Goodwill is an intangible asset that enables a company to generate profits exceeding the standard average. In essence, when one company acquires another for a price exceeding its net worth, this additional amount is termed goodwill.
Treatment of Goodwill involves handling the portion of the purchase price that surpasses the combined fair value of all assets purchased, including liabilities and acquisitions.
There are two approaches of treatment of goodwill when a new partner joins a firm:
Premium Method:
Goodwill can be accounted for in the cash flow statements. Under this method of treatment of goodwill, the incoming partner contributes their share of goodwill in cash based on a predetermined ratio. The existing partners then divide this amount among themselves. If the new partner privately pays the goodwill sum to the old partner in cash, these transactions are not recorded in the firm's official books.
Revaluation Method:
This method of treatment of goodwill is employed when the new partner opts not to contribute their share of goodwill in cash. In such cases, the firm can increase the goodwill account by debiting it and crediting the old partners' capital account according to the existing profit-sharing ratio.
Accounting Treatment of Goodwill When a Partner Retires/Died
When a partner retires or passes away, they are entitled to their portion of the firm's goodwill because the goodwill has been collectively built by the efforts of all the existing partners.
The accounting treatment for goodwill in this scenario depends on whether or not goodwill is already accounted for in the firm's books.
Treatment of Goodwill When Goodwill Does not Exist in the Books:
Suppose goodwill was not previously recorded in the firm's books. In that case, the retiring partner is credited for their share of goodwill by debiting the goodwill account and crediting the individual capital accounts of the gaining partners according to their gaining ratio. The journal entry for this transaction would be as follows:
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Debit Gaining Partners' Capital Accounts (Individually)
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Credit Retiring Partner's Capital Account (To adjust the retiring partner's share of goodwill)
To illustrate, let's consider an example: A, B, and C are partners in a firm, sharing profits in a 3:2:1 ratio. B decides to retire, and the firm's goodwill is valued at Rs. 60,000. A and C continue the business with a new profit-sharing ratio of 3:1. In this case, the journal entry to adjust the goodwill would be:
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Debit A's Capital Account by Rs. 15,000
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Debit C's Capital Account by Rs. 5,000
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Credit B's Capital Account by Rs. 20,000
(This entry ensures that B's share of goodwill is distributed and adjusted in the capital accounts of the remaining partners according to their gaining ratio.)
Treatment of Goodwill When Goodwill Already Exist in the Books:
When goodwill is already documented in a firm's records, typically, no adjustments are needed if the recorded value aligns with the current worth of the goodwill. This recorded value must match the actual present value. As long as the goodwill is accurately credited in the accounts of all partners, including the retiring one, no modifications are necessary.
However, when the current value of goodwill differs from its recorded value, adjustments are required to address the disparity. There are two possible scenarios:
When the Book Value of Goodwill is Lower than its Current Value:
If the goodwill's book value is less than its current value, the goodwill account is debited with the excess of its present worth over the book value. Simultaneously, all partners' capital accounts are credited in their original profit-sharing ratio. For instance, consider partners Deepak, Suraj, and Roshni, sharing profits in the ratio of 5:3:2. If the firm's books show goodwill at Rs. 50,000, but its actual value is Rs. 30,000 on the day Deepak retires, the following journal entry is made:
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Debit Goodwill Account by Rs. 20,000
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Credit Deepak's Capital Account by Rs. 10,000
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Credit Suraj's Capital Account by Rs. 6,000
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Credit Roshni's Capital Account by Rs. 4,000
(This entry reflects the increase in the goodwill value distributed among the partners' capital accounts based on their original profit-sharing ratio of 5:3:2.)
When the Book Value of Goodwill is Higher than its Current Value:
Conversely, if the book value of goodwill exceeds its current worth, the goodwill account is credited with the difference between the book value and its present value. At the same time, all partners' capital accounts are debited in their original profit-sharing ratio. For example, if the firm's books show goodwill at Rs. 70,000 but its current value is Rs. 50,000 on the day Deepak retires, the following journal entry is made:
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Debit Deepak's Capital Account by Rs. 10,000
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Debit Suraj's Capital Account by Rs. 6,000
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Debit Roshni's Capital Account by Rs. 4,000
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Credit Goodwill Account by Rs. 20,000
(This entry reflects the decrease in the goodwill value distributed among the partners' capital accounts based on their original profit-sharing ratio of 5:3:2.)
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Accounting Treatment of Goodwill During Admission of a Partner
When a new partner joins a firm and acquires their share of profits from existing partners, they often provide an additional sum to compensate these existing partners for the loss of their portion of the extra profits.
Case1: Treatment of Goodwill When the New Partner Brings Goodwill in Cash:
If the new partner brings in cash as a premium for goodwill, this amount is distributed among the existing partners based on their sacrificing ratio. When the payment is made directly to the old partners by the new partner (privately), no entry is recorded in the firm's books. However, if the payment is made through the firm, the following journal entries are made:
(i) Debit Bank Account and Credit Premium for Goodwill Account (representing the amount brought by the new partner as a premium).
(ii) Debit Goodwill Account and Credit Sacrificing Partners' Capital Accounts individually (reflecting the distribution of goodwill among the existing partners in their sacrificing ratio).
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If the partners decide to retain the amount of premium for goodwill in the business, no additional entry is needed. However, if they choose to withdraw their respective amounts, an additional entry is made:
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Debit the Existing Partner's Capital Account (individually) and Credit Bank Account (representing the withdrawal of the goodwill amount by the existing partners).
Case 2: When the New Partner Does Not Bring Goodwill in Cash, Partially or Fully:
If the new partner does not bring any or only a part of the goodwill in cash, the goodwill amount not brought is debited to the new partner's current account. Simultaneously, the capital accounts of the sacrificing partners are credited for their respective shares.
There are two scenarios for this situation:
(a) Goodwill does not exist in the books:
In this case, the sacrificing partners are credited with their share of goodwill, and the new partner is debited for the amount of goodwill not brought by them. The journal entry in this case records the transaction.
(b) Goodwill already exists in the books:
When goodwill is already in the books, the same principles apply, but the accounting entries reflect the adjustments related to the specific amounts not brought by the new partner, either in cash or in their capital account.
