Partnership and LLP Accounts — Treatment of Goodwill in Partnership Accounts
Learning Outcomes
- Understand when does the need for valuation of goodwill arise.
- Learn the accounting of goodwill.
2.1 Goodwill
- Goodwill is the value of reputation of a firm in respect of profits expected in future over and above the normal rate of profits.
- In simpler terms, Goodwill is nothing more than the probability that old customer will resort to old place again and again.
- Goodwill is an intangible asset; it cannot be seen; it cannot be felt; it cannot be transported physically.
KNOWLEDGE NUGGET
- Goodwill: Value of reputation — future profits over normal rate
- Intangible Asset: Cannot be seen or touched
- Necessity for Valuation:
- Change in profit sharing ratio
- Admission of new partner
- Retirement or death of partner
- Dissolution or sale of business
Factors Affecting Value of Goodwill
- (i) The quality of the goods sold.
- (ii) The personal reputation of the owners.
- (iii) The location of the business premises.
- (iv) The possession of near monopoly right.
- (v) The possession of trademarks and patents.
- (vi) The presence of managerial skill.
- (vii) The cost of research and development.
- (viii) The possession of special contracts for the availability of materials.
Recommendation of Accounting Standard
- An intangible asset must have the characteristics of an asset — clearly identifiable.
- Future probable economic benefits will flow to the business enterprise.
- The cost of the intangible asset can be measured reliably.
INTERNALLY GENERATED GOODWILL
- Not recorded in books because:
- Not an identifiable resource
- Difficult to assess future benefits
- Cost cannot be reliably measured
- Only purchased goodwill should be recorded
- On reconstitution, goodwill should not be raised in books
- Adjust through capital accounts only
2.2 Methods for Goodwill Valuation
There are three methods for valuation of goodwill:
- 1) Average profit basis — Simple and Weighted
- 2) Super profit basis — Number of Year Purchase, Annuity basis, and Capitalization of Super Profit
- 3) Capitalization basis — Average Profits
(1) Average Profit Basis
- In this case, the average profits of past years are adjusted for any expected change in future.
- If there exists clear increasing or decreasing trend of profits, use weighted average.
- If there is no clear trend, use simple average.
FORMULA — WEIGHTED AVERAGE PROFIT
Weighted Average Profit = Total Weighted Profit / Total Weights
Goodwill = Average Profit × Number of Years' Purchase
EXAMPLE — AVERAGE PROFIT BASIS
Profits of five years: ₹50,000; ₹40,000; ₹52,000; ₹48,000; ₹56,000
Total profits = ₹2,46,000
Average profit = ₹2,46,000 ÷ 5 = ₹49,200
Goodwill (4 years' purchase) = ₹49,200 × 4 = ₹1,96,800
(2) Super Profit Basis
- In case of super profit method, goodwill is valued on the basis of super profits earned by the firm.
FORMULAE — SUPER PROFIT METHOD
- Super Profit = Actual Profit — Normal Profit
- Normal Profit = Normal Rate of Return (NRR) × Capital Employed
- Goodwill = Super Profit × Number of Years' Purchase
EXAMPLE — SUPER PROFIT METHOD
- Capital Employed: ₹1,00,000
- Average Profit: ₹25,000
- Normal Rate of Return: 22%
- Normal Profit = 22% × ₹1,00,000 = ₹22,000
- Super Profit = ₹25,000 — ₹22,000 = ₹3,000
- Goodwill (5 years' purchase) = ₹3,000 × 5 = ₹15,000
(a) Number of Years Purchase Method
- Goodwill is valued by multiplying the amount of super profit by certain number of years.
(b) Annuity Method
- Considers time value of money — discounted value of super profit.
EXAMPLE — ANNUITY METHOD
- Super Profit: ₹3,000 (for 5 years)
- Interest Rate: 15%
- Present Value of Annuity (5 years @ 15%): 3.3522
- Goodwill = ₹3,000 × 3.3522 = ₹10,056.60
(c) Capitalization of Super Profit
FORMULA
Goodwill = Super Profit / Normal Rate of Return (NRR)
(3) Capitalization Basis
- Value of whole business is determined applying normal rate of return.
- If such value is higher than the capital employed in the business, the difference is goodwill.
