Goodwill: Meaning, Need for Valuation, and Its Treatment on Admission

Goodwill is the money value of the reputation, customer loyalty and superior earning capacity that a firm has built up over the years of running its business — it is what allows an established firm to earn profits above the NORMAL return a similar new business could expect to earn in the same trade. This extra earning capacity is largely the result of the old partners' own years of effort, investment and relationship-building, well before the new partner ever joined.

When a new partner is admitted, he becomes entitled, from that date onward, to share in the firm's future profits — profits that will, in part, keep flowing precisely because of the reputation the old partners already built. Fairness therefore requires the incoming partner to compensate the old partners for the share of this built-up goodwill he will now silently benefit from — this compensation is called the PREMIUM FOR GOODWILL, and it is distributed among the old partners strictly in their sacrificing ratio (Section 2), never in the old profit-sharing ratio, if the two happen to differ.

Two situations commonly arise in AP Board of Intermediate Education (BIEAP) Class 12 Commerce Accountancy examinations:

(a) The new partner brings his share of goodwill in CASH, in addition to his capital. The cash is first recorded through a Premium for Goodwill Account, then transferred to the old partners' Capital Accounts in their sacrificing ratio: Bank A/c Dr (capital + premium); To New Partner's Capital A/c (capital only); To Premium for Goodwill A/c (premium only). Then: Premium for Goodwill A/c Dr; To Old Partners' Capital A/cs (in sacrificing ratio). Where the old partners are permitted to withdraw some or all of this premium in cash, a further entry follows: Old Partners' Capital A/cs Dr (amount withdrawn); To Bank A/c. …