or licence-dependent one. |
| Longevity of the firm | An older, well-established firm has had time to build connections. Age alone is not enough, but age plus profitability is powerful. |
| Market situation and competition | Little competition, or a protected market, means secure profits and higher goodwill. Heavy competition erodes it fast. |
| Special advantages | Patents, trademarks, long-term supply contracts, import licences or a well-known brand name all lift goodwill because rivals cannot copy them. |
| Capital required and rate of return | If a firm produces a high return while employing relatively little capital, its earning power — and therefore its goodwill — is high. |
One warning before we move on. Every factor above works in both directions. A brilliant location becomes worthless if a flyover is built over the road; a famous brand collapses after one scandal. That is precisely why goodwill has to be re-valued each time the partnership arrangement changes rather than carried forward at an old figure.
3. Why and When a Firm Values Goodwill
Here is the thing about a partnership: the profit-sharing ratio is a promise about the future. When partners agree to share profits 3:2:1, they are dividing up the future earning power of the firm. And that earning power — goodwill — was built by all of them together over the years.
So the moment anyone’s share of that future changes, somebody is quietly handing over a slice of something valuable, and somebody is quietly receiving it. Fairness demands that the one who receives compensates the one who gives. To do that, we must first put a rupee figure on the whole thing. That is the need for valuation.
The occasions on which a partnership firm values goodwill are:
- Change in the profit-sharing ratio among existing partners — the focus of this chapter. Nobody joins, nobody leaves, but the slices are recut.
- Admission of a new partner — the newcomer buys into a reputation they did not help create, so they must pay for it.
- Retirement or death of a partner — the outgoing partner (or their legal heirs) helped build the goodwill and is entitled to their share of it.
- Dissolution of the firm when the business is sold as a going concern rather than broken up piece by piece.
- Amalgamation of two partnership firms, or conversion of a firm into a company.
CBSE prescribes exactly three methods of valuation: the average profit method, the super profit method, and the capitalisation method. We will take them one at a time, and by the end you will know not just how to compute each one but how to spot from the wording of a question which one the examiner wants.
4. Valuation Method 1: Average Profit
This is the friendliest method, and it rests on a simple piece of common sense: if a business has earned roughly a lakh a year for the last few years, a buyer will probably keep earning about a lakh a year. So take the average of past profits and multiply it by the number of years’ worth of extra earnings the buyer is willing to pay for.
The arithmetic is easy. The marks are lost somewhere else entirely — in adjusting the past profits before you average them. Past profits as reported are often contaminated by one-off events and by expenses that were never charged. The examiner puts those contaminants in on purpose.
Step 1 — total the profits.
86,000 + 94,000 + 78,000 + 1,02,000 = ₹3,60,000.
Step 2 — average over four years.
3,60,000 ÷ 4 = ₹90,000.
Step 3 — multiply by years’ purchase.
90,000 × 3 = ₹2,70,000.
Goodwill = ₹2,70,000.
Why it works: the buyer expects ₹90,000 a year of earning power to continue, and is willing to pay three years of it today to own that stream.
Now the version that actually appears in board papers. Watch each adjustment and, more importantly, watch the direction of each adjustment.
(i) the 2023–24 profit includes an abnormal gain of ₹24,000 from the sale of a machine;
(ii) the 2024–25 profit was arrived at after debiting an abnormal loss of ₹15,000 caused by a fire;
(iii) a partner has been managing the firm without any remuneration; reasonable remuneration of ₹24,000 per year should be charged.
Goodwill is to be valued at two and a half years’ purchase of the average profit.
Step 1 — remove abnormal items. Abnormal gains will not repeat, so subtract them. Abnormal losses will not repeat either, so add them back.
2022–23: 1,20,000 (nothing abnormal) = 1,20,000
2023–24: 1,44,000 − 24,000 = 1,20,000
2024–25: 1,17,000 + 15,000 = 1,32,000
Step 2 — charge the missing expense in every year. Remuneration of ₹24,000 should have been deducted each year, so deduct it now.
2022–23: 1,20,000 − 24,000 = ₹96,000
2023–24: 1,20,000 − 24,000 = ₹96,000
2024–25: 1,32,000 − 24,000 = ₹1,08,000
Step 3 — average the adjusted profits.
96,000 + 96,000 + 1,08,000 = ₹3,00,000; ₹3,00,000 ÷ 3 = ₹1,00,000.
Step 4 — apply years’ purchase.
1,00,000 × 2.5 = ₹2,50,000.
Goodwill = ₹2,50,000.
