What is a goodwill? A simple realistic example is when you have something (maybe a toy, shirt, PC games or etc) that you wouldn’t want to give away to your friend, but your friend insisted on having them. In that case, you might be selling them at a higher price, say a limited edition toy that you purchased originally at $100 and your friend are willing to use $120 to purchase the toy (and it is also the price you are willing to give away.) You settled the deal because $120 is attractive! This extra $20 is actually the goodwill.
As for businesses, goodwill arises when the following events happened,
1) existing partners wanted to change profit and loss sharing ratios,
2) new partner is introduced, and
3) one of the partners retires or dies.
There are two ways in showing goodwill, one is to show them in the balance sheet (open a goodwill account) and the other one is to not show them in the balance sheet (do not open a goodwill account).
So, let’s start with opening a goodwill account. In the events (shown above), there will be a change in profit and loss sharing ratio. Something to note in mind that you don’t just ignore the OLD profit and loss sharing ratio, but you will need to do something with it. The steps to opening a goodwill account can be summarised as shown below:
1) Open a goodwill account and Dr the Goodwill amount based on old profit sharing ratio (Note that goodwill is an intangible asset)
2) Open up a capital account with opening balance and CR goodwill in Capital Account.
Here is an example with opening a goodwill account with partners A. B and C changing their profit sharing ratio from existing 2:1:1 to 2:2:1 and that the business has a goodwill value of $4,000. The capital brought forward from A, B and C are $5,000, $4,000 and $2000 respectively.
For second step, you will just need to transfer goodwill above to it’s respective partners’ capital account (remember double entry) in which you have already done a Debit entry above and now you will need to Credit Capital account (shown below).
Step 2: Capital Account
And that’s just it. It is pretty simple but for additional information, you will need to know the before and after adjustment of goodwill which is shown below.
Before and After
So, if goodwill account is to be opened, you will actually find goodwill to be included in the balance sheet, increasing the total assets and that the two steps that you have done earlier will also help you to arrive at the new capital balances.
For the complicated bit will be where goodwill account is not to be opened. Even though it’s complicated but you don’t actually need to do a lot of work! It’s really just a one step working.
Step 1 (and ONLY) is to open up a capital account and then apportion goodwill account based on both OLD and NEW profit sharing ratio.
Capital Account 1
Then that’s done. Since goodwill account is not to be maintained, you skipped the need to open up a goodwill account and then did all the adjustments required in the capital accounts by debiting and crediting capital accounts (increase and decrease by $4,000 resulting in no movement in capital account – see below) but does affect the individual partners.
Before and After1
What happens to treatment of goodwill on new admission of a partner?
Same things applies as shown above for both ways but this new partner will never have apportionment using OLD profit sharing ratio. You will only need to apportion the new profit sharing ratio to this new partner.
What happens to treatment of goodwill on death or withdrawal of a partner?
Same things applies as shown above for both ways.
Things to bear in mind to score well in this topic:
1) For goodwill to be opened, you only apportion using OLD ratio. Whilst for goodwill not to be opened, remember to apportion using both ratio.
2) When preparing for balance sheet, do make sure to include goodwill account in intangible asset (if goodwill account is to be opened).
3) Remember the formats well.