accounting for goodwill -...
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Goodwill
Goodwill = Selling price as a going concern –
Fair value of separate net assets
Goodwill = Selling price – (Assets – Liabilities)
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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
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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
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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
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Calculation of Goodwill
Subjective Judgement
Average Sales/Fees/Profits Method
Super Profit Method
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Subject Judgement
Estimate the value of goodwill with reference
to some intangible factors and according to
their professional judgement
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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
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Year Annual Sales
$
1995 100000
1996 200000
1997 300000
(a) Goodwill is valued at 3 years’ purchase of the average annual sales of the past
3 years:
Average annual sales = ($100000+200000+300000 ) /3
= $200000
Goodwill = $200000 X3
= $600000
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(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
= (100000 x 1 + 200000 x 2 + 300000 x 3)
1+2+3
= 1400000
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= 233333 (Calculation to the nearest dollar)
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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
profitStatement Calculating Super Profit
Average annual net profit X
Less: Reasonable remuneration to the owner X
Reasonable return on the capital employed in the
tangible assets X X
Super profit X
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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 1994-1997 is $5000, $6500, $6500, $7000
Expected return on net tangible assets = Net tangible assets * 10%. Expected return is $5000.
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Answer
Statement Calculating Super Profit
$ $
Average net profit
(5000+6500+6500+7000)/4 6250
Less: Management fee 500
Expected rate of return
on net tangible assets 5000 5500
Super profit 750
Goodwill= $750 X 3
= $2250
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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
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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
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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
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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
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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
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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
Assets 1,200 CapitalChan 600
Wong 600
1,200 1,200
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Goodwill account opened
GoodwillCapital: Chan (1/2) 150
Wong (1/2) 150
300 300
Capital
Chan Wong Lee Chan Wong Lee
Balance c/f 750 750 600
Goodwill 150 150
Cash 600
750 750 600 750 750 600
Balance c/f 300
Balance b/f 600 600
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Goodwill account opened
Balance Sheet as at 31 December 1998
Assets
Goodwill 300
Capital
Chan 750
Other Assets (1,200 + 600) 1,800 Wong 750
Lee 600
2,100 2,100
New capital balance
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Goodwill account not openedCapital
Chan Wong Lee Chan Wong Lee
Goodwill :
new ratio 100 100 100 Goodwill: old ratio 150 150Cash 600
750 750 600 750 750 600
Balance c/f 650 650 500
Balance b/f 600 600
Before admission After admission
Partner Old ratio Share of
goodwill
New ratio Share of
goodwill
Gain/loss
Chan 1/2 $150 1/3 $100 $50 loss
Wong 1/2 $150 1/3 $100 $50 loss
Lee 1/3 $100 $100 gain
$300 $300
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Goodwill account not opened
Balance Sheet as at 31 December 1998Assets Capital
Chan 650
Wong 650
Lee 500
1,800 1,800
Assets (1,200 + 600) 1,800
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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
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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
1997.
The balance sheet before Lau’s retirement is shown as follows:
Ho, Tang and Lau
Balance Sheet as at 31 December 1997
Goodwill 1,000 CapitalHo 14,000
Tang 14,000Other Assets 41,000
Lau 14,000
42,000 42,000
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Goodwill account openedGoodwill
Balance b/f 1,000
Capital
Ho Tang Lau Ho Tang Lau
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 10,000
Balance c/f 17,000 17,000
17,000 17,000 17,000
Bank 17,000
Balance c/f 10,000
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Ho and Tang
Balance Sheet as at 31 December 1998
Goodwill 1,000 CapitalHo 17,000
Tang 17,000Other Assets
(41000-17000) 24,000
34,000 34,000
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Goodwill account not openedCapital
Ho Tang Lau Ho Tang LauBank 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) 24,000 Capital: Ho 12,000
Tang 12,000
24,000 24,000
Balance b/f 14,000 14,000 14,000
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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.
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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 1,000 Capital: Yip 30,000
Chow 30,000
80,000 80,000
Other Assets 79,000Au 20,000
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Goodwill account openedGoodwill
Balance b/f 1,000
Capital
Yip Chow Au Yip Chow 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
9,0009,000
33,000 33,000 22,000
Balance b/f 30,000 30,000 20,000
Balance c/f 9,000
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Goodwill account openedBalance Sheet as at 31 December 1998
Goodwill 9,000 CapitalYip 33,000
Chow 33,000
Au 22,000
Other Assets 79,000
88,000 88,000
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Goodwill account not openedCapital
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
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Yip, Chow & Au
Balance Sheet as at 31 December 1998
Assets 79,000 Capital: Yip 30,000
Chow 30,000
79,000 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.