This is defined as the advantage, whatever it may be, a person gets by continuing to be entitled to represent to the outside would that he is carrying on a business which has been carried on for sometime previously. “Judge Warey in Hull V Frases”
Goodwill is the element that arises from a business due to its reputation and therefore, enjoys benefits that a new business may not get. (e.g.) A new business may not make profits easily during the first year of trading.
Factors that contribute to goodwill
1. Quality of products/Services
2. Good personnel
In accounting, goodwill is very important for ascertaining the element or the share of a partner’s effort to improve the business. The problem is normally to ascertain the value or cost of goodwill.
There are two types of goodwill:
- Non-Purchase goodwill
Non- purchased goodwill is determined by using subjective estimates. There are various approaches to these. Goodwill maybe arrived at by taking the average profits for lets say three previous years of trading.
Due to this subjective estimate, this type of goodwill is not maintained or shown in the accounts.
- Purchased goodwill
This is less subjective because it is the excess amount paid for a business above its net assets. This is less subjective because it is the excess amounts paid for a business above its net assets.
(e.g) If a business pays Sh.3.5 m to acquire the net assets (i.e. in these case the net assets will be total assets less total liabilities) of another business that is still trading on and the value of the net asset is 3 M, therefore the purchased goodwill may be
shown in the accounts as an intangible asset. Purchased goodwill can be treated in the following three main ways:
- Goodwill is written off from the accounts
- Is carried at its value an amortized over a period of time
- Carried at its value without being amortized.
The practice is normally to carry it in the accounts together with the other assets (as an intangible asset) and amortize it over estimated period of time. In a partnership, there are normally three situations where goodwill is accounted for in the
- If there is a change in the profit sharing ratio.
- On admission of a new partner.
- On retirement of an old partner.
Example (when there is a change in profit sharing ratio) When there is a change in the profit sharing ratio, then goodwill is introduced in the accounts by Dr. Goodwill account Cr. Partner’s capital account (the credit is based on the old profit sharing ratio.)
The goodwill may remain in the accounts and therefore no partner entries will be made. If the goodwill is to be written off from the accounts, this will be done by Debiting partner’s capital account (in the new profit sharing ratio) Crediting goodwill account