We know that every business involves certain level of risk. As a result of the risk factor, the amount of profit earned by a business firm also fluctuates. Sometimes, in order to insulate the partners against such fluctuations, a partner/s is/are assured of a minimum amount of profits by the way of Guarantee of Profits. Such guarantee can either be given by all the partners of a firm (in an agreed ratio) or by any one or some of them. The partner to whom such guarantee of profit is made is known as Guaranteed Partner and the partner who has given such guarantee is known as Guaranteeing Partner. The amount of minimum profit that is to be paid to the guaranteed partner is known as Guaranteed Profit.
Note: It should be noted that the guaranteed profit is payable to the guaranteed partner only when his/her actual share of profit (as per the profit sharing ratio) falls short of the guaranteed amount.
Different Situations of Guarantee of Profit
Guarantee of Profit can be classified under the following three cases.
- Guarantee by one partner to another
- Guarantee by all other partners to one partner
- Guarantee by partners and by firm
- Guarantee by partner to firm
Case I: Guarantee by One Partner to Another
In this case, a partner guarantees a minimum amount of profit to another partner. If in case, the amount of profit of the guaranteed partner (as per his profit share) falls short of the guaranteed profit, then the deficiency will be borne by the guaranteeing partner (the one who has given the guarantee). For example, Ram, Shyam and Mohan are partners sharing profits and losses in the ratio 3:2:1 and the firm earned a profit of Rs 18,000. Mohan was guaranteed by Ram to receive a minimum profit of Rs 5,000.
In this case, the share of profit as per the profit sharing ratio of 3:2:1 amounts to Rs 9,000 (to Ram), Rs 6,000 (to Shyam) and Rs 3,000 (to Mohan). As the amount of Mohan’s profit falls short of the guaranteed profit of Rs 5,000, so the deficiency of Rs 2,000 (i.e. Rs 5,000 – Rs 3,000) has to be borne by Ram (as Ram has given the guarantee to Mohan). However, if Mohan’s profit share would have been Rs 5,000 or above (as per the profit sharing ratio), then no deficiency was to be brone by Ram.
Case II: Guarantee by All Other Partners to One Partner
In this case, a partner is assured of the guaranteed minimum profit by all the other partners of a firm. Unlike the above case, the deficiency will be borne by the other partners. It should be noted that deficiency can either be borne by the other partners in some specified ratio (mentioned in the question) or in their profit sharing ratio (if agreed ratio is not mentioned). For example, Ram, Shyam and Mohan are partners sharing profits and losses in the ratio 3:2:1 and the firm earned a profit of Rs 18,000. Mohan was guaranteed by Ram and Shyam to receive a minimum profit of Rs 5,000. In case of any deficiency to the guaranteed profit, then it will be borne by Ram and Shyam in the ratio 4:1. In this case, the share of profit as per the profit sharing ratio of 3:2:1 amounts to Rs 9,000 (to Ram), Rs 6,000 (to Shyam) and Rs 3,000 (to Mohan).
Case III: Simultaneous Guarantee by Partners and by Firm
Example: J, K, L and M are four partners in a partnership firm sharing profits and losses equally. Their capital account balances in the books appeared as Rs 1,00,000, Rs 1,25,000, Rs 75,000 and Rs 1,50,000 respectively.
- Interest on capital is 10% p.a.
- Salary to L is 2,500 per month.
- Interest on partners’ loan to the firm is 4% p.a.
- L was guaranteed by the firm of a minimum profit of Rs 50,000 p.a.
- M on the other hand, was guaranteed by J of a minimum profit of Rs 60,000.
Case IV: Guarantee by Partner to the Firm
In this case, the partner ensures a minimum amount of profit to the firm. If in case, the amount of profit of the firm falls short of the guaranteed profit by the partner, then the deficiency will be borne by the guaranteeing partner (the one who has given the guarantee).
Example: A, B and C are partners sharing profits and losses in the ratio of 3 : 2 : 1. C gives guarantee that the gross fee earned by him for the firm shall not be less than Rs 30,000. However, C actually earned Rs 15,000 for the firm. Show the distribution of profit by preparing Profit and Loss Appropriation Account when profit earned by the firm was Rs 60,000.
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