Partnership

Accounting for goodwill

Goodwill
Goodwill = Selling price as a going concern Fair value of separate net assets Goodwill = Selling price (Assets Liabilities)

Goodwill

Buyer may be willing to pay more for a business as a going concern because of:
Good location Good customer relations Good reputation Well-known products Experienced and efficient employees and management team Good relation with suppliers
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Types of Goodwill

Inherent Goodwill Purchased Goodwill

Inherent Goodwill

Goodwill generated internally because of the above advantages Inherent goodwill is only an estimation. Therefore, it should not be brought into the books, and no accounting entry is required

Purchased Goodwill
It is the goodwill generated during the acquisition of a business It is the difference between the selling price of a business as a going concern and the total value of its separable net assets It can be treated as an intangible fixed asset. Some companies may write it off immediately against reserves, or amortized through the profit and loss account over its useful economic life

Calculation of Goodwill

Subjective Judgement Average Sales/Fees/Profits Method Super Profit Method

Subject Judgement

Estimate the value of goodwill with reference to some intangible factors and according to their professional judgement

Average Sales/Fees/Profit Method

It can be calculated on gross average or weight average Goodwill = Average annual sales/fees/profits over a stated number of years * a factor
The factor is usually stated as a certain number of years purchase of the average sales/fees/profits

Example 1

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Year

Annual Sales $ 100000 200000 300000

1995 1996 1997

(a) Goodwill is valued at 3 years purchase of the average annual sales of the past 3 years:

Average annual sales = ($100000+200000+300000 ) /3 = $200000

Goodwill = $200000 X3 = $600000
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(b) Goodwill is valued at the 3 years purchase of the weighted average of the annual sales of the past 3 years

Weighted average annual sales = (100000 x 1 + 200000 x 2 + 300000 x 3) 1+2+3 = 1400000 6 = 233333 (Calculation to the nearest dollar)

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Super Profit Method

A business with goodwill is expected to be able to earn more profit than a business without goodwill The extra profit earned is called the super profit
Statement Calculating Super Profit Average annual net profit X

Less: Reasonable remuneration to the owner

Reasonable return on the capital employed in the tangible assets Super profit

X X

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Example 2

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Chan is leaving the partnership, and goodwill is to be revalued at 3 years purchase of the super profit. The expected rate of return on net tangible assets is 10 %, after paying a management fee of $500. The calculation of the super profit is to be based on the average profits of the last four years. Net profit from 1994-1997 is $5000, $6500, $6500, $7000 Expected return on net tangible assets = Net tangible assets * 10%. Expected return is $5000.
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Answer Statement Calculating Super Profit $ Average net profit (5000+6500+6500+7000)/4 Less: Management fee 500 Expected rate of return on net tangible assets 5000 Super profit

$ 6250

5500 750

Goodwill= $750 X 3 = $2250

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Accounting for Goodwill in

Partnership

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Accounting for goodwill in partnership

Only purchased goodwill is to be brought into the accounts. In sole traders accounts, goodwill is to be recognized and recorded in the books only if the business is acquired as a going concern In partnerships, however, goodwill is brought into the books whenever there is a change in the partnership such as:

Admission of a new partner Retirement of an old partner Change of the profit-sharing ratio
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Each partner has a share of the profit-sharing ratio. At a change in the partnership, goodwill must be taken into account and shared among the existing partners, according to the existing profit-sharing ratio

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Goodwill on the admission of a new partner

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Goodwill on the admission of a new partner

The new partner is required to pay for his share of the tangible assets as well as the goodwill, according to the profit-sharing ratio On the admission of a new partner, goodwill must be revalued However, not all business keep a goodwill account in their books. Goodwill adjustments can be done:

Goodwill account opened Goodwill account not opened

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Goodwill account opened

The value of the goodwill will be credited to the old partners capital accounts, which represents an increase in the resources they own, while the new partner will not have a share of the goodwill
Dr Goodwill account Cr Capital account ( old partners only
Dr Goodwill account Cr Capital account ( old partner Dr Capital account (old partner) Cr Goodwill account

With the value of goodwill With their share of goodwill in old ratio
With the increase in the value of goodwill, share in the old ratio With the decrease in the value of goodwill, share in the old artio

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Goodwill account not opened

Goodwill is intangible in nature. It cannot be disposed of separately. Therefore, some businesses prefer not to maintain a goodwill account The new partner may be required to pay extra cash, or have his capital balance reduced, for his share of goodwill Share goodwill among old partners in old profit-sharing ratio Written off goodwill among all partners in the new profit-sharing ratio
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Dr Goodwill account Cr Capital account (old partners only) Dr Capital account ( all partners) Cr Goodwill account

Example 3

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Chan and Wong were partners sharing profits and losses equally. On 1 January 1998, they admitted Lee as a new partner who was required to introduce $600 as capital. The profits are now to be shared among Chan, Wong and Lee equally. Goodwill is valued at $300. The balance sheet before the admission of the new partner is shown as follows:
Chan and Wong Balance Sheet as at 31 December 1997

Assets

1,200

Capital Chan Wong

600 600 1,200

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1,200

Goodwill account opened

Capital: Chan (1/2) Wong (1/2)
Goodwill 150 Balance c/f 150 300
Capital Chan Wong Lee Chan Wong Lee

300 300

Balance c/f

750

750

600

Balance b/f
Goodwill Cash

600
150

600
150 600

750

750

600

750

750

600

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Goodwill account opened

Balance Sheet as at 31 December 1998
Assets Goodwill Other Assets (1,200 + 600) 300 1,800 2,100 Capital Chan Wong Lee New capital balance 750 750 600 2,100

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Goodwill account not opened Capital

