Goodwill (Cambridge International A-Level Accounting)

Spec point — goodwill and the difference between purchased goodwill and inherent goodwill

Goodwill

What is goodwill?

• Goodwill is an intangible non-current asset
• It has no physical existence
• It cannot be sold separately from the business

Why might a business have goodwill?

• The following are reasons why a business might have goodwill

  • A good reputation, well-known brand and strong image
  • Having many loyal customers
  • Having good relationships with suppliers
  • Being in a good location
  • Having experienced and efficient employees

What is the difference between inherent and purchased goodwill?

• Inherent goodwill is internally generated

  • A business gains this naturally over time by their continued efforts

• Inherent goodwill is not included in the financial statements or maintained in the book of accounts because:

  • its valuation is highly subjective as there is not an agreed formula to measure it
  • the assets of a business should not be overstated according to the prudence concept
  • the factors that create goodwill (like reputation) are difficult to measure in monetary terms

• Purchased goodwill is gained when a business is purchased or taken over by another business

• Purchased goodwill is calculated by subtracting the fair value of the net assets from the price paid

• Purchased goodwill is included in the financial statements and maintained in the book of accounts

Why should I use a goodwill account for inherent goodwill?

• Use a goodwill account when there is a change in a partnership

  • change in the partners' profit-sharing ratio
  • introduction of a new partner
  • retirement of an existing partner
  • dissolution of a partnership

• The partners' capital accounts are adjusted so that the goodwill account can be immediately written off

  • The value of the goodwill is added to the partners' capital accounts using the old profit-sharing ratio

    • These are credit entries to the capital accounts

  • The goodwill is then eliminated by subtracting the value from the partners' capital accounts using the new profit-sharing ratio

    • These are debit entries to the capital accounts

What is the layout of a goodwill account?

• Goodwill is raised by making entries on the debit side

  • It is shared between the partners' capital accounts using the old ratio
  • It is on the debit side as it represents an asset

• Goodwill is written off by making entries on the credit side

  • It is shared between the partners' capital accounts using the new ratio

Layout of a goodwill account for inherent goodwill

Exam Hint You will not be asked to prepare a goodwill account for inherent goodwill. However, you can still use one if you find them helpful.

Worked Example Tom and Jerry are in a partnership and they share profits and losses equally.

On 1 January 2026, they changed their partnership agreement so that the profit and loss sharing ratio would be Tom 40% and Jerry 60%.

The balances on the capital accounts at 31 December 2025 were:

	$
Tom	40 000
Jerry	50 000

Goodwill was valued at two times the average profits of the last three years.

The profits for the last three years were:

	$
2025	42 000
2024	38 000
2023	31 000

Calculate the capital account balance of each partner at 1 January 2026.

Answer:

Calculate the average profit of the last three years

\frac{\ 42 000 + $ 38 000 + $ 31 000}{3} = $ 37 000$

Find the value of the goodwill

2 \times \ 37 000 = $ 74 000$

Calculate the share of the goodwill using the old ratio

Tom: \ 74 000 \div 2 = $ 37 000$

Jerry: \ 74 000 \div 2 = $ 37 000$

Calculate the share of the goodwill using the new ratio

Tom: \ 74 000 \times 40 % = $ 29 600$

Jerry: \ 74 000 \times 60 % = $ 44 400$

Calculate the new capital balances

• Add the share of goodwill using the old ratio
• Subtract the share of goodwill using the new ratio

	Tom $	Jerry $
Balance at 31 December 2025	40 000	50 000
Goodwill	37 000	37 000
Goodwill eliminated	(29 600)	(44 400)
Capital account at 1 January 2026	Final answer: 47 400	Final answer: 42 600