Treatment Of Goodwill -
Accounting Entries

Accounting entries for treatment for goodwill in case of admission, retirement or death of a partner, also methods of valuation of goodwill.

Goodwill is an intangible asset. It is that extra value which is paid to the selling company at the time of acquisition of company.

At the time of acquisition, when the purchasing company pays to the selling company more than the fair value of net identifiable assets, the excess of price which is paid over the fair value of net identifiable assets (assets minus liabilities) is recorded as a separate asset called goodwill.

Goodwill is the extra value of reputation or other advantages possessed by a business organisation with the help of which it earns high profits on the amount of capital employed. It is an intangible asset and falls under real account.

Goodwill is the value of the reputation of a firm in respect of profits expected in future over and above the normal profits.

In the words of Eric L. Kohler, "Goodwill is the present value of expected future income in excess of a normal return on the investment in tangible assets."

Factors Affecting Value of Goodwill:

1. Management Skill:

The capabilities of the management affect the earning capacity of the firm and eventually the value of its goodwill.

2. Location of the Firm:

The location of the business also influences the value of goodwill. A firm located at a favorable place with higher sale, the value of goodwill will be correspondingly higher.

3. Business Deals:

Favorable business contracts also affect the value of goodwill of the firm.

Long term business contracts for purchase and sale of products at favorable prices determines certainty and avoids business fluctuations. This provides a far reaching affect in the profits and goodwill of the firm.

4. Risk Involved:

With the involvement of less risk, the business stands in the position of creating more goodwill.

Treatment Of Goodwill:

Methods of Valuation of Goodwill:

1. Average Profits Method:

Under this method, the normal profits of business of past few years are taken into account. The profits taken into account are totaled and their average is arrived at. The average profit so found is then multiplied by the number year's purchases to arrive at the value of goodwill.

Goodwill may be calculated as follows:

1. Past Normal Profit:

Past Normal Profit = Net Profit+Abnormal loss=Abnormal Gain

2. Average Normal Profit:

Average normal Profit = Total Past normal profit/No of years

3. Calculation Of Goodwill:

Goodwill = Average normal profit x no. of year's purchase

II Super Profit Method:

Super Profits is the profit earned in excess of the normal Profit.

Super Profit= Actual Profit - Normal.

Normal profits mean the profit which the firms could normally earns in a particular business.

Under this method, goodwill is calculated by deducting the following two from the average net profit:

  1. The reasonable amount of managerial remunerations.
  2. The reasonable amount of return from the invested capital.Super profit is then multiplied by an agreed number of year to arrive at the value of goodwill.
Capitalization Method:

There are two ways of calculating Goodwill under this method:

  1. Capitalization of Average Profits Method
  2. Capitalization of Super Profits Method
i) Capitalization of Average Profits Method:

Under this method, the average profits is first calculated and then appraise the capital required for earning such average profits on the basis of normal rate of return. Such capital so obtained is termed as capitalized value of average profits.

The Capitalized Value of Average Profits = Average Profits X (100 / Normal Rate of Return)

Capital Employed = Assets-Liabilities

Goodwill = Capitalized Value of Average Profits-Capital Employed

Accounting Treatment For Goodwill: In Case Of Change In The Profit Sharing Ratio Meaning or Concept Of Goodwill:

Goodwill is the extra value of reputation or other advantages possessed by a business organisation with the help of which enables it to earn high profits on the amount of capital employed. It is an intangible asset and falls under real account.

Goodwill is the value of the reputation of a firm in respect of profits expected in future over and above the normal profits.

In the words of Eric L. Kohler, "Goodwill is the present value of expected future income in excess of a normal return on the investment in tangible assets."

Factors Affecting Value of Goodwill:

1. Management Skill:

The capabilities of the management affect the earning capacity of the firm and eventually the value of its goodwill.

2. Location of the Firm:

The location of the business also influences the value of goodwill. A firm located at a favorable place with higher sale, the value of goodwill will be correspondingly higher.

3. Business Deals:

Favorable business c

ontracts also affect the value of goodwill of the firm.

Long term business contracts for purchase and sale of products at favorable prices determines certainty and avoids business fluctuations. This provides a far reaching affect in the profits and goodwill of the firm.

4. Risk Involved:

With the involvement of less risk, the business stands in the position of creating more goodwill.

Treatment Of Goodwill:

Methods of Valuation of Goodwill:

1. Average Profits Method:

Under this method, the normal profits of business of past few years are taken into account. The profits taken into account are totaled and their average is arrived at. The average profit so found is then multiplied by the number year's purchases to arrive at the value of goodwill.

