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Saturday, July 31, 2010

Goodwill in Partnership Accounts

From the accountants’ viewpoint, goodwill, in the sense of attracting custom, has little significance unless it has a saleable value. To the accountant, therefore, goodwill may be said to be that elements arising from the reputation, connection or other advantages possessed by a business which enables it to earn grater profits than the return normally to be expected on the capital represented by the net tangible assets employed in the business. In considering the return normally to be expected, regard must be had to the nature of business, the risks involved, fair management remuneration and any other relevant circumstances.

The goodwill possessed by a firm may be due, inter Alia, to the following:
  • The location of the business premises.
  • The nature of the firms’ products or the reputation of its service.
  • The possession of favorable contracts, complete or partial monopoly.
  • The personal reputation of the partners.
  • The possession of efficient and contented employees.
  • The possession of trade marks, partners or well known business name.
  • The continuance of advertising campaigns.
  • The maintenance of the quality of the firms’ product, and development of the business with changing conditions.
  • Freedom from legislative restrictions.

Although a firm may possess goodwill, it is not customary to raise an accountant for it in the books expected to the extent that cash or other assets of the firm have been used to pay for it. It follows, therefore, that when goodwill exists and is unrecorded in the books, the capitals of the partners of the firm are under stated to the extent of the value of their respective share of the goodwill.

Even though a goodwill account may at some time have been raised in the books, the goodwill account would not be adjusted to give effect to every variation in its value, and in most cases, therefore, the partners’ capitals are at all times understated or overstated in the books to some extent by their shares of the unrecorded appreciation or depreciation in the value of goodwill.
As the amount by which goodwill is undervalued or overvalued in the books is a profit or loss to be shared by the partners in their agreed profit sharing ratio, any alteration in the proportions in which profits and losses are shared, without first making an adjustment on the book value of goodwill, will result in an advantage to one or more partners and a disadvantage to others.

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