Change in Profit Sharing Ratio — Study Notes

1. Introduction

In a partnership firm, the profit sharing ratio among partners may change for various reasons such as the admission of a new partner, the retirement or death of an existing partner, or simply a voluntary change agreed upon by the partners. When the ratio changes, the partners who gain a higher share of profits acquire an advantage at the expense of those who lose a share. This gain or sacrifice must be compensated by the sacrificing partner, which is done through the valuation and adjustment of goodwill.

A change in the profit sharing ratio is essentially a change in the ownership rights of the partners. From an accounting perspective, whenever the ratio changes, the firm must revalue its assets and liabilities and adjust the existing goodwill, reserves, and accumulated profits and losses. This ensures that the existing partner whose share is reduced is compensated for the loss of his share in the firm's accumulated wealth and goodwill.

The chapter introduces the concept of sacrificing and gaining ratios, and explains how to pass adjustment entries for goodwill, reserves, accumulated profits, revaluation of assets and liabilities, and changes in the capitals of the partners. These concepts are the building blocks for the chapters on admission and retirement of partners.

2. Sacrificing Ratio and Gaining Ratio

The sacrificing ratio is the ratio in which the old partners give up their share of profit in favour of a new partner or among themselves. It is calculated as:

$$\text{Sacrificing Ratio} = \text{Old Ratio} - \text{New Ratio}$$

The gaining ratio is the ratio in which the continuing partners gain a share of profit when a partner retires or dies, or when the ratio changes among existing partners:

$$\text{Gaining Ratio} = \text{New Ratio} - \text{Old Ratio}$$

If the difference is positive, the partner has gained; if negative, the partner has sacrificed. Partners who sacrifice are compensated by those who gain.

3. Accounting Treatment of Goodwill on Change in Ratio

When the profit sharing ratio changes and there is no change in the ownership of the firm, the goodwill already existing in the books must be adjusted. The partner whose share increases must compensate the partner whose share decreases.

The journal entry is:

Gaining Partner's Capital/Current A/c Dr.
    To Sacrificing Partner's Capital/Current A/c

If the firm shows goodwill in its books, the existing goodwill is first written off in the old ratio and then the gaining partner is debited and the sacrificing partner credited with the value of goodwill in the sacrificing ratio.

3.1 Treatment When Goodwill Not Shown in Books

If goodwill is not already shown in the books, the gaining partner's capital account is debited and the sacrificing partner's capital account is credited with the proportionate value of goodwill based on the change in ratio.

4. Revaluation of Assets and Liabilities

When the profit sharing ratio changes, the assets and liabilities are revalued so that the partners sharing in the changed ratio do not gain or lose unfairly from a change in the book value of assets. The Revaluation Account (also called Profit and Loss Adjustment Account) is prepared.

$$\text{Revaluation Account: Increase in Assets / Decrease in Liabilities} = \text{Profit, credited to partners in old ratio}$$

$$\text{Decrease in Assets / Increase in Liabilities} = \text{Loss, debited to partners in old ratio}$$

The resulting profit or loss on revaluation is transferred to the old partners' capital accounts in their old ratio, because the revaluation relates to the period before the change in ratio.

5. Treatment of Reserves and Accumulated Profits

Reserves, accumulated profits, and any undistributed losses belong to the old partners in the old ratio. On a change in the profit sharing ratio, these must be transferred to the capital accounts of the old partners in the old ratio. If they were not transferred earlier, an adjustment entry is passed.

If accumulated losses exist, the old partners' capital accounts are debited in the old ratio and the loss account is credited. Similarly, undistributed profits are credited to the old partners in the old ratio.

6. Adjustment of Capital Accounts

On a change in the profit sharing ratio, the partners may also decide to adjust their capitals in proportion to the new profit sharing ratio. If the capitals are to be adjusted:

• Determine the total capital of the firm.
• Compute each partner's capital in the new ratio.
• The partner whose capital is less brings in the shortfall; the partner whose capital is more withdraws the excess, or the difference is transferred to their current accounts.

Alternatively, the partners may decide to keep their capitals unchanged and maintain current accounts.

7. Adjustment Entry for Past Items Omitted

Sometimes items like interest on capital, interest on drawings, or partner's salary for earlier years are omitted or wrongly recorded. Such past adjustments are made through a single journal entry comparing the correct amount with the amount already credited. The net effect is debited to the partner who was overcredited and credited to the partner who was undercredited.

Quick Revision Tables

Table 1: Ratio Concepts

Table 2: Adjustments on Change in Profit Sharing Ratio

Table 3: Revaluation Account Debit and Credit Items

Mind Map

Important Diagrams (SVG)

Diagram 1: Journal Entry Flow for Goodwill Adjustment

Diagram 2: Revaluation Account Structure

Common Mistakes

1. Computing sacrificing ratio as New Ratio - Old Ratio; it should be Old Ratio - New Ratio. The positive result indicates sacrifice.
2. Passing the goodwill adjustment entry in the profit sharing ratio instead of the sacrificing ratio.
3. Writing off existing goodwill among the new ratio partners; it must be written off among the old partners in the old ratio.
4. Transferring the revaluation profit or loss in the new ratio instead of the old ratio.
5. Forgetting to adjust accumulated losses, which must be debited to the old partners' capital accounts in the old ratio.
6. Confusing a decrease in liabilities (profit) with an increase in liabilities (loss) while preparing the revaluation account.
7. Not considering the effect of unrecorded assets and unrecorded liabilities while preparing the revaluation account.

Exam Tips

1. Always present the sacrificing and gaining ratio working notes separately, showing the computation clearly.
2. Remember that revaluation profit or loss is shared by old partners in the old ratio because the change in ratio takes effect from the date of revaluation.
3. When goodwill adjustment is combined with reserves, prepare a combined single entry to avoid multiple entries.
4. Check whether the capitals are to be adjusted in the new ratio; if yes, compute the total capital and each partner's share systematically.
5. Practise questions in which the new ratio of all partners is not directly given but must be derived from the sacrificing ratio.
6. Treat negative results as sacrifices or gains appropriately and be careful with the sign convention.
7. In the revaluation account, balance both sides and ensure the profit or loss is transferred in the old ratio only.

Conclusion

A change in the profit sharing ratio redistributes the ownership of the firm's wealth among partners, so the sacrifices and gains must be quantified and adjusted. The sacrificing ratio and gaining ratio identify who compensates whom, the goodwill adjustment transfers value from the gaining partner to the sacrificing partner, and the revaluation of assets and liabilities along with the transfer of reserves ensures that past profits and losses are correctly apportioned. A thorough understanding of these adjustments directly prepares the student for the more complex scenarios of admission and retirement, where similar techniques are applied on a larger scale.