Reconstitution of a Partnership Firm – Change in Profit Sharing Ratio

Change in Profit Sharing Ratio – Meaning and New Ratio

Chapter 2: Reconstitution of a Partnership Firm – Change in Profit Sharing Ratio

Page 1: Meaning and the New Ratio

Imagine three friends, Aman, Priya, and Rohan, who start a boutique and agree to share profits equally. After two successful years, Aman decides to invest more capital and take on a larger management role. To reflect this, they all agree that Aman should get a bigger share of the profits. This decision changes their fundamental relationship and requires a formal adjustment in their accounts.

This scenario is a classic example of the reconstitution of a partnership firm. It's not the end of the business, but rather the end of the old agreement and the beginning of a new one. A change in the profit-sharing ratio among existing partners is a primary mode of reconstitution, often triggered by changes in capital contribution or active participation.

{{VISUAL: diagram: A balance scale showing the old partnership agreement on one side (e.g., 1:1:1) and the new agreement on the other (e.g., 2:1:1), indicating a shift in the partners' relationship.}}

{{KEY: type=definition | title=Reconstitution of a Partnership Firm | text=Any change in the existing agreement among the partners which leads to an end of the existing agreement and the formation of a new one. The partnership firm continues its business.}}

This single change in the profit-sharing ratio necessitates several crucial accounting adjustments to ensure fairness. In this chapter, we will explore this entire process step-by-step.

You will learn how to:

• Determine the sacrificing ratio and the gaining ratio.
• Account for the valuation and adjustment of goodwill.
• Handle the revaluation of assets and the reassessment of liabilities.
• Adjust for accumulated profits, reserves, and losses.

{{VISUAL: diagram: A simple flowchart showing 'Change in Profit Ratio' leading to two branches: 'Partner(s) Sacrifice Share' and 'Partner(s) Gain Share', which both then point to 'Accounting Adjustments Required'.}}

The very first step is to mathematically determine who has given up a portion of their profit share and who has gained. Let's move to the next page to learn how to calculate this.

Sacrificing Ratio and Gaining Ratio

{{FORMULA: expr=Sacrificing Share = Old Profit Share – New Profit Share | symbols=Sacrificing Share:The portion of profit share given up, Old Profit Share:The partner's share before the change, New Profit Share:The partner's share after the change}}

The Need for Adjustment: A Question of Fairness

Imagine you and two friends, Aman and Priya, run a small business and agree to share profits equally (1:1:1). After a year, you decide to take on more responsibility, and everyone agrees you should get a larger share of the profits. The new agreement is that you get half, while Aman and Priya share the other half equally (2:1:1).

What just happened? For you to gain a larger share, Aman and Priya had to give up a part of their share. This act of giving up a portion of future profits is called a sacrifice, and the act of acquiring a larger portion is called a gain.

In a partnership, this change in the profit-sharing ratio (PSR) is a form of reconstitution. It's a fundamental shift in the partners' rights. It would be unfair for some partners to gain at others' expense without any adjustment. This adjustment is primarily for the firm's goodwill – the value of its reputation. The gaining partner must compensate the sacrificing partner for the share of goodwill they are giving up.

To calculate this compensation accurately, we must first determine the exact proportion of profit that each partner has sacrificed or gained. This brings us to two very important calculations: the Sacrificing Ratio and the Gaining Ratio.

Calculating the Sacrificing Ratio

The sacrificing ratio is the proportion in which existing partners agree to surrender a part of their share of profits in favour of other existing partners. It pinpoints exactly who is losing out in the new arrangement and by how much.

{{KEY: type=definition | title=Sacrificing Ratio | text=The ratio in which one or more existing partners forego or surrender their share of profits in favour of one or more other existing partners.}}

The calculation is straightforward and is done for each partner individually. The formula is:

Sacrificing Share = Old Profit Share – New Profit Share

If the result of this calculation is a positive fraction, it represents a sacrifice. If the result is negative, it actually represents a gain!

{{VISUAL: diagram: A pie chart split into three equal parts labeled 'Old Ratio (A, B, C)'. An arrow points to a second pie chart where A's slice is smaller, and B's slice is larger, with C's slice unchanged, illustrating A sacrificing for B.}}

Example Walkthrough

Anu and Binu are partners sharing profits in the ratio of 3:2. From 1st April 2023, they decide to share profits equally (1:1). Let's calculate their sacrifice or gain.

1. Identify Old and New Ratios:

   • Old Ratio (Anu:Binu) = 3:2 or Anu = 3/5, Binu = 2/5
   • New Ratio (Anu:Binu) = 1:1 or Anu = 1/2, Binu = 1/2

2. Apply the Formula for Each Partner:

   • Anu's Sacrifice = Old Share – New Share = 3/5 – 1/2 Taking the LCM of 10, we get: (6 – 5) / 10 = 1/10. Since the result is positive, Anu has made a sacrifice of 1/10th share.

