The share of profit of old partner (either retired or deceased) is certainly taken by the existing partners for which they have to compensate the old partner. This compensated amount is known as Goodwill.
When a new partner is admitted, Goodwill of the business is valued again. The value of Goodwill is the value associated with the total business including the existing Goodwill. If the existing goodwill is not written off, it will have the effect of crediting partners with an excessive amount of Goodwill.
To put it in other words, if we want to carry forward existing Goodwill in the books, then the value of existing Goodwill should be deducted from the new value of Goodwill. This excess value of Goodwill must be credited to the existing partners capital accounts in their profit sharing ratio.
Goodwill to partners of a partnership firm.
Background: A partner of a firm is an owner or proprietor of a firm, as he has all the rights of the partnership firm formed by him or on account of other underlying factors, which may be;
1. Say a PF ( Partnership Firm) would have been started by a partner some years ago and would have established creditability, so when he is retiring, he will leave behind all his credibility which will give high to huge profits to the existing partners, which the existing or new partners cannot have established or cannot be established in the short period of time. So the outgoing partner is paid a sum of consideration, which is in nature if royalty, called goodwill.
2. There may be cases, a partner started a chartered accountant PF 2 to 3 decades ago, but at the time of his qualification, there were no such standards on accounting, auditing, digitalization, automation or such similar things. Now his clients want the only application of such new things as accounting standards, auditing standards, internal financial controls, digitalization, automation, ERP etc or such similar services. This old partner has no idea of these things, so he may induct a smart CA as a partner to his PF and pay the royalty for this latest knowledge and contribution to the new partner (the smart CA), this royalty is also called goodwill.
3. Now further elaborating on point no. 2, both the old and new partners are continuing the PF, after some time the old partner decides to retire, so he may or can demand a goodwill for setting up such a wonderful PF, with all reputation of delivering services of experience and latest trends (that means, accounting standards, auditing standards, internal financial controls, digitalization, automation, ERP etc ).
4. Another reason for point no.3 is the new partner joining in cannot enjoy the profits generated by the PF if the new partner(s) were to start a new PF on their own, so the outgoing partner can ask the incoming partner to bring in more capital and pay the outgoing partner the goodwill.
5. There can be a scenario where the (smart CA) can ask the new incoming partners, that he has also contributed a lot to generate huge economic resources, past, current and for the future to the PF by his valuable contribution. The reason there can be the same as in point no. 4.
6. There may be cases where an existing PF is acquired by another PF, then there may be conditions where the new PF may ask the all or some of the partners to resign, in such cases the existing partners can demand goodwill or the new PF will suo moto pay goodwill to the existing partners. The reason there can be the one pointed in point no.4 above.
7. Goodwill need not be paid in one lump sum, it can be fixed at a certain amount, but paid in instalments or as and when cash is available in the PF. In this case, the goodwill is recognized in the same year, only payment is deferred.
8. Or it can be agreed that he will be paid for the next 5 or 10 years at a fixed amount each year or at a certain percentage of profit generated by the PF for the next 5 to 10 years and paid at the end of each year. In these cases, goodwill is recognized only in such years after determination of profits on closing the books of accounts. Alternatively, the first payment can be capitalized as goodwill and subsequent payments can be charged to expenses.
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Conclusion: So it is not necessary that only the outgoing or retiring partners need to be paid goodwill. There can be many such cases generated based on the above approach.
Did you Know?
What is the nature of partners capital account?
Answer: Partners’ capital accounts are contemplated as shareholders equity. They are neither assets nor liabilities.