Guarantee of Profit to a Partner –
When a new partner is admitted to the partnership firm, he/she becomes eligible to share the profits earned by the firm in the agreed profit sharing ratio.
For eg – A and B are partners in a firm and they admitted C as a new partner as they wanted to expand their managerial expertise. Together A, B and C decided to share profits in the ratio of 3:2:1. During the year, the firm earned Rs 60,000 as profits. As per the agreement, the share of partner A = Rs 30,000 (3/6 of Rs 60,000), B = Rs 20,000 (2/6 of Rs 60,000), and C = Rs 10,000 (1/6 of Rs 60,000).
But in certain situations, a new partner can be admitted to the firm with a guarantee that he/she shall receive a minimum amount in the form of profits of the firm. This minimum amount is known as the guarantee of profit to a partner.
This assurance of guarantee of profit to a partner may be given either by –
a) collectively all the existing (old) partners in a specified ratio or,
b) by one of the existing (old) partners.
This concept of guarantee of profit to a partner comes into play when the share of profit of the new partner calculated on the basis of agreed profit sharing ratio is short of the minimum amount guaranteed.
Example –
Situation 1 – If guarantee of profit to a partner was given collectively by all the old partners –
A and B are partners in a firm and they decided to admit C as a new partner. Together A and B gave a guarantee of a minimum profit of Rs 20,000 to C. The agreed profit sharing ratio of the three partners is 3:2:1 and the firm earned Rs 60,000 as profits during the year.
As per the agreement, the share of partner A = Rs 30,000 (3/6 of Rs 60,000), B = Rs 20,000 (2/6 of Rs 60,000), and C = Rs 10,000 (1/6 of Rs 60,000).
To calculate the amount that is short of the guaranteed amount, the following formula is used.
Deficit = Profits guaranteed – Profits calculated as per Profit sharing ratio
In the above example, Deficit = Rs 20,000 – Rs 10,000
Therefore, we can see that share of C in profits is short by Rs 10,000 that what was guaranteed. This difference shall be made good by the old partners in their profit sharing ratio, i.e., 3:2.
Share of old partners in deficiency –
A = Rs 6,000 (3/5 of Rs 10,000)
B = Rs 4,000 (2/5 of Rs 10,000)
So, revised share of profits of old partners would be calculated by using the formula given below –
Share of profits of old partners = Profits calculated as per profit sharing ratio – Share in deficiency
Now, the division of profits between the partners would be as follows –
A = Rs 30,000 – Rs 6,000 = Rs 24,000
B = Rs 20,000 – Rs 4,000 = Rs 16,000
C = Rs 10,000 + Rs 6,000 + Rs, 4000 = Rs 20,000
Situation 2 – If one partner decides to give guarantee of profit to a partner –
Following the above example, if instead of both A and B, only A decides to give guarantee to C of a minimum profit of Rs 20,000. Then the whole amount of deficiency of Rs 10,000 would be met by A only.
Distribution of profit in that case would be –
A = Rs 30,000 – Rs 10,000 = Rs 20,000
B = Rs 20,000 – NIL = Rs 20,000
C = Rs 10,000 + Rs 10,000= Rs 20,000
Conclusion – At times, a new partner can be admitted to the partnership firm with a guarantee of minimum amount as the share of profits. Any difference between the amount guaranteed and profits distributed as per profit sharing ratio would be compensated by the old partners.
Chapter 2 – Accounting for Partnership: Basic Concepts
- Nature of Partnership
- Partnership Deed
- Maintenance of Capital Accounts of Partners
- Distribution of Profit among Partners
- Guarantee of Profit to a Partner
- Past Adjustments