Partnership Accounting for goodwill 1 Goodwill Selling price

Partnership Accounting for goodwill 1

Goodwill = Selling price as a going concern – Fair value of separate net assets Goodwill = Selling price – (Assets – Liabilities) 2

Goodwill o 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 - 3

Types of Goodwill o o Inherent Goodwill Purchased Goodwill 4

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 5

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 6

Calculation of Goodwill o o o Subjective Judgement Average Sales/Fees/Profits Method Super Profit Method 7

Subject Judgement o Estimate the value of goodwill with reference to some intangible factors and according to their professional judgement 8

Average Sales/Fees/Profit Method o 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 9

Example 1 10

Year Annual Sales $ 1995 1996 1997 100000 200000 300000 (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 X 3 = $600000 11

(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) 12

Super Profit Method o o 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 Less: Reasonable remuneration to the owner X X Reasonable return on the capital employed in the tangible assets Super profit X X X 13

Example 2 14

o o o 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, $7000 Expected return on net tangible assets = Net tangible assets * 10%. Expected return is $5000. 15

Answer Statement Calculating Super Profit $ Average net profit (5000+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 16

Accounting for Goodwill in Partnership 17

Accounting for goodwill in partnership o o Only purchased goodwill is to be brought into the accounts. In sole trader’s 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: n n n Admission of a new partner Retirement of an old partner Change of the profit-sharing ratio 18

o 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 19

Goodwill on the admission of a new partner 20

Goodwill on the admission of a new partner o o o 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: n n Goodwill account opened Goodwill account not opened 21

Goodwill account opened o The value of the goodwill 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 With the value of goodwill With their share of goodwill in old ratio Dr Goodwill account Cr Capital account ( old partner With the increase in the value of goodwill, share in the old ratio Dr Capital account (old partner) Cr Goodwill account With the decrease in the value of goodwill, share in the old artio 22

Goodwill account not opened o o 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 Dr Goodwill account Share goodwill among old partners in old Cr Capital account (old profit-sharing ratio partners only) Dr Capital account ( all Written off goodwill among all partners) in the new profit-sharing ratio Cr Goodwill account 23

Example 3 24

o o o 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 1, 200 25

Goodwill account opened Goodwill 150 Balance c/f 150 Capital: Chan (1/2) Wong (1/2) 300 300 Capital Balance c/f Chan Wong Lee 750 750 600 Chan Wong Balance b/f 600 Goodwill Cash 150 Lee 600 750 600 26

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 750 600 2, 100 27

Goodwill account not opened Capital Chan Goodwill : new ratio Balance c/f Wong Lee Balance b/f 100 650 100 500 750 600 Before admission Chan Wong 600 Goodwill: old ratio 150 Cash 750 150 750 Lee 600 After admission Partner Old ratio Share of goodwill New ratio Share of goodwill Gain/loss Chan 1/2 $150 1/3 $100 $50 loss Wong 1/2 $150 1/3 $100 $50 loss 1/3 $100 gain Lee $300 28

Goodwill account not opened Balance Sheet as at 31 December 1998 Assets (1, 200 + 600) 1, 800 Capital Chan Wong Lee 650 500 1, 800 29

Goodwill on the Retirement of a Partner 30

Goodwill on the Retirement of a Partner o o 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 31

Example 4 32

o o 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 Lau’s retirement is shown as follows: Ho, Tang and Lau Balance Sheet as at 31 December 1997 Goodwill Other Assets 1, 000 42, 000 Capital Ho Tang Lau 14, 000 42, 000 33

Goodwill account opened Goodwill 1, 000 Balance c/f Balance b/f Capital: Ho (1/3) Tang (1/3) Lau (1/3) 3, 000 10, 000 9, 000 10, 000 Capital Ho Tang Bank Balance c/f Lau 17, 000 17, 000 Ho Balance b/f Goodwill Tang Lau 14, 000 3, 000 17, 000 34

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 34, 000 35

Goodwill account not opened Capital Bank Goodwill: new ratio Balance c/f Ho Tang Lau 17, 000 5, 000 12, 000 Balance b/f Ho Tang Lau 14, 000 Goodwill : old ratio 3, 000 17, 000 Ho and Tang Balance Sheet as at 31 December 1998 Assets (41, 000 – 17, 000) 24, 000 Capital: Ho Tang 24, 000 3, 000 17, 000 12, 000 24, 000 36

Goodwill on a change in the profit-sharing ratio 37

Goodwill on a change in the profitsharing ratio o 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. 38

Example 5 39

o o 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 firm’s balance sheet on 31 December 1997 was: Goodwill Other Assets Yip, Chow and Au Balance Sheet as at 31 December 1997 1, 000 Capital: Yip 79, 000 Chow Au 80, 000 30, 000 20, 000 80, 000 40

Goodwill account opened Goodwill Balance b/f 1, 000 Capital: Yip (3/8) Chow (3/8) Au (2/8) 3, 000 2, 000 Balance c/f 9, 000 8, 000 9, 000 Capital Yip Balance c/f Chow Au 33, 000 22, 000 Balance b/f Goodwill 33, 000 22, 000 Yip Chow Au 30, 000 20, 000 3, 000 2, 000 33, 000 22, 000 41

Goodwill account opened Balance Sheet as at 31 December 1998 Goodwill Other Assets 9, 000 79, 000 88, 000 Capital Yip Chow Au 33, 000 22, 000 88, 000 42

Goodwill account not opened Capital Yip Goodwill: new ratio Balance c/f Chow Au 3, 000 30, 000 19, 000 33, 000 22, 000 Yip Balance b/f Goodwill: old ratio Chow Au 30, 000 20, 000 3, 000 2, 000 33, 000 22, 000 43

Assets Yip, Chow & Au Balance Sheet as at 31 December 1998 79, 000 Capital: Yip Chow Au 79, 000 30, 000 19, 000 79, 000 44

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 year’s purchase of the average annual profits (weighted average) of the past four years. Goodwill is not to be brought into the partnership’s 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 December 2000 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 45 admission of Joe.

Valuation of Goodwill : 25, 000 x 1 + 40, 000 x 2 + 75, 000 x 3 + 60, 000 x 4 1 + 2 + 3 + 4 57, 000 46