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CBSE Class 12 Commerce Accounting For Partnership Firms Change In The Profit Sharing Ratio Notes

CBSE Class 12 Commerce Accounting For Partnership Firms Change In The Profit Sharing Ratio : CBSE is an eminent educational board and since its inception, it provides quality education to all students across India. It is a self-financing body and maintains its praise worthy educational standards without taking any grant-in-aid from Government. Several public and private schools are affiliated to this board and its well-structured syllabi and examination pattern are equally implemented in these schools. Keeping in mind the students’ basic requirements in terms of knowledge and mental development, the syllabus of each class is structured in a comprehensive manner. All essential topics are incorporated in the syllabus to make students up-to-date in all respects. Several subject experts are associated with this board and they are involved in preparing syllabus from class I to 12. Hence, students get clear ideas on different topics and it inspires them to a great extent. Two important exams including AISSCE for class 10 and 12 are conducted by this boar

CBSE Class 12 Commerce Accounting For Partnership Firms Change In The Profit Sharing Ratio Notes

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CBSE Class 12 Commerce Accounting For Partnership Firms Change In The Profit Sharing Ratio Notes

CBSE Class 12 Commerce Accounting For Partnership Firms Change In The Profit Sharing Ratio : If the existing partners decide to make a change in the existing profit sharing ratio, the future profit sharing will be different from the existing ratio. By making changes in the profit sharing ratio, some partner will lose his share of the profit in future and some partner will gain. The partner, who gains in the new ratio, will have to compensate the losing partner.

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In other words, one partner makes a purchase of a share of profits from one partner, who was enjoying it previously. For instance, A and B are partners sharing profits in the ratio of 2: 1. They mutually agreed to make changes in the profit sharing ratio as 1: 1, and then A is forgoing or selling to B 1 /6th share of profits. Because the mutual profit sharing ratio changes, now A gets 3/6 (2/3 – 1/6) and B gets 3/6 (1/3 + 1/6). That is, 1/6th share of profit is gained by B and to that extent A is losing. If the profit is Rs 60,000, according to old profit sharing ratio, A gets Rs 40,000 and B gets Rs 20,000.

After the change of profit sharing ratio, A and B get equal share i.e. each gets Rs 30,000. Thus, now A loses Rs 10,000, which is a gain to B. Therefore, B will pay to A an amount equal to 1/6th of the total value of goodwill. If the total value of goodwill is Rs 18,000, B must pay to A 1/6th of Rs 18,000 i.e. Rs 3,000.

Illustration:

A and B are trading in partnership sharing profits and losses in the ratio of 3: 1. As from 1st January 2005, it was decided to change the profit sharing ratio to 3: 2. Goodwill will be valued at two years’ purchase of the average of three years’ profits. The profits for 2002 Rs. 15,000; 2003 Rs. 20,000 and 2004 Rs. 25,000. Pass the necessary journal entry to give effect to the arrangement.

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CBSE Class 12 Commerce Accounting For Partnership Firms Change In The Profit Sharing Ratio Notes

CBSE Class 12 Commerce Accounting For Partnership Firms Change In The Profit Sharing Ratio : When there is a change in profit sharing ratio, it means that some of the partners will get higher profits based on the new ratios in the future while others will loose or will get lower profits.

Those who will get higher  profits therefore need to pay for the higher profits whereas those who will get lower profits thus need to be compensated for the reduction in their profit share.

To achieve this objective, goodwill is normally introduced in the accounts by crediting the partners capital accounts according to their old profit sharing ratio (PSR) and written off again by debiting the partners capital accounts according to their new PSR.

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Changing in Profit sharing ratio means to change the ratio from old ratio to new ratio. Now, we think, why did partner take this decision? Very simple answer. They normally take this decision when they see that division among the partner is not good. For example, you are 4 brothers. You are living in a big house. Now, you have decided to divide this. If one of your brother got 70% proportion and other three is just getting 30% proportion. It will be real Justice. Actually, 90% is 90/100 or 9/10 and 30% is 30/100 or 3/10. So, their ratio is 7 : 1 : 1 : 1. So, it is not good. Every brother should have equal right. They have to get 25%. So, three brother went to court and court has given decision to change the ratio from 7 : 1 : 1 : 1 to 1 : 1 : 1 : 1.

Above example is just for your learning. Like this, when a partner sees that he bring more capital. He does more work but he gets less proportion of profit. He can demand share of profit in total profit. At that time, other partner may agree to change the ratio for giving him more proportion.

How to Change in Profit Sharing Ratio 

Changing in profit sharing ratio is done on the basis of justice rule. When we change the ratio from old to new, it will give more benefit to some partner, it may give more loss to other partner. So, all the partners who will suffer loss of profit due to changing in the profit sharing ratio. So, gaining partners will give money to loss suffering partners if their capital is already equal or on past agreement basis. This money can be given in the form of goodwill. Goodwill is intangible asset but for getting other partner’s share, it can be given.

