Run through a scenario with our tutor on final accounts preparation after a partnership dissolves, and the accounting adjustments necessary to record significant changes in the ownership of a partnership.
Final accounts preparation when partnerships dissolve
- Part 1 – FAPR when partnerships dissolve, taking goodwill into account
- Part 2 – Accounting adjustments for significant changes in partnerships
This is the last of a number of articles I’ve written on partnership accounts. Previous pieces have looked at appropriation and current accounts and this article concludes the topic of goodwill and capital accounts, for those studying towards the AAT Advanced Diploma in Accounting.
By the end of part 1 – Final accounts preparation when partnerships dissolve, we had considered what goodwill is and how, as an intangible asset, it’s different to, and therefore accounted for separately from, the tangible assets of a business.
The articles are all based on a scenario in which you and I are in partnership. However, you’re leaving at the end of our fourth year of trading. This article therefore, focuses on the accounting adjustments required to record significant changes in the ownership of a partnership.
Example Partnership Scenario
Let’s just quickly re-cap how much the business owes you. You have £30,000 of long-term capital invested in the partnership:
The current accounts have been updated as part of the year end processes and show the partnership owes you £250 of short-term capital:
So the ‘financed by’ section of the statement of financial position shows that at the end of the year, your share of the business’s tangible assets is £30,250.
We also had the goodwill of the business valued at £12,000 and calculated that you’re owed £8,000 of it, which means you want to leave the partnership with £38,250 in total.
I haven’t got enough resources to buy you out though so we’ve reached an agreement whereby you will leave with £25,000 cash and lend the partnership the rest of your investment to be paid off over 12 months. I have also agreed with another local cafe owner that we will collaborate, so Sty will buy into the business for £18,000 and we will share the profits equally.
Significant changes within a partnership
I think you’ll agree we are now in the realms of significant changes with a partner leaving, another joining and a new profit sharing ratio. And when significant changes occur the business’s goodwill is valued and the capital accounts are utilised. Let’s see how it all works in practice, starting with you leaving and then, the following day, Sty joining.
We said in the previous article that goodwill is an intangible asset with a theoretical value and as such it is subjective and also changeable. Just think about the impact a few negative reviews on social media can have on a business’s reputation and you’ll understand what I mean. It’s because of the changeable nature of goodwill, that it’s only valued at a given time and for a specific purpose. It’s also why, in partnerships, it is accounted for in an account which is opened purely for the purpose of dividing it between the partners and dealing with the change. Then it is closed.
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Step 1 – Introducing goodwill
As goodwill is an asset, albeit intangible, its value is entered into the goodwill account on the debit side and double entered into the partner’s capital accounts as it increases the amount the partnership owes us. It’s shared between us using the existing profit ratio, in our case, 2:1 with you getting two thirds and me one third:
Step 2 – Consolidating the leaving partner’s capital
You want to take all of your investment out of the partnership so we need to consolidate what you’re owed in the short-term, with what you’re owed in the long-term. This is done by closing your current account and transferring the balance to your capital account:
Step 3 – Partner leaves
Now all of your capital is in the same place, we can make the adjustments to pay you off and set up the loan account, the combination of which will enable your capital account to be closed:
Step 4 – Eliminating goodwill
So that’s you gone! However, the goodwill account is still open and must be closed. Goodwill is always eliminated using the new profit sharing ratio. As I’m temporarily the sole owner, this means reducing the balance on both the goodwill and my capital account by the full £12,000:
You can see that the goodwill account is now closed and that the £8,000 of goodwill you have taken out of the partnership has been paid for out of my long-term capital which was increased by £4,000 but then reduced by £12,000.
Note: when a partner leaves they are not necessarily replaced, therefore, I have shown step 4 as an end point so that the following steps can be seen as the start of a separate process (although in this scenario, steps 4 and 5 could have been combined).
If we look afresh at the accounts we can see that there is a £12,000 balance on my capital account:
Replacing your previous partner…
Step 5 – Introducing goodwill before a new partner joins
A new partner joining is a significant change so the goodwill needs introducing before Sty can join. This is because he will buy a share of the goodwill as part of buying into the partnership:
Step 6 – New partner joins
Sty invests in the partnership:
Step 7 – Eliminating goodwill
Our new profit sharing ratio of 50:50 is now used to eliminate the goodwill:
You can see that the goodwill account is closed and that whilst Sty paid £18,000 into the bank account, his initial investment is only £12,000. This is because he has in effect paid me £6,000 in recognition of the goodwill at this time.
Hopefully, the new partnership will flourish and our profitability and reputation will grow. If they do, the value of the partnership’s intangible assets will increase and when there is another significant change this will be reflected in the value of the goodwill.
Read more on final accounts preparation;
- Final Accounts Preparation when partnerships dissolve – part 1
- Appropriation accounts within FAPR
- Current accounts within FAPR
Gill Myers is a self-employed accounts consultant. She has taught AAT qualifications since 2005 and written numerous articles and e-learning resources.