Admission of a New Partner.—In Chapter XXXIII a distinction was made between buying out an interest in a business and making an investment in a business. In the former case no new capital is acquired, while in the latter the capital of the firm is increased by the amount of the new partner’s contribution.

When a new partner is admitted he usually acquires not merely the right to share in the profits, but he also obtains a share in the net worth (often called “net assets”) of the enterprise. For this reason it is necessary that all the partners, including the new member, agree on the value of the net assets, and in this connection any of the following possibilities may arise:

First Case.—In the first case little difficulty is met in making the opening entry admitting the new partner. For instance, if the balance sheet shows a net worth of $30,000, and the new partner wishes to make an investment in order to secure a one-fourth interest in the firm, the amount to be contributed is manifestly $10,000. Assuming that he makes a cash investment of $10,000, the following entry meets all accounting requirements:

As a result of this cash investment of $10,000, the net worth of the new firm is increased to $40,000 and the one-fourth interest belonging to A is evidenced by his capital account at $10,000. The new firm may now continue the old records and no further adjustments need be made.

Second Case.—In the second case it is necessary to place a new valuation upon the assets of the old firm and the accounts of the old partners must be adjusted accordingly. For instance, suppose A and B are equal partners and the financial status of the firm is shown by the following balance sheet:

More capital is needed and C is invited to make an investment. Upon investigation he finds that there are included under Accounts Receivable many old items, of which it is estimated $1,000 will be uncollectible; that the merchandise is overvalued to the amount of $500; and that the building and equipment are worth $1,500 less than is shown on the books. He offers to make an investment to secure a one-fourth interest and his offer is accepted.

As a result of the new valuations placed upon the assets, the net worth of the firm is now $18,000, against the old showing of $21,000. Consequently, the capital accounts of A and B are reduced from $10,500 to $9,000 each. The new partner is to invest a certain sum sufficient to acquire a one-fourth interest in the new business. Hence the combined capital of A and B, amounting to $18,000, will represent three-fourths of the new capital, and consequently the amount to be invested by C is $6,000. Thus the new capital of the firm will amount to $24,000, one-fourth of which, or $6,000, is credited to C’s capital account.

The balance sheet of the new firm will show:

The firm has thus secured $6,000 additional capital, on a basis somewhat unfavorable for the present, but inasmuch as the books now show conservative values, no real injustice results.

Third Case.—The third case shows the firm in a position to demand something more than book values as the basis for admission of the new partner. The presumption is that the old firm is favorably known, has an established trade and patronage, built by fair dealing and judicious advertising, by its favorable location, and the numerous other ways in which a substantial business may be developed. Its standing in the community is a factor of value to the firm because it brings trade to its doors. Other conditions being equal, a firm which enjoys a good reputation is worth more than a new venture. Such a reputation is known as “good-will” and constitutes an exceedingly valuable though an intangible asset. The essence of good-will is the ability to produce more than normal profits, i.e., profits above the average in that line. Consequently, whenever the members of a firm consider the admission of a new partner, good-will is regarded as one of the assets of the existing enterprise, thereby increasing its net worth.

The valuation of good-will, however, is a difficult matter and it is a well-established principle that good accounting will not allow the asset good-will to be set up on the books of a concern unless it has come into possession of it by purchase or unless a part of its own good-will is sold to a new partner. In this case the price received for the portion sold represents an outsider’s valuation and may therefore become the basis for valuing the whole of it.

The following case will serve as an illustration:

There are three ways of treating this good-will element, viz.:

Of the three methods, the second usually proves the most satisfactory.

A similar problem involving the handling of good-will is encountered when a member of an existing firm sells out his interest, including a share of the good-will, to one who takes his place in the firm. Here the transaction may be looked upon as a private deal between buyer and seller, in which case the buyer merely succeeds to the seller’s interest in the firm, his capital appearing on the books at the same amount as the seller’s former capital figure even though the new partner pays more for it; or the good-will may be brought onto the books and the capitals of all the partners be shown at increased figures, as under the second method discussed above.

Consolidation of Partnerships.—There are various reasons why the consolidation of partnerships may be of mutual advantage to the individual firms concerned. When two or more firms consolidate, the competition which formerly existed between them is eliminated and co-operation takes its place. Also by uniting their businesses, many of the operations which were formerly performed separately are now amalgamated with resulting savings. Many other advantages may result from such consolidations.

From the standpoint of the accountant, the consolidation of partnerships is essentially the same as the admission of new partners, the same principles applying to both. Before actual consolidation takes place, it is necessary for each of the partnerships to place a new valuation upon its assets and for all concerned to agree upon the new figures. In almost all cases good-will is an important factor. The valuation of good-will requires an investigation of the profits and profit-earning capacity of the member firms. Conditions affecting the profits of the various firms must be equalized as nearly as possible so that the earning capacity of each can be compared on an equitable basis. Such questions as the way in which partners’ salaries, interest on capitals, withdrawals, and loans have been handled; the relation of outside sources of income, if any, to the profit of any of the member firms; and whether the consolidation contemplates taking over such source of profits—these and similar questions must be considered and treated equitably for all concerned.

The following illustration is given to indicate the bookkeeping problems incident to consolidations:

After the adjustments the new balance sheets appear as follows: