Accountancy · Ch 3 — Reconstitution of a Partnership Firm — Admission of a Partner
Need for Valuation of Goodwill
Need for Valuation of Goodwill
The need to value goodwill does not arise every day in a partnership. It becomes necessary only when the firm undergoes a change in its constitution — that is, when the existing agreement between partners is altered in a way that affects their mutual rights and claims.
The most obvious situation is the sale of the business as a going concern. When a business is sold, the buyer pays not just for the tangible assets but also for the firm's ability to earn super profits in the future — that extra payment is goodwill. However, in a partnership firm, the need for valuation arises in several specific internal events, even when the business is not being sold to an outsider.
Here are the circumstances, exactly as listed in the textbook:
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Change in the profit-sharing ratio amongst the existing partners. When partners simply agree to share future profits in a new ratio, the partner who gains a higher share is effectively buying a portion of the other partner's share. The gaining partner must compensate the sacrificing partner for the value of goodwill that the sacrificing partner gives up.
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Admission of a new partner. This is the most common context in your syllabus. The new partner brings in capital but also acquires a right to share in the firm's future profits. Since the firm's existing goodwill has been built by the old partners, the new partner must compensate them for this right. This is done by bringing in a premium for goodwill.
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Retirement of a partner. When a partner leaves, the remaining partners continue the business. The retiring partner is entitled to his or her share of the firm's goodwill, because that value was created during his or her tenure. The continuing partners (who will now enjoy the higher profits) must pay the retiring partner for this share.
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Death of a partner. The legal heirs of the deceased partner are entitled to the deceased partner's share of goodwill, exactly as in the case of retirement. The amount is credited to the deceased partner's capital account and paid to the estate.
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Dissolution of a firm involving sale of business as a going concern. If the firm is dissolved but the business is sold as a running enterprise (not piecemeal), the sale price will include goodwill. The partners need to value it to determine the total amount to be distributed among themselves. …