Why it works: goodwill is a payment for future earning power. Anything that will not happen again (fire, one-off sale) must be stripped out, and anything that will have to be paid in future (a manager’s salary) must be charged, or you would be selling the buyer a rosier future than the firm can deliver.
Step 1 — multiply each profit by its weight.
60,000 × 1 = 60,000
70,000 × 2 = 1,40,000
80,000 × 3 = 2,40,000
90,000 × 4 = 3,60,000
Total of products = ₹8,00,000
Step 2 — total the weights.
1 + 2 + 3 + 4 = 10
Step 3 — divide.
Weighted average profit = 8,00,000 ÷ 10 = ₹80,000
Step 4 — apply years’ purchase.
80,000 × 3 = ₹2,40,000.
Goodwill = ₹2,40,000.
Why it works: a simple average would have given ₹75,000, treating the distant past as importantly as last year. When profits are trending, the most recent year is the best guide to next year, so it deserves the heaviest weight. Weighted average gives a fairer — and here, higher — figure.
5. Valuation Method 2: Super Profit
The average profit method has a blind spot. It pays for all the profit, even the part that any ordinary business would have earned anyway. Think about it: if you put ₹8,00,000 into a fixed deposit or into any similar business, you would earn something without any reputation at all. Why should a buyer pay goodwill for the ordinary part?
The super profit method fixes this. It says: work out what a normal firm would earn on the same capital, subtract that from what this firm actually earns, and pay only for the excess. That excess is the true measure of reputation.
Super Profit = Actual Average Profit − Normal Profit.
Goodwill = Super Profit × Number of Years’ Purchase.
Capital employed usually means the capital the firm has invested in the business — commonly computed as total assets (excluding goodwill and any fictitious assets) minus outside liabilities. The normal rate of return is given to you; it is the return earned by comparable firms in the same industry.
Step 1 — find the normal profit.
8,00,000 × 12/100 = ₹96,000. This is what any ordinary firm with this much capital would earn.
Step 2 — find the actual (adjusted) profit.
1,36,000 − 16,000 = ₹1,20,000. Always charge the omitted remuneration before comparing.
Step 3 — find the super profit.
1,20,000 − 96,000 = ₹24,000. This ₹24,000 a year is the firm’s reward for its reputation.
Step 4 — apply years’ purchase.
24,000 × 3 = ₹72,000.
Goodwill = ₹72,000.
Why it works: a buyer will not pay goodwill for the ₹96,000 they could have earned anywhere. They will pay only for the ₹24,000 of extra earnings that exist purely because this firm has this name.
Step 1 — normal profit. 12,00,000 × 15/100 = ₹1,80,000.
Step 2 — super profit. 2,25,000 − 1,80,000 = ₹45,000.
Step 3 — goodwill. 45,000 × 2 = ₹90,000.
Goodwill = ₹90,000.
Why it works: notice how a higher normal rate of return shrinks super profit. A firm earning ₹2,25,000 looks impressive, but when comparable firms earn 15%, most of that is simply the going rate. Only ₹45,000 is genuinely special.
6. Valuation Method 3: Capitalisation
Capitalisation asks a slightly different question: how much capital would a normal firm need in order to earn what this firm earns? If our firm earns as much as a normal firm with far more capital, the difference must be goodwill.
There are two forms of this method, and the difference between them is a classic source of confusion, so let us separate them cleanly.
| Capitalisation of Super Profit | Capitalisation of Average Profit | |
|---|---|---|
| Formula | Goodwill = Super Profit × 100 / Normal Rate of Return | Goodwill = Capitalised Value of Business − Capital Employed |
| What you capitalise | Only the excess earnings | The whole average profit |
| What you need | Super profit and the normal rate | Average profit, normal rate, and net assets |
| Typical wording | “value goodwill by capitalising super profit” | “value goodwill by the capitalisation method” / “capitalisation of average profit” |
Step 1 — capitalise the super profit.
Goodwill = Super Profit × 100 / Normal Rate = 24,000 × 100 / 12
= 24,000 × 100 = 24,00,000; 24,00,000 ÷ 12 = ₹2,00,000.
Goodwill = ₹2,00,000.
Why it works: ask yourself how much capital a normal firm would need to earn ₹24,000 a year at 12%. The answer is ₹2,00,000, because 2,00,000 × 12% = 24,000. So our firm’s reputation is doing the work of ₹2,00,000 of capital. That is what the reputation is worth.
Notice this gives ₹2,00,000 while Example 5 gave ₹72,000 for the very same firm. Both are correct — they answer different questions. Capitalisation assumes the super profit continues indefinitely; years’ purchase assumes it lasts only three years. Always use the method the question names.
