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Principles and Practice of Accounting > Treatment of Goodwill > Accounting treatment of Goodwill- Change in PSR.
Treatment of Goodwill

Accounting treatment of Goodwill- Change in PSR.

Goodwill represents the reputation of a firm. Which provides some extra benefits/profits in the future in comparison to other firms. It builds up when the business has continued for some time. This is treated as intangible assets in accounts. It is not a fictitious asset. Goodwill may be defined as the value of a firm. Let us learn about the treatment of goodwill after a change in PSR.

Accounting treatment of Goodwill

The need for the valuation of goodwill in a firm arises in the following cases:

  1. When the profit-sharing ratio (PSR) of  partners is changed;
  2. In case of a new partner is admitted;
  3. In case of death or retirement of a partner;
  4. When the entire business is sold;

In each of the above situation, the Goodwill adjustment is required. So we value Goodwill by selecting any of the following methods.. The methods for valuation of the Goodwill:

  • Average profit method
  • Super profit method
  • Capitalization method

Now we are going to discuss accounting treatment when there is a change in the profit sharing ratio (PSR) of partners.Change in PSR

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Accounting treatment in case of the change in Profit Sharing Ratio (PSR)

When there is any change in the profit sharing ratio of partners, Goodwill is valued. One partner may gain a share of profit and others may sacrifice.

So, we adjust Goodwill through capital accounts of partners. Debit the Gaining partner’s capital account and credit the sacrificing partner’s capital account. The basis of this adjustment is the profit sacrificing ratio.

If partners decide to change the profit-sharing ratio in the future, the gaining partner shall compensate the losing partner in the agreed ratio. The compensation will be the value of goodwill represented by the gain.

The change in profit-sharing ratio represents that one partner is purchasing the share of profit from another partner. Suppose, X and Y, are partners sharing profits in the ratio of 3: 1 respectively. It is decided that in the future they will be equal partners; it means that X is selling to Y 1/4th share of profits.

Therefore, Y will pay X  an amount equal to one-fourth of the total Goodwill valued. In other words, suppose, the profit is Rs 120000, previously X would get Rs 90000 and Y would get Rs 30000. After the change in their agreed profit-sharing ratio, each would get Rs 60000, X loses annually Rs 30000 and Y gains Rs 30,000. If the goodwill is valued at Rs 300,000, X must pay to Y one-fourth of Rs 300,000 viz., Rs 75000.

Following is the journal entry:

Date Particular   Amount (Dr.) Amount (Cr.)
Partner’s capital A/c Dr. (gaining partners)
To Partner’s capital A/c (sacrificing partners)
(Being goodwill adjusted through partner’s capital account)

                                                   Learn various methods of Goodwill Valuation here. 

Solved Example on Change in PSR

Q: Ram, Shyam, and Bharat are partners who were sharing profits in the ratio of 6:5:2 respectively. On 1st April 2017, they, agree to become equal partners. The value of the firm’s goodwill is Rs 78,000. Pass the necessary adjustment entry.

Ans:

Date Particular   Amount (Dr.) Amount (Cr.)
2017
Apr 1 Bharat’s capital A/c Dr. 14000
To Ram’s capital A/c 10000
To Shyam’s capital A/c 4000
(Being goodwill adjusted through partner’s capital account)

Adjustment entry in respect of Goodwill on the change in profit sharing ratio by whichShyamm gains 7/39th share, Ram loses 5/39th share and Shyam loses 2/39th share; firm’s Goodwill being Rs.78000.

Working notes:

  • Old profit sharing ratio among Ram, Shyam & Bharat=6:5:2 or \(\frac{6}{13}\):\(\frac{5}{13}\):\(\frac{2}{13}\)
  • New profit sharing among Ram, Shyam & Bharat=1:1:1 or \(\frac{1}{3}\):\(\frac{1}{3}\):\(\frac{1}{3}\)
  • Bharat’s gain=\(\frac{1}{3}\)-\(\frac{2}{13}\) = \(\frac{7}{39}\)
  • Sacrifice by Ram=\(\frac{6}{13}\)-\(\frac{1}{3}\) = \(\frac{5}{39}\)
  • Sacrifice by Shayam= \(\frac{5}{13}\) – \(\frac{1}{3}\) =\(\frac{2}{39}\)
  • The ratio of sacrifice between Ram& Shayam=5:2
  • The total value of Goodwill=78000
  • Goodwill equal to Bharat’s gain=78000 x \(\frac{7}{39}\) =14000
  • Sacrifice by Ram=14000 x \(\frac{5}{7}\) = 10000
  • Sacrifice by Shyam=14000 x \(\frac{2}{7}\) =4000
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