Key Accounting Concepts: Goodwill & Depreciation
Goodwill: Partner Admission & Valuation
1. Meaning of Goodwill
Goodwill is an intangible asset that represents the value of a firm’s reputation, brand name, customer loyalty, favorable location, employee relations, and other non-physical advantages that allow it to earn higher-than-normal profits.
Definition:
According to the Institute of Chartered Accountants of India (ICAI),
“Goodwill is the value of the reputation of a firm which enables it to earn higher profits than the normal return on capital.”
2. Characteristics of Goodwill
Intangible: Cannot be touched or seen but has value.
Valuable: Represents future economic benefits.
Not a physical asset: It is not created by a specific transaction.
Arises over time: Built gradually through years of good service and customer satisfaction.
Subjective valuation: Different methods and assumptions may lead to different values.
3. Importance in Partner Admission
When a new partner is admitted into an existing partnership firm, goodwill plays a crucial role for several reasons:
A. Compensation for Existing Partners
The new partner gets a share in the reputation and future profits of the firm that existing partners have built over the years. Hence, the new partner must compensate existing partners for this share of goodwill.
B. Adjustment in Capital Accounts
Goodwill is either brought in cash by the new partner or adjusted through capital accounts. This maintains fairness and recognizes the efforts of the existing partners.
C. Ensures Fairness
Goodwill ensures that:
Existing partners are not at a loss due to the admission.
The new partner pays for the share of benefits he will receive.
4. Accounting Treatment for Admission
A. Goodwill Brought in Cash
If the new partner brings goodwill in cash:
Entry:
Cash A/c Dr.
To Premium for Goodwill A/c
Then the premium is transferred to old partners’ capital accounts in sacrificing ratio:
Entry:
Premium for Goodwill A/c Dr.
To Old Partners’ Capital A/c (in sacrificing ratio)
B. Goodwill Not Brought in Cash
Entry:
New Partner’s Capital A/c Dr.
To Old Partners’ Capital A/c (in sacrificing ratio)
5. Methods of Goodwill Valuation
Some common methods include:
| Method | Description |
|---|---|
| Average Profit Method | Goodwill = Average Profits × Number of Years’ Purchase |
| Super Profit Method | Goodwill = Super Profit × Years’ Purchase (Super Profit = Actual Profit – Normal Profit) |
| Capitalization Method | Goodwill = Capitalized Value – Net Assets |
| Annuity Method | Considers time value of money for super profits |
6. Example Scenario
Let’s assume A and B are partners sharing profits in 3:2. C is admitted for 1/4 share. Goodwill of the firm is valued at ₹40,000.
C’s share in goodwill = 1/4 × 40,000 = ₹10,000
If C brings ₹10,000 in cash, it is distributed to A and B in sacrificing ratio.
7. Conclusion on Goodwill
Goodwill is highly important at the time of admission of a new partner. It ensures that the value of the firm’s reputation is recognized, and the existing partners are fairly compensated for the share of profits they are sacrificing. Proper accounting of goodwill maintains transparency, trust, and fairness in partnership changes.
Depreciation Methods Explained
1. Introduction to Depreciation
Depreciation is the systematic reduction in the value of a fixed asset due to wear and tear, passage of time, obsolescence, or usage. It is treated as an expense in the accounting books to allocate the cost of an asset over its useful life.
2. Meaning of Depreciation
“Depreciation is the permanent and continuing diminution in the quality, quantity, or value of an asset.”
– Institute of Chartered Accountants of India (ICAI)
3. Importance of Depreciation
To match cost of asset with revenue generated (Matching Principle)
To ascertain true profit or loss
To show correct asset value in Balance Sheet
To create reserve for replacement of assets
To comply with accounting standards and taxation laws
4. Depreciation Methods
There are several methods used to charge depreciation. The most common ones are described below:
A. Straight Line Method (SLM)
Also called Fixed Installment Method.
Formula:
Depreciation per year = (Cost of Asset – Residual Value) / Useful LifeFeatures:
Same amount of depreciation is charged every year.
Simple and easy to apply.
Example:
Asset cost = ₹1,00,000, Residual Value = ₹10,000, Life = 5 years
Annual Depreciation = (1,00,000 – 10,000) / 5 = ₹18,000Best for: Assets with consistent use (e.g., furniture, buildings).
B. Diminishing Balance Method (WDV)
Formula:
Depreciation = Fixed Rate × Book Value at beginning of yearFeatures:
Depreciation decreases every year.
Book value never reaches zero.
Example:
Asset Cost = ₹1,00,000, Rate = 20%
Year 1: 20% of 1,00,000 = ₹20,000 → Balance: ₹80,000
Year 2: 20% of 80,000 = ₹16,000 → Balance: ₹64,000Best for: Machinery, vehicles, where repair costs rise with age.
5. Method Comparison Table
| Method | Depreciation Amount | Best Suited For |
|---|---|---|
| Straight Line Method | Same every year | Buildings, furniture |
| Written Down Value Method | Reduces every year | Machinery, vehicles |
| Units of Production | Based on actual use | Machines, power plants |
| Sum-of-Years-Digits | Higher in earlier years | Technology-heavy assets |
| Annuity Method | Equal annual charge | Leaseholds, large assets |
| Depletion Method | Based on extraction | Natural resources |
6. Conclusion on Depreciation
The choice of depreciation method depends on the asset type, its usage, and the accounting policy of the business. Proper depreciation ensures that profit is not overstated, and asset values remain realistic in the books.