What is Goodwill in accounting?

I have spent a long time hunting for a subject to write about, but then I hit upon the subject of Goodwill!…  Goodwill? Hunting?  Anyone?

Ok, I will get my coat, but before I do I want to tell you a bit about the accounting version of goodwill, which is covered in the AAT ‘Final Accounts Preparation’ unit.

What is Goodwill in accounting?

I have spent a long time hunting for a subject to write about, but then I hit upon the subject of Goodwill!…  Goodwill? Hunting?  Anyone?

Ok, I will get my coat, but before I do I want to tell you a bit about the accounting version of goodwill, which is covered in the AAT ‘Final Accounts Preparation’ unit.

What is Goodwill in accountancy terms?

Goodwill is the amount someone would pay over and above what the assets are actually worth on paper when buying a business. You may pay more than what the assets are worth because the company has a great reputation, which you think will lead to future sales.

Alternatively, it may have a unique research and development team, which consistently develops market leading products.  Basically, it is something which you cannot see, but you feel will bring money into the business in the future.

It is difficult to assign a specific value to goodwill. Each business’ goodwill is unique to that business and fluctuates, so we do not show it in the final accounts.  The only time when we know the value of the goodwill, is when someone buys the goodwill. Then it is worth what someone is willing to pay for it.

Let’s look at a scenario

Matt and Ben own a small film production business and run it as a partnership. Matt is the talented one and does all the hard work, Ben tends to ride on Matt’s coat tails, so they split the profit in the ratio of 2:1 in favour of Matt.  So, for every £3.00 of profit generated, Matt will receive £2.00 and Ben will receive £1.00.

After a few years, the company begins to perform really well, and Robin wants to join the partnership. The business only really owns a few computers, but the Robin is willing to pay £60,000 in excess of the value of the computers. This is because they have just secured the rights to a film about someone with extreme memory loss, which is sure to be a box office success.

Robin is well known in the film industry, so when he joins the partnership they agree to split the profits in the ratio of 2:1:2, or for every £5.00 profit the business marks, Matt will get £2.00, Ben will get £1.00 and Robin will get £2.00.

As a percentage of every pound of profit earned going forward, Matt and Ben will actually keep less than before. Effectively, they have sold a proportion of their rights to any future profits, and instead of receiving cash, their capital account (the amount the business owes them personally) is increased, which they could later take out of the business in cash.

To credit their capital accounts, we introduce the goodwill in to the accounts using the original profit share ratio. So, remember Matt and Ben used to split the profits 2:1.  As a result, we debit goodwill (being an asset) and we credit the capital accounts, in the ratio of the original profit share agreement.

The double entry will be:

DEBIT

CREDIT

Goodwill account £60,000

Matt’s capital account £40,000

Ben’s capital account £20,000

 

We do not keep the goodwill in the accounts, as it is so subjective. The goodwill was worth £60,000 at that point in time, and was only worth £60,000 to Robin. We need to eliminate the goodwill from the accounts. So, we remove it by crediting the goodwill, and debiting the capital accounts in the ratio of the new profit share agreement, which if you remember was 2:1:2, to Matt, Ben and Robin respectively.

As such, the double entry for this will be:

DEBIT CREDIT
Matt’s capital account £24,000
Ben’s capital account £12,000
Robin’s capital account £24,000
Goodwill account £60,000

 

The overall effect is that the goodwill has gone, and Matt’s capital account has been credited with £16,000 (the credit of £40,000 less the debit of £24,000) and Ben’s capital account has been credited with £8,000 (the credit of £20,000 less the debit of £12,000). This is their financial compensation for the loss of some potential future profits.  Whereas, Robin’s capital account is a debit of £24,000, this means he owes the business money!  This is money he owes for the right to receive his share of any potential future profits.

Partnership accounting is a large part of this unit and it will play a big part as to whether or not you will pass the exam. However, if you follow the rule of bringing in the goodwill under the old profit share ratio and removing it under the new profit share ratio, you should not go wrong.

Why don’t you have a go at this scenario?

Norman and Stanley share profits equally, until Fletcher joins the partnership. At the time Fletcher joins the partnership, goodwill is valued at £66,000.  Going forward the business will split the profit equally between all three partners.  What will be the closing balance on each partner’s capital account after Fletcher joins the partnership?

You can see me work out the answers below:

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