Step 1 — capitalise the average profit.
Capitalised value of the business = Average Profit × 100 / Normal Rate
= 1,05,000 × 100 / 12 = 1,05,00,000 ÷ 12 = ₹8,75,000.
This is what the whole business is worth on an earnings basis.
Step 2 — find the capital employed (net assets).
Capital Employed = Total Assets − Outside Liabilities = 9,00,000 − 1,50,000 = ₹7,50,000.
This is what the tangible things are worth.
Step 3 — the difference is goodwill.
8,75,000 − 7,50,000 = ₹1,25,000.
Goodwill = ₹1,25,000.
Why it works: the business is worth ₹8,75,000 judged by what it earns, but you can only point at ₹7,50,000 of actual net assets. The missing ₹1,25,000 is not missing at all — it is the reputation that generates the extra earnings.
7. Change in Profit-Sharing Ratio Among Existing Partners
We now turn to the second half of the chapter. Nobody is joining the firm. Nobody is leaving. The same partners simply decide that, from a given date, they will share profits differently. Perhaps one partner is scaling back her hours; perhaps another has begun bringing in most of the business and wants a larger share.
This is called a reconstitution of the firm. The old partnership agreement ends and a new one begins, even though the firm carries on trading without a pause. And because the agreement has changed, four things must be settled between the partners before the new arrangement starts.
| Adjustment | What it settles | Ratio used |
|---|---|---|
| 1. Goodwill | Compensating the sacrificing partner for the share of future earning power handed over | Sacrificing / gaining ratio |
| 2. Reserves and accumulated profits or losses | Sharing out past profits and losses that belong to the old agreement | Old ratio |
| 3. Revaluation of assets and liabilities | Recognising rises and falls in value that occurred under the old agreement | Old ratio |
| 4. Adjustment of capitals (if required) | Bringing capitals into the new profit-sharing ratio | New ratio |
Let us start with the most basic skill: spotting who has actually gained and who has sacrificed. It is nothing more than subtraction, but you must put both ratios over a common denominator first.
Step 1 — write the old shares.
Old total = 3 + 2 + 1 = 6. So A = 3/6, B = 2/6, C = 1/6.
Step 2 — write the new shares over the same denominator.
Equal means 1/3 each. Converting to sixths: 1/3 = 2/6. So A = 2/6, B = 2/6, C = 2/6.
Step 3 — subtract: Old share − New share.
A: 3/6 − 2/6 = +1/6 → a positive answer means sacrifice
B: 2/6 − 2/6 = 0 → neither gains nor sacrifices
C: 1/6 − 2/6 = −1/6 → a negative answer means gain
Answer: A sacrifices 1/6; B is unaffected; C gains 1/6.
Check: total sacrifice must equal total gain. 1/6 = 1/6. It balances.
Why it works: the firm’s profits are one whole pie. If nobody joins and nobody leaves, every extra slice one partner takes must have come off somebody else’s plate. So the sacrifices and the gains must always cancel out exactly.
8. Sacrificing Ratio and Gaining Ratio
Once you know who sacrificed and who gained, you often need the ratio in which they did so — because when two partners sacrifice, the compensation must be split between them fairly.
Gaining Ratio = the ratio of the gains, where Gain = New Share − Old Share (positive values).
Total sacrifice always equals total gain.
Step 1 — find a common denominator.
Old ratio 3:2:1 has total 6. New ratio 5:3:4 has total 12. The convenient common denominator is 12.
Old shares in twelfths: A = 3/6 = 6/12, B = 2/6 = 4/12, C = 1/6 = 2/12.
New shares: A = 5/12, B = 3/12, C = 4/12.
Step 2 — subtract, Old − New.
A: 6/12 − 5/12 = +1/12 (sacrifice)
B: 4/12 − 3/12 = +1/12 (sacrifice)
C: 2/12 − 4/12 = −2/12 (gain of 2/12)
Step 3 — state the ratios.
Sacrificing Ratio (A : B) = 1/12 : 1/12 = 1 : 1
Gaining Ratio = C alone gains, so C’s gain is 2/12 = 1/6; there is no gaining ratio to split because only one partner gains.
Check: total sacrifice 1/12 + 1/12 = 2/12; total gain 2/12. Balanced.
Why it works: A and B each gave up the same 1/12 of the future profits, so when C compensates them, C must pay each of them the same amount. That is exactly what a 1:1 sacrificing ratio tells us to do.
Sometimes the question does not give you the new ratio directly. Instead it tells you what fractions one partner acquired from the others, and expects you to build the new ratio yourself. Do not be thrown by this — it is the same arithmetic running forwards instead of backwards.
Step 1 — write old shares in twelfths.
A = 3/6 = 6/12, B = 2/6 = 4/12, C = 1/6 = 2/12.
Step 2 — deduct what each gave away.
A’s new share = 6/12 − 1/12 = 5/12
B’s new share = 4/12 − 1/12 = 3/12
Step 3 — add what C received.
C’s new share = 2/12 + 1/12 + 1/12 = 4/12
Step 4 — state the new ratio.
5/12 : 3/12 : 4/12 = 5 : 3 : 4
Step 5 — sacrificing ratio.
A sacrificed 1/12 and B sacrificed 1/12, so the sacrificing ratio is 1 : 1.
Check: 5/12 + 3/12 + 4/12 = 12/12 = 1. The whole pie is accounted for.
Why it works: this is Example 10 read from the other end. The examiner can hand you either the destination (the new ratio) or the journey (the fractions transferred), and both must lead to the same place. Always finish by checking that the new shares add up to one — if they do not, you have made an arithmetic slip.
9. Treatment of Goodwill on Change in Ratio
Here is where the two halves of the chapter meet. We know how to value goodwill. We know who sacrificed and who gained. Now we make the gaining partner pay the sacrificing partner — and we do it without opening a Goodwill Account, because AS 26 does not permit self-generated goodwill to be recorded.
Gaining Partner’s Capital A/c Dr. (Firm’s Goodwill × Gain)
To Sacrificing Partner’s Capital A/c (Firm’s Goodwill × Sacrifice)
The two sides must always be equal, because total gain always equals total sacrifice.
Step 1 — recall the sacrifices and gains (from Example 10).
A sacrifices 1/12, B sacrifices 1/12, C gains 2/12.
Step 2 — multiply each fraction by the firm’s goodwill.
A’s share of goodwill = 1,44,000 × 1/12 = ₹12,000 (to be credited)
B’s share of goodwill = 1,44,000 × 1/12 = ₹12,000 (to be credited)
C’s share of goodwill = 1,44,000 × 2/12 = ₹24,000 (to be debited)
Step 3 — pass the entry.
Why it works: C’s share of future profits went up by 2/12. Over the life of the firm that extra 2/12 of the goodwill — ₹24,000 — will flow to C. A and B gave that up, so C pays them for it today, in the ratio in which they gave it up.
Sometimes goodwill is already sitting in the balance sheet from an earlier transaction. AS 26 requires it to be removed before any new adjustment, and it is written off among all partners in their old ratio — because it belonged to them under the old agreement.
Step 1 — write off the existing goodwill in the OLD ratio 3:2:1.
A: 36,000 × 3/6 = ₹18,000
B: 36,000 × 2/6 = ₹12,000
C: 36,000 × 1/6 = ₹6,000
A: −18,000 + 12,000 = ₹6,000 debit
B: −12,000 + 12,000 = nil
C: −6,000 − 24,000 = ₹30,000 debit
Total debits 6,000 + 30,000 = ₹36,000, which is exactly the goodwill removed from the assets side. The books stay in balance.
Why it works: the old goodwill figure was earned under the old agreement, so it must be shared out on old-agreement terms. Only after the slate is clean can the new valuation be adjusted on new terms. Never net the two together in one step — the ratios are different.
Step 1 — old and new shares over a common denominator.
Old: R = 3/5 = 6/10, S = 2/5 = 4/10.
New: equal, so 1/2 each = 5/10 each.
Step 2 — Old − New.
R: 6/10 − 5/10 = +1/10 (sacrifice)
S: 4/10 − 5/10 = −1/10 (gain)
Step 3 — value the transfer.
80,000 × 1/10 = ₹8,000
Step 4 — the entry.
10. Reserves, Accumulated Profits and Losses
A firm’s balance sheet often carries profits that were earned but never distributed — a General Reserve, a credit balance of Profit and Loss, a Workmen Compensation Reserve. It may also carry accumulated losses: a debit balance of Profit and Loss, or an Advertisement Suspense Account.
All of these were created under the old agreement. So the rule is beautifully simple, and it never changes.
Step 1 — distribute the General Reserve (a profit) in 3:2:1.
A: 90,000 × 3/6 = ₹45,000 | B: 90,000 × 2/6 = ₹30,000 | C: 90,000 × 1/6 = ₹15,000
Step 2 — distribute the Workmen Compensation Reserve. With no claim expected, the whole reserve is a free profit.
