Goodwill in partnerships
Goodwill is the value of a firm's reputation and customer base above its net assets. When a partner joins or leaves, it is valued and adjusted between partners.
What goodwill is
Goodwill is the extra value a business has because of its good name, loyal customers, location, skilled staff and supplier links. It lets the firm earn more than a normal return on its net assets. In a partnership, goodwill belongs to the partners in their old profit-sharing ratio. Whenever the ratio changes, through the admission of a new partner, the retirement or death of a partner, or a change in the ratio, goodwill is valued so that partners who give up a share are paid for it.
Worked example 1: average profits method
A firm's profits for the last four years were Rs. 600,000, Rs. 720,000, Rs. 680,000 and Rs. 800,000. Goodwill is to be valued at three years' purchase of the average profit.
- Total profit: 600,000 + 720,000 + 680,000 + 800,000 = 2,800,000.
- Average profit: 2,800,000 ÷ 4 = 700,000.
- Goodwill: 700,000 × 3 = 2,100,000.
Goodwill = Rs. 2,100,000.
Worked example 2: super profits method
The average profit is Rs. 700,000. Capital employed is Rs. 5,000,000 and the normal rate of return in the industry is 10%. Value goodwill at three years' purchase of the super profit.
- Normal profit: 10% × 5,000,000 = 500,000.
- Super profit: 700,000 − 500,000 = 200,000.
- Goodwill: 200,000 × 3 = 600,000.
- For comparison, capitalising the super profit gives 200,000 ÷ 10% = 2,000,000.
Goodwill = Rs. 600,000 by the super profits method.
Worked example 3: goodwill on admission (not kept in the books)
Amal and Nuwan share profits 3:2. Chathura is admitted and the new ratio is Amal 2 : Nuwan 2 : Chathura 1. Goodwill is valued at Rs. 600,000 and is not to remain in the books.
- Create goodwill in the old ratio 3:2: Dr Goodwill 600,000; Cr Amal capital 360,000; Cr Nuwan capital 240,000.
- Write it off in the new ratio 2:2:1: Dr Amal 240,000; Dr Nuwan 240,000; Dr Chathura 120,000; Cr Goodwill 600,000.
- Net effect: Amal 360,000 − 240,000 = +120,000; Nuwan 240,000 − 240,000 = 0; Chathura −120,000.
- Check by sacrifice: Amal falls from 3/5 to 2/5, a sacrifice of 1/5 × 600,000 = 120,000; Nuwan stays at 2/5.
Chathura's capital is debited Rs. 120,000 and Amal's credited Rs. 120,000; Nuwan is unaffected.
Two ways to handle goodwill on admission
The Sri Lanka Accounting Standards do not allow internally generated goodwill to be shown as an asset, which is why many questions ask you not to keep it in the books.
When a respected Colombo audit or law partnership admits a new partner, the newcomer gains a share of the firm's reputation and client base. Valuing goodwill makes sure the existing partners are paid fairly for it.
Short answer: “Define goodwill.” The value of a business above the fair value of its identifiable net assets, arising from reputation, customers, location and staff.
Structured question: “Value goodwill by the average profits and super profits methods from the given data.” Average the profits and multiply by the years' purchase; then normal profit = rate × capital employed, super profit = average − normal, × years' purchase.
Essay: “Explain the need for valuing goodwill in a partnership and show the entries on the admission of a partner.” Define, list the occasions (admission, retirement, death, change in ratio), value it by one method, then journalise creation in the old ratio and write-off in the new ratio.
Goodwill: create in the OLD ratio, write off in the NEW ratio. The partner whose share falls is the one who is compensated.