Goodwill may be calculated as follows:

1. Past normal profit:

Past Normal Profit = Net Profit+Abnormal lossess+Abnormal Gain

2. Average Normal Profit:

Average normal Profit = Total Past normal profit/no of years

3. Calculation Of Goodwill:

Goodwill = Average normal profit x no. of year's purchase

II Super Profit Method:

Super Profits is the profit earned in excess of the normal

Profit.

Super profit= Actual Profit-Normal.

Normal profits mean the profit which the firms could normally earns in a particular business.

Under this method, goodwill is calculated by deducting the following two from the average net profit:

  1. The reasonable amount of managerial remunerations.
  2. The reasonable amount of return from the invested capital.
    Super profit is then multiplied by an agreed number of year to arrive at the value of goodwill.
Capitalization Method:

There are two ways of calculating Goodwill under this method:

  1. Capitalization of Average Profits Method
  2. Capitalization of Super Profits Method
i) Capitalization of Average Profits Method:

Under this method, the average profits is first calculated and then appraise the capital required for earning such average profits on the basis of normal rate of return. Such capital so obtained is termed as capitalized value of average profits.

The Capitalized Value of Average Profits = Average Profits X (100 / Normal Rate of Return)

Capital Employed = Assets-Liabilities

Goodwill = Capitalized Value of Average Profits-Capital Employed

ii) Capitalization of Super Profits:

Under this method first the Super Profits is calculated and then the capital required for earning such super profits is found out on the basis of normal rate of return. This Capital is the value of our Goodwill.

Goodwill = Super Profits X (100/ Normal Rate of Return)

V Annuity Method:

In this method we first of all calculate annuity. Annuity means annual value. These days, different annuity tables are used for calculating annuity.

Goodwill = Annuity Factor x Super Profit

ii) Capitalization of Super Profits:

Under this method first the Super Profits is calculated and then the capital required for earning such super profits is found out on the basis of normal rate of return. This Capital is the value of our Goodwill.

Goodwill = Super Profits X (100/ Normal Rate of Return)

V Annuity Method:

In this method we first of all calculate annuity. Annuity means annual value. These days, different annuity tables are used for calculating annuity.

Goodwill = Annuity Factor x Super Profit

Accounting Treatment For Goodwill On Admission Of A Partner:

In case of admission of a new partner, goodwill may be treated in any of the following case:

  1. When the new partner brings his share of premium for goodwill in cash.
  2. When the new partner brings his share of premium for goodwill in the form of asset.
  3. When the new partner is unable to bring his share of premium for goodwill.
  4. When the new partner brings his share of premium for goodwill in cash but only a portion and not as a whole.
1. When The New Partner Brings His Share Of Goodwill In Cash:

When the new partner brings his share of goodwill in cash and payment is made outside the business, no accounting entry is required to be passed as it does not affect the business accounting transaction.

2. When The New Partner Brings His Share Of Goodwill In Cash And Is Retained In The Business.

The following journal entry may be passed:

Bank A/c----------------------------Dr.

 To Goodwill A/c

(Being premium for goodwill brought in by the new partner)

Goodwill A/c--------------------------------Dr.

 To Old Partners' Capital A/c

(Being premium for goodwill credited to old partners in their sacrificing ratio)

3. When The New Partner Brings His Share Of Goodwill In Cash And The Amount Of Goodwill Is Not Be Appeared In The Books Of Account.

Cash A/c----------------------------Dr.

 To Premium For Goodwill A/c

(Being premium for goodwill brought by the new partner)

Goodwill A/c----------------------------Dr.

 To Old Partners' Capital A/c

(Being the amount of premium for goodwill brought in divided among old partners in their sacrificing ratio)

Old Partners' Capital A/c----------------------------Dr.

 To Bank A/c

(Being the proportionate amount of premium for goodwill withdrawn)

Note:

 In case the sacrifice is made only by one partner, the amount of premium for goodwill is to be credited only to the Sacrificing Partner's Capital A/c and can be withdrawn by the sacrificing partner only.

4. (a) When The Existing Goodwill In The Books Of The Firm Is To Be Withdrawn:

Old Partners' Capital A/c----------------------------Dr.

 To Goodwill A/c

(Being the value of goodwill appearing in the book written off in the old ratio)

(b)When The New Partner's Share Of Premium For Goodwill Is To Be Retained In The Business.

Bank A/c----------------------------Dr.

 To Premium For Goodwill A/c

(Being premium for goodwill brought in by the new partner)

(c) When The New Partner's Share Of Premium For Goodwill Is To Be Withdrawn In The Business.

Premium For Goodwill A/c----------------------------Dr.

