ICAI Notes- Unit 2: Treatment of Goodwill in Partnership Accounts | Principles and Practice of Accounting - CA Foundation PDF Download

 Page 1


10.41 
PARTNERSHIP AND LLP ACCOUNTS 
 
LEARNING OUTCOMES 
UNIT – 2:  TREATMENT OF GOODWILL IN 
PARTNERSHIP ACCOUNTS 
After studying this unit, you will be able to: 
? Understand when does the need for valuation of goodwill arise. 
? Learn the accounting of goodwill. 
 
 
Necessity for valuation of goodwill  
Change in profit 
sharing ratio 
Admission of  
partner 
Retirement or 
death of partner 
When business is 
dissolved or sold 
 
Methods of 
valuation of 
goodwill
Annuity 
basis
Super profit
Capitalization 
basis
Average 
profit
UNIT OVERVIEW 
© The Institute of Chartered Accountants of India
Page 2


10.41 
PARTNERSHIP AND LLP ACCOUNTS 
 
LEARNING OUTCOMES 
UNIT – 2:  TREATMENT OF GOODWILL IN 
PARTNERSHIP ACCOUNTS 
After studying this unit, you will be able to: 
? Understand when does the need for valuation of goodwill arise. 
? Learn the accounting of goodwill. 
 
 
Necessity for valuation of goodwill  
Change in profit 
sharing ratio 
Admission of  
partner 
Retirement or 
death of partner 
When business is 
dissolved or sold 
 
Methods of 
valuation of 
goodwill
Annuity 
basis
Super profit
Capitalization 
basis
Average 
profit
UNIT OVERVIEW 
© The Institute of Chartered Accountants of India
  
ACCOUNTING
1.42 
10.42 
2.1  GOODWILL 
Goodwill is the value of reputation of a firm in respect of profits expected in future over and 
above the normal rate of profits. 
In simpler terms, Goodwill is nothing more than the probability that old customer will resort 
to old place again and again. The capacity of a business to earn super profits in the future is 
basically what is meant by term goodwill. Goodwill is an intangible asset; it cannot be seen; 
it cannot be felt; it cannot be transported physically. Even then it is very real. From 
accounting point of view, it is necessary that it has some monetary or saleable value. The 
implication of the term over and above is that there is always a certain normal rate of profits 
earned by similar firms in the same locality. The excess profit earned by a firm may be due to 
its locational advantage, better customer service, possession of a unique patent right, personal 
reputation of the partner or for similar other reasons. The necessity for valuation of goodwill 
in a firm arises in the following cases: 
a) When the profit sharing ratio amongst the partners is changed; 
b) When a new partner is admitted; 
c) When a partner retires or dies; and 
d) When the business is dissolved or sold. 
Let us take a simple example. There is a small Book business owned by a firm. Its net worth 
i.e. Asset–liabilities, is ` 140,000. Now if a purchaser is willing to pay ` 150,000 for it, the extra 
` 10,000 is known in accounting as goodwill. The next question is: Why the purchaser is willing 
to pay ` 10,000 for goodwill.  
One reason may be the future capability of the business to earn more profit than the normal 
profit. It may be on account of favourable location.  
The major factors which affect value of goodwill are as follows: 
The list is in no way exhaustive but only provides the basic guidelines: 
(i) The quality of the goods sold.  
(ii) The personal reputation of the owners i.e., their ability to attract the customers.  
(iii) The location of the business premises e.g., a good position in a congested market.  
(iv) The possession of near monopoly right e.g. main agent for a particular vehicle like, 
Maruti car, Bajaj scooter, etc.  
(v) The possession of trademarks and patents. 
(vi) The presence of managerial skill.  
© The Institute of Chartered Accountants of India
Page 3


10.41 
PARTNERSHIP AND LLP ACCOUNTS 
 
LEARNING OUTCOMES 
UNIT – 2:  TREATMENT OF GOODWILL IN 
PARTNERSHIP ACCOUNTS 
After studying this unit, you will be able to: 
? Understand when does the need for valuation of goodwill arise. 
? Learn the accounting of goodwill. 
 