FORMULAE — CAPITALIZATION METHOD
- Normal Value of Business = Average Profit / Normal Rate of Return
- Goodwill = Normal Value of Business — Actual Capital Employed
EXAMPLE — CAPITALIZATION METHOD
- Capital Employed: ₹1,00,000
- Average Profit: ₹20,000
- Normal Rate of Return: 15%
- Normal Value of Business = ₹20,000 / 15% = ₹1,33,333
- Goodwill = ₹1,33,333 — ₹1,00,000 = ₹33,333
Illustration 1
Lee and Lawson are in equal partnership. They agreed to take Hicks as one-fourth partner. For this it was decided to find out the value of goodwill. M/s. Lee and Lawson earned profits during 2019-2022 as follows:
SOLUTION
Weighted Average Profit:
| Year | Profit (₹) | Weight | Weighted Profit (₹) |
|---|---|---|---|
| 2019 | 1,20,000 | 1 | 1,20,000 |
| 2020 | 1,25,000 | 2 | 2,50,000 |
| 2021 | 1,30,000 | 3 | 3,90,000 |
| 2022 | 1,50,000 | 4 | 6,00,000 |
| Total | 10 | 13,60,000 | |
Weighted Average Profit = ₹13,60,000 ÷ 10 = ₹1,36,000
Method (1): Average Profit Basis (3 years' purchase)
Goodwill = ₹1,36,000 × 3 = ₹4,08,000
Method (2): Super Profit Basis
- Normal Profit = 20% on ₹5,00,000 = ₹1,00,000
- Super Profit = ₹1,36,000 — ₹1,00,000 = ₹36,000
- Goodwill (3 years' purchase) = ₹36,000 × 3 = ₹1,08,000
Method (3): Annuity Basis
- Interest rate = 20% p.a., 3 years' purchase
- Annuity factor (20%, 3 years) = 2.1065
- Goodwill = ₹36,000 × 2.1065 = ₹75,834
Method (4): Capitalisation Basis
- Normal Value of Business = ₹1,36,000 / 20% = ₹6,80,000
- Less: Capital Employed = ₹5,00,000
- Goodwill = ₹1,80,000
2.4 Valuation of Goodwill in Case of Admission of a Partner
- When a new partner is admitted, certain adjustments in accounts become necessary.
- Goodwill is a compensation to old partners for their sacrifice in connection with admission of a new partner.
- It is credited to the partners according to their profit sacrificing ratio.
- Sacrificing Ratio = Old Share — New Share
PROFIT SACRIFICING RATIO
- Sacrificing Ratio = Old Profit Sharing Ratio — New Profit Sharing Ratio
- Only those existing partners who sacrifice their share get compensation
- If only new partner's share is given, sacrificing ratio = old profit sharing ratio
2.5 Accounting Treatment of Goodwill in Case of Admission of a New Partner
JOURNAL ENTRIES — ADMISSION OF PARTNER
Case 1: When goodwill is brought in cash:
- Bank A/c Dr.
- To New Partner's Capital A/c (Capital amount)
- To Old Partners' Capital A/c (Goodwill in sacrificing ratio)
Case 2: When goodwill is adjusted through capital accounts:
- New Partner's Capital A/c Dr.
- To Old Partners' Capital A/c (Goodwill in sacrificing ratio)
Illustration 3
SOLUTION
Journal Entries (Goodwill adjusted through capital accounts):
- Bank A/c Dr. ₹20,000
- To Black's Capital A/c ₹20,000
- Black's Capital A/c Dr. ₹11,250
- To Yellow's Capital A/c ₹8,100
- To Green's Capital A/c ₹3,150
Balance Sheet as on 31st December, 2022
| Liabilities | Amount (₹) | Assets | Amount (₹) |
|---|---|---|---|
| Trade payables | 20,000 | Cash at Bank | 30,000 |
| Capital: | Sundry Assets | 55,000 | |
| Yellow | 33,100 | ||
| Green | 23,150 | ||
| Black | 8,750 | ||
| Total | 85,000 | Total | 85,000 |
2.6 Accounting Treatment of Goodwill in Case of Change in Profit Sharing Ratio
- In case of change in profit sharing ratio, the value of goodwill should be determined and preferably adjusted through capital accounts of the partners on the basis of profit sacrificing ratio.
ILLUSTRATION 7
A, B & C are equal partners. They wanted to change the profit sharing ratio into 4:3:2. Goodwill of the firm is valued at ₹90,000.
