CHANGE IN PROFIT SHARING RATIO ACCOUNTANCY CLASS 12

CHANGE IN PROFIT SHARING RATIO ACCOUNTANCY CLASS 12

What is Profit-Sharing Ratio?

The profit-sharing ratio is a ratio in which the profits or losses of a business are shared. These ratios will be set out in the partnership agreement. This amount refers to a percentage of the total profits, given to each partner. The partnership agreement can specify a different capital-sharing ratio. If no specific agreement has been made, profits and losses will be shared equally in accordance with the Partnership Act 1890.

Change in profit-sharing ratio

Change in Profit Sharing Ratio among Existing Partners is one of the forms of reconstitution of the firm. There only change is the profit-sharing ratio among existing partners. This change may be due to a change in capital contribution or increased participation in management by one or more partners which leads to the dissolution of the partnership. However, there is no change in the partners carrying on the business of the firm.
The aggregate amount of gain by one or more partners = Aggregate amount of sacrifice by other partners

Change in profit-sharing ratio includes the adjustments: Determination of gaining and sacrificing ratio, Accounting treatment of goodwill, Accounting treatment of reserves and accumulated profit/loss, Revaluation of assets and reassessment of liabilities, Adjustment of capital.

Sacrificing Ratio:

It refers to the ratio in which the old partners surrender their share of profit in favor of new partner(s). It is equal to the difference between the old ratio and the new ratio of the old partner/s.

Gaining Ratio: 

It is the ratio in which the remaining partners acquire the outgoing partner’s share of profit it is equal to the difference between the new ratio and old ratio of the old partner/s.

Goodwill

Goodwill refers to the difference between the fair or market value of the net assets of the partnership and their book value. An increase in the share of profit means the purchase of a share of profit from another partner by acquiring his or their share. The compensation paid by gaining a partner to sacrificing partner is known as “goodwill” or “premium for goodwill”. This compensation is paid in their sacrificing ratio.
Accounting treatment of goodwill:
Amount of compensation = value of a firm’s goodwill X share of profit gained
Entries to adjust Goodwill:

A. When goodwill is adjusted through partners’ capital account :

(i) In the case of fluctuating capital :
Gaining a partner’s Capital A/Cs
To sacrificing partner’s Capital A/Cs

(ii) In the case of fixed capital :
Gaining a partner’s Current A/Cs
To sacrificing partner’s Current A/Cs

B. When the goodwill account is opened:
(a) Goodwill A/c
To partners’ capital/current A/cs
(b) Partners’ capital/current A/cs
To goodwill A/c

In case any goodwill is appearing in the books then this goodwill is to be written off because the fresh valuation of goodwill is made. If existing goodwill is not written off, it will lead to an accounting of goodwill twice up to the extent of existing goodwill.
The following entry is to be made:
All partners’ capital/current accounts …Dr (in the old ratio)
To Goodwill A/c (with the existing value of goodwill)

Reserves and accumulated profits or losses

Accumulated earnings are the sum of a company’s profits, retained earnings, earned surplus, or retained capital, after dividend payments, since the company’s inception.
Accumulated losses refer to the advertisement expenditure and also previous year losses (if any) which have not been distributed among partners.
These accrued gains or losses perfectly fits the partners and should be transferred to the capital a/c of the partners in their OPSR (Office of Public Services Reform).
Following journal entries have to be made:

For transfer of reserves and accumulated profits :
Reserves A/c

Profit and loss A/c (Cr balance)
Workmen compensation A/c
Investment fluctuation reserve/c
To all partner’s capital/current A/cs

For transfer of accumulated losses:
All partners’ capital/current A/cs
To Profit and loss A/c (Dr Balance)
To deferred Revenue expenditure A/c (say, advertisement suspense a/c)

Workmen compensation reserves (WCR)

Workmen Compensation reserve is a reserve besides free reserves to be paid for any mishappening and accident happen to workmen at the workplace. It may or may not arise or if arises claim may be equal to, higher or lower than the amount of reserve.
When a claim against WCR does not exist, the amount of Workmen compensation reserves is transferred to the partner’s capital account in their old profit-sharing ratio.

The following entry is made:

Workmen compensation A/c
To partner’s capital/current A/c
(Being WCR is transferred to partner’s cap/current a/c)

When a claim against WCR exist and claim = WCR
Workmen compensation reserve A/c

To provision for Workmen compensation claim A/c

• When a claim against WCR exist and claim > WCR
• Wosrkmen compensation reserve A/c

Revaluation A/c           

To provision for Workmen compensation claim A/c
Partner’s capital/current A/c
To Revaluation A/c

• When a claim against WCR exist and claim < WCR
  Workmen compensation reserve A/c
  To provision for Workmen compensation claim A/c
  To partner’s capital/current A/cs

Investment Fluctuation Reserve (IFR)

Investment Fluctuation Reserve is a reserve created out of the profits to meet the fall in the market value of investments. Excess of Investment Fluctuation Reserve over the difference between book value and market value is credited to old partners in their old profit sharing ratio.
When book value and market value are the same, the amount of IFR is transferred to Old partner’s capital or Current Accounts in their old profit sharing ratio when the market value of the investment is less than the book value.
If fall in value is less than the reserve, IFR, to the extent of fall in the value, is transferred to Investment Account and the balance is distributed among the old partners in their old profit sharing ratio
If the fall in value is equal to reserve, the amount of IFR is transferred to Investment Account and no amount is distributed among the old partners
If the fall in value is more than the reserve, the amount in excess of the amount of Investment Fluctuation Reserve is debited to Revaluation Account.
When there is an increase in the market value of the investment, the entire reserve is distributed to old partners in their old profit-sharing ratio and an increase in value is credited to Revaluation Account.

Adjustments of Reserves, Accumulated Profits, and Losses

Any reserves or accumulated profits/losses appearing on the balance sheet should be transferred to the partner’s capital accounts but sometimes a partner may decide that existing balances of profit and loss account or reserves should continue to appear at the same amount in the balance sheet of reconstituted firm. If the partners decide to leave them undisturbed it is necessary to make an adjustment entry in the books of the firm. In such a situation, the gain or sacrifice of partners is calculated and an adjustment entry is passed on the basis of gained or sacrificed share because, at present, the partners are entitled to share such reserves and profits in the old ratio.
To make an adjustment entry, calculate the net effect of reserves, accumulated profits, losses then calculate gain/loss of share and share of gaining and sacrificing partner in net accumulated profit, losses and reserves.

CAPITAL ADJUSTMENT

This capital rearrangement means the contribution of partners towards capitals is rearranged on the basis of a new profit-sharing ratio. For this purpose, adjustments are made for the change in values of assets and liabilities, goodwill and distribution of reserves, accumulated profits and losses and capital of partners change. Partners whose capital falls short or has a shortage of required capital may have to bring more capital while partner whose capital is in surplus of the required capital may withdraw surplus or excess capital.
The following entries are made:
(i)For adjusting shortage of capital
Bank A/c or concerned partner’s current A/c ….Dr
To concerned partner’s capital A/c
(ii)For adjusting the surplus of capital
Concerned partner’s capital A/c….Dr
To Bank A/c or concerned partner’s current A/c

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