 
Necessity for valuation of goodwill  
Change in profit 
sharing ratio 
Admission of  
partner 
Retirement or 
death of partner 
When business is 
dissolved or sold 
 
Methods of 
valuation of 
goodwill
Annuity 
basis
Super profit
Capitalization 
basis
Average 
profit
UNIT OVERVIEW 
© The Institute of Chartered Accountants of India
  
ACCOUNTING
1.42 
10.42 
2.1  GOODWILL 
Goodwill is the value of reputation of a firm in respect of profits expected in future over and 
above the normal rate of profits. 
In simpler terms, Goodwill is nothing more than the probability that old customer will resort 
to old place again and again. The capacity of a business to earn super profits in the future is 
basically what is meant by term goodwill. Goodwill is an intangible asset; it cannot be seen; 
it cannot be felt; it cannot be transported physically. Even then it is very real. From 
accounting point of view, it is necessary that it has some monetary or saleable value. The 
implication of the term over and above is that there is always a certain normal rate of profits 
earned by similar firms in the same locality. The excess profit earned by a firm may be due to 
its locational advantage, better customer service, possession of a unique patent right, personal 
reputation of the partner or for similar other reasons. The necessity for valuation of goodwill 
in a firm arises in the following cases: 
a) When the profit sharing ratio amongst the partners is changed; 
b) When a new partner is admitted; 
c) When a partner retires or dies; and 
d) When the business is dissolved or sold. 
Let us take a simple example. There is a small Book business owned by a firm. Its net worth 
i.e. Asset–liabilities, is ` 140,000. Now if a purchaser is willing to pay ` 150,000 for it, the extra 
` 10,000 is known in accounting as goodwill. The next question is: Why the purchaser is willing 
to pay ` 10,000 for goodwill.  
One reason may be the future capability of the business to earn more profit than the normal 
profit. It may be on account of favourable location.  
The major factors which affect value of goodwill are as follows: 
The list is in no way exhaustive but only provides the basic guidelines: 
(i) The quality of the goods sold.  
(ii) The personal reputation of the owners i.e., their ability to attract the customers.  
(iii) The location of the business premises e.g., a good position in a congested market.  
(iv) The possession of near monopoly right e.g. main agent for a particular vehicle like, 
Maruti car, Bajaj scooter, etc.  
(v) The possession of trademarks and patents. 
(vi) The presence of managerial skill.  
© The Institute of Chartered Accountants of India
10.43 
PARTNERSHIP AND LLP ACCOUNTS 
(vii) The cost of research and development which enables the production at low cost and 
of good quality.  
(viii) The possession of special contracts for the availability of materials 
RECOMMENDATION OF ACCOUNTING STANDARD 
Accounting Standards require an enterprise to recognize an intangible asset, only if and only 
if, certain conditions are satisfied, namely: 
(i) An intangible asset must have the characteristics of an asset. It means that it must 
have some value and must be clearly identifiable, so that it can be sold without 
disposing other assets or future benefits flowing from other assets. 
(ii) An intangible asset should be recognized only if the future probable economic 
benefits (i.e., increased revenue from sales) will flow to the business enterprise and 
not to others. It means that management can make reasonable estimates of future 
benefits. 
(iii) The cost of the intangible asset can be measured reliably, that is, the cost is 
objectively verifiable. If the cost cannot be measured reliably, then it cannot be 
recognized as an asset. 
It is thus clear that none of the conditions is satisfied by internally generated goodwill or 
inherent goodwill. The reasons are simple to explain. First, it is not an identifiable resource 
like patent, trademark or copyright. Second, it is very difficult to assess its future benefits. 
Finally, the cost of internally generated goodwill cannot be reliably measured in the absence 
of any consideration in money or money’ worth. There is no documentary evidence to support 
the value of goodwill as a resource. 
Goodwill should be recorded in the books only when some consideration in money or money’ 
worth has been paid for it. Accordingly, on admission or retirement/death of a partner or even 
when there is a change in profit sharing ratio amongst the existing partners, goodwill should 
not be raised in the books of account of the partnership firm because no consideration in 
money or money’ worth has been paid for it. The conclusion is that only purchased goodwill 
should be recorded in the books of account whether the payment is made directly in cash or 
money’ worth. For example, ‘A’ and ‘B’ purchase the net assets (assets minus liabilities) of ‘C’ 
amounting to ` 2,50,000 for ` 3,00,000 in cash, the additional payment of ` 50,000 is a payment 
for goodwill in cash. It is a case of purchased goodwill (an asset) and can be validly recorded 
in the books of A and B. When no payment is made for the purchase of goodwill and goodwill 
account is raised in the books, it is a case of internally generated goodwill or inherent goodwill 
and as per Accounting Standards, it is not permitted. For example, in the event of 
reconstitution of the firm due to admission, or retirement or death of a partner or even a 
change in the profit sharing ratio without reconstitution, goodwill of the firm is evaluated. In 
© The Institute of Chartered Accountants of India
Page 4