A: 48,000 × 3/6 = ₹24,000 | B: 48,000 × 2/6 = ₹16,000 | C: 48,000 × 1/6 = ₹8,000
Step 3 — distribute the debit balance of Profit and Loss (a loss).
A: 30,000 × 3/6 = ₹15,000 | B: 30,000 × 2/6 = ₹10,000 | C: 30,000 × 1/6 = ₹5,000 — all debited.
Step 4 — the entries.
A: 45,000 + 24,000 − 15,000 = ₹54,000
B: 30,000 + 16,000 − 10,000 = ₹36,000
C: 15,000 + 8,000 − 5,000 = ₹18,000
Check: 54,000 + 36,000 + 18,000 = ₹1,08,000, which equals 90,000 + 48,000 − 30,000. And 54,000 : 36,000 : 18,000 simplifies to 3 : 2 : 1, confirming the old ratio was used throughout.
Why it works: these balances are the leftovers of years the partners lived through together under the old agreement. Whatever they change tomorrow cannot alter who earned what yesterday.
Two reserves need a little more care, because part of them may not be free to distribute.
Part A — Workmen Compensation Reserve.
Step 1: set aside the claim as a real liability. Provision for Workmen Compensation Claim = ₹18,000.
Step 2: distribute only the balance. 48,000 − 18,000 = ₹30,000 free.
A: 30,000 × 3/6 = ₹15,000 | B: 30,000 × 2/6 = ₹10,000 | C: 30,000 × 1/6 = ₹5,000
Step 1: measure the fall in value. 1,20,000 − 1,08,000 = ₹12,000. The reserve exists precisely to absorb this, so charge it against the reserve.
Step 2: distribute the balance. 30,000 − 12,000 = ₹18,000 free.
A: 18,000 × 3/6 = ₹9,000 | B: 18,000 × 2/6 = ₹6,000 | C: 18,000 × 1/6 = ₹3,000
Finally, a variation the examiner loves. Sometimes the partners decide that the reserves should not be distributed and should continue to appear in the books at their existing figures. In that case we cannot touch the reserve account — but the gaining partner is now entitled to a bigger slice of a reserve they did not fully earn. So we make a single adjustment through capital accounts, exactly like goodwill.
Step 1 — recall the sacrifices and gains. A sacrifices 1/12, B sacrifices 1/12, C gains 2/12.
Step 2 — apply those fractions to the reserve.
C is now entitled to 2/12 more of the reserve than before, so C must compensate:
90,000 × 2/12 = ₹15,000
A: 90,000 × 1/12 = ₹7,500 | B: 90,000 × 1/12 = ₹7,500
Step 3 — the entry.
Why it works: the reserve stays on the balance sheet, so its total is untouched. But by leaving it there, C will eventually receive 4/12 of it instead of 2/12. C therefore pays A and B today for the extra 2/12 — the same logic as goodwill, applied to a past profit instead of a future one.
11. Revaluation of Assets and Reassessment of Liabilities
Balance sheet figures grow stale. Land bought fifteen years ago is carried at cost; machinery may have worn out faster than the depreciation charged; a creditor may have quietly disappeared. Every one of those changes in value happened during the old agreement, so the resulting profit or loss belongs to the partners in the old ratio.
We collect all of them in a single account called the Revaluation Account (also called the Profit and Loss Adjustment Account). Think of it as a small holding tray: losses go on the debit side, gains on the credit side, and whatever is left over is shared out.
| Goes on the DEBIT side (losses) | Goes on the CREDIT side (gains) |
|---|---|
| Decrease in the value of any asset | Increase in the value of any asset |
| Increase in the amount of a liability | Decrease in the amount of a liability |
| A new or increased provision (e.g. for doubtful debts) | A liability written back as no longer payable |
| An unrecorded liability now brought into the books | An unrecorded asset now brought into the books |
Step 1 — sort each item into gain or loss.
Credit side (gains): Land and Building appreciation ₹60,000; creditors written back ₹9,000. Total gains = ₹69,000.
Debit side (losses): Machinery ₹24,000; Stock ₹9,000; provision for doubtful debts ₹6,000; outstanding repairs ₹6,000. Total losses = ₹45,000.
Step 2 — find the balance.
69,000 − 45,000 = ₹24,000 profit on revaluation.
Step 3 — share it in the old ratio 3:2:1.
A: 24,000 × 3/6 = ₹12,000 | B: 24,000 × 2/6 = ₹8,000 | C: 24,000 × 1/6 = ₹4,000
Step 4 — the transfer entry.
Step 1 — sort the items.
Credit side (gains): Investments ₹15,000. Total = ₹15,000.
