Hello! Let's dive into the next crucial step in the admission of a partner: accounting for goodwill.
In our last lesson, you mastered the calculation of the new profit-sharing ratio and, most importantly, the sacrificing ratio. We established that when a new partner joins, the old partners give up a portion of their future profits. Today, we'll see how they are compensated for this sacrifice.
This lesson directly addresses the learning outcome: Account for goodwill on admission using the premium method (cash) and adjustment through capital accounts (non-cash). You will learn the specific journal entries required to record the goodwill brought in (or not brought in) by the new partner and how to distribute it correctly among the old partners using the sacrificing ratio you now know how to calculate.
Why is Goodwill Adjusted on Admission?
When a new partner joins an established firm, they benefit from the firm's reputation and customer base, which were built over time by the old partners. This allows the new partner to start earning profits immediately, a benefit they wouldn't have if they started a new business from scratch.
To compensate the old partners for the future profits they are sacrificing, the new partner contributes an amount for goodwill. This amount is often called Premium for Goodwill.
ADMISSION - Accounting for Goodwill | Class 12 | Accounts | Part 3
To start, let's watch a short explanation of why this goodwill compensation is necessary and how the new partner's share of goodwill is determined.
Watch the video from 01:16 to 03:46. The speaker, Rajat Arora, explains the logic behind a new partner bringing in their share of goodwill.
A Crucial First Step: Dealing with Existing Goodwill
Before we record the new partner's goodwill, we must check one thing: does goodwill already appear as an asset in the firm's Balance Sheet?
If it does, accounting standards require that this existing goodwill must be written off among the old partners in their old profit-sharing ratio. This is done to avoid any dispute with the new partner, who might object to paying for goodwill that was already valued and recorded in the books.
Admission of a Partner | Chapter 3 | Accountancy Class 12 | Part 3
This is a critical preliminary step. Let's watch an explanation of why we write off existing goodwill and the journal entry required to do so.
Watch this section from 05:53 to 10:38. Focus on the rationale provided for writing off existing goodwill and the journal entry passed.
The journal entry to write off existing goodwill is:
| Date | Particulars | L.F. | Debit (₹) | Credit (₹) |
|---|---|---|---|---|
| Old Partners' Capital A/cs (Individually) Dr. (In Old Profit Sharing Ratio) |
xxx | |||
| To Goodwill A/c | xxx | |||
| (Being existing goodwill written off) |
With that preliminary step covered, let's move to the main accounting treatments for the new partner's goodwill.
Method 1: The Premium Method (Goodwill Brought in Cash)
This is the most common scenario. The new partner brings their capital and their share of goodwill in cash (or by cheque). The accounting involves two main journal entries.
-
For receiving the cash/cheque for capital and goodwill:
Date Particulars L.F. Debit (₹) Credit (₹) Bank A/c Dr. xxx To New Partner's Capital A/c xxx To Premium for Goodwill A/c xxx (Being capital and goodwill premium brought in) -
For distributing the goodwill premium to the old partners: This is where your knowledge of the sacrificing ratio becomes essential. The premium is transferred from the "Premium for Goodwill" account to the capital accounts of the sacrificing partners in their sacrificing ratio.
Date Particulars L.F. Debit (₹) Credit (₹) Premium for Goodwill A/c Dr. xxx To Sacrificing Partners' Capital A/cs (Individually)
(In Sacrificing Ratio)xxx (Being goodwill premium distributed)
Let's see this in action.
ADMISSION - Accounting for Goodwill | Class 12 | Accounts | Part 3
This part of the video will walk you through the journal entries for the premium method.
Watch from 05:29 to 08:07. Pay close attention to the two distinct entries and the emphasis on using the sacrificing ratio for the distribution.
What if the partners withdraw the goodwill amount?
Sometimes, the old partners decide to withdraw the goodwill amount credited to their accounts. This requires a third journal entry.
| Date | Particulars | L.F. | Debit (₹) | Credit (₹) |
|---|---|---|---|---|
| Sacrificing Partners' Capital A/cs (Individually) Dr. | xxx | |||
| To Bank A/c | xxx | |||
| (Being goodwill amount withdrawn by partners) |
This entry simply reduces the partners' capital and the firm's bank balance.
Test your understanding!
A and B are partners sharing profits 3:2. They admit C for a 1/4th share. C brings in ₹1,00,000 as capital and ₹20,000 as premium for goodwill. The new ratio is 2:1:1.