Chan Goodwill : new ratio Balance c/f 100 650 Wong 100 650 Lee Chan Wong Lee

Balance b/f
100 500

600

600
150

Goodwill: old ratio 150 Cash

600 750 600

750

750

600

750

Before admission

After admission

Partner
Chan Wong Lee

Old ratio
1/2 1/2

Share of goodwill
$150 $150 $300

New ratio
1/3 1/3 1/3

Share of goodwill
$100 $100 $100 $300

Gain/loss
$50 loss $50 loss $100 gain
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Goodwill account not opened

Balance Sheet as at 31 December 1998
Assets Assets (1,200 + 600) 1,800 Capital Chan Wong Lee 650 650 500 1,800

1,800

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Goodwill on the Retirement of a Partner

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Goodwill on the Retirement of a Partner

When a partner wants to withdraw from a partnership, the partnership should revalue all the assets which belongs to the leaving partner in order to compute the total amount of money that he can withdraw from the partnership Goodwill adjustment should be calculated in order to compensate the leaving partner

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Example 4

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Ho, Tang and Lau were partners sharing profits and losses equally. On 31 December 1997, Lau left the partnership. The other two partners agreed to share profits and losses equally. The goodwill is revalued at $10,000. Lau received cash from the partnership for the amount due to him on 31 December 1997. The balance sheet before Laus retirement is shown as follows:
Ho, Tang and Lau Balance Sheet as at 31 December 1997

Goodwill Other Assets

1,000 41,000

Capital Ho Tang Lau

14,000 14,000 14,000 42,000

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42,000

Goodwill account opened

Balance b/f
Capital: Ho (1/3) Tang (1/3) Lau (1/3) 3,000 3,000 3,000

Goodwill 1,000 Balance c/f

9,000 10,000 Capital Ho Tang Lau 17,000 Ho

10,000

10,000

Tang

Lau

Bank Balance c/f 17,000 17,000

Balance b/f Goodwill

14,000 14,000 14,000 3,000 3,000 3,000 17,000 17,000 17,000

17,000 17,000 17,000

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Ho and Tang Balance Sheet as at 31 December 1998 Goodwill Other Assets (41000-17000) 1,000 24,000 34,000 Capital Ho Tang 17,000 17,000 34,000

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Goodwill account not opened

Capital Ho Bank Goodwill: new ratio Balance c/f Tang Lau 17,000 Balance b/f Ho Tang Lau 14,000 14,000 14,000 3,000 3,000 3,000 5,000 5,000 12,000 12,000 17,000 17,000 17,000 Ho and Tang Balance Sheet as at 31 December 1998 Assets (41,000 17,000) 24,000 Capital: Ho Tang

Goodwill : old ratio

17,000 17,000 17,000

12,000 12,000

24,000

24,000

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Goodwill on a change in the profit-sharing ratio

Goodwill on a change in the profitsharing ratio

When there is a change in the profit-sharing ratio, the value of goodwill should also be reassessed, so as to ascertain the amount of resources a partner has to give up ( in terms of a reduction in the relative capital balance) for the gain in his share of profits/loss.

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Example 5

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Yip, Chow and Au are partners in a trading firm and share profits and losses in the ratio 3:3:2. On 31 December 1997, they wanted to change the profitsharing ratio to 1:1:1. The goodwill is revalued at $9,000. The firms balance sheet on 31 December 1997 was:
Yip, Chow and Au Balance Sheet as at 31 December 1997 1,000 Capital: Yip 79,000 Chow Au 80,000

Goodwill Other Assets

30,000 30,000 20,000 80,000

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Goodwill account opened

Goodwill Balance b/f
Capital: Yip (3/8) Chow (3/8) Au (2/8) 3,000 3,000 2,000 1,000

Balance c/f

9,000

8,000 9,000 Capital 9,000

Yip

Chow

Au Balance b/f Goodwill

Balance c/f

33,000 33,000 22,000

Yip Chow Au 30,000 30,000 20,000 3,000 3,000 2,000

33,000 33,000 22,000

33,000 33,000 22,000

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Goodwill account opened

Balance Sheet as at 31 December 1998
Goodwill Other Assets 9,000 79,000 Capital Yip Chow Au 33,000 33,000 22,000 88,000

88,000

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Goodwill account not opened

Capital Yip Goodwill: new ratio Balance c/f Chow Au Yip Chow Au 3,000 3,000 3,000 30,000 30,000 19,000 33,000 33,000 22,000

Balance b/f Goodwill: old ratio

30,000 30,000 20,000

3,000 3,000 2,000

33,000 33,000 22,000

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Assets

Yip, Chow & Au Balance Sheet as at 31 December 1998 79,000 Capital: Yip Chow Au 79,000

30,000 30,000 19,000 79,000

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Cindy and Candy were in partnership. They shared profits and losses in ratio of 3:2 On 1 January 2001, they decided to admit Joe. Goodwill is valued at one years purchase of the average annual profits (weighted average) of the past four years. Goodwill is not to be brought into the partnerships book. Joe brought $40,000 cash into the business for capital. No extra cash is paid for goodwill. The new profit-sharing ratio is 3:2:1.
The balance sheet as at 31 December2000 before the admission of Joe is as follows: Assets 110,000 Capital : Cindy 65,000 Cash 25,000 Candy 70,000 Annual net profits for 1997 to 2000 were $25,000,$40,000, $75,000 and $60,000 respectively. Record the above change in the partnership in the partners capital accounts in columnar form, and show the balance sheet after the admission of Joe.

Valuation of Goodwill :
25,000 x1 + 40,000x2 + 75,000 x3 + 60,000 x 4 1 + 2 + 3 + 4 57,000