Professional Documents
Culture Documents
Goodwill
Goodwill = Selling price as a going concern Fair value of separate net assets Goodwill = Selling price (Assets Liabilities)
Goodwill
Buyer may be willing to pay more for a business as a going concern because of:
Good location Good customer relations Good reputation Well-known products Experienced and efficient employees and management team Good relation with suppliers
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Types of Goodwill
Inherent Goodwill
Goodwill generated internally because of the above advantages Inherent goodwill is only an estimation. Therefore, it should not be brought into the books, and no accounting entry is required
Purchased Goodwill
It is the goodwill generated during the acquisition of a business It is the difference between the selling price of a business as a going concern and the total value of its separable net assets It can be treated as an intangible fixed asset. Some companies may write it off immediately against reserves, or amortized through the profit and loss account over its useful economic life
Calculation of Goodwill
Subject Judgement
Estimate the value of goodwill with reference to some intangible factors and according to their professional judgement
It can be calculated on gross average or weight average Goodwill = Average annual sales/fees/profits over a stated number of years * a factor
The factor is usually stated as a certain number of years purchase of the average sales/fees/profits
Example 1
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Year
(a) Goodwill is valued at 3 years purchase of the average annual sales of the past 3 years:
(b) Goodwill is valued at the 3 years purchase of the weighted average of the annual sales of the past 3 years
Weighted average annual sales = (100000 x 1 + 200000 x 2 + 300000 x 3) 1+2+3 = 1400000 6 = 233333 (Calculation to the nearest dollar)
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A business with goodwill is expected to be able to earn more profit than a business without goodwill The extra profit earned is called the super profit
Statement Calculating Super Profit Average annual net profit X
X X
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Example 2
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Chan is leaving the partnership, and goodwill is to be revalued at 3 years purchase of the super profit. The expected rate of return on net tangible assets is 10 %, after paying a management fee of $500. The calculation of the super profit is to be based on the average profits of the last four years. Net profit from 1994-1997 is $5000, $6500, $6500, $7000 Expected return on net tangible assets = Net tangible assets * 10%. Expected return is $5000.
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Answer Statement Calculating Super Profit $ Average net profit (5000+6500+6500+7000)/4 Less: Management fee 500 Expected rate of return on net tangible assets 5000 Super profit
$ 6250
5500 750
Partnership
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Only purchased goodwill is to be brought into the accounts. In sole traders accounts, goodwill is to be recognized and recorded in the books only if the business is acquired as a going concern In partnerships, however, goodwill is brought into the books whenever there is a change in the partnership such as:
Admission of a new partner Retirement of an old partner Change of the profit-sharing ratio
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Each partner has a share of the profit-sharing ratio. At a change in the partnership, goodwill must be taken into account and shared among the existing partners, according to the existing profit-sharing ratio
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The new partner is required to pay for his share of the tangible assets as well as the goodwill, according to the profit-sharing ratio On the admission of a new partner, goodwill must be revalued However, not all business keep a goodwill account in their books. Goodwill adjustments can be done:
The value of the goodwill will be credited to the old partners capital accounts, which represents an increase in the resources they own, while the new partner will not have a share of the goodwill
Dr Goodwill account Cr Capital account ( old partners only
Dr Goodwill account Cr Capital account ( old partner Dr Capital account (old partner) Cr Goodwill account
With the value of goodwill With their share of goodwill in old ratio
With the increase in the value of goodwill, share in the old ratio With the decrease in the value of goodwill, share in the old artio
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Goodwill is intangible in nature. It cannot be disposed of separately. Therefore, some businesses prefer not to maintain a goodwill account The new partner may be required to pay extra cash, or have his capital balance reduced, for his share of goodwill Share goodwill among old partners in old profit-sharing ratio Written off goodwill among all partners in the new profit-sharing ratio
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Dr Goodwill account Cr Capital account (old partners only) Dr Capital account ( all partners) Cr Goodwill account
Example 3
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Chan and Wong were partners sharing profits and losses equally. On 1 January 1998, they admitted Lee as a new partner who was required to introduce $600 as capital. The profits are now to be shared among Chan, Wong and Lee equally. Goodwill is valued at $300. The balance sheet before the admission of the new partner is shown as follows:
Chan and Wong Balance Sheet as at 31 December 1997
Assets
1,200
1,200
300 300
Balance c/f
750
750
600
Balance b/f
Goodwill Cash
600
150
600
150 600
750
750
600
750
750
600
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Balance b/f
100 500
600
600
150
750
750
600
750
Before admission
After admission
Partner
Chan Wong Lee
Old ratio
1/2 1/2
Share of goodwill
$150 $150 $300
New ratio
1/3 1/3 1/3
Share of goodwill
$100 $100 $100 $300
Gain/loss
$50 loss $50 loss $100 gain
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1,800
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When a partner wants to withdraw from a partnership, the partnership should revalue all the assets which belongs to the leaving partner in order to compute the total amount of money that he can withdraw from the partnership Goodwill adjustment should be calculated in order to compensate the leaving partner
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Example 4
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Ho, Tang and Lau were partners sharing profits and losses equally. On 31 December 1997, Lau left the partnership. The other two partners agreed to share profits and losses equally. The goodwill is revalued at $10,000. Lau received cash from the partnership for the amount due to him on 31 December 1997. The balance sheet before Laus retirement is shown as follows:
Ho, Tang and Lau Balance Sheet as at 31 December 1997
1,000 41,000
42,000
10,000
10,000
Tang
Lau
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Ho and Tang Balance Sheet as at 31 December 1998 Goodwill Other Assets (41000-17000) 1,000 24,000 34,000 Capital Ho Tang 17,000 17,000 34,000
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12,000 12,000
24,000
24,000
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When there is a change in the profit-sharing ratio, the value of goodwill should also be reassessed, so as to ascertain the amount of resources a partner has to give up ( in terms of a reduction in the relative capital balance) for the gain in his share of profits/loss.
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Example 5
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Yip, Chow and Au are partners in a trading firm and share profits and losses in the ratio 3:3:2. On 31 December 1997, they wanted to change the profitsharing ratio to 1:1:1. The goodwill is revalued at $9,000. The firms balance sheet on 31 December 1997 was:
Yip, Chow and Au Balance Sheet as at 31 December 1997 1,000 Capital: Yip 79,000 Chow Au 80,000
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Balance c/f
9,000
Yip
Chow
Balance c/f
41
88,000
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Assets
Yip, Chow & Au Balance Sheet as at 31 December 1998 79,000 Capital: Yip Chow Au 79,000
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Cindy and Candy were in partnership. They shared profits and losses in ratio of 3:2 On 1 January 2001, they decided to admit Joe. Goodwill is valued at one years purchase of the average annual profits (weighted average) of the past four years. Goodwill is not to be brought into the partnerships book. Joe brought $40,000 cash into the business for capital. No extra cash is paid for goodwill. The new profit-sharing ratio is 3:2:1.
The balance sheet as at 31 December2000 before the admission of Joe is as follows: Assets 110,000 Capital : Cindy 65,000 Cash 25,000 Candy 70,000 Annual net profits for 1997 to 2000 were $25,000,$40,000, $75,000 and $60,000 respectively. Record the above change in the partnership in the partners capital accounts in columnar form, and show the balance sheet after the admission of Joe.
Valuation of Goodwill :
25,000 x1 + 40,000x2 + 75,000 x3 + 60,000 x 4 1 + 2 + 3 + 4 57,000