Debit side (losses): Building ₹40,000; provision for legal claim ₹11,000. Total = ₹51,000.
Step 2 — find the balance.
51,000 − 15,000 = ₹36,000 loss on revaluation.
Step 3 — share the loss in 3:2:1.
A: 36,000 × 3/6 = ₹18,000 | B: 36,000 × 2/6 = ₹12,000 | C: 36,000 × 1/6 = ₹6,000
Step 4 — the entry, which now runs the other way.
12. Putting It All Together
Time to do the whole thing in one go. This is the shape a six- or eight-mark board question takes, and the only real difficulty is order. Follow the same four steps every time and the balance sheet will close itself.
Liabilities: Creditors ₹1,10,000; General Reserve ₹90,000; Workmen Compensation Reserve ₹48,000; Capitals — A ₹3,00,000, B ₹2,00,000, C ₹1,00,000. Total ₹8,48,000.
Assets: Cash ₹60,000; Debtors ₹1,20,000; Stock ₹1,38,000; Machinery ₹2,30,000; Land and Building ₹3,00,000. Total ₹8,48,000.
From 1 April 2026 they decide to share profits in the ratio 5:3:4, on these terms:
(i) Goodwill of the firm is valued at ₹1,44,000.
(ii) A claim of ₹18,000 on account of workmen compensation is to be provided for.
(iii) Land and Building is to be raised to ₹3,60,000 and Machinery reduced to ₹2,06,000.
(iv) Stock is to be reduced to ₹1,29,000 and a provision for doubtful debts of 5% is to be created on debtors.
(v) Creditors of ₹9,000 are no longer payable; outstanding repairs of ₹6,000 are to be provided.
STEP 1 — Sacrificing and gaining.
Old (in twelfths): A 6/12, B 4/12, C 2/12. New: A 5/12, B 3/12, C 4/12.
A: 6/12 − 5/12 = +1/12 sacrifice | B: 4/12 − 3/12 = +1/12 sacrifice | C: 2/12 − 4/12 = 2/12 gain.
STEP 2 — Goodwill adjustment (sacrificing/gaining ratio).
C pays 1,44,000 × 2/12 = ₹24,000; A receives 1,44,000 × 1/12 = ₹12,000; B receives ₹12,000.
General Reserve ₹90,000 → A ₹45,000, B ₹30,000, C ₹15,000.
Workmen Compensation Reserve ₹48,000 less claim ₹18,000 = ₹30,000 free → A ₹15,000, B ₹10,000, C ₹5,000.
Debit side (losses): Machinery 2,30,000 − 2,06,000 = ₹24,000; Stock 1,38,000 − 1,29,000 = ₹9,000; Provision for doubtful debts 5% of 1,20,000 = ₹6,000; Outstanding repairs ₹6,000. Total ₹45,000.
Credit side (gains): Land and Building 3,60,000 − 3,00,000 = ₹60,000; Creditors written back ₹9,000. Total ₹69,000.
Profit on revaluation = 69,000 − 45,000 = ₹24,000, shared 3:2:1 → A ₹12,000, B ₹8,000, C ₹4,000.
A: 3,00,000 + 12,000 (goodwill) + 45,000 (GR) + 15,000 (WCR) + 12,000 (revaluation) = ₹3,84,000
B: 2,00,000 + 12,000 + 30,000 + 10,000 + 8,000 = ₹2,60,000
C: 1,00,000 − 24,000 + 15,000 + 5,000 + 4,000 = ₹1,00,000
Total capitals = 3,84,000 + 2,60,000 + 1,00,000 = ₹7,44,000
STEP 6 — Balance Sheet as at 1 April 2026 (after reconstitution).
Liabilities: Creditors 1,10,000 − 9,000 = ₹1,01,000; Outstanding Repairs ₹6,000; Workmen Compensation Claim ₹18,000; Capitals — A ₹3,84,000, B ₹2,60,000, C ₹1,00,000. Total ₹8,69,000.
Assets: Cash ₹60,000; Debtors 1,20,000 less provision 6,000 = ₹1,14,000; Stock ₹1,29,000; Machinery ₹2,06,000; Land and Building ₹3,60,000. Total ₹8,69,000.
It balances. 1,01,000 + 6,000 + 18,000 + 7,44,000 = 8,69,000, and 60,000 + 1,14,000 + 1,29,000 + 2,06,000 + 3,60,000 = 8,69,000.
