Admission of a Partner and Goodwill
Dineo and Kagiso share profits 3:2 and have capital balances of P240,000 and P160,000. They admit Lesego on 1 July, giving her a one-fifth share. Lesego contributes P150,000 cash, of which P60,000 is stated to be for goodwill. Before admission, the partnership's net assets at carrying amount are P400,000, but a valuation shows land is undervalued by P80,000. The partners agree that the goodwill brought in by Lesego should be retained in the business, and the land revaluation is to be recorded. Dineo is unsure whether the old partners' capital accounts should change and by how much.
1. Show the entries for the goodwill and the revaluation, and calculate each partner's capital balance after admission.
Read the worked answer
Goodwill brought in by Lesego: P60,000 cash. Since the goodwill is to be retained, it is credited to the old partners in their old profit-sharing ratio 3:2: Dineo P36,000, Kagiso P24,000. Lesego's capital is credited with the non-goodwill element only: 150,000 - 60,000 = P90,000.
Revaluation of land: gain P80,000 shared 3:2 - Dineo P48,000, Kagiso P32,000.
Capital accounts after admission:
- Dineo: 240,000 + 36,000 + 48,000 = P324,000
- Kagiso: 160,000 + 24,000 + 32,000 = P216,000
- Lesego: P90,000 Total capital = 324,000 + 216,000 + 90,000 = P630,000.
Check against net assets: original 400,000 + land uplift 80,000 + cash introduced 150,000 = P630,000. Agrees.
Note that Lesego's one-fifth share of the P630,000 total is P126,000, but her capital is only P90,000; the P36,000 difference is the goodwill she paid for the old partners' established reputation.
2. Explain why the goodwill is credited to the old partners rather than to all three, and what would change if the partners instead decided to write the goodwill off immediately.
Read the worked answer
Goodwill paid on admission compensates the existing partners for the value built up before the new partner arrived. Lesego has not contributed to that reputation, so crediting her with goodwill would give her a share of an asset she did not help create and would dilute the old partners unfairly. The 3:2 split reflects the ratio in which they shared the risks that built the business.
If the goodwill were written off immediately, it would be charged against all partners in the new profit-sharing ratio. The new ratio: Dineo and Kagiso retain 4/5 between them in 3:2, so Dineo 12/25, Kagiso 8/25, Lesego 5/25. Writing off P60,000 would reduce Dineo by 28,800, Kagiso by 19,200 and Lesego by 12,000. Lesego's capital would fall to P78,000. This is why the choice between retaining and writing off goodwill is not cosmetic: it shifts P12,000 of capital from the new partner to the old ones. Retaining goodwill keeps the asset on the statement of financial position, which is only acceptable if it is genuinely supported by earning power.
3. Advise on whether Lesego's one-fifth share is fairly priced, using the capital figures you calculated.
Read the worked answer
Total capital after admission is P630,000. A one-fifth interest is therefore P126,000. Lesego has contributed P150,000 in cash but has only P90,000 credited as capital, with P60,000 going to the old partners as goodwill. On the face of it she has paid P150,000 for an interest worth P126,000 - a premium of P24,000.
Whether that is fair depends on the value of the goodwill. If the business's future profits justify goodwill of P300,000 in total (Lesego's P60,000 being one-fifth), the price is reasonable. If profits are declining, she has overpaid. The old partners also benefit from the land revaluation, which was recognised before admission and so does not dilute Lesego - but she shares in it only through her one-fifth of total capital, not through a revaluation share.
Advice: obtain a profit-based valuation before agreeing. If the P60,000 goodwill cannot be supported, it should be reduced or written off, and the admission terms renegotiated. Recording goodwill without evidence overstates net assets and misleads future lenders.