Goodwill is defined as the difference between the
Goodwill is defined as the difference between the value of a business as a whole and the fair value of its separable new assets. Goodwill = Selling price as a going concern – Fair value of separate net assets = Selling price – (Assets –Liabilities)
Value of business as a whole > Aggregate value of net assets Goodwill Admission of new partner Retirement of a partner Treated as in tangible fixed assets Goodwill account opened Change in profit-sharing ratio Written off immediately Goodwill account not opened
• Reason for payment of goodwill • In buying the an existing business which has been established for some time, there may be quite a few possible advantages.
• (1) A large number of regular customers who will continue to deal with the new owner. • (2) The business has a good reputation. • (3) It has experienced, efficient and reliable employees. • (4) The business is situated in a good location. • (5) It has good contacts with suppliers. • (6)Well-known products • (7)The possession of favourable contracts. None of these advantage are available to completely new businesses. For this Reason, many people would decide to buy existing business and pay an amount for Goodwill.
Goodwill ︰ Average annual sales / fees / profits over certain number of years X a factor Existence of goodwill Goodwill does not necessarily exist in a business. If the business has a bad reputation an inefficient labour force or other negative factors, the owner may be unlikely to be paid for goodwill on selling the business.
Average sales method ‧In many retail businesses, the average yearly sales for the past few years are multiplied by an agreed figure. ‧ For instance, suppose it is agreed that the goodwill should be three times the Average yearly sales for the last two years.
• Exhibit Year Sales $ • 2005 • 2006 Total Average sales=$300000/2 = $150000 Goodwill calculated=3 x $150000 = $450000 140000 160000 300000 =======
Annual fees method • Professional firms, such as accountants or lawyers, often use a method based on gross annual income from fees, before charging expenses.
Exhibit A firm of accountants is selling its business. It is asking a figure for goodwill which is 2. 5 times the average annual fees received for the last two years. • Year Fees $ • 2005 180000 • 2006 220000 400000 ======= Average annual fees $400000/2 = $200000
Average net annual profits method • Using this method, the average net profits for a number of years is multiplied by a States amount.
Exhibit Suppose goodwill is taken to be four times the average net annual profits for the past Three years. • • Year Net profit 2004 62000 • 2005 69000 • 2006 • 210000 ==== Average net annual profits $210000/3 = $70000 Goodwill calculated 4 x $70000 = 280000 79000
Super profits method • It may be argued, as in the case of a sole trader, that the net profits are not ‘ true profit ’. This is because the net profit does not reflect the following circumstances.
• (1) Services of the proprietor. He has worked in the business, but he has not charged for such services. Any drawings he makes are charged to a capital account, not to the profit and loss account. • (2) The use of the money he has invested in the business. If he had invested his money elsewhere, he would have earned interest or dividends on such investments.
It is usually calculated as: $ $ Annual net profits 80000 Less (1) Remuneration proprietor would have earned for similar work elsewhere 20000 (2) Interest that would have been earned if capital had been invested elsewhere 10000 30000 Annual super profits 50000 ======= The annual super profits are then multiplied by a number agreed by the seller and the purchaser of the business.
Accounting for Goodwill in Partnership ‧Any change in profit-sharing ratio means that the ownership of the goodwill also change. ‧In each of the following cases ,a change in the profitsharing ratio takes place and therefore goodwill adjustments must be made︰ ~ Admission of a new partner ~ Retirement of an old partner ~ Change of profit-sharing ratio between existing partners
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. Therefore goodwill must be revaluated. (1) Goodwill Account Opened (2) ‧Goodwill account will be shown in the Balance Sheets as “Intangible Fixed Asset”. (3) ‧Accounting entries︰ Dr-Goodwill Account Cr-Capital Accounts(old partners only With the value of goodwill With their share of goodwill in old ratio
(2)Goodwill Account Not Opened ‧Goodwill account will not be shown in the Balance Sheet. ‧Accounting entries︰ Dr-Goodwill Account Cr-Capital Accounts(old partners only Dr-Capital Accounts(all partner) Cr-Goodwill Account Share goodwill among all partners in the old profit-sharing ratio. Write off goodwill among all partners in the new profit-sharing ratio. ‧The new partner may be required to pay extra cash,or have his capital balance reduced,for his share of goodwill.
Retirement of a partner (1)Goodwill Account Opened Dr-Goodwill Account Cr-Capital Account(all Partners) or Cr-Goodwill Account Dr-Current Account(leaving partner) Cr-Capital Account(leaving partner) or Dr-Capital Account(leaving partner) Cr-Current Account(leaving partner) Dr-Capital Account(leaving With the increase in the value of goodwill,shared in the old ratio. With the decrease in the value of goodwill,shared in the old ratio Transfer the balance in the current account of the leaving partner to the capital account. Cash paid to leaving partner or
(2)Goodwill Account Not Opened Dr-Goodwill Account Cr-Capital Account(all Partners) Dr-Capital Account(remaining partner) Cr-Goodwill Account Dr-Current Account(leaving partner) Cr-Capital Account(leaving partner) or Dr-Capital Account(leaving partner) Cr-Current Account(leaving partner) Dr-Capital Account(leaving partner) With the increase in the value of goodwill,shared in the old ratio. Write off the goodwill,in new ratio. Transfer the balance in the current account of the leaving partner to the capital account. Cash paid to leaving partner or the
Change in the Profit-sharing Ratio (1)Goodwill Account Opened Dr-Goodwill With the Account increase in the value of Cr-Capital goodwill,shared Account(all (2)Goodwill Account Not Opened in the old ratio. partners) Dr-Goodwill Account With the increase in Cr-Capital Account(all the value of goodwill, shared in the old ratio. partners) Dr-Capital Accounts Cr-Goodwill Account Write off the goodwill, in new ratio.
Revaluation of assets
Chang of partnership --Admission of new partners --Retirement of partners --Change in profit-sharing ratio Revaluation of asset
Introduction In the changes of a partner, admission or retirement of a partner, the assets and liabilities may be revalued to reflect the fair value of the business. Ant profits or losses on revaluation are normally entered in the partners’ capital account according to the profit sharing ratio before Change.
Accounting for a Revaluation
With increase in value of assets Assets Revaluation XXX Dr-Assets Cr. Revaluation Assets XXX
With decrease in value of assets Dr-Revaluation Cr-Assets Revaluation Assets XXX Assets Revaluation XXX
With provision for depreciation on revalued assets Dr-Provision for depreciation Cr-Revaluation Provision for depreciation Revaluation XXX Revaluation Depreciation XXX
With increase in provision for bad debt Dr-Revaluation Cr-Provision for Bad Debts Revaluation Provision for Bad Debts XXX
With profit on revaluation (shared among partners, according to the old profitsharing ratio) Dr=Revaluation Cr-Capital Revaluation XXXX XXX Bal B/d: Partner A XX Partner B XX Capital XXXX XXX A Profit on revaluation B XX XX
With loss on revaluation (shared among partners, according to the old profit sharing ratio) Dr-Capital Cr-Revaluation Capital A Loss on XX revaluation B XXXX Share loss: XX XXX Partner A XX Partner B XX
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