Why it works: look at what happened to the totals. The balance sheet grew from ₹8,48,000 to ₹8,69,000, an increase of ₹21,000 — which is exactly the revaluation profit of ₹24,000 less the workmen’s claim of ₹18,000 plus the creditors written back of ₹9,000 already inside that revaluation figure. Meanwhile the goodwill adjustment moved ₹24,000 between partners without changing the total at all, which is precisely what an adjustment through capital accounts should do.
Practice Worksheet
Ten original questions, arranged roughly from gentle to board level. Please write your answer on paper before you click — reading a solution creates a comfortable feeling of understanding that vanishes in the exam hall. Solving creates the real thing.
Show Answer
40,000 + 50,000 + 62,000 + 48,000 + 70,000 = ₹2,70,000
Step 2 — average over five years.
2,70,000 ÷ 5 = ₹54,000
Step 3 — apply years’ purchase.
54,000 × 2 = ₹1,08,000
Goodwill = ₹1,08,000.
Show Answer
Year 3: 1,20,000 − 15,000 = ₹1,05,000
Step 2 — charge the omitted remuneration in every year.
Year 1: 1,50,000 − 30,000 = ₹1,20,000
Year 2: 1,80,000 − 30,000 = ₹1,50,000
Year 3: 1,05,000 − 30,000 = ₹75,000
Step 3 — average the adjusted profits.
1,20,000 + 1,50,000 + 75,000 = ₹3,45,000; ₹3,45,000 ÷ 3 = ₹1,15,000
Step 4 — apply years’ purchase.
1,15,000 × 2 = ₹2,30,000
Goodwill = ₹2,30,000.
Show Answer
5,00,000 × 10/100 = ₹50,000
Step 2 — actual (adjusted) profit.
82,000 − 12,000 = ₹70,000
Step 3 — super profit.
70,000 − 50,000 = ₹20,000
Step 4 — goodwill.
20,000 × 3 = ₹60,000
Goodwill = ₹60,000.
Show Answer
Step 2 — capitalise.
Goodwill = Super Profit × 100 / Normal Rate
= 20,000 × 100 / 10 = 20,00,000 ÷ 10 = ₹2,00,000
Goodwill = ₹2,00,000.
Note the contrast with Question 3. Three years’ purchase gave ₹60,000; capitalisation gives ₹2,00,000. Capitalisation assumes the super profit continues for ever, so it always yields the larger figure. Use whichever method the question actually names.
Show Answer
Average Profit × 100 / Normal Rate = 1,20,000 × 100 / 15
= 1,20,00,000 ÷ 15 = ₹8,00,000
Step 2 — capital employed (net assets).
9,50,000 − 2,00,000 = ₹7,50,000
Step 3 — goodwill is the difference.
8,00,000 − 7,50,000 = ₹50,000
Goodwill = ₹50,000.
Show Answer
Old: P = 5/10, Q = 3/10, R = 2/10
New: P = 2/10, Q = 4/10, R = 4/10
Step 2 — compute Old − New for each partner.
P: 5/10 − 2/10 = +3/10 → sacrifice of 3/10
Q: 3/10 − 4/10 = −1/10 → gain of 1/10
R: 2/10 − 4/10 = −2/10 → gain of 2/10
Step 3 — state the ratios.
Sacrificing Ratio: only P sacrifices, so P sacrifices 3/10 alone.
Gaining Ratio (Q : R) = 1/10 : 2/10 = 1 : 2
Check: total gain = 1/10 + 2/10 = 3/10 = total sacrifice. Balanced.
Show Answer
P (sacrifices 3/10): 60,000 × 3/10 = ₹18,000 credit
Q (gains 1/10): 60,000 × 1/10 = ₹6,000 debit
R (gains 2/10): 60,000 × 2/10 = ₹12,000 debit
Step 2 — the journal entry.
Q’s Capital A/c Dr. 6,000
R’s Capital A/c Dr. 12,000
To P’s Capital A/c 18,000
(Being adjustment for goodwill on change in profit-sharing ratio)
Check: 6,000 + 12,000 = 18,000. The entry balances, as it must, because total gain equals total sacrifice.
Note: no Goodwill Account is opened. Under AS 26, self-generated goodwill is not recorded; the whole adjustment passes through capital accounts.
Show Answer
Step 2 — distribute the General Reserve.
A: 75,000 × 2/5 = ₹30,000 | B: 75,000 × 2/5 = ₹30,000 | C: 75,000 × 1/5 = ₹15,000
Step 3 — write off the Advertisement Suspense.
A: 25,000 × 2/5 = ₹10,000 | B: ₹10,000 | C: 25,000 × 1/5 = ₹5,000
Step 4 — the entries.