Let me explain with an example 

A and B are two partner. They divide the profit in the ratio of 5 : 3, it means 62.5 : 37.5  or 62.5% and 37.5%. Now, they decided to divide in 3 : 1. It means new ratio will be 75 : 25 or 75% for A and 25% for B. It means, A is getting 75% – 62.5% = 12.5% benefit after changing in the ratio and B is suffering 12.5% loss after changing in the ratio. So, it is the duty of A that he should pay the money in the form of goodwill to b.

Suppose, total goodwill is Rs. 20,000 and its 12.5% is Rs. 2500 which is paid by A to B.

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CBSE Class 12 Commerce Accounting For Partnership Firms Change In The Profit Sharing Ratio Notes

CBSE Class 12 Commerce Accounting For Partnership Firms Change In The Profit Sharing Ratio : Calculation of New Profit Sharing Ratio and Sacrificing Ratio.

First: Ascertain always sacrifice of old partners.(Old share – New Share) if both given in the question.

Second: verify with the share of new partner.

Lastly: Compute the new share of old partners.

Treatment of Goodwill i.e. appearing in the balance sheet prior to reconstitution

If there is any existing goodwill  in the books at the time of reconstitution, it must written off first by debiting all partners capital account and crediting goodwill account in old profit sharing ratio.

Secondly goodwill can only be shown in the books of reconstituted firm if any          consideration is paid for the goodwill.

Accounting entry:

All Partners Capital/Current A/c      Dr.

       To Goodwill A/c   Cr. (In the old ratio)

Revaluation of Assets and Reassessment of Liabilities

If Assets and liabilities are to be shown in the balance sheet of reconstituted firm at  revalued figures.

If Assets and liabilities are to be shown in the balance sheet of the reconstituted firm not at the revalued figures but at the existing figures.

Step.1

Prepare revaluation A/C by crediting all gains and debiting all losses.

Gains:

Increase in the value of assets

Unrecorded asset realized

Decrease in the value of liabilities

Losses:

Decrease in the value of assets

Unrecorded liability raised

Increase in the value of liabilities

Step.2

Then Distribute profits or losses of revaluation among the partners in old profit sharing ratio.

Revaluation A/C   Dr. (if there is revaluation profit)

   To Partner’s Capital A/c

                  Or

Partner’s capital A/c Dr.(if there is revaluation loss)

   To Revaluation A/c

Step.3

Prepare balance sheet of the reconstituted firm with amended figures of assets and liabilities.

In Case II. Only change is that the profits or losses of revaluation are not distributed among the partners as in the balance sheet of reconstituted firm assets and liabilities are reflected at same values.

The effect of revaluation is thus reflected by passing an Adjustment Entry:
Gaining Partner Capital A/c          Dr.
To sacrificing Partner capital A/c       Cr.

(Being adjustment entry passed among the partners for profit or losses of revaluation in sacrificing ratio).

Then prepare balance sheet Assets and liabilities are reflected with the same values as they are appearing prior reconstitution.

Accounting treatment of Reserves and Accumulated Profits

If reserves and accumulated profits are not to be shown in the balance sheet of reconstituted firm, treatment will be:

All free reserves and accumulated profits are debited and existing partner capital accounts are credited in old profit sharing ratio.

Reserves/Accumulated Profits   Dr.

         To All Partners Capital A/C         Cr.

If reserves and accumulated profits are to be appeared in the balance sheet of reconstituted firm with same figures as per partnership deed, then treatment will be instead of above an adjusting entry is passed among the partners in sacrificing ratio:

Gaining partner capital A/C    Dr.

     To Sacrificing partner capital A/C  Cr.

( Being adjustment entry for crediting reserves and accumulated profits on reconstitution).

This is because at present, the partners are entitled to share such reserves and profits in the old profit-sharing ratio where as in future they will be entitled to share such reserves and profits in the new profit sharing ratio. So the gaining partner compensate the sacrificing partner.

Examples of Reserves:

  1. Workmen compensation reserve
  2. Investment fluctuation reserve
  3. General reserve
  4. Profit & Loss (Cr. Balance)
  5. Contingencies Reserve
  6. Dividend Equalization Reserve

In the absence of any information reserves are treated as free.

However if some information is given against the reserve, say any liability raised against any reserve,

Example 1: Workmen compensation claim

There is claim against workmen compensation reserve, then that claim may be either:

  1. Claim =WMC reserve.

            Wmc reserve dr

                To provision for wmc claim cr

  1. Claim <WMC reserve.

             Wmc reserve dr

                 To Provision for wmc claim cr

                 To old partners capital A/c  cr

  1. Claim >WMC reserve

             Wmc reserve      dr

             Revaluation A/c dr

                To Provision for wmc claim  cr

           Then,

            Old partners capital A/c dr

                 To revaluation.

CBSE Class 12 Commerce Accounting For Partnership Firms Change In The Profit Sharing Ratio Notes

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