Hidden Goodwill in case of Retirement of a Partner

Goodwill is an intangible asset that is either self-generated or purchased. It is the value of benefits that a business has because of the factors that help in increasing its profitability say its location, favourable contracts, access to supplies and customer loyalty, etc. Goodwill is the reputation earned by the business through hard work, honesty and quality, and satisfactory services to customers. The efforts and hard work done by the existing partners frame the goodwill of the firm.

” Goodwill is the probability that the old customers will resort to the old place.”  – Lord Eldon

What is Hidden Goodwill?

At the time of retirement of a partner, when the value of goodwill is not given or mentioned, it is called hidden or inferred goodwill. Hidden goodwill is calculated based on the inferred method of profit-sharing ratio or capitalization. Hidden goodwill is not specified with the amount of capital that the retiring partner is to be paid for as his/her share in the firm. Goodwill is inferred with the share of capital paid to the retiring partner.

At the time of retirement of the partner, the excess of the amount paid to the concerned retiring partner to the amount due to him is the hidden goodwill of his share in the firm’s goodwill. Amount due to him/her is the adjusted capital, i.e. capital, revaluation of assets and reassessment of liabilities, share in reserves, undistributed profit, accumulated loss, etc. The remaining partner decides and agrees to pay the retiring partner in full settlement of his/her claim in excess including his share in goodwill of the firm without specifically mentioning the amount as his goodwill share. This is done either as a way of appreciation for his work and dedication to the firm or as a treatment of goodwill in a hidden form.

Calculation of Hidden Goodwill:

Step 1: Calculate the gaining ratio of the remaining partners.

Gaining Ratio = New Ratio – Old Ratio

Step 2: Calculate the adjusted capital of the retiring partner. Adjusted capital is calculated after making adjustments related to revaluation, undistributed profit and reserves, and accumulated losses.

Step 3: Calculate the share of hidden goodwill of the retiring partner.

Hidden Goodwill = Amount given to Retiring partner – Actual amount to be paid

Step 4: Retiring partner share in goodwill, i.e. hidden goodwill is accounted for by debiting the remaining partner’s capital account and crediting the retiring partner’s capital account.

Journal entry passed at the time of retirement of a partner:

Illustration 1: 

Suman, Ankita, and Sarita are partners in the firm sharing profit and loss in the ratio of 5:3:2. Ankita retires, and her capital stood at ₹3,64,500, after adjustments related to reserves, undistributed profits, and profit on revaluation. Suman and Sarita decided and agrees to pay Ankita ₹3,80,000 in full settlement of Ankita’s claim. Suman and Sarita decided to share their future profit sharing ratio to be 6:4. Pass the necessary journal entry.

Solution:

Hidden Goodwill = Amount given to Retiring partner – Actual amount to be paid

Ankita’s share of Goodwill = ₹3,80,000 – ₹3,64,500

= ₹15,500

Working Notes:

Calculation of gaining ratio:

Illustration 2: 

C, D, and E are partners in the firm sharing profit and loss in the ratio of 3:2:1. C retires from the firm on 31st March 2022. C’s capital after adjusting undistributed profit and loss, reserves, and revaluation is ₹87,100. D and E agree to pay ₹94,000 in full settlement of C’s claim on his retirement. Record Journal entries for the treatment of goodwill. D and E agree to their future profit-sharing ratio to be the same.

Solution:

Working Notes:

Calculation of gaining ratio: