Principles of Accounting: Goodwill and Partnership businesses

• Now that we have explained the idea of goodwill
• It is time we examine the concept of goodwill in relation with partnerships
• As already explained accounting standards require that goodwill be recorded only when a business is bought or sold
• Partnership business are special in their nature:
• Technically a partnership business ceases to exist when the following happens:
  • One partner dies
  • A partner leaves the partnership
  • A new partner is admitted
  • When there is a change in the profit sharing ratio among existing partners
• It is often the case that when either of these events occur the partners will continue in business
• However from an accounting and legal standpoint it means the business was in essence “sold” by the old partners and “sold” to the new partners
• For this reason it is necessary to account for goodwill when either one of these things occur in a partnership business
• This is because even though it is not recorded goodwill already exist in a business before it is sold/bought
• Unless it has been agreed differently, partners own a share in the goodwill in the same ratio in
  which they share profits
• Each partner therefore is entitled to their share of goodwill up to the point where change occurs
• To reiterate this is true even if there is no goodwill account i.e. goodwill is not on the books
• When these changes occur it essentially means one of the partners is giving up their share of goodwill
• To make sure that they get something in return partnership changes such as those above are accompanied by certain entries
• These goodwill entries are unique to partnerships

Illustration

• To drive home this point consider two partners A and B who share profits equally
• If their business were to be sold today for $20 000 above the net asset price
• Each would be entitled to $10 000 share of goodwill
• However if they change their profit sharing ratio to A 25% and B 75%
• A would be entitled to $5 000 and B $15 000
• In essence A has lost $5 000 merely due to the change in ratios
• Entries have to be made in the books to make sure that this does not happen

To access more topics go to the Principles of Accounts Notes.