   • Binu's Sacrifice = Old Share – New Share = 2/5 – 1/2 Taking the LCM of 10, we get: (4 – 5) / 10 = -1/10. The negative result indicates that Binu has not sacrificed; instead, Binu has gained a 1/10th share.

Calculating the Gaining Ratio

The gaining ratio is the flip side of the coin. It's the proportion in which partners have acquired a share of profit from other partners. While you can identify a gain from the sacrificing ratio formula (as a negative result), you can also calculate it directly.

{{KEY: type=definition | title=Gaining Ratio | text=The ratio in which one or more existing partners acquire a share of profits from other existing partners due to a change in the profit-sharing agreement.}}

The formula is simply the reverse of the sacrificing formula:

Gaining Share = New Profit Share – Old Profit Share

Using this, a positive result signifies a gain, and a negative result signifies a sacrifice.

{{VISUAL: diagram: A clear, bold formula box showing "Gaining Share = New Profit Sharing Ratio - Old Profit Sharing Ratio".}}

Let's re-calculate for Binu using the Gaining Share formula:

• Binu's Gain = New Share – Old Share = 1/2 – 2/5 Taking the LCM of 10, we get: (5 – 4) / 10 = 1/10. The result is positive, confirming that Binu has gained a 1/10th share.

{{KEY: type=exam | title=Interpreting the Result | text=When using Old – New, a positive result is a SACRIFICE and a negative result is a GAIN. When using New – Old, a positive result is a GAIN and a negative result is a SACRIFICE. Stick to one formula (Old - New is standard) to avoid confusion.}}

The Fundamental Equation: Total Sacrifice = Total Gain

In any change of profit-sharing ratio, the shares are merely reallocated among the existing partners. Profit share is not created or destroyed. This leads to a critical verification rule:

The sum of shares sacrificed by partners must always be equal to the sum of shares gained by other partners.

In our Anu and Binu example:

• Total Sacrifice (by Anu) = 1/10
• Total Gain (by Binu) = 1/10
• Thus, Total Sacrifice = Total Gain. Our calculation is correct!

This is an essential check to perform in exams to ensure your calculations are accurate before proceeding with goodwill adjustments.

{{VISUAL: diagram: A balance scale with "Total Sacrificed Shares" on one pan and "Total Gained Shares" on the other pan, perfectly balanced to represent equality.}}

{{KEY: type=points | title=Purpose of these Ratios | text=- To determine the amount of compensation (for goodwill) payable by the gaining partner(s).

• To determine the amount of compensation (for goodwill) receivable by the sacrificing partner(s).
• It forms the basis for passing the necessary journal entry for the treatment of goodwill.}}

A Comprehensive Example

Let's apply this to a firm with three partners.

Problem: X, Y, and Z are partners sharing profits and losses in the ratio of 5:3:2. With effect from 1st April 2023, they decide to share future profits and losses in the ratio of 2:3:5. Calculate each partner's sacrifice or gain.

Solution: We will use the standard formula: Sacrifice/(Gain) = Old Share – New Share.

{{VISUAL: chart: A simple table showing the calculation for X, Y, and Z, identical to the one above, with columns for Partner, Old Share, New Share, and Sacrifice/(Gain).}}

Analysis:

• X's share has decreased, so X is the sacrificing partner. X has sacrificed a 3/10th share.
• Y's share is unchanged. Y has neither sacrificed nor gained.
• Z's share has increased, so Z is the gaining partner. Z has gained a 3/10th share.

Verification:

• Total Sacrifice = 3/10 (by X)
• Total Gain = 3/10 (by Z)
• The condition Total Sacrifice = Total Gain is satisfied.

The calculation of sacrificing and gaining ratios is the first and most critical step in ensuring financial fairness among partners whenever their profit-sharing relationship is altered. It sets the stage for all subsequent accounting adjustments.

Accounting for Revaluation of Assets & Reassessment of Liabilities

Page 3: Accounting for Revaluation of Assets & Reassessment of Liabilities

When partners decide to change their profit-sharing ratio, the firm is reconstituted. But think about this: over the years, the value of the firm's assets and liabilities recorded in the books (their book value) might be very different from their current market value. For example, a piece of land bought for ₹10,00,000 ten years ago might be worth ₹50,00,000 today!

This increase in value of ₹40,00,000 happened before the profit-sharing ratio changed. Therefore, this gain belongs to the partners in their old ratio. It would be unfair for a partner who is gaining a larger share in the future to benefit from a past appreciation they didn't 'earn' under the old agreement.

To solve this, we must bring all assets and liabilities to their current, fair market values. This process is called revaluation of assets and reassessment of liabilities.

The Revaluation Account

To record these changes, we prepare a special account called the Revaluation Account. It is also sometimes known as the Profit and Loss Adjustment Account.

{{KEY: definition | title=Revaluation Account | text=A nominal account prepared to record the changes in the value of assets and liabilities at the time of reconstitution of a partnership firm. Its purpose is to ascertain the net gain or loss arising from such changes.}}

Being a nominal account, the Revaluation Account follows a simple rule:

• Debit all expenses and losses.
• Credit all incomes and gains.