Calculation:
- A's gain = 4/9 — 1/3 = 1/9
- B's gain = 1/3 — 1/3 = 0
- C's loss = 1/3 — 2/9 = 1/9
- A compensates C: ₹90,000 × 1/9 = ₹10,000
Journal Entry:
- A's Capital A/c Dr. ₹10,000
- To C's Capital A/c ₹10,000
2.7 Accounting Treatment of Goodwill in Case of Retirement or Death of a Partner
- In case of retirement, the continuing partners will gain in terms of profit sharing ratio.
- They have to pay to retiring partner for his share of goodwill in the gaining ratio.
- In case of death, the continuing partners should bear the share of goodwill due to the heirs of the deceased partner.
JOURNAL ENTRY — RETIREMENT OF PARTNER
Example: A, B & C are equal partners. C retires. Goodwill valued at ₹90,000.
- A's Capital A/c Dr. ₹15,000
- B's Capital A/c Dr. ₹15,000
- To C's Capital A/c ₹30,000
(C's share of goodwill adjusted in gaining ratio)
Illustration 11
Cu and Au were in partnership sharing profits and losses in the ratio 5:3. On 1st April 2022, they decided to admit Ag. Calculate amount of goodwill Ag is supposed to bring.
SOLUTION
Adjusted Profits:
| Particulars | 2018-19 | 2019-20 | 2020-21 | 2021-22 |
|---|---|---|---|---|
| Profits | 2,10,000 | 2,60,000 | 2,10,000 | 3,05,000 |
| Less: Salary to Cu | (24,000) | (24,000) | (30,000) | (36,000) |
| Less: Interest on Capital | (56,000) | (56,000) | (56,000) | (56,000) |
| Add: Machine to be capitalised | — | — | 40,000 | — |
| Less: Depreciation | — | — | (4,000) | (7,200) |
| Other adjustments | 10,000 | (20,000) | 20,000 | (5,800) |
| Adjusted Profits | 1,40,000 | 1,60,000 | 1,80,000 | 2,00,000 |
Weighted Average Profit = ₹18,00,000 / 10 = ₹1,80,000
Goodwill (3 years' purchase) = ₹1,80,000 × 3 = ₹5,40,000
Ag's share (1/4) = ₹5,40,000 / 4 = ₹1,35,000
Journal Entry:
- Bank A/c Dr. ₹1,35,000
- To Cu's Capital A/c ₹67,500
- To Au's Capital A/c ₹67,500
Summary
- Goodwill is the value of reputation of a firm in respect of profits expected in future over and above the normal rate of profits.
- Necessity for valuation of goodwill arises in the following cases:
- When the profit sharing ratio amongst the partners is changed
- When a new partner is admitted
- When a partner retires or dies
- When the business is dissolved or sold
Methods for Valuation of Goodwill
- (1) Average Profit Basis:
- Average Profit = Total profit / Number of years
- Goodwill = Average Profit × Number of Years' Purchase
- (2) Super Profit Basis:
- Capital Employed = Assets — Liabilities
- Normal Profit = Capital Employed × Normal Rate of Return
- Super Profit = Average Actual Profit — Normal Profit
- Goodwill = Super Profit × Number of Years' Purchase
- (3) Annuity Basis:
- Goodwill = Super Profit × Annuity Number
- (4) Capitalization Basis:
- Goodwill = Super Profit / Normal Rate of Return
Test Your Knowledge
True and False
- 1. Goodwill is intangible asset therefore it cannot be valued. False
- 2. Goodwill is valued whenever there is change in the profit sharing ratio among the partners. True
- 3. Goodwill is the value of reputation of a firm in respect of profits expected in future over and above the normal rate of profits. True
- 4. At the time of admission or retirement of a partner, goodwill can be raised in the books of accounts and shown as an asset. False
- 5. Only simple average method can be used for valuation of goodwill. False
- 6. Super profit means excess of actual average profit over normal profit. True
- 7. Normal profit means profit earned by similar companies in the same industry. True
- 8. Normal profit depends upon Normal Rate of Return and past profits. False
- 9. At the time of admission/retirement of a partner, since goodwill cannot be raised in the books of accounts it is recorded through capital accounts of the partners. True
- 10. At the time of admission of a partner, goodwill brought in by the new partner is shared equally by old partners. False
Multiple Choice Questions
| 1. Goodwill brought in by incoming partner in cash for joining in a partnership firm is taken away by the old partners in their _____ ratio. | (a) Capital. (b) New Profit Sharing. (c) Sacrificing. |
