Accounting Treatment of Goodwill
As directed by AS 10, the Goodwill is to be recorded in the books solely for some consideration in terms of money or the money’s worth that is being paid for the same. This is also the case at the time of admission of the partner, retirement or the death of a partner, the goodwill is not to be raised in the books of the firm.
Goodwill is a type of asset which is both fictitious and intangible, which may be found on the Balance Sheet of a company. The goodwill at times is hidden too, thus when accounting for the partnership firms the accounting treatment of goodwill in various situations is very much important.
What is Goodwill?
The popular intangible asset which is associated in terms of business and is also connected with the purchase of one company by another is termed as Goodwill. Specifically, to say, goodwill is the portion of the purchase price which is higher than the sum of the fair value of all the assets that are being purchased in the acquisition and the liabilities which is assumed in the process. Goodwill recounts the value of a company’s brand name, the company’s solid customer base, good customer relations with the employees, good employee relations with the company, and the proprietary technology represents some reasons why the goodwill exists.
Understanding Goodwill
For calculating goodwill, a fairly straightforward principle is required which is quite complex in practice. In order to determine the value of goodwill in a simplistic formula, we need to take the purchase price of a company and subtract the net fair market value of the assets and liabilities from the same.
Goodwill Calculation = P-(A-L)
P is the Purchase price of the target company
A is the Fair market value of assets
L is the Fair market value of liabilities.
What Goodwill Tells You
The value of goodwill arises while the acquirer purchases a target company. Then the amount of the acquiring company paying for the target company over the target’s net assets at fair value usually values for the value of the target’s goodwill. If the acquiring company pays less than the target’s book value, in that case it has negative goodwill. This means that it purchased the company at a bargain in a situation of distress sale.
Goodwill is recorded in the balance sheet as an intangible asset on the acquiring company's balance sheet under the long-term assets account. Under GAAP and the IFRS, companies are required to evaluate the value of the goodwill on their financial statements at least once a year and record any of the impairments. Goodwill is to be considered as an intangible also a non-current asset as it is not a physical asset like the buildings or the equipment.
Accounting Treatment of Goodwill Change in PSR
The valuation of goodwill is done in a firm when the following is risen up in the following cases:
At the time when profit-sharing ratio (PSR) of partners is changed
When a new partner is being admitted.
At the time of death or the retirement of a partner.
The entire business is being sold.
In the above situation, the Goodwill adjustment is required. Then we value the goodwill by selecting any of the following methods.
Average profit method
Super profit method
Capitalization method
Accounting Treatment in Case of the Change in Profit Sharing Ratio (PSR)
With the change in the profit-sharing ratio of the partners, the goodwill is valued. One partner may gain a share of profit and the others may sacrifice.
Hence, we adjust the Goodwill through the capital accounts of the partners. The Gaining partner’s capital account is debited and the sacrificing partner’s capital account is then credited. This adjustment of account is done in the profit-sharing ratio.
Also, when the partners decide to change the profit-sharing ratio in the future, the gaining partner compensates the losing partner in the agreed ratio. The compensation will then be the value of goodwill that is represented by the gain.
The change in the profit-sharing ratio represents that one partner is purchasing the share of profit from one partner to another.
FAQs on Goodwill Adjustment in Profit Sharing Ratio
1. What does goodwill adjustment mean when partners change their profit-sharing ratio?
Goodwill adjustment is an accounting process to ensure fairness when partners decide to share future profits differently. It compensates the sacrificing partners (who give up a share of future profits) by taking a proportionate amount from the gaining partners (who acquire a larger share of future profits). This is done because the firm's goodwill was built by the past efforts of all partners in the old ratio.
2. What is the basic journal entry used for adjusting goodwill in a change in profit-sharing ratio?
The standard journal entry for adjusting goodwill without opening a Goodwill Account is:
Gaining Partner's Capital A/c (Dr.)
To Sacrificing Partner's Capital A/c (Cr.)
This entry directly transfers the value of the gained share of goodwill from the gaining partner's capital to the sacrificing partner's capital.
3. Why is it necessary to use the sacrificing and gaining ratio for this adjustment?
The sacrificing and gaining ratio is used because it precisely measures the exact fraction of profit share that one partner has given up and another has acquired. Goodwill represents future profits. Therefore, the partner who gains a larger share of future profits must compensate the partner who sacrifices their share. Using this ratio ensures the compensation is accurate and equitable.
4. Can you explain the goodwill adjustment with a simple example?
Of course. Imagine partners A and B share profits equally (1:1). They decide to change their ratio to 3:2. The firm's goodwill is valued at ₹50,000.
- A's old share was 1/2, and the new share is 3/5. A has gained (3/5 - 1/2) = 1/10 share.
- B's old share was 1/2, and the new share is 2/5. B has sacrificed (1/2 - 2/5) = 1/10 share.
5. What is the difference between adjusting goodwill and writing it off?
There is a key difference:
- Adjusting Goodwill: This is done through a journal entry between partners' capital accounts. A Goodwill account is not opened in the books. It's an internal adjustment.
- Writing Off Goodwill: This applies when goodwill already exists as an asset in the balance sheet. It involves closing this account by debiting all partners in the old ratio and crediting the Goodwill account. As per AS-26, purchased goodwill can be shown, but self-generated goodwill should not be recorded as an asset.
6. How does goodwill treatment for a change in ratio differ from the treatment during a new partner's admission?
The main difference lies in who provides the compensation.
- Change in Ratio: The compensation is paid by an existing gaining partner to an existing sacrificing partner. It's an internal settlement.
- Admission of a Partner: The new partner brings in cash (or an equivalent asset) as a 'Premium for Goodwill' to compensate the old partners for acquiring a share in their established firm.
7. What should be done if goodwill already appears in the balance sheet before the ratio change?
If a Goodwill account already exists in the books, it must first be written off before making any new adjustments. This is done by debiting all partners' capital accounts in their old profit-sharing ratio and crediting the Goodwill account to close it. After this step, the new value of goodwill (if any) is adjusted using the gaining and sacrificing ratio as usual.
