Treatment of Goodwill

The retiring or deceased partner has contributed to building the firm’s goodwill during their association with the firm. At the time of retirement or death, that partner is entitled to receive their share of the firm’s goodwill. The continuing partners benefit because they acquire the retiring partner’s share of future profits — so they must compensate the retiring partner for this gain. The compensation is paid in the gaining ratio (the ratio in which the continuing partners have gained the retiring partner’s share).

The accounting treatment depends on one key question: Does goodwill already appear in the books of the firm?

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Case 1: Goodwill already appears in the books

If goodwill is already shown as an asset in the firm’s balance sheet, it must be written off first. This is because the existing goodwill figure is old and may not reflect the current value. Writing it off removes it from the books.

Journal entry to write off existing goodwill:

Reason: Goodwill is an asset. When written off, it reduces the capital of all partners in their old ratio — including the retiring partner. This ensures that the retiring partner does not get compensated twice (once from the old goodwill and again from the new valuation).

After this write-off, the firm proceeds to record the retiring partner’s share of the revalued goodwill (as per Case 2 below).

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Case 2: Goodwill does NOT appear in the books (or after writing off the old goodwill)

The retiring partner’s share of goodwill is calculated and then adjusted through the continuing partners’ capital accounts. No goodwill account is opened in the books — the adjustment is done directly between partners’ capital accounts.

Step 1: Value the firm’s goodwill as per the partnership agreement.

Step 2: Calculate the retiring partner’s share:

Retiring partner’s share of goodwill = Firm’s total goodwill × Retiring partner’s profit share

Step 3: The continuing partners will bear this amount in their gaining ratio.

Journal entry:

Reason: The continuing partners are gaining the right to the retiring partner’s share of future profits. They pay for this gain by reducing their own capital and crediting the retiring partner’s capital. The retiring partner’s capital account thus increases by their share of goodwill, which will be paid out at settlement.

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Summary of the accounting treatment …