10.41 
PARTNERSHIP AND LLP ACCOUNTS 
 
LEARNING OUTCOMES 
UNIT – 2:  TREATMENT OF GOODWILL IN 
PARTNERSHIP ACCOUNTS 
After studying this unit, you will be able to: 
? Understand when does the need for valuation of goodwill arise. 
? Learn the accounting of goodwill. 
 
 
Necessity for valuation of goodwill  
Change in profit 
sharing ratio 
Admission of  
partner 
Retirement or 
death of partner 
When business is 
dissolved or sold 
 
Methods of 
valuation of 
goodwill
Annuity 
basis
Super profit
Capitalization 
basis
Average 
profit
UNIT OVERVIEW 
© The Institute of Chartered Accountants of India
  
ACCOUNTING
1.42 
10.42 
2.1  GOODWILL 
Goodwill is the value of reputation of a firm in respect of profits expected in future over and 
above the normal rate of profits. 
In simpler terms, Goodwill is nothing more than the probability that old customer will resort 
to old place again and again. The capacity of a business to earn super profits in the future is 
basically what is meant by term goodwill. Goodwill is an intangible asset; it cannot be seen; 
it cannot be felt; it cannot be transported physically. Even then it is very real. From 
accounting point of view, it is necessary that it has some monetary or saleable value. The 
implication of the term over and above is that there is always a certain normal rate of profits 
earned by similar firms in the same locality. The excess profit earned by a firm may be due to 
its locational advantage, better customer service, possession of a unique patent right, personal 
reputation of the partner or for similar other reasons. The necessity for valuation of goodwill 
in a firm arises in the following cases: 
a) When the profit sharing ratio amongst the partners is changed; 
b) When a new partner is admitted; 
c) When a partner retires or dies; and 
d) When the business is dissolved or sold. 
Let us take a simple example. There is a small Book business owned by a firm. Its net worth 
i.e. Asset–liabilities, is ` 140,000. Now if a purchaser is willing to pay ` 150,000 for it, the extra 
` 10,000 is known in accounting as goodwill. The next question is: Why the purchaser is willing 
to pay ` 10,000 for goodwill.  
One reason may be the future capability of the business to earn more profit than the normal 
profit. It may be on account of favourable location.  
The major factors which affect value of goodwill are as follows: 
The list is in no way exhaustive but only provides the basic guidelines: 
(i) The quality of the goods sold.  
(ii) The personal reputation of the owners i.e., their ability to attract the customers.  
(iii) The location of the business premises e.g., a good position in a congested market.  
(iv) The possession of near monopoly right e.g. main agent for a particular vehicle like, 
Maruti car, Bajaj scooter, etc.  
(v) The possession of trademarks and patents. 
(vi) The presence of managerial skill.  
© The Institute of Chartered Accountants of India
10.43 
PARTNERSHIP AND LLP ACCOUNTS 
(vii) The cost of research and development which enables the production at low cost and 
of good quality.  
(viii) The possession of special contracts for the availability of materials 
RECOMMENDATION OF ACCOUNTING STANDARD 
Accounting Standards require an enterprise to recognize an intangible asset, only if and only 
if, certain conditions are satisfied, namely: 
(i) An intangible asset must have the characteristics of an asset. It means that it must 
have some value and must be clearly identifiable, so that it can be sold without 
disposing other assets or future benefits flowing from other assets. 
(ii) An intangible asset should be recognized only if the future probable economic 
benefits (i.e., increased revenue from sales) will flow to the business enterprise and 
not to others. It means that management can make reasonable estimates of future 
benefits. 
(iii) The cost of the intangible asset can be measured reliably, that is, the cost is 
objectively verifiable. If the cost cannot be measured reliably, then it cannot be 
recognized as an asset. 
It is thus clear that none of the conditions is satisfied by internally generated goodwill or 
inherent goodwill. The reasons are simple to explain. First, it is not an identifiable resource 
like patent, trademark or copyright. Second, it is very difficult to assess its future benefits. 
Finally, the cost of internally generated goodwill cannot be reliably measured in the absence 
of any consideration in money or money’ worth. There is no documentary evidence to support 
the value of goodwill as a resource. 
Goodwill should be recorded in the books only when some consideration in money or money’ 
worth has been paid for it. Accordingly, on admission or retirement/death of a partner or even 
when there is a change in profit sharing ratio amongst the existing partners, goodwill should 
not be raised in the books of account of the partnership firm because no consideration in 
money or money’ worth has been paid for it. The conclusion is that only purchased goodwill 
should be recorded in the books of account whether the payment is made directly in cash or 
money’ worth. For example, ‘A’ and ‘B’ purchase the net assets (assets minus liabilities) of ‘C’ 
amounting to ` 2,50,000 for ` 3,00,000 in cash, the additional payment of ` 50,000 is a payment 
for goodwill in cash. It is a case of purchased goodwill (an asset) and can be validly recorded 
in the books of A and B. When no payment is made for the purchase of goodwill and goodwill 
account is raised in the books, it is a case of internally generated goodwill or inherent goodwill 
and as per Accounting Standards, it is not permitted. For example, in the event of 
reconstitution of the firm due to admission, or retirement or death of a partner or even a 
change in the profit sharing ratio without reconstitution, goodwill of the firm is evaluated. In 
© The Institute of Chartered Accountants of India
  
