1 Partnership Accounting for goodwill

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

3 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

4 Types of Goodwill  Inherent Goodwill  Purchased Goodwill

5 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

6 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

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

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

9 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

10 Example 1

11 YearAnnual Sales $ (a)Goodwill is valued at 3 years ’ purchase of the average annual sales of the past 3 years: Average annual sales = ($ ) /3 = $ Goodwill = $ X3 = $600000

12 (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 = ( x x x 3) = = (Calculation to the nearest dollar)

13 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 profitX Less: Reasonable remuneration to the owner X Reasonable return on the capital employed in the tangible assetsXX Super profitX

14 Example 2

15  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 is $5000, $6500, $6500, $7000  Expected return on net tangible assets = Net tangible assets * 10%. Expected return is $5000.

16 Answer Statement Calculating Super Profit$ Average net profit ( )/46250 Less: Management fee500 Expected rate of return on net tangible assets Super profit750 Goodwill= $750 X 3 = $2250

17 Accounting for Goodwill in Partnership

18 Accounting for goodwill in partnership  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: Admission of a new partner Retirement of an old partner Change of the profit-sharing ratio

19  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

20 Goodwill on the admission of a new partner

21 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

22 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 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

23 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 Dr Goodwill account Cr Capital account (old partners only) Share goodwill among old partners in old profit-sharing ratio Dr Capital account ( all partners) Cr Goodwill account Written off goodwill among all partners in the new profit-sharing ratio

24 Example 3

25  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 Assets1,200Capital Chan600 Wong600 1,200

26 Goodwill account opened Goodwill Capital: Chan (1/2)150 Wong (1/2) Capital ChanWong LeeChanWongLee Balance c/f Goodwill Cash Balance c/f300 Balance b/f

27 Goodwill account opened Balance Sheet as at 31 December 1998 Assets Goodwill 300 Capital Chan750 Other Assets (1, ) 1,800Wong750 Lee600 2,100 New capital balance

28 Goodwill account not opened Capital ChanWong LeeChanWongLee Goodwill : new ratio Goodwill: old ratio Cash Balance c/f Balance b/f Before admissionAfter admission PartnerOld ratioShare of goodwill New ratioShare of goodwill Gain/loss Chan1/2$1501/3$100$50 loss Wong1/2$1501/3$100$50 loss Lee1/3$100$100 gain $300

29 Goodwill account not opened Balance Sheet as at 31 December 1998 AssetsCapital Chan650 Wong650 Lee500 1,800 Assets (1, ) 1,800

30 Goodwill on the Retirement of a Partner

31 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

32 Example 4

33  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  The balance sheet before Lau ’ s retirement is shown as follows: Ho, Tang and Lau Balance Sheet as at 31 December 1997 Goodwill1,000Capital Ho 14,000 Tang 14,000 Other Assets 41,000 Lau 14,000 42,000

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

35 Ho and Tang Balance Sheet as at 31 December 1998 Goodwill1,000Capital Ho 17,000 Tang 17,000 Other Assets ( ) 24,000 34,000

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

Goodwill on a change in the profit-sharing ratio

38 Goodwill on a change in the profit- sharing ratio  When there is a change in the profit-sharing ratio, the value of goodwill should also be re- assessed, 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.

39 Example 5

40  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 profit- sharing ratio to 1:1:1.  The goodwill is revalued at $9,000.  The firm ’ s balance sheet on 31 December 1997 was: Yip, Chow and Au Balance Sheet as at 31 December 1997 Goodwill 1,000Capital: Yip 30,000 Chow 30,000 80,000 Other Assets 79,000 Au 20,000

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

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

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

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

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 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 ,000