TREATMENT OF GOODWILL WHEN THERE IS CHANGE IN THE PROFIT SHARING RATIO OF EXISTING PARTNERS

A change in Profit Sharing Ratio basically implies that one partner is purchasing from another partner, a share of profits previously belonging to the latter. The purchasing

or gaining partner must compensate the sacrificing partner by paying the proportionate amount of goodwill. In other words, the gaining partner should pay the sacrificing partner that share of goodwill which is equal to the share gained by him. For example,
suppose A and B are sharing profits in the proportion of4/ 5 : 1/5 . If it is decided that in future they will share profits in the proportion of 3/5 :2/ 5 , it implies that A is selling 1/5 of  4/5  − 3/5 of his share to B. If the profits of the firm are  1,00,000 p.a. A will lose  20,000 and B will gain 20,000 annually. This must be compensated by B by paying to A an amount equal to 1/5 th of total present value of goodwill of the firm. If the goodwill is valued at  5,00,000 B must pay to A 15 th of 5,00,000 example :  1,00,000.

Such an adjustment is made by passing an adjustment entry wherein B’s Capital Account will be debited and A’s Capital Account will be Credited by 1,00,000.

Example:

M and N were partners in a firm sharing profits in the Ratio of 3 : 2. With effect from 31st March 2014 they agreed to share profits equally. For this purpose the goodwill of the firm was valued at ` 3,00,000. Pass the necessary adjustment entry :

Solution :
Old Ratio of M and N = 3 : 2
New Ratio of M and N = 1 : 1

M = 3/5 – 1/2 =6-5 /10  = 1/10 (Sacrifice)

N = 2 /5 − 1/2 = 4 − 5/10= 1/10 (Gain)
Since M has sacrificed, he will be credited by 1/10 of 3,00,000 = 30,000
Since N has gained, he will be debited by 1/10 of 300000 = 30,000

N’s Capital A/c     30,000
To M’s Capital A/c     30,000
(Adjustment for goodwill due to change in
profit sharing ratio)

Example 2:

P, Q and R are partners sharing profits and losses in the ratio of 5 : 4 : 1. It was decided that with effect from 1st January 2014 the profit sharing ratio will be 9 : 6 : 5. Goodwill is to be valued at 2 year’s purchase of average of 3 year’s profits. The profits for 2011, 2012 and 2013 were ` 96,000; ` 84,000 and ` 1,20,000 respectively.

Pass the necessary journal entry for the treatment of goodwill without opening Goodwill Account.

Solution :

Average Profit = 96,000 + 84,000 +1,20,000 /1,00,000 = 3
Value of Goodwill at 2 year’s purchase = ` 1,00,000 x 2 = 2,00,000

Old Ratio of P, Q and R = 5 : 4 : 1
New Ratio of P, Q and R = 9 : 6 : 5
Sacrifice or Gain :
P = (Sacrifice)
Q = 4 /10− 6/20= 8 − 6/20= 2/20 (Sacrifice)

R = 1/10 − 5/20= 2 − 5/20= 3 /20(Gain)

Since P has sacrificed, he will be credited by 1/20 of 2,00,000 =  10,000
Since Q has sacrificed, he will be credited by 2/20 of  2,00,000 = 20,000

Since R has gained, he will be debited by 3 /20of 2,00,000 = 30,000

R’s Capital A/c Dr. 30,000
To P’s Capital A/c 10,000
To Q’s Capital A/c 20,000
(Treatment for goodwill due to change in profit
sharing ratio)

Example :

Ram and Ramesh were partners sharing profits and losses in the ratio of 3 : 1. They decided that with effect from 1st January 2013, they would share profits and losses in the ratio of 5 : 3. The partnership deed provides that in the event of any change in profit sharing ratio, the goodwill should be valued at the total of two year’s profits preceding the date the decision became effective. The profits for 2010, 2011 and 2012 were  6,00,000;  7,00,000 and  9,00,000 respectively. Pass the necessary Journal entry to give effect to the above arrangement.

Solution :

Value of goodwill =  7,00,000 +  9,00,000 =  16,00,000

Calculation of Sacrifice or Gain :

Old Ratio = 3 : 1
New Ratio = 5 : 3
Ram = 3/4 − 5/8= 6 − 5/8= 1/8 (Sacrifice)

Ramesh = 1/4 − 3/8= 2 − 3/8= 1 /8(Gain)

Since Ram has sacrificed, he will be credited by 8 of  16,00,000 = 2,00,000

Since Ramesh has gained, he will be debited by 8 of  16,00,000 =  2,00,000

Ramesh’s Capital A/c Dr. 200000
To Ram’s Capital A/c    200000
(Adjustment for goodwill due to change in
profit sharing ratio)

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