ACCOUNTING
1.44 
10.44 
such a situation, the value of goodwill should not be brought into books of account because 
it is inherent or self-generated goodwill since no money or money’ worth has been paid for 
it. The only way out is that the value of goodwill as calculated with the help of different 
valuation methods should be adjusted through capital accounts of the partner(s) of the firm. 
In no case the goodwill account is to be raised in the books of account, either on the 
reconstitution of the firm or change in the profit sharing ratio. 
The amount of goodwill is written off over a period of time. In case when the goodwill account 
exists at the time of reconstitution of firm, it should be written off immediately whether it is 
internally generated or goodwill has been bought for some consideration. 
2.2  METHODS FOR GOODWILL VALUATION 
There are three methods for valuation of goodwill 
1) Average profit basis,-Simple and Weighted 
2) Super profit basis,-Number of Year Purchase, Annuity basis, and Capitalization of Super 
Profit 
3) Capitalization basis- Average Profits 
(1) Average Profit Basis: In this case the average profits of past years are adjusted for 
any expected change in future. The number of year are decided on the basis of judgement 
and negotiation. 
? For averaging the past profit, either simple average or weighted average may be 
employed depending upon the circumstances. If there exists clear increasing or 
decreasing trend of profits, it is better to give more weight to the profits of the recent 
years than those of earlier years. But, if there is no clear trend of profit, it is better to 
go by simple average. 
? Let us suppose profits of a partnership firm for the last five years were 
` 
30,000,  
` 
40,000,
` 
50,000, 
` 
60,000 and 
` 
70,000. In this case, a clear increasing trend is noticed 
and therefore, average profit may be arrived at by assigning appropriate weights as 
shown below : 
1 2 3 4 = 2 × 3 
Year Profit Weight Weighted Profit 
 
` 
  
 
` 
  
1 30,000 1 30,000 
2 40,000 2 80,000 
© The Institute of Chartered Accountants of India
Page 5


10.41 
PARTNERSHIP AND LLP ACCOUNTS 
 
LEARNING OUTCOMES 
UNIT – 2:  TREATMENT OF GOODWILL IN 
PARTNERSHIP ACCOUNTS 
After studying this unit, you will be able to: 
? Understand when does the need for valuation of goodwill arise. 
? Learn the accounting of goodwill. 
 