General Reserve A/c Dr. 75,000
To A’s Capital A/c 30,000
To B’s Capital A/c 30,000
To C’s Capital A/c 15,000
A’s Capital A/c Dr. 10,000
B’s Capital A/c Dr. 10,000
C’s Capital A/c Dr. 5,000
To Advertisement Suspense A/c 25,000
Step 5 — net amounts credited.
A: 30,000 − 10,000 = ₹20,000
B: 30,000 − 10,000 = ₹20,000
C: 15,000 − 5,000 = ₹10,000
Check: 20,000 + 20,000 + 10,000 = ₹50,000 = 75,000 − 25,000, and the amounts are in the ratio 2:2:1.
Show Answer
Credit side (gains): Building appreciation ₹80,000; unrecorded investment recorded ₹15,000. Total ₹95,000.
Debit side (losses): Furniture ₹12,000; Stock ₹8,000; provision for doubtful debts ₹5,000; provision for claim for damages ₹20,000. Total ₹45,000.
Step 2 — find the balance.
95,000 − 45,000 = ₹50,000 profit on revaluation
Step 3 — share in the old ratio 3:1.
X: 50,000 × 3/4 = ₹37,500
Y: 50,000 × 1/4 = ₹12,500
Step 4 — the transfer entry.
Revaluation A/c Dr. 50,000
To X’s Capital A/c 37,500
To Y’s Capital A/c 12,500
(Being profit on revaluation transferred in the old ratio)
Check: 37,500 + 12,500 = ₹50,000, split 3:1. Remember an unrecorded asset being brought in is a gain, while an unrecorded liability or claim is a loss.
Show Answer
Old: M = 3/5 = 6/10, N = 2/5 = 4/10. New: 1/2 each = 5/10 each.
M: 6/10 − 5/10 = +1/10 sacrifice | N: 4/10 − 5/10 = 1/10 gain
Step 2 — goodwill adjustment (sacrificing/gaining ratio).
1,20,000 × 1/10 = ₹12,000
N’s Capital A/c Dr. 12,000
To M’s Capital A/c 12,000
(Being adjustment for goodwill on change in profit-sharing ratio)
Step 3 — General Reserve (old ratio 3:2).
M: 50,000 × 3/5 = ₹30,000 | N: 50,000 × 2/5 = ₹20,000
General Reserve A/c Dr. 50,000
To M’s Capital A/c 30,000
To N’s Capital A/c 20,000
(Being general reserve distributed in the old ratio)
Step 4 — Revaluation Account.
Gains: Land ₹45,000 + creditors written back ₹4,000 = ₹49,000
Losses: provision for doubtful debts ₹5,000 + stock ₹14,000 = ₹19,000
Profit on revaluation = 49,000 − 19,000 = ₹30,000
Shared 3:2 → M: 30,000 × 3/5 = ₹18,000; N: 30,000 × 2/5 = ₹12,000
Land A/c Dr. 45,000
Creditors A/c Dr. 4,000
To Revaluation A/c 49,000
(Being increase in value of land and creditors written back)
Revaluation A/c Dr. 19,000
To Provision for Doubtful Debts A/c 5,000
To Stock A/c 14,000
(Being provision created and stock written down)
Revaluation A/c Dr. 30,000
To M’s Capital A/c 18,000
To N’s Capital A/c 12,000
(Being profit on revaluation transferred in the old ratio)
Check: M is credited 12,000 + 30,000 + 18,000 = ₹60,000; N is credited 20,000 + 12,000 = ₹32,000 and debited ₹12,000, a net ₹20,000. The goodwill entry moved value between partners; the reserve and revaluation entries brought value in from the books. Notice again that only goodwill used the 1/10 sacrifice, while everything else used the old 3:2 ratio.
A Last Word Before You Close This Page
If some of this still feels slippery, that is completely normal and it is not a verdict on your ability. Reconstitution is genuinely the point where Accountancy stops being bookkeeping and starts asking you to think about fairness between people. Nobody sees the whole picture on the first reading. What actually works is small and unglamorous: open your notebook tomorrow, redo Example 10 without looking, and if you get the sacrificing ratio right, move on to Example 12. That is all. You do not need a dramatic six-hour study session; you need to get one more correct question than yesterday, and then do that again the day after.
Keep the four-step order taped somewhere you will see it — sacrifice and gain, goodwill, reserves and revaluation, then the balance sheet. Keep reminding yourself that everything from the past uses the old ratio and only goodwill uses the sacrificing ratio. Those two habits will carry you through every question in this unit, including the ones nobody warned you about. You have got this, and you are closer than you think.