In the world of partnerships, changes in the profit-sharing ratio among partners are a common occurrence. Such changes can arise due to various reasons such as the admission of a new partner, retirement or death of an existing partner, or simply a re-negotiation among partners. Understanding how to account for these changes is crucial for maintaining accurate financial records and ensuring fair distribution of profits and losses.
When a new partner is admitted into the partnership, the existing profit-sharing ratio among the old partners changes to accommodate the new partner.
When a partner retires or passes away, the remaining partners need to re-distribute the profit-sharing ratio among themselves.
Sometimes, partners may mutually agree to change the profit-sharing ratio without any external changes, such as admission or retirement.
Note
It's important to document any changes in the partnership agreement to avoid future disputes.
The sacrificing ratio is the ratio by which the old partners sacrifice their share of profit in favor of the new partner.
$$ \text{Sacrificing Ratio} = \text{Old Ratio} - \text{New Ratio} $$
Example
If Partner A and Partner B share profits in the ratio 3:2 and they admit Partner C with a 1/5 share, the new ratio might be 3:2:1. The sacrificing ratio for A and B would be:
The gaining ratio is the ratio by which the remaining partners gain the share of the retiring or deceased partner.
$$ \text{Gaining Ratio} = \text{New Ratio} - \text{Old Ratio} $$
Example
If Partner A, B, and C share profits in the ratio 3:2:1 and Partner C retires, the new ratio might be 3:2. The gaining ratio for A and B would be:
Whenever there is a change in the profit-sharing ratio, it is important to revalue the assets and liabilities of the firm to reflect the current market value.
Tip
Revaluation ensures that the incoming or outgoing partner gets a fair share of the firm's value.
Goodwill is an intangible asset that represents the value of the firm's reputation. When the profit-sharing ratio changes, goodwill must be adjusted.
Goodwill is often calculated as a multiple of the average or super-profits of the firm.
$$ \text{Goodwill} = \text{Average Profit} \times \text{Number of Years' Purchase} $$
The goodwill adjustment entry depends on whether it is being raised or written off.
Example
If the goodwill of the firm is valued at $50,000 and the new partner is admitted, the goodwill is shared among the old partners in the sacrificing ratio.
If Partner A and Partner B share profits in the ratio 3:2 and they admit Partner C with a 1/5 share, the sacrificing ratio for A and B would be 1:10 and 1:15 respectively.
The journal entry would be:
Common Mistake
Do not forget to adjust the goodwill based on the sacrificing or gaining ratio. Failing to do so can result in unfair distribution of profits.
Let's consider a partnership firm with three partners, A, B, and C, sharing profits in the ratio 4:3:2. They decide to admit a new partner, D, who brings in capital and agrees to share profits equally with the existing partners.
Note
Ensure all partners agree to the new terms and document the changes in the partnership deed.
Understanding and accurately accounting for changes in the profit-sharing ratio is essential in partnership firms. It ensures that all partners are fairly compensated and the firm's financial records remain accurate. Always remember to revalue assets, adjust goodwill, and document changes to avoid future complications.
Tip
Regularly review and update the partnership agreement to reflect any changes in the profit-sharing ratio.