| Balance Sheet of X, Y & Z | |||
| Cash | $ 2,000.00 | Liabilities | $10,000.00 |
| Other Assets | 48,000.00 | X, Capital | 20,000.00 |
| Y, Capital | 10,000.00 | ||
| Z, Capital | 10,000.00 | ||
| $50,000.00 | $50,000.00 | ||
An outsider, R, is now to be admitted to a one-fifth interest by making an investment in the business. The relative shares of the others are to remain as before. Hence, after R’s admission, X will have two-fifths, and Y, Z, and R one-fifth interest each. It is further assumed that no revaluation of the tangible assets is necessary.
The net worth of the old firm, according to the books, is $40,000, and if this were taken as the basis for admitting R, an investment of $10,000 would be sufficient to acquire a one-fifth interest in the new firm. However the business is considered to be worth $10,000 more than the $40,000 shown in the balance sheet, and for this reason, instead of paying $10,000, R is required to invest $12,500. The excess of $2,500 is paid by R as an offset to the shares of the others in the good-will of the firm.
There are three ways of treating this good-will element, viz.:
First Method. Debit the Good-Will account for the amount actually paid for it by R, viz., $2,500, and credit the capital accounts of the old partners in proportion to their shares in the profits:
| Good-Will | 2,500.00 | ||
| X, Capital | 1,250.00 | ||
| Y, Capital | 625.00 | ||
| Z, Capital | 625.00 | ||
As a result of this entry, the capital account of X is $21,250, and those of Y and Z $10,625 each. The capital account of R, however, shows a credit of $12,500. In other words, R’s interest in the net assets—although not in the profits—of the business as shown by his account is larger than that of Y and Z, while as a matter of fact he is to have an equal share. For this reason, this method of treating good-will is not satisfactory.
Second Method. This method regards the matter from a different standpoint. Taking book values as a basis, the share bought by R is worth only $10,000. However, on account of good-will, the real value of this share is considered to be higher and R is required to pay $12,500 for it. Hence, in order that the books may show actual values, the good-will item must be added to the assets of the old firm, at the same time increasing the capital accounts of X, Y, and Z in proportion to their shares in the profits. The entry is:
| Good-Will | 10,000.00 | ||
| X, Capital | 5,000.00 | ||
| Y, Capital | 2,500.00 | ||
| Z, Capital | 2,500.00 | ||
As a result of this adjustment the capital of the old firm is shown as $50,000. R now invests $12,500, and the capital is thereby increased to $62,500. The capital accounts of the four partners now show $25,000, or two-fifths for X, and $12,500 or one-fifth each for Y, Z, and R.