 
Necessity for valuation of goodwill  
Change in profit 
sharing ratio 
Admission of  
partner 
Retirement or 
death of partner 
When business is 
dissolved or sold 
 
Methods of 
valuation of 
goodwill
Annuity 
basis
Super profit
Capitalization 
basis
Average 
profit
UNIT OVERVIEW 
© The Institute of Chartered Accountants of India
  
ACCOUNTING
1.42 
10.42 
2.1  GOODWILL 
Goodwill is the value of reputation of a firm in respect of profits expected in future over and 
above the normal rate of profits. 
In simpler terms, Goodwill is nothing more than the probability that old customer will resort 
to old place again and again. The capacity of a business to earn super profits in the future is 
basically what is meant by term goodwill. Goodwill is an intangible asset; it cannot be seen; 
it cannot be felt; it cannot be transported physically. Even then it is very real. From 
accounting point of view, it is necessary that it has some monetary or saleable value. The 
implication of the term over and above is that there is always a certain normal rate of profits 
earned by similar firms in the same locality. The excess profit earned by a firm may be due to 
its locational advantage, better customer service, possession of a unique patent right, personal 
reputation of the partner or for similar other reasons. The necessity for valuation of goodwill 
in a firm arises in the following cases: 
a) When the profit sharing ratio amongst the partners is changed; 
b) When a new partner is admitted; 
c) When a partner retires or dies; and 
d) When the business is dissolved or sold. 
Let us take a simple example. There is a small Book business owned by a firm. Its net worth 
i.e. Asset–liabilities, is ` 140,000. Now if a purchaser is willing to pay ` 150,000 for it, the extra 
` 10,000 is known in accounting as goodwill. The next question is: Why the purchaser is willing 
to pay ` 10,000 for goodwill.  
One reason may be the future capability of the business to earn more profit than the normal 
profit. It may be on account of favourable location.  
The major factors which affect value of goodwill are as follows: 
The list is in no way exhaustive but only provides the basic guidelines: 
(i) The quality of the goods sold.  
(ii) The personal reputation of the owners i.e., their ability to attract the customers.  
(iii) The location of the business premises e.g., a good position in a congested market.  
(iv) The possession of near monopoly right e.g. main agent for a particular vehicle like, 
Maruti car, Bajaj scooter, etc.  
(v) The possession of trademarks and patents. 
(vi) The presence of managerial skill.  
© The Institute of Chartered Accountants of India
10.43 
PARTNERSHIP AND LLP ACCOUNTS 
(vii) The cost of research and development which enables the production at low cost and 
of good quality.  
(viii) The possession of special contracts for the availability of materials 
RECOMMENDATION OF ACCOUNTING STANDARD 
Accounting Standards require an enterprise to recognize an intangible asset, only if and only 
if, certain conditions are satisfied, namely: 
(i) An intangible asset must have the characteristics of an asset. It means that it must 
have some value and must be clearly identifiable, so that it can be sold without 
disposing other assets or future benefits flowing from other assets. 
(ii) An intangible asset should be recognized only if the future probable economic 
benefits (i.e., increased revenue from sales) will flow to the business enterprise and 
not to others. It means that management can make reasonable estimates of future 
benefits. 
(iii) The cost of the intangible asset can be measured reliably, that is, the cost is 
objectively verifiable. If the cost cannot be measured reliably, then it cannot be 
recognized as an asset. 
It is thus clear that none of the conditions is satisfied by internally generated goodwill or 
inherent goodwill. The reasons are simple to explain. First, it is not an identifiable resource 
like patent, trademark or copyright. Second, it is very difficult to assess its future benefits. 
Finally, the cost of internally generated goodwill cannot be reliably measured in the absence 
of any consideration in money or money’ worth. There is no documentary evidence to support 
the value of goodwill as a resource. 
Goodwill should be recorded in the books only when some consideration in money or money’ 
worth has been paid for it. Accordingly, on admission or retirement/death of a partner or even 
when there is a change in profit sharing ratio amongst the existing partners, goodwill should 
not be raised in the books of account of the partnership firm because no consideration in 
money or money’ worth has been paid for it. The conclusion is that only purchased goodwill 
should be recorded in the books of account whether the payment is made directly in cash or 
money’ worth. For example, ‘A’ and ‘B’ purchase the net assets (assets minus liabilities) of ‘C’ 
amounting to ` 2,50,000 for ` 3,00,000 in cash, the additional payment of ` 50,000 is a payment 
for goodwill in cash. It is a case of purchased goodwill (an asset) and can be validly recorded 
in the books of A and B. When no payment is made for the purchase of goodwill and goodwill 
account is raised in the books, it is a case of internally generated goodwill or inherent goodwill 
and as per Accounting Standards, it is not permitted. For example, in the event of 
reconstitution of the firm due to admission, or retirement or death of a partner or even a 
change in the profit sharing ratio without reconstitution, goodwill of the firm is evaluated. In 
© The Institute of Chartered Accountants of India
  
