A change in the profit-sharing ratio in partnership accounts refers to the alteration in the distribution of profits among the partners. This can occur for several reasons, such as:
- Changes in the contributions, responsibilities, or skills of the partners
- A desire to reflect changes in the business environment
- Admission of a new partner
- Retirement of a partner
Any change in the profit-sharing ratio must be agreed upon by all of the partners and documented in a written agreement.
Here is an example of how to calculate the new profit-sharing ratio when there is a change in the capital contributions of the partners:
Old profit sharing ratio: 2:1 (Partner A: Partner B)
New capital contributions: Partner A = $100,000, Partner B = $200,000
New profit sharing ratio:
Partner A: 100,000 / 300,000 = 1/3 Partner B: 200,000 / 300,000 = 2/3
The new profit-sharing ratio is 1/3:2/3 (Partner A: Partner B).
Change in Profit Sharing Ratio
There is a requirement for a valuation of goodwill whenever there is a change in the profit-sharing ratio of the current partners since this initiates the necessity for the valuation.
When the profit-sharing ratio is adjusted, one of the partners will benefit financially while the other will suffer a loss. As a consequence of this, the partner who benefits from the new ratio is obligated to make up for the other partner’s loss.
In terms of the profit share, the partner who is profiting may choose to buy his share of profits from any one or two other partners, depending on the circumstances. It is possible for the partners who sell the shares to make sacrifices in amounts that are equal or unequal. Always in proportion to the degree of the sacrifice made, the quantity of goodwill credited to the partner or partners from whom the gaining partner purchases his share of the business.
To accomplish this goal with the journal entry, one partner’s capital account will be debited with the proportionate share of goodwill, and the capital account or accounts of the other partners will be credited with the same amount. The partner who gains will be the one who benefits from this transaction.