Tom and Jerry have had a meeting and have decided that to continue the success of the business while lacking accounting skills for business, they need to admit Spike into the partnership, as he can bring in his expertise in managing business finances and accounting skills. Spike is also introducing £30,000 of capital into the partnership.
Tom and Jerry’s profit share ratio was always 50:50, but with the admission of Spike, they have opted to split their profits 2:2:1 respectively.
Spike is joining the existing partnership, whereas before he was his own boss, so he will benefit from the reputation which they have created, along with their existing customer base. To make an allowance for this benefit, Spike will be charged a premium of goodwill.
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What is goodwill?
Goodwill is the difference between the business’s collective value and the net value of its assets and liabilities.
This happens because as the business trades successfully:
- It builds up a good reputation
- It develops its customer base
- The workforce’s skills have been developed
- The business location is established
First, a valuation of goodwill needs to be agreed. Tom and Jerry have valued the goodwill at £50,000.
Goodwill is an intangible asset, so we need to create an account for this. This needs to be increased (debited) with the £50,000.
The credit entry is to the existing partners’ capital accounts and is increasing the amount of capital in these accounts. The £50,000 goodwill needs to be split in the 50:50 profit share ratio.
This goodwill now needs to be written off. So the £50,000 is credited to the goodwill account in the new profit share ratio.
The balance on the goodwill account is now zero. The debit entry is to all members of the partnership (including the new partner): this reduces their capital account. The £50,000 is split between the partners in the new profit sharing ratio.
Why open and close the goodwill account?
Tom had a balance on his capital account of £40,000. It was then increased to £65,000 with the added value of goodwill.
When the goodwill is written off, it is written off in the new profit share ratio. For Tom, only £20,000 is written off.
The net effect of this is that Tom’s capital account has increased by £5,000. So, because of the business that Tom and Jerry had built before Spike joined, Tom has an additional £5,000 capital – this is exactly the same for Jerry.
What is the effect for Spike?
When Spike joined the partnership, he introduced £30,000 capital. Once the goodwill has been written off, his capital account is only worth £20,000. This is because he has been charged a premium of £10,000 goodwill for joining an existing business partnership.
Accounting skills to run your own business and bookkeeping skills for business owners are covered in greater depth within the Accounting Fundamentals for Small Businesses course.