Methods of computing and accounting for goodwill

This method involves calculating the super profit, which is the profit earned by the business over and above the normal profit. The normal profit is the expected profit based on the capital employed or industry standards. The super profit is then multiplied by an agreed number of years to determine the goodwill.

Steps

• Step 1: Calculate the normal profit (usually based on the capital employed or expected profit rate in the industry).

$\text{Normal Profit} = \text{Capital Employed} \times \text{Normal Rate of Return}$

• Step 2: Calculate the actual profit for the period.
• Step 3: Calculate the super profit.

$\text{Super Profit} = \text{Actual Profit} - \text{Normal Profit}$

• Step 4: Multiply the super profit by the number of years (usually agreed upon) to determine goodwill.

$\text{Goodwill} = \text{Super Profit} \times \text{Number of Years Purchase}$

Example

• Assume the normal profit is Tsh 40,000 and the actual profit is Tsh 70,000.
• The super profit would be:

$\text{Super Profit} = 70{,}000 - 40{,}000 = 30{,}000$

• If the agreed number of years is 4, the goodwill would be:

$\text{Goodwill} = 30{,}000 \times 4 = \text{Tsh } 120{,}000$

This method capitalizes the average profits of the business at an appropriate rate of return to determine the total value of the business (including goodwill). The formula for calculating goodwill under this method involves dividing the average profit by the capitalization rate.

Steps

• Step 1: Calculate the average annual profit of the business.

$\text{Average Annual Profit} = \frac{\text{Sum of Profits}}{\text{Number of Years}}$

• Step 2: Determine the capitalization rate (the expected return on investment, expressed as a percentage).
• Step 3: The total capitalized value of the business (including goodwill) is:

$\text{Capitalized Value} = \frac{\text{Average Annual Profit}}{\text{Capitalization Rate}}$

• Step 4: Calculate the goodwill by subtracting the capital employed (or net assets) from the capitalized value.

$\text{Goodwill} = \text{Capitalized Value} - \text{Capital Employed}$

Example

• Assume the average annual profit is Tsh 60,000 and the capitalization rate is 10%.

$\text{Capitalized Value} = \frac{60{,}000}{0.10} = 600{,}000$

• If the capital employed (or net assets) is Tsh 500,000, then:

$\text{Goodwill} = 600{,}000 - 500{,}000 = \text{Tsh } 100{,}000$

Method	How Goodwill is Calculated	When to Use
Average Profit Method	Average annual profits × Multiple	When past performance is stable and there's no significant fluctuation in profit.
Super Profit Method	Super Profit × Number of Years Purchase	When there is a significant difference between actual and normal profit.
Capitalization Method	Average annual profit ÷ Capitalization rate	When capital employed and return rates are important considerations.

Each method has its advantages depending on the available data and the nature of the partnership business.

When accounting for goodwill in a partnership, there are two primary methods of handling goodwill once it is valued: the Premium Method and the Revaluation Method. Each of these methods involves specific treatments for the existing partners' capital accounts and the recognition of the new partner's share of goodwill.

a. Premium method (or capitalization method)

The Premium Method is often used when the value of goodwill is paid directly to the existing partners by the new partner. In this method, goodwill is treated as a premium paid for the right to enter into the partnership, and it is shared among the old partners based on their profit-sharing ratio.

Key features of the premium method

1. The new partner pays a certain premium for their share of the goodwill, which is credited to the existing partners' capital accounts.
2. No goodwill account is maintained in the books of the partnership, as it is directly allocated to the partners' capital accounts.
3. The goodwill amount is determined based on the value agreed upon (e.g., average profit method, super profit method, etc.).
4. The new partner's share of goodwill is calculated based on their agreed share in the partnership and is paid in cash or assets.