 To Old Partners' Capital A/c

(Being premium for goodwill brought in by new partner shared by the old partners)

(d)If The Premium For Goodwill Amount Brought In By The New Partner Is To Be Withdrawn By The Old Partners:

Old Partners' Capital A/c----------------------------Dr.

 To Bank A/c

(Being the amount of premium for goodwill withdrawn from bank)

(e)If It Is Unanimously Agreed That The Original Value Of Goodwill Is To Be Reflected In The Books, The Following Entry Needs To Be :

Goodwill A/c-----------------------Dr.

 To All Partners Capital A/c

(Being the value of goodwill raised in the books of the firm)

4. When The New Partner Brings His Share Of Goodwill In Kind:

The new partner may bring his share of goodwill in kind i.e. the form of assets instead of cash and also because of his personal reputation among the customers in the market he may be recognized for his goodwill and as a result of which he will be required to pay lesser amount of assets than the amount of credited to him.

This requires two journal entries:

Assets A/c----------------------------Dr.

 To Premium For Goodwill A/c

(Being premium for goodwill brought in kind by the new partner)

Premium For Goodwill A/c----------------------------Dr.

 To Old Partners' Capital A/c

(Being the amount of goodwill proportionate to the value of fixed assets shared by the old partners)

5. When The New Partner Is Unable To Bring His Share Of Goodwill:

When the new partner is unable to bring in his share of premium for goodwill, the existing goodwill of the firm is to be raised at its full value and written off in the old ratio in the Old Partners Capital Account:

(a)For Raising Of Goodwill:

Goodwill A/c----------------------------Dr.

 To Old Partners' Capital A/c

(Being the value of goodwill raised in the books at its full value and credited to the old partners in old ratio)

(b)For Raising Of And Writing Off:

Goodwill A/c----------------------------Dr.

(excess value)

 To Old Partners' Capital A/c

(Being the value of goodwill raised in the books of the firm)

Old Partners' Capital A/c----------------------------Dr.

 To Goodwill A/c

(Being the goodwill written off by the reduction in value)

(c)For Transfer Of Goodwill:

All Partners' Capital A/c----------------------------Dr.

 To Goodwill A/c

(Being the value of goodwill written off)

6. When The New Partner Can Bring Only A Portion Of His Share Of Goodwill

When the new partner cannot bring the entire amount of his share premium for goodwill and brings only a part of it, the amount of premium brought in is shared by the old partners in sacrificing ratio. And the balance of premium is adjusted from the capital account of the new partner. It is also to be noted that, if any existing goodwill is remaining in the books, it is to be transferred and written off to the Old Partners Capital A/c in the old profit sharing ratio.

The following journal entries are required to be passed

Goodwill A/c----------------------------Dr.

 To Old Partners' Capital A/c

(Being the existing amount of goodwill transferred to old partners capital account in the old profit sharing ratio)

Old Partners' Capital A/c----------------------------Dr.

 To Goodwill A/c

(Being the existing amount of goodwill written off)

Bank A/c----------------------------Dr.

 To Capital A/c

 To Goodwill A/c

(Being capital and portion of premium for goodwill brought in by new partner)

Goodwill A/c----------------------------Dr.

 To Old Partners' Capital A/c

(Being the goodwill brought in by new partner credited to old partners)

New Partners' Capital A/c----------------------------Dr.

 To Old Partners Capital A/c

(Being the remaining amount of goodwill adjusted from the capital account of the new partner)

Note:

Accounting Standard 26 does not deal with the accounting treatment of goodwill in case of admission or retirement of a partner. It states that intangible assets like goodwill until and otherwise purchased, should not be reflected in the Balance Sheet.

Illustration:

A and B are partners sharing profits and losses equally. They admit C into the partnership who brings in 55,000.00 as Capital and Premium for goodwill.

(Rs.50,000.00 as capital and Rs.5,000.00 for goodwill). C who was supposed to bring 10,000.00 as premium for goodwill could bring only 5,000.00 as premium money.

Now form the accounting point of view, two options are available with A and B. Firstly, debit the Capital A/cof the new partner with amount of unpaid premium money and credit the Capital A/c of the old partners A and B in the agreed ratio Secondly, A and B can debit C's current account with Rs.5, 000.00 and take credit in their capital accounts. At the end of the year when profit is credited to C's current account, he will withdraw Rs.5, 000.00 less. This also amount to payment by C of Rs.5, 000.00. If nothing is mentioned about the nature of capital accounts (fixed or fluctuating), we assume them to be fluctuating, hence all adjustments including for goodwill are carried out through capital account.