Change in Profit Sharing Ratio Among the Existing Partners

A change in the profit-sharing ratio among existing partners signifies a modification in the agreed-upon ratio for sharing losses or profits in a business partnership. The reasons for changing the profit-sharing ratio might be the introduction of a new partner or the retirement of any existing partner, or there might be a mutual understanding amongst the partners to modify their terms under the partnership agreement. It is also important to note the recording of the new ratio, adjustment for goodwill, and proper revaluation of assets and liabilities to ensure equity in the distribution of profits and losses. In this article, we will consider the intricacies of a change in profit sharing ratio among existing partners, from calculating new ratios to necessary adjustments, and what implications this will have on the partnership business.

New Profit Sharing Ratio

The new profit sharing ratio follows mutual consent among the present partners or according to provisions in the partnership agreement. If parties do not have an established formal agreement, they would need to negotiate and agree on the terms. Now, one should add that a change in the ratio may not necessarily be symmetric. One partner may get a greater share of the profits, while others get a lesser share. The ratio can be determined based on various factors, such as:

The contribution of capital by each partner.
The effort and skill each partner brings to the business.
The duration of involvement in the partnership.

For example, if Partner A, Partner B, and Partner C originally shared profits in the ratio of 4:3:3, and now they decide to change it to 3:3:4, the new profit sharing ratio is 3:3:4, where Partner C’s share increases, and Partner A and B’s share decreases. This shift in the ratio will impact how we distribute profits and losses. But it also necessitates adjusting various factors.

Sacrificing Ratio

Current partners use the sacrificing ratio to reduce the share of profit, either to let in a new partner or to alter the ratio amongst themselves. Essentially, it determines the proportion of profit a partner is willing to sacrifice for the benefit of others. This is especially important when an existing partner compromises a part of their profit share to either introduce a new partner or alter the distribution to reflect the changes in business dynamics.

To calculate the sacrificing ratio, follow these steps:

Calculate the old profit sharing ratio: Determine the profit distribution before any changes.
Calculate the new profit sharing ratio: Establish the new sharing ratio agreed upon by the partners.
Subtract the new ratio from the old ratio for each partner: This difference represents the percentage of the profit each partner is sacrificing.

For instance, if Partner A originally had 50%, but their share is reduced to 40% in the new ratio, then Partner A is sacrificing 10%. The sacrificing ratio will show this reduction for each partner accordingly.

Gaining Ratio

The gaining ratio is the mirror image of the sacrificing ratio. Partners can apply it to determine the amount that each partner is going to gain from the changes made in the profit-sharing ratio. Whenever a set of partners sacrifices part of their share, then the remaining set of partners will benefit due to this change. The gaining ratio signifies the increased amount of profit that every partner is going to receive due to the modification made in the profit-sharing structure.

Calculating the gaining ratio:

Calculating the difference between the new and old profit-sharing ratio for each partner.
Totaling the increases for all partners to determine how much each partner has gained as a result of the sacrifice made by others.

For example, if Partner A’s share increases from 30% to 40%, they gain 10%. Similarly, if Partner B’s share increases from 40% to 45%, their gain is 5%.

Subsequent Adjustments

After the existing partners decide on the new profit-sharing ratio, they must make several subsequent adjustments to reflect the changes. There are revaluation of assets and liabilities, adjustments in reserves, accumulated profits and losses, and adjustments in goodwill.

Revaluation of Assets and Liabilities

Some of the most fundamental adjustments include revaluing assets and liabilities if the profit-sharing ratio is to change. This is so because such a revaluation would indicate the fair market value, which could differ from book value. Such adjustments in this respect ensure that partners reasonably compensate for the changes in profit-sharing ratios.

Revaluation involves:

Assessing the current value of assets such as property, machinery, and stock.
Determining any liabilities, such as loans or outstanding bills that may have changed in value.
Adjusting the books to reflect these new values.

Revaluation will result in either profit or loss. If the increase occurs, then the result will be a profit if it is a decrease in value. The partners present can divide these revaluations of profits or losses among themselves using their old ratio unless they state otherwise.

Adjustments of Reserves, Accumulated Profits, and Losses

When the profit-sharing ratio changes, we have to adjust existing reserves, accumulated profits, or losses.
Partners usually create reserves and accumulated profits over time, which represent earnings that they have not distributed.

The adjustments involve:

Transferring reserves: If there are existing reserves such as general reserves, partner-specific reserves, or revaluation reserves, these must be adjusted according to the new profit-sharing ratio.
Distributing accumulated profits: Allocate any undistributed profits from prior years based on the new profit-sharing ratio.
Handling losses: Partners must allocate any accumulated losses among themselves according to the revised ratio.

The calculation for each partner’s share of the reserves, profits, or losses will follow the same principle as the new profit-sharing ratio. For example, if Partner A’s share of accumulated profits is 40% and the ratio changes to 50%, Partner A will receive a higher proportion of any accumulated profits.

Adjustment for Goodwill

Goodwill refers to an intangible asset whereby the value created in business is reflected within a business’s reputation and customer base, brand name recognition, and other factors that do not have a material form. In the partnership context, goodwill is influential in instances where there happens to be a change in the profit-sharing ratio among already existing partners. The present partners can decide in regards to adjusting the goodwill as their contribution to that particular partnership.

There are two primary methods for adjusting goodwill:

No consideration of goodwill: In this case, the new partners are simply brought into the partnership without any goodwill payment. This approach is common when a partner is leaving, and there is no exchange of value for goodwill.
Goodwill payment: A change in the profit-sharing ratio among existing partners signifies a modification in the agreed-upon ratio for sharing losses or profits in a business partnership. For example, if Partner C is joining, they may need to pay a certain amount to the existing partners in proportion to their share of the goodwill.

The books adjust goodwill, and partners record the amount paid or received. Partners share any goodwill created or written off during the adjustment process in their old profit-sharing ratio unless they agree otherwise.

Change in Profit Sharing Ratio FAQs

What is the significance of the change in profit-sharing ratio?

A change in profit-sharing ratio ensures that the distribution of profits and losses among partners reflects their new roles, contributions, or agreement changes.

How is the sacrificing ratio calculated?

The sacrificing ratio is calculated by determining the difference between a partner’s old and new share of profits. This difference represents how much each partner is willing to sacrifice.

What are the implications of revaluation of assets when changing profit-sharing ratio?

Revaluation ensures that the assets and liabilities reflect their current market value. Any increase or decrease in value is shared among the partners in their old profit-sharing ratio.

Is goodwill always considered when changing the profit-sharing ratio?

No, goodwill is not always considered. It depends on the agreement among the partners and whether any payments for goodwill are being made.

How are reserves and accumulated profits adjusted during a change in profit-sharing ratio?

Reserves and accumulated profits are distributed among the partners according to the new profit-sharing ratio after adjustments for any changes in assets or liabilities.