Accounting Treatment of Goodwill Change in PSR

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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.  

FAQ (Frequently Asked Questions)

1. What is Capital Account?

Ans. In accounting terminology, a capital account is a type of general ledger account which is used to record the owners' contributed capital and retained earnings, this cumulative amount of a company's earnings since this was formed, minus the cumulative dividends that is paid to the shareholders.

The capital account of the proprietor or the owner is represented as the owner's in the company balance sheet. The partners in a company and the limited liability partnership abbreviated as LLP. The company holds the capital accounts of the partners. When the partners enter, the individual is making a capital commitment to the business, by investing in this business.

2. What is Hidden Goodwill?

Ans. Hidden Goodwill is the value of goodwill which is not specified at the time of the admission of a partner. In other words, this can be said that Goodwill is the Inferred Goodwill. Hidden goodwill is not given in the question but is implied from being brought in capital by the new partner for his share in the company.

Hidden Goodwill also known as the inferred goodwill is the excess of desired total capital of the firm over the combined actual capital of all the partners.

3. What is the Fair Market Value of the Assets?

Ans. Fair market value, abbreviated as FMV is the price in which an asset would sell for on the open market. Fair market value represents the price of an asset under the following conditions: 

prospective buyers and sellers with reasonable knowledge about the asset.

  • Sellers and buyers behaving with best interest 

  • free of pressure to the trade

  • reasonable time period for completing the transaction.