Steps in the premium method

1. Determine the goodwill value using one of the methods (average profit method, super profit method, or capitalization method).
2. Calculate the new partner's share of goodwill based on their agreed percentage of the total partnership.
3. Distribute the premium amount (new partner's contribution to goodwill) among the existing partners in the old profit-sharing ratio.
4. The new partner's capital account is credited with the amount paid for goodwill, and the corresponding entries are made in the existing partners' capital accounts.

Example

1. Goodwill is valued at Tsh 120,000.
2. The profit-sharing ratio between the existing partners is 3:2.
3. The new partner is contributing Tsh 60,000 as their share of goodwill.

In the premium method:

1. Partner A will receive Tsh 72,000 (Tsh 120,000 × 3/5).
2. Partner B will receive Tsh 48,000 (Tsh 120,000 × 2/5).
3. The new partner's capital account will be credited with Tsh 60,000 for their share of goodwill.

Journal entries

For the new partner's contribution to goodwill:

1. Debit Cash/Bank or Asset (new partner's contribution) Tsh 60,000
2. Credit Partner A's Capital Tsh 72,000
3. Credit Partner B's Capital Tsh 48,000

b. Revaluation method

The Revaluation Method involves adjusting the values of the partnership's assets and liabilities to reflect their current market values. The increase in the value of the business is then considered as part of the goodwill. The goodwill is shared among the existing partners based on their profit-sharing ratio.

Key features of the revaluation method

1. The goodwill is treated as a revaluation surplus, where the partnership's assets and liabilities are revalued, and the resulting increase in value is recognized as goodwill.
2. A goodwill account is maintained in the books, and it reflects the revalued assets and liabilities of the business.
3. After the goodwill is determined, it is credited to the capital accounts of the existing partners in their profit-sharing ratio.
4. The new partner's share of goodwill is calculated, and adjustments are made accordingly.

Steps in the revaluation method

1. Revalue the assets and liabilities of the business to their fair market value.
2. Determine the total increase in value (which is considered as goodwill) by subtracting the old book value of the assets from the new revalued amounts.
3. Share the goodwill among the existing partners in the old profit-sharing ratio.
4. Adjust the capital accounts of the existing partners to reflect their share of the goodwill, and credit the new partner's capital account for their agreed share.

Example

1. Assume the partnership has assets that were originally valued at Tsh 200,000, but after revaluation, the value increases to Tsh 240,000. The increase of Tsh 40,000 is considered as goodwill.
2. The existing partners share the goodwill based on a profit-sharing ratio of 4:3.
3. The new partner's contribution is Tsh 20,000 for their share of goodwill.

In the revaluation method:

1. Partner A will receive Tsh 22,857 (Tsh 40,000 × 4/7).
2. Partner B will receive Tsh 17,143 (Tsh 40,000 × 3/7).
3. The new partner's capital account will be credited with Tsh 20,000 for their share of goodwill.

Journal entries

1. For the revaluation of assets:
   • Debit Asset accounts (for the increase in value) Tsh 40,000
   • Credit Revaluation Surplus (Goodwill) Tsh 40,000
2. For the distribution of goodwill:
   • Debit Revaluation Surplus (Goodwill) Tsh 40,000
   • Credit Partner A's Capital Tsh 22,857
   • Credit Partner B's Capital Tsh 17,143
   • Credit New Partner's Capital (for their share of goodwill) Tsh 20,000

Method	Treatment of Goodwill	When to Use
Premium Method	Goodwill is paid by the new partner as a premium, directly credited to existing partners' capital accounts.	When the new partner is contributing to goodwill and paying a premium to join the partnership.
Revaluation Method	Goodwill is created by revaluing assets and liabilities, and the increase is shared among the partners.	When assets and liabilities are revalued and the partnership wants to recognize the increase in value as goodwill.

Both methods ensure that the new partner's entry is fair, and the existing partners' capital accounts are adjusted to reflect their share of the goodwill. The Premium Method is simpler as it involves cash payments, while the Revaluation Method involves adjustments to asset values and is often used when there is a significant increase in the value of the partnership's assets.