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Let's get technical: goodwill hunting

Nick Craggs explains the concept of goodwill, and how to account for it

October 2016

I have spent a long time hunting for a subject for this monthís article, but then I hit upon the subject of goodwill. Goodwill? Hunting? Anyone?
Ok, Iíll 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 ĎFinal accounts for sole traders and partnershipsí unit, and its replacement under AQ2016, ĎFinal Accounts preparationí.
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 that 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 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, as each businessí 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, as then it is worth what someone is willing to pay for it.
Letís 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 Mattís 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 Goodwill account £60,000
Credit Mattís capital account £40,000
Credit Benís 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 Mattís capital account £24,000
Debit Benís capital account £12,000
Debit Robinís capital account £24,000
Credit goodwill account £60,000

The overall effect is that the goodwill has gone, and Mattís capital account has been credited with £16,000 (the credit of £40,000 less the debit of £24,000) and Benís 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 Robinís 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 donít 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 partnerís capital account after Fletcher joins the partnership?
You can see me work out the answers at: http://www.firstintuition.co.uk/ category/
ē Nick Craggs is a tutor at First Intuition

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