| 2. A & B are partners sharing profits and losses in the ratio 5:3. On admission, C brings ₹70,000 cash and ₹48,000 against goodwill. New profit sharing ratio between A, B and C are 7:5:4. Find the sacrificing ratio of A:B. | (a) 3:1. (b) 4:7. (c) 5:4. |
| 3. Following are the factors affecting goodwill except: | (a) Nature of business. (b) Efficiency of management. (c) Location of the customers. |
| 4. Weighted average method of calculating goodwill should be followed when: | (a) Profits has increasing trend. (b) Profits has decreasing trend. (c) Either 'a' or 'b'. |
| 5. In the absence of any provision in the partnership agreement, profits and losses are shared | (a) In the ratio of capitals. (b) Equally. (c) In the ratio of loans given by them to the partnership firm. |
| 6. The profits and losses for the last 4 years are: 2018-19 Losses ₹10,000; 2019-20 Losses ₹2,500; 2020-21 Profits ₹98,000 & 2021-22 Profits ₹76,000. Average capital employed is ₹2,00,000. Rate of interest expected is 12%. Remuneration of partners is ₹1,000 per month. Calculate goodwill on the basis of two years purchase of super profits based on average of four years. | (a) ₹9,000. (b) ₹8,750. (c) ₹8,250. |
| 7. A, B and C are partners sharing profits and losses in the ratio 3:2:1. They decide to change their profit sharing ratio to 2:2:1. They value goodwill at ₹30,000. Pass the necessary journal entry if Goodwill not appearing in the old balance sheet and should not appear in the new balance sheet. | (a) B's Capital Account Dr. ₹2,000 C's Capital Account Dr. ₹1,000 To A's Capital Account ₹3,000 (b) Goodwill Account Dr. ₹30,000 To A's Capital Account ₹15,000 To B's Capital Account ₹10,000 To C's Capital Account ₹5,000 (c) A's Capital Account Dr. ₹12,000 B's Capital Account Dr. ₹12,000 C's Capital Account Dr. ₹6,000 To Goodwill Account ₹30,000 |
High-Yield Interactive Quiz — Treatment of Goodwill in Partnership Accounts
Q1. Goodwill is classified as:
Correct Answer: B. Goodwill is an intangible asset; it cannot be seen, felt, or transported physically.
Q2. In the absence of a Partnership Deed, goodwill is valued when:
Correct Answer: D. Goodwill is valued in all cases of reconstitution: admission, retirement, death, change in profit sharing ratio, and dissolution.
Q3. Super Profit is calculated as:
Correct Answer: B. Super Profit = Actual Profit — Normal Profit. Normal Profit = Normal Rate of Return × Capital Employed.
Q4. At the time of admission of a new partner, goodwill brought in cash is credited to:
Correct Answer: B. Goodwill brought in by the new partner is credited to the old partners' capital accounts in their profit sacrificing ratio.
Q5. Under the Capitalization Method, goodwill is:
Correct Answer: C. Under the Capitalization Method, Goodwill = Super Profit / Normal Rate of Return.
Q6. When a partner retires, the continuing partners compensate the retiring partner for goodwill in:
Correct Answer: B. When a partner retires, the continuing partners gain in terms of profit sharing ratio and compensate the retiring partner in their gaining ratio.
Q7. Internally generated goodwill:
Correct Answer: B. Internally generated goodwill should not be recorded in the books because no consideration in money or money's worth has been paid for it.
Q8. Weighted average method is used when:
Correct Answer: B. Weighted average method is used when there is a clear increasing or decreasing trend of profits. More weight is given to recent years.
Q9. The annuity method of goodwill valuation considers:
Correct Answer: B. The annuity method considers the time value of money by discounting the super profits to their present value.
Q10. Sacrificing ratio is calculated as:
Correct Answer: B. Sacrificing Ratio = Old Share — New Share. A positive difference indicates sacrifice, a negative difference indicates gain.
Q11. Normal Profit is based on:
Correct Answer: B. Normal Profit = Normal Rate of Return (NRR) × Capital Employed. It represents the profit a similar firm would earn under normal circumstances.
Q12. Under the Average Profit Basis, if there is a clear increasing trend of profits, which method should be used?
Correct Answer: B. If there is a clear increasing or decreasing trend of profits, it is better to give more weight to the profits of recent years using the weighted average method.