From the fact that the law looks upon the partnership as a combination or collection of sole owners, some of the accounting problems arising out of the partnership form of organization are unique, and a partial or full treatment of some of these problems will be given in this chapter.

Profit-Sharing in the Partnership.—Of these problems perhaps the one occurring most frequently is that concerning the division of profits. Attention was called in Chapter XXXII to the need of explicit statement on this point in the articles of copartnership under the head of the intrapartnership relations. Since men combine their capitals for the purpose of realizing profits, it would naturally be supposed that all partnership agreements would be specific on that point. Yet it very often happens that many contingencies relating to the matter of profit-sharing have not been foreseen and as a result disputes arise.

The fundamental principles governing profit distribution may be stated as follows:

1. Where the agreement is silent, the law provides that profits shall be divided equally among the partners regardless of the amounts of their respective investments of capital. Some partners may have made no investments of money or property, setting up their particular skill and aptitude or standing in the community as their share and contribution to the profit-earning capacity of the organization. Unless it is specifically agreed otherwise, these will share equally in any profits.

2. Where profits are to be shared in the same ratio as capital, the agreement should specify whether the basis of division is to be the original investments or the capitals as shown at the beginning of each period, which would be the original investments plus profits left in the business. This latter interpretation would usually result in a changing ratio for succeeding periods, whereas under the former interpretation the ratio of profit-sharing would be always the same.

3. Provision should be made, either in the original articles or at a subsequent time, for a change in the profit-sharing ratio in the event of a partner’s withdrawing some portion of his original investment if such withdrawal is allowed. It may be stated here that an agreement between the partners as to any ratio for division of profits can be made at any time and will govern such ratio, but must be on a determinable basis.

4. Where the articles are silent as to the division of losses, the profit-sharing ratio governs. Where a different ratio is desired, specific statement of it must be made. Of course, upon the inception of an undertaking losses are not contemplated, but the experience of others should cause provision to be made for apportionment of losses in order to avoid possible difficulties or disputes.

5. Unless the articles—or subsequent agreements—provide for the payment of salaries to any or all of the partners, none are allowed.

6. The conditions governing the partners’ drawings should be explicit as to the amount to be drawn during a given period. It should be stated explicitly whether excess drawings shall be regarded as a charge against capital, or as the basis for an interest charge, or simply as an excess drawing standing in the partner’s current account without penalty other than a disallowance of future drawings until lapse of time brings the total amount drawn within the agreed limitations.

7. The manner of handling undrawn profits should be made definite. Are they to be transferred to the capital account and so be made a part of capital, resulting in changing capital ratios; or are they to be carried as open balances in the drawing accounts and thus take on the nature of temporary loans subject to withdrawal at any time?

Average Investment as a Basis for Profit-Sharing.—Attention should be called to a basis for profit-sharing sometimes employed for special partnerships, entered into for the performance of a specific contract or for doing any special work. In these cases the capital needed may not be known at the start, or if known may not all be required then but is to be furnished by whichever partner may have available funds at the time of need. In such cases the basis of profit-sharing may be made the amount of capital furnished by each partner and the length of time of its use in the enterprise. Two methods of determining the ratio may be employed.

First Method. Each investment may be multiplied by the number of days occurring between the date on which the investment was made and the date of profit determination, giving a result which may be called “day-dollars” of investment in a sense similar to the term foot-pound in physics. From the total day-dollars of investment must be subtracted the day-dollars of withdrawals, arrived at similarly, thus showing net investment in terms of day-dollars. The sum of all the investments in day-dollars becomes the basis on which to prorate profits, each partner’s share being the part which his individual net investments bear to this total net investment.

Second Method. The original investment of each partner may be multiplied by the time it remains unchanged, i.e., until it is added to or some portion is withdrawn. Similarly, this changed capital is multiplied by the time it remains fixed, and so for every change. The total of these items constitutes each partner’s net investment, from which the profit-sharing ratio is determinable as above. In the problem given below, for purposes of illustration the dates are so taken that the calculation can be made on a month-dollar instead of a day-dollar basis, thus shortening the operation. The capital accounts of the partners, showing investments and withdrawals, are as follows:

Profits as on July 1, 19—, were $5,000. Determine each share.

Solution
(Using the second method)

The first method will, of course, give identical results. The second method has the slight advantage that the Investment Months column will always total the same as the length of the fiscal period, provided each partner makes his initial investment at the first of the period—which is not always the case—and acts as a check on the accuracy of that part of the calculation.

Interest on Partners’ Investments.—A second problem of importance in connection with partnership accounting is the interest on partners’ investments. The purpose of allowing such interest is twofold: First, it may serve as an indication of the excess of the profits in this enterprise over the return on the investment of a like amount in the money market, thus dividing the partnership profits into two parts, interest and management earnings; and second, it may serve as a method of distributing profits up to a certain amount on the basis of capital investments, where the agreed-on ratio is different from the capital ratio, thus distributing the period’s profits on two different bases or ratios.

This is done sometimes to equalize somewhat the comparatively smaller-ratio profits of the partners who have made the larger investments. This problem, however, will be treated more fully in a later chapter where the methods of booking the interest, its treatment in case of a loss instead of a profit, and the computation of interest on drawings as well as on investments will be discussed and illustrated. Suffice it to say here that disputes frequently occur in connection with these problems and that detailed provision as to their handling should be made in the partnership agreement.

Valuation and Correct Booking of Original Investments.—A third matter of importance is the valuation and correct booking of the original investments other than cash. In the case of the sole proprietor this is of comparatively little importance because he will always reap the entire gain and therefore suffer no harm ultimately from present undervaluation of his property investments. In the partnership, however, where separate investment and personal accounts must be kept with each member, the correct valuation of the assets is of importance, inasmuch as the property of the partnership is the joint property of all partners and all will share ultimately in the effect of any under-or over-valuation at the time of investment. The partners’ accounts are set up for the purpose of showing their respective interests in the enterprise, and after investments are once brought onto the books these accounts govern the equities of the various partners.

Distinction between Buying Out an Interest and Making an Investment to Secure an Interest.—The taking in of a partner by a sole proprietor or his admission as a new member to an existing partnership raises a point about which there must be a very definite understanding. A distinction must be made between purchasing from the owners an interest in the business as it stands at any given time and making an investment in a business to secure such an interest. The first transaction is of a personal nature between the owners and a third party who is a purchaser; in the other transaction the third party, who is an investor, puts in money to acquire an interest and his investment becomes the common property of all the owners of whom he is now one. In the one case the capital of the business is not increased, in the other case it is increased by the amount of the new investment. For example, if a balance sheet shows:

and Jackson sells a half-interest to B. Killian for a given consideration, the new balance sheet becomes:

In this case no new capital has come into the business because the purchase price does not go to the business as such but to A. Jackson as a private individual.

If, however, Killian is admitted as a half-interest partner by making a cash investment equal to the amount of Jackson’s interest on the basis of book values, the balance sheet of Jackson and Killian will read:

showing an investment of double the capital in the original Jackson business.

The question of good-will which frequently comes up when an interest in a going business is secured will be treated in Chapter XXXV, where also the manner of closing the books of the old business and opening those of the new firm will be shown.

Final Considerations.—From the foregoing discussion it is evident that the partnership relation gives rise to some of the most vexing questions which confront the accountant and the lawyer. It is a truism, therefore, that in drawing up the partnership agreement, all eventualities should be foreseen as nearly as possible and that they should be carefully provided for. As a final safeguard it is well to provide for the submission to arbitrators of disputes subsequently arising, the decision to be binding upon all the partners. This will avoid endless, expensive, and usually unsatisfactory actions at law and will more nearly secure justice to all. As a step in the same direction, it is suggested that provision be made for the drawing up of correct balance sheets and profit and loss statements, that sufficient time be allowed each partner to examine them as to their correctness and, if satisfied, that each be compelled to subscribe to them. This will localize any dissatisfaction within a limited time period and secure its adjustment while all salient points are still fresh in the minds of the interested parties.