Run through a scenario with our tutor on how to prepare final accounts when a partnership dissolves, taking goodwill value into account.
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
In previous articles we’ve looked at the subject of how to appropriate the profit or loss generated by a partnership that is operating as a going concern. We’ve considered the concept of capital, the role of the appropriation account and how to update partners’ current accounts at year-end.
In those articles we clarified the difference between a partners’ long-term capital, recorded in their capital account, and their short-term capital, recorded in their current account. We stated that the current accounts record the routine changes to the amount a business owes each partner that comes about in the normal course of business, and that the capital accounts record each partners’ initial investment. We’ve said that the capital accounts are only adjusted if significant capital injections or withdrawals are made.
When ownership of a partnership changes
It is these circumstances that we are now going to consider, and look at what happens when there are significant changes in the ownership of a partnership, such as partners leaving or joining.
Let’s continue our previous scenario where you and I are in partnership. If you remember our third year of trading was slow, so let’s imagine that in year four business didn’t really pick up and we decided it was time for a change. You work part time in the partnership and your other interests are becoming more time consuming so you have decided to leave at the end of the financial year.
Leaving a business is more complicated than handing in your notice and leaving a job. There probably still needs to be a notice period and practical arrangements but the key difference is that you don’t want to just walk out with a box containing your personal belongings, you want to leave with your share of the partnership’s value as well.
We know the statement of financial position (SoFP) calculates the net assets of an organisation, in other words, what it is worth at that point in time. We also know that the ‘financed by’ section on the SoFP shows how the net assets are comprised of the elements of the owner(s) equity and on a partnerships’ SoFP those are the balances on both the capital and current accounts.
The financial statements for the fourth year have been prepared and our current accounts updated.
An extract from the SoFP shows:
The written down value of the partnership is £55,875 of which £30,250 is owed to you. But would you be happy walking away with that amount?
I wouldn’t if I were you! We’ve been in partnership for four years and whilst things are slow at the moment we are still generating profit and are expecting to trade into the foreseeable future. We have both invested more than money into building the business and all that time, effort and expertise has value.
Goodwill value of a business
The name for that value is goodwill. It can be understood as the worth of a business over and above that of its written down assets. In other words, on paper our partnership is worth £55,875, a figure that is calculated by deducting the business’s liabilities from its assets. However, it is worth more than that.
Assets are not just current and non-current they are also tangible and intangible. The difference is that tangible assets have actual monetary value, for example:
- shop fittings
- and the balance on the receivables account.
Whilst intangible assets have theoretical value, for example:
- a good location
- well trained staff
- and repeat customers.
We haven’t said what our business is but let’s say its a cafe on the high street of a picturesque village which attracts both regular locals and tourists. The kitchen equipment, tables, chairs, crockery and glassware are all examples of tangible assets. However, the fact that the cafe is located on the sunny side of the street, with safe seating set back from the road, and has a reputation for good service and delicious food, undoubtedly attracts customers and generates sales. These, therefore, are intangible assets and examples of goodwill.
So, the next question is how much is the goodwill of our partnership worth?
Determining the goodwill value
This is a hard question to answer as goodwill is subjective and you may think it’s worth more than I do. In reality the best course of action is to seek professional advice because valuing a business is a complex and specialised area.
For arguments sake let’s assume that we have sought help and been advised that the value of goodwill is currently £12,000. We both agree this is a fair figure and can now work out how much the partnership owes you.
Dividing up the partnership
We already know you are owed £30,250 which is your share of the tangible assets and by using the profit sharing ratio, from our partnership agreement, we can calculate your share of the intangible assets. The ratio is 2:1 which means you get two thirds of our profits, losses and goodwill. Therefore, that you are owed a further £8,000, which gives £38,250 in total.
In the second part of this article, we’ll look at the accounting adjustment required to record you leaving the partnership, how I’m going to be able to buy you out and what I’m going to do without you.
Read more on final accounts preparation;
- FAPR Accounting adjustments when partnerships dissolve – part 2
- 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.