ACCOUNTING TREATMENT OF GOODWILL

ACCOUNTING FOR PARTNERSHIP FIRMS 

LESSON - 11

ACCOUNTING TREATMENT OF GOODWILL

            Goodwill is an intangible asset which means it cannot be seen like other physical assets Example: Furniture, machinery etc. It is called an asset because it places the firm at an advantageous position so that the firm may earn higher amount of profits than the other similar firms. Goodwill cannot be formed overnight, is has to be earned by the efforts made by the firm over the past years.

            Goodwill will allow the firm to earn more profits than normal in the future with the same amount of efforts. There are many factors that contribute towards goodwill of a firm. Example location of the firm, brands, trademarks, patents, regular customer, reputation of the firm and its partners etc.

CLASSIFICATION OF GOODWILL:

1) PURCHASED GOODWILL

            A goodwill is said to be purchased goodwill if it is acquired by the firm by paying cash or any equivalent kind for it. This situation happens during purchase of new businesses. Purchased goodwill is to be recorded in the book of accounts.

2) SELF-GENERATED GOODWILL

            Self generated goodwill is earned by the efforts of the business. It depends upon the efforts and commitment the business has made all these years.

            According to ACCOUNTING STANDARD - 26 goodwill should be recorded in the books of accounts only if consideration in money is paid for it. Self generated good will will not be recorded in the books of accounts unless it is sold or purchased or any cash/equivalent is paid for it.

           As goodwill is recorded only when consideration in money is paid for it. So at the time of admission or retirement or death or change in profit-sharing ratio, goodwill is mostly not raised, it is adjusted through the capital accounts of the partners. During these times when the agreements are revised, when there is a change in the profit sharing ratio among the partners the gaining partner should compensate the sacrificing partners in the form of goodwill.

FORMULA:

                                Amount of compensation       =    Value of firm's  * Share of profit

                                                    payable                           goodwill                  gained

JOURNAL ENTRIES

1) WHEN FOLLOWING FLUCTUATING CAPITAL METHOD:

            Gaining partner's capital a/c                 Dr.             XXX

                To sacrificing partner's capital a/c                                    XXX

            (being adjustment made for goodwill)

2) WHEN FOLLOWING FIXED CAPITAL METHOD:

            Gaining partner's current a/c                 Dr.             XXX

                To sacrificing partner's current account                           XXX

            (being adjustment made for goodwill)

WHEN IS VALUATION OF GOODWILL DONE ?

        - Change in profit sharing ratio among partners

        - Any new partner is admitted to the firm

        - Any partners dies or retires from the firm

        - When partnership firm is sold

        - When two or more partnership firms joins together

METHODS OF VALUATION OF GOODWILL

1) AVERAGE PROFIT METHOD

a) Simple average profit method

b) Weighted average profit method

2) SUPER PROFIT METHOD

3) CAPITALIZATION METHOD

a) Capitalization of average profit

b) capitalization of super profit

Note: These methods of valuation of goodwill will be discussed individually in detail.