| Balance Sheet of A & B | |||
| Cash | $ 1,000.00 | Notes Payable | $ 3,000.00 |
| Accounts Receivable | 10,000.00 | Accounts Payable | 5,000.00 |
| Merchandise | 6,000.00 | Mortgage on Bldg | 4,000.00 |
| Building and Equipment | 16,000.00 | A, Capital | 10,500.00 |
| B, Capital | 10,500.00 | ||
| $33,000.00 | $33,000.00 | ||
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:
| Balance Sheet of A, B & C | ||||
| Cash | $ 7,000.00 | Notes Payable | $ 3,000.00 | |
| Accounts Rec. | $10,000 | Accounts Payable | 5,000.00 | |
| Less—Reserve | 1,000 | 9,000.00 | Mortgage on Bldg | 4,000.00 |
| A, Capital | 9,000.00 | |||
| Merchandise | 5,500.00 | B, Capital | 9,000.00 | |
| Building and Equipment | 14,500.00 | C, Capital | 6,000.00 | |
| $36,000.00 | $36,000.00 | |||
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:
Problem. Assume that X has a one-half interest in a firm, and Y and Z a one-fourth interest each, the balance sheet showing the following summarized facts: