How will you deal with a change in profit sharing ratio among existing partners? Take imaginary figures to illustrate your answer.
To deal with a change in the profit sharing ratio among existing partners, the firm first ascertains the new profit sharing ratio. For instance, if partners Harry, Porter, and Ali share profits in the ratio of 2:2:1, and they decide to share future profits equally, the new ratio will be 1:1:1. If the partners agree that the change should apply retrospectively for past years, the profits for those years are recalculated based on the new ratio. This involves determining the difference between what a partner originally received and what they are now entitled to.
The necessary adjustment is recorded through an adjustment entry. The partners who gain from the change are debited, while those who sacrifice are credited. For example, if Ali gains a share retrospectively, Harry and Porter (the sacrificing partners) would be debited, and Ali would be credited to reflect the adjustment in their capital accounts.
Explanation
The provided context contains a specific example regarding partners Harry, Porter, and Ali, where Ali wants an equal share and wishes for the change to apply retrospectively. The answer uses this specific context to explain the process: calculating the new ratio (equal share implies 1:1:1) and passing an adjustment entry for retrospective changes. The context also supports the method of passing adjustment entries (illustrated by the X, Y, Z example) to rectify or adjust partner accounts.
Solution Steps
Step 1: Determine the new profit sharing ratio based on the agreement (e.g., changing from 2:2:1 to equal shares 1:1:1).
Step 2: Calculate the effect of the retrospective change on past profits.
Step 3: Pass an adjustment entry where gaining partners' accounts are debited and sacrificing partners' accounts are credited.