A decrease in an asset's value is a loss, so we debit the Revaluation Account. An increase in an asset's value is a gain, so we credit it. The opposite is true for liabilities.

{{VISUAL: diagram: A T-account format of the Revaluation Account, showing 'Decrease in Assets' and 'Increase in Liabilities' on the Debit side, and 'Increase in Assets' and 'Decrease in Liabilities' on the Credit side.}}

Accounting Treatment and Journal Entries

Let's break down the specific journal entries passed to record these changes. Remember, every entry will affect the Revaluation Account and the specific asset or liability account.

1. For an Increase in the Value of an Asset This is a gain for the firm. We debit the asset to increase its value and credit the Revaluation Account. Journal Entry: Asset A/c Dr. To Revaluation A/c (Being the increase in the value of the asset recorded)

2. For a Decrease in the Value of an Asset This is a loss for the firm. We debit the Revaluation Account and credit the asset to decrease its value. Journal Entry: Revaluation A/c Dr. To Asset A/c (Being the decrease in the value of the asset recorded)

3. For an Increase in the Amount of a Liability Having to pay more is a loss. We debit the Revaluation Account and credit the liability to increase its amount. Journal Entry: Revaluation A/c Dr. To Liability A/c (Being the increase in the amount of the liability recorded)

4. For a Decrease in the Amount of a Liability Having to pay less is a gain. We debit the liability to decrease its amount and credit the Revaluation Account. Journal Entry: Liability A/c Dr. To Revaluation A/c (Being the decrease in the amount of the liability recorded)

{{KEY: points | title=Rules for Revaluation Account | text=- Debit the Revaluation Account for any decrease in the value of assets and any increase in the value of liabilities.

• Credit the Revaluation Account for any increase in the value of assets and any decrease in the value of liabilities.
• Also, debit for unrecorded liabilities and credit for unrecorded assets.}}

Sometimes, we discover assets or liabilities that were not recorded in the books at all!

5. For an Unrecorded Asset Finding a new asset is a clear gain. We create an account for the asset and credit the Revaluation Account. Journal Entry: Unrecorded Asset A/c Dr. To Revaluation A/c (Being the unrecorded asset now brought into the books)

6. For an Unrecorded Liability Discovering a new liability is a loss. We debit the Revaluation Account and create a new liability account. Journal Entry: Revaluation A/c Dr. To Unrecorded Liability A/c (Being the unrecorded liability now brought into the books)

{{VISUAL: diagram: A flowchart showing the four main types of revaluation changes (Asset increase/decrease, Liability increase/decrease) and how each one flows into either the Debit or Credit side of the Revaluation Account.}}

Preparing the Revaluation Account and Distributing the Result

After posting all the above journal entries to the Revaluation Account ledger, we balance it.

• If the Credit side > Debit side, the result is a Profit on Revaluation.
• If the Debit side > Credit side, the result is a Loss on Revaluation.

This resulting profit or loss is the net effect of all the adjustments. It represents a gain or loss that belongs to the partners from the period before the reconstitution.

The most critical step is to transfer this profit or loss to the Partners' Capital (or Current) Accounts in their OLD PROFIT SHARING RATIO.

{{VISUAL: chart: A sample Revaluation Account with dummy entries. For example, Land (Increase) on the credit side, Machinery (Decrease) on the debit side, Creditors (Increase) on the debit side, and showing the calculation of 'Profit on Revaluation' as the balancing figure.}}

Journal Entry for Transfer of Profit: Revaluation A/c Dr. To Partner A's Capital A/c To Partner B's Capital A/c To Partner C's Capital A/c (Being profit on revaluation transferred to partners' capital accounts in their old ratio)

Journal Entry for Transfer of Loss: Partner A's Capital A/c Dr. Partner B's Capital A/c Dr. Partner C's Capital A/c Dr. To Revaluation A/c (Being loss on revaluation transferred to partners' capital accounts in their old ratio)

{{KEY: exam | title=Crucial Exam Point | text=The profit or loss on revaluation is ALWAYS distributed among the partners in their OLD profit sharing ratio. This is because the change in asset/liability values occurred before the new agreement came into effect.}}

After this transfer, the Revaluation Account is closed. The assets and liabilities will now appear at their revised values in the new Balance Sheet of the reconstituted firm.

{{VISUAL: diagram: An illustrative pie chart split into three sections representing three partners in an old ratio (e.g., 3:2:1). An arrow points from 'Profit on Revaluation' to this pie chart, indicating the distribution.}}

{{ZOOM: title=Why not just change the Balance Sheet? | text=Preparing a separate Revaluation Account creates a clear, transparent record of all changes in value. It isolates the gain or loss from these specific adjustments, making it easier to calculate and distribute correctly among partners according to the old agreement, before moving on to the reconstituted firm's finances.}}