Goodwill is the amount by which the value of a business as a going concern exceeds the value of its net assets, if they were sold separately. It is an intangible asset because it cannot be touched or seen physically. Goodwill may not be shown in the balance sheet for reasons that will be explained later. Nevertheless, it must be considered when a partnership change occurs.
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Factors that can give rise to goodwill are as follows:
- The location of the company.
- The quality of the product and services.
- The quality of the employees willing to continue after the business changes hand.
- Monopolistic advantage of the company.
- Possession of trademarks and patent rights to be used by the buyer.
- Opportunity for the buyer to retain the same name.
- Quality of the research and development that can be taken over.
- Good public image and reputation build by organization over the years.
Introduction of Goodwill
Goodwill may be introduced if any of the following situations occur:
- Admission of a new partner
- Change in profit-sharing ratio of partners
- Retirement or death of a partner
- Dissolution of partnership business
- Business purchase
Types of Goodwill
- Inherent goodwill
- Fugitive goodwill
- Purchased goodwill
The first two are non-purchased goodwill. Value cannot be placed on them. These types of goodwill exist in a business but will disappear immediately as the business changes hand. Examples include goodwill attached to the owner of the business, location, employees and so on. When any of these are not taken over, the goodwill will be vanished.
However, purchased goodwill arises as a result of one company acquiring another. This type of goodwill remains in the business even if the ownership changes. The value of goodwill is the difference between the purchase price (purchase consideration) and the book value of the assets.
Valuation of Goodwill
There are many methods of valuing goodwill, the method adopted is the sole responsibility of the partnership. The common methods are as follows:
- Purchase of average profit
- Purchase of average gross fee income
- Purchase of average super profit
- Excess of purchase price of a business over value of tangible net assets taken over.
Accounting for Goodwill in the Books of a Partnership Business
Irrespective of the method of a valuation of goodwill used, the value of goodwill can be retained in the books or written off immediately. Goodwill account is opened and credited to partners in their old profit-sharing ratio.
How to account for goodwill when no goodwill account is opened.
Partner often do not wish to record goodwill in their books for two reasons:
- The value placed on goodwill is usually very difficult to justify being a matter of opinion; it may not even exist.
- If goodwill is shown in the balance sheet, it would be difficult to persuade a prospective purchaser of the business to pay more, even if the value had increased since goodwill was first introduced into the books.
When there is a partnership change and the partners decide not to open a goodwill account, the procedure to be followed is as follows:
Step 1: Credit the partner’s capital accounts with their share of goodwill in their old profit-sharing ratio
Step 2: Debit the partners’ capital accounts with their share of goodwill in their new profit-sharing ratio.
Apportionment of Profit
Partnership changes often occur in the middle of a firm’s financial year. If a profit and loss account is not prepared at the time of the change, the profit and loss for the financial year must be apportioned between the periods before and after the change. If the profit and loss is assumed to have been earned evenly throughout the year, it should be divided between the old and new partnership on a time basis. However, any expenses not incurred on time basis must be allocated to the period to which they belong. The profit and loss account can be prepared in columnar form to show the apportionment of profit.
Illustration 4: Change in profit-sharing ratio
Shola and Shogo are partners sharing profits and losses equally after allowing Shola a salary of N10,000 p.a. On 1 January 2010, their capital and current accounts balances were as follows:
On 1 July, 2010, the partners agree to the following revised terms of partnership.
- Shola to transfer N5,000 from his capital accounts to a loan account on which he would be entitled to interest at 10% per annum.
- Shogo to bring his private car into the firm at a valuation of N12,000
- Shogo to receive a salary of N5,000 per annum.
- Profits and losses to be shared: Shola – , Shogo-
Additional information for the year ended 31 December, 2010 is as follows:
|Sales (spread evenly throughout the year)|
Cost of Sales
Of the general expenses, N5,000 was incurred in the 6 months to 30 June 2010.
Shogo’s car is to be depreciated over four years on the straight line basis and is assumed to have no value at the end of that time.
All sales produces a uniform rate of gross profit.
- Prepare the trading, profit and loss and appropriation accounts for the year ended 31 December 2010.
- Prepare the partners current accounts for the year ended 31 December 2010.
Shola and Shogo
Trading, Profit and Loss and Appropriation Account for the
Year Ended 31 December 2010
Less: cost of sales
Gross profit c/d
| Year to|
|Gross profit b/d||56,250||56,250||112,500|
|Depreciation – Car||1,500||1,500|
|Less: Salary – Shola|
|Net profit b/f||16,250||12,000||28,250|
|Share of profit|
|Shola ( ), ( )||8,125||7,200||15,325|
|Shogo ( ), ( )||8,125||4,800||12,925|
(b) Partners Current Account
|Bal. c/d||27,825||20,425||Bal. b/d|
Share of profit