Pass the necessary journal entries for the treatment of goodwill.
Show answer
Step 1: Calculate the Sacrificing Ratio
Sacrificing Ratio = Old Ratio - New Ratio
- A's Sacrifice =
- B's Sacrifice =
- The Sacrificing Ratio is A:B = 2:3.
Step 2: Distribute the Goodwill Premium
- A's Share =
- B's Share =
Step 3: Journal Entries
| Date | Particulars | L.F. | Debit (₹) | Credit (₹) |
|---|---|---|---|---|
| (i) | Bank A/c Dr. | 1,20,000 | ||
| To C's Capital A/c | 1,00,000 | |||
| To Premium for Goodwill A/c | 20,000 | |||
| (Being capital and goodwill premium brought by C) | ||||
| (ii) | Premium for Goodwill A/c Dr. | 20,000 | ||
| To A's Capital A/c | 8,000 | |||
| To B's Capital A/c | 12,000 | |||
| (Being goodwill premium credited to sacrificing partners in 2:3 ratio) |
Method 2: Adjustment via Capital Accounts (Goodwill NOT Brought in Cash)
What happens if the new partner is unable to bring their share of goodwill in cash? The compensation still needs to be made. In this case, we pass an adjustment entry directly through the partners' accounts.
The entry debits the new partner's account and credits the sacrificing partners' accounts.
| Date | Particulars | L.F. | Debit (₹) | Credit (₹) |
|---|---|---|---|---|
| New Partner's Current A/c Dr. | xxx | |||
| To Sacrificing Partners' Capital A/cs (Individually) (In Sacrificing Ratio) |
xxx | |||
| (Being new partner's share of goodwill adjusted) |
Why the Current Account?
Debiting the new partner's Current Account instead of their Capital Account is the preferred method. It ensures that the new partner's capital contribution remains intact in the business. The debit balance in the current account signifies that the firm will recover this amount from the new partner's future share of profits.
ADMISSION - Accounting for Goodwill | Class 12 | Accounts | Part 3
Let's watch the explanation for when a partner cannot bring goodwill in cash.
Watch from 08:07 to 10:20. Note the use of the new partner's Current Account and the reasoning behind it.
Other Important Scenarios
A couple of other variations are worth noting:
- Goodwill Paid Privately: If the new partner pays the goodwill amount directly to the old partners outside the business, there is no journal entry in the firm's books. It's a private transaction.
- Goodwill Brought "in Kind": The new partner might contribute assets (like stock, machinery, etc.) for their share of goodwill. The accounting is similar to the premium method, but instead of debiting
Bank A/c, you debit the respectiveAsset A/cs.
For a full walkthrough of these scenarios with solved illustrations, you can refer to the following article.
Accounting Treatment of Goodwill in case of Admission of a ...
This GeeksforGeeks article, 'Accounting Treatment of Goodwill...', provides a great textual summary with clear journal entries and examples for all the cases we've discussed, including when goodwill is brought in kind or only paid in part.
Skim through this article to see the layout of journal entries for each case. Pay attention to: Case 1B: Goodwill brought in cash (Premium Method). Case 1C: Goodwill brought in kind. Case 1D: Goodwill not brought in cash. Case 2: How to handle problems when goodwill already appears in the books (our preliminary step).
Conclusion
Great job! You have now learned the complete accounting procedure for goodwill on the admission of a partner. This is a very common and important topic in your exams.
Key Takeaways:
- First Step: Always check for and write off any existing goodwill in the old partners' old profit-sharing ratio.
- Premium Method (Cash): When goodwill is brought in cash, use two entries:
Bank A/c Dr. To Premium for Goodwill A/cand thenPremium for Goodwill A/c Dr. To Sacrificing Partners' Capital A/cs(in SR). - Non-Cash Method: When goodwill is not brought in cash, pass a single adjustment entry:
New Partner's Current A/c Dr. To Sacrificing Partners' Capital A/cs(in SR). - The Sacrificing Ratio is non-negotiable: It is the only ratio used to distribute the new partner's goodwill contribution.
Preview of the Next Lesson:
In all the scenarios today, the value of goodwill was either given or you learned how to calculate it in previous lessons. But what if the value isn't stated at all? In our next lesson, we will tackle Hidden Goodwill, where you will learn to infer the value of goodwill from the partners' capital contributions and profit-sharing arrangements.