ACCOUNTING
1.44 
10.44 
such a situation, the value of goodwill should not be brought into books of account because 
it is inherent or self-generated goodwill since no money or money’ worth has been paid for 
it. The only way out is that the value of goodwill as calculated with the help of different 
valuation methods should be adjusted through capital accounts of the partner(s) of the firm. 
In no case the goodwill account is to be raised in the books of account, either on the 
reconstitution of the firm or change in the profit sharing ratio. 
The amount of goodwill is written off over a period of time. In case when the goodwill account 
exists at the time of reconstitution of firm, it should be written off immediately whether it is 
internally generated or goodwill has been bought for some consideration. 
2.2  METHODS FOR GOODWILL VALUATION 
There are three methods for valuation of goodwill 
1) Average profit basis,-Simple and Weighted 
2) Super profit basis,-Number of Year Purchase, Annuity basis, and Capitalization of Super 
Profit 
3) Capitalization basis- Average Profits 
(1) Average Profit Basis: In this case the average profits of past years are adjusted for 
any expected change in future. The number of year are decided on the basis of judgement 
and negotiation. 
? For averaging the past profit, either simple average or weighted average may be 
employed depending upon the circumstances. If there exists clear increasing or 
decreasing trend of profits, it is better to give more weight to the profits of the recent 
years than those of earlier years. But, if there is no clear trend of profit, it is better to 
go by simple average. 
? Let us suppose profits of a partnership firm for the last five years were 
` 
30,000,  
` 
40,000,
` 
50,000, 
` 
60,000 and 
` 
70,000. In this case, a clear increasing trend is noticed 
and therefore, average profit may be arrived at by assigning appropriate weights as 
shown below : 
1 2 3 4 = 2 × 3 
Year Profit Weight Weighted Profit 
 
` 
  
 
` 
  
1 30,000 1 30,000 
2 40,000 2 80,000 
© The Institute of Chartered Accountants of India
10.45 
PARTNERSHIP AND LLP ACCOUNTS 
3 50,000 3 1,50,000 
4 60,000 4 2,40,000 
5 70,000 5 3,50,000
  
15 8,50,000 
So, Weighted Average Profit = 
8,50,000
15
 = `   56,667 (approx) 
If goodwill is valued at three years’ purchase of profit, then in this case the value of goodwill 
is ` 56,667 (approx) × 3 = ` 1,70,000. 
However, if any such trend is not visible from the figures of past profits, then one should take 
simple average profit and calculate goodwill accordingly. Let us suppose, profits of a 
partnership firm for five years were ` 30,000, ` 25,000, ` 20,000, ` 30,000 and ` 28,000. In this 
case, there is no clear increasing or decreasing trend of profit. So average profit comes to  
` 26,600 (arrived at by taking simple average). If the goodwill is valued by taking three years’ 
of purchase of profit, the ninth is case, value of goodwill becomes ` 79,800. 
Weighted average is used when profit has increasing or decreasing Trend. Highest weight is 
always given to current year, as it reflects the more realistic view of the future profitability 
Example 
The past profits of five years of a partnership firm are: ` 50,000; ` 40,000; ` 52,000; ` 48,000 
and ` 56,000 respectively. Calculate the value of goodwill on the basis of 4 years’ purchase of 
the average profits of the last five years. 
Answer 
Total profits for five years = ` (50,000 + 40,000 + 52,000 + 48,000 + 56,000) = ` 2,46,000 
Average profit = Sum of profits/No. of years 
Average Profit = ` 2,46,000 ÷ 5 = ` 49,200 
Value of goodwill (being four years’ purchase of the average profit of five years) = 4 ×  
` 49,200 = ` 1,96,800. 
(2) Super Profit Basis: In case of super profit method, goodwill is valued on the basis of 
super profits earned by the firm. 
Super Profit=Actual Profit-Normal Profit 
Actual Profit is average maintainable profit  
Normal Profit=Normal rate of Return (NRR) x Capital Employed 
 
© The Institute of Chartered Accountants of India