2. Treatment of Goodwill

Treatment of Goodwill

The retiring or deceased partner is entitled to his share of goodwill at the time of retirement/death because the goodwill has been earned by the firm with the efforts of all the existing partners. Hence, at the time of retirement/death of a partner, goodwill is valued as per agreement among the partners the retiring/ deceased partner compensated for his share of goodwill by the continuing partners (who have gained due to acquisition of share of profit from the retiring/ deceased partner) in their gaining ratio. The accounting treatment for goodwill in such a situation depends upon whether or, not goodwill already appears in the books of the firm.

When goodwill does not appear in the books

When goodwill does not appear in the books of the firm, credit in given to the retiring partner for the share in goodwill by debiting the goodwill account to gaining partners capital accounts (individually) in their gaining ratio. The journal entry is :

Gaining Partners Capital A/c     Dr.   (Individually) To Retiring Partners Capital A/c

(Share in goodwill of retiring partner adjusted)

Let us take an example to understand the treatment of goodwill.

A, B and C are partners in a firm sharing profits in the ratio of 3:2:1 B retired and the value of goodwill of the firm in valued at Rs. 60,000. A and C continue the business sharing profits in the ratio of 3:1. The journal entry for adjustment of goodwill will be :

(B's share of goodwill adjusted to remaining partners' capital accounts in their gaining ratio)
It may also happen that as a result of decision on the new profit sharing ratio among the remaining partners, a continuing partner may also sacrifice a part of his share in future profits. In such a situation his capital account will also be credited along with the retiring/deceased partner’s capital account in proportion to his sacrifice and the other continuing partners’ capital accounts will be debited based on their gain in the future profit ratio.

Revision  6

Keshav, Nirmal and Pankaj are partners sharing profits and losses in the ratio of 4 : 3 : 2. Nirmal retires and the goodwill is valued at Rs. 72,000. Keshav and Pankaj decided to share future profits and losses in the ratio of 5 : 3. Record necessary journal entries.

Solution

Journal

Working Notes

Vimal’s share of goodwill = Rs. 72,000 ×  3/9  = Rs. 24,000
Calculation of Gaining Ratio
Gaining Share     =  New Share – Old Share
Keshav’s Gaining Share = 5/8 – 4/9 = 13/72
Pankaj’s Gaining Share =  3/8  −  2/9  =  11/72
Hence, Gaining Ratio between Keshav and Pankaj is 13:11 i.e. 13/24 : 11/24

Revision  7

Jaya, Kirti, Ekta and Shewata are partners in a firm sharing profits and losses in the ratio of 2 : 1 : 2 : 1. On Jaya’s retirement, the goodwill of the firm is valued at Rs. 36,000. Kirti, Ekta and Shewata decided to share future profits equally. Record the necessary journal entry for the treatment of goodwill without opening ’Goodwill Account’.

Solution

Books of Kirti,  Ekta and Shewata

Journal

Working Notes

1.  Jaya’s Share of Goodwill

= Rs. 36,000 × 2/6  = Rs. 12,000

2.  Calculation of Gaining Ratio

Gaining Share  = New Share – Old Share
Kirti’s Gain    = 1/3 – 1/6 = 2/6  − 1/6 = 1/6
Ekta’s Gain      =   1/3  −  2/6  =  2/6  − 2/6  =  0  (Neither Gain nor Sacrifice)
Shewata’s Gain =  1/3  −  1/6  =  2/6  − 1/6  =  1/6
Hence, Gaining  ratio between Kirti and  Shewata 1/6 : 1/6  = 1:1

Revision  8

Deepa, Neeru and Shilpa were partners in a firm sharing profits in the ratio of 5 : 3 : 2. Neeru retired and the new profit sharing ratio between Deepa and Shilpa was 2 : 3. On Neeru’s retirement, the goodwill of the firm was valued at Rs. 1,20,000. Record necessary journal entry for the treatment of goodwill on Neeru’s retirement.

Solution

Books of Deepa and Shilpa

Journal

Working Notes

1.  Calculation of Gaining Ratio

Gaining Share  =  New Share – Old Share

Deepa’s Gaining Share  = 2/5 – 5/10 =  4/10  − 5/10 =  - 1/10 = (1/10)  i.e., Sacrifice.

Shilpa’s Gaining Share = 3/5  − 2/10 = 6/10  – 2/10 =  4/10  i.e., Gain

2. Hence, Shilpa will compensate both Neeru (retiring partner) and Deepa (continuing partner who has sacrificed) to the extent of their sacrifice worked out as follows:

Deepa’s Sacrifice = Goodwill of the firm × Sacrificing Share

= Rs. 1,20,000 ×  1/10  = Rs. 12,000

Neeru’s (Retiring Partner’s Sacrifice) = Rs. 1,20,000 ×  3/10  =  Rs. 36,000.

Revision  9

Hanny, Pammy and Sunny are partners sharing profits in the ratio of 3 : 2 : 1. Goodwill is appearing in the books at a value of Rs. 60,000. Pammy retires and at the time of Pammy’s retirement, goodwill is valued at Rs. 84,000. Hanny and Sunny decided to share future profits in the ratio of 2:1. Record the necessary journal entries.

Solution

 Books of Hanny and Sunny

Journal

Working Notes

(i)  Pammy’s share of current value of goodwill   1/3 of Rs. 84,000

= 1/3 ×  84,000 = Rs. 28,000

(ii)  Gaining Share   =  New Share – Old Share

Hanny’s Gaining Share =  2/3  − 3/6  = 1/6

Sunny’s Gaining Share = 1/3 – 1/6 = 1/6

This gaining Ratio of Hanny and Sunny is 1/6  : 1/6  = 1:1

Hidden Goodwill

If the firm has agreed to settle the retiring or deceased partner’s account by paying him a lump sum amount, then the amount paid to him in excess of what is due to him, based on the balance in his capital account after making necessary adjustments in respect of accumulated profits and losses and revaluation of assets and liabilities, etc., shall be treated as his share of goodwill (known as hidden goodwill).
For example, P, Q and R are partners in a firm sharing profits in the ratio of 3:2:1. R retires, and the balance in his capital account after making necessary adjustments on account of reserves, revaluation of assets and liabilities workout to be Rs. 60,000, P and Q agreed to pay him Rs. 75,000 in full settlement of his claim. It implies that Rs. 15,000 is R’s share of goodwill of the firm. This will be debits to the capital accounts of P and Q in their gaining ratio (3:2 assuming no change in their own profit sharing ratio) and crediting R’s capital Account as follows: