Ambiguity of Definition of Profits.—The term “profits” as applied to business is perhaps used with as little uniformity as any term met with. When a concern speaks of its profits, it is difficult to know exactly what is intended, because the meaning of the term depends very largely on the methods of accounting of that particular concern. The reported profits of different firms are not, therefore, a true basis for judging their relative worths. For instance, although the net profits of a single proprietorship and of a partnership are usually determined in the same manner, there is nevertheless variation in the treatment of some items such as salaries, drawings, interest on capital invested, etc. The partnership form, like the single proprietorship, contemplates an investment on the part of the owners not only of capital but also of time and effort. This is one of the differences in working organization between these forms of business and the corporation. Investment in the corporation is of capital only. If services are employed by the corporation, they are paid for and charged as services, salaries, etc.

Compensation for Time and Services.—In the partnership form of organization, the active and direct management of the business is usually vested in the owners. Where this is not the situation, as in a limited partnership, or whenever one or more of the partners does not take an active part in the management of the business, his share of the profit is usually curtailed by the allowance of salaries to the managing partners before any distribution of profits in the agreed ratio is made to the partners. Thus, partnership profits include not only the salaries of the owners but, in general, a recompense for the time and ability of the proprietors. The man who makes an investment in a partnership does so usually because he desires to invest his time as well as his capital. He expects, therefore, to receive not only a fair rate of interest on his money but also pay for the services he renders.

Interest on Investment.—The rate paid for the use of money is dependent both on the money market and on the element of risk involved in the particular investment. In mining ventures, for instance, where there is frequently considerable uncertainty as to the return of the principal, the interest rate is sufficiently high to offset, during the life of the loan, the possible loss of the principal at the end. So an investor in a partnership, because of the greater element of risk in comparison with other and safer investments, requires a higher rate of return in interest than he would ordinarily secure through the investment of his capital in sound securities.

Partnership Profits Defined.—Partnership profits, therefore, contain these two elements—interest and recompense for services. If profits are extraordinary or above normal, such excess may be and usually is the measure of the more-than-average ability of the partners, unless it results from the monopolistic character of the business.

In speaking of profits the term is used in a technical accounting sense and has reference to the manner of their showing in the Profit and Loss account and its content. That account or the Profit and Loss statement usually develops a so-called “net profit” which is distributed to the partners. Such profits are more easily defined by stating what should not be considered in their determination, than by attempting to give an itemized list of the income and expense items entering therein.

In accordance with the theory of the law of partnership, the net profit of a partnership is the balance of the Profit and Loss account before interest on owners’ capital investments and the recompense to the partners on account of time and services are taken into account. In the accounting for an ordinary partnership, such items as interest on capital investments, salaries to partners, etc., are not to be considered as expense items to be deducted from profits before the net earnings are determined, but as a part of the net profits to be distributed to the several owners of the business. The payment of salaries and interest on capital is made simply for the purpose of distributing net profits according to certain methods agreed upon by the members of the firm.

Profit and Loss for Comparative Purposes.—For the purpose of comparing results between different periods, the Profit and Loss account should have a fairly uniform content from year to year. It should set forth the amount of the net operating profit, in the calculation of which account should be taken of all ordinary income and expenses incurred in the operation of the business. This will provide the basis for comparison, as between periods, of the ordinary normal activities of the business.

In the “Non-Operating” or “Other Income” sections any “outside-the-business” income and expense should be shown, such as income from outside investments, and expenses in connection therewith. Items of extraordinary income and expense, however, such as the profits arising through the sale of good-will, the sale of real estate, extraordinary losses from fire, etc., usually are taken directly into the partners’ accounts so as not to destroy the value (for purposes of comparison) of the results shown by the Profit and Loss account from year to year.

In this way, while the purpose of the Profit and Loss account is to summarize the temporary proprietorship accounts, some proprietorship items may be omitted for the sake of making the summary of greater value to the proprietors. Such a method of handling does not conflict with principles previously laid down, but rests upon the general principle that accounting methods and forms must be flexible in order to conform to the requirements of particular cases; else they fail in fulfilling their full purpose.

Allowance of Salaries.—The allowance of salaries to partners is not so much for the purpose of measuring the excess of the profits of the partnership over what the individual owners might have earned by working for others, as it is for the purpose of equalizing or adjusting their interests on an equitable basis. When, on the one hand, men invest their abilities and services in addition to their capitals, and on the other hand, the profit and loss-sharing ratio is determined on the basis of capitals invested, the greater ability of a given partner may be recognized and compensated by a salary. Thus a partner of exceptional ability secures a larger share in the profits by receiving a fixed amount under the head of salary, the remaining part of the net profits being divided among all the partners in the profit and loss-sharing ratio.

Allowance of Interest.—As explained in Chapter XXXIII, it is not unusual in partnerships where the profit and loss ratio differs from the capital ratio, to allow interest on capital. The effect of such a provision is to secure a distribution of profits on a dual basis, viz., a part as interest on the capitals in the capital ratio and the remainder in the profit and loss ratio. Thus, two partners, A and B, whose capitals are $10,000 and $15,000 respectively, with a 6% interest allowance on capital and a subsequent half-and-half distribution of profits, share the profits in effect on two different bases. Suppose the profits are $6,000. The interest requirement will give A $600 and B $900, after which $4,500 will be divided equally. Interest on partners’ capitals is thus in no sense an operating expense and should be handled always in the appropriation section of the Profit and Loss.

If the partnership agreement makes specific provision (but not otherwise), interest may be charged on partners’ drawings. This is merely an additional device for adjusting the partners’ interests, and causes a slight difference in the net shares of profits. Where interest is allowed on capitals and also charged on drawings, the partners’ accounts, Personal and Capital, when considered together, comprise virtually an account current, and the interest computations may be made as will be explained in Chapter L in connection with accounts current.

Another method of profit-sharing sometimes introduced in the partnership agreement is the device of an interest allowance for a contribution in excess of the agreed amount and an interest charge on partners’ deficiency of capital. This method of equalizing unequal investments, as illustrated in Chapter XXXIV, is a fair arrangement to all concerned.

Interest on Partners’ Loans.—Careful differentiation must be made between interest on partners’ capitals and on partners’ loans. If a loan is secured from outside parties, its interest cost is a business expense, to be taken into account before determining net profits. A loan from a partner does not in the least change the manner of showing its cost. Interest on partners’ loans is not, therefore, to be handled in the appropriation section of the Profit and Loss account, but should be charged to the regular Interest Cost account, which is cleared in the regular way through Profit and Loss. The credit is to Cash if actually paid, or to the partners’ personal accounts if unpaid, although the amount is sometimes credited to the partners’ loan accounts in order to secure a compounding of the interest.

Reserved Profits.—In rare cases, before the partners’ shares in the net profit are determined, a portion of it may be reserved for some specific purpose. The portion so reserved is transferred from Profit and Loss to some specified reserve account, to indicate the retention of the profits in the business. If the profits were transferred to the partners’ accounts, they would be subject to withdrawal from the business. Even when shown in the reserve account, however, they belong to the proprietors and are just as much a part of the net worth of the business as if credited to the proprietors’ accounts. Such reservation of profits may be for the purpose of providing for the replacement of some fixed asset when it wears out, as buildings, machinery, etc., or for meeting a liability when it comes due, or for some similar purposes. Such reservations, however, are seldom made in partnership accounting and a complete treatment of the subject is reserved for the work of the second year in connection with corporation accounting.

It should be noted that reserves created from profits are not to be confused with valuation accounts, such as reserves for depreciation and doubtful accounts. Valuation accounts in no sense represent a reservation of net profits. They represent the credit side of certain asset accounts. The contra debits—to depreciation or bad debts—of these credit reserves are expenses of the business which must be taken into account before the amount of net profit can be determined.

Closing Profits to Partners’ Accounts.—The disposition of profits under a partnership does not differ materially from that under the single proprietorship form. When the net profits are determined, they belong to the proprietors and are usually transferred to their accounts. The method of transfer may be either by way of the partners’ personal accounts or direct to the capital accounts. The principle involved in either treatment was discussed at the time of closing the books for the single proprietorship and will not be repeated here. Where the partners do not desire to have any change shown in their original capital accounts, the profits may be transferred to the loan accounts of the partners or stand as open balances in their personal accounts.

The Appropriation Section—Distributing a Deficit.—The appropriation section of the Profit and Loss account shows the distribution of net profits to the partners’ accounts. A thorough understanding of the partnership agreement is necessary before the proper distribution can be made. If the agreement provides for salaries and interest on capitals and drawings, these requirements must first be met, even though the net profits are insufficient to satisfy them. Their purpose, as explained above, is to equalize conditions and interests among the partners preliminary to their sharing in the profit and loss ratio. If this equalization results in a deficit, such deficit will be distributed in the agreed ratio and to that extent nullify some portion of the profits distributed as salaries and interest. If specific provision in the articles of copartnership requires a different handling of the salaries and interest items, that provision of course governs. Otherwise these items should be treated as above.

If any of the partners leave profits in the business, this usually results in a changing ratio of the capital account balances. Where the distribution of profits is based upon the original contributions, it is advisable to transfer the profits left in the business to separate loan accounts for the partners. The partners’ capital accounts then always show their original contributions.

Partners’ Withdrawals.—Partners’ withdrawals and salaries are usually handled in a very unsystematic way. The amount of the drawings allowed each partner during a given period—week or month—should be definitely determined by agreement, and regular checks should be issued for these amounts. The payment of partners’ personal bills and the handling of any other personal items should, as a matter of standard practice, be made out of personal funds.

If the partnership agreement provides for salaries these should be credited, when due, to the partners’ drawing accounts which will then be charged with all actual drawings, whether for salary or otherwise. The offsetting charge at the time the salary credit is made should be to a “Partners’ Salaries” account, which at the close of the fiscal period is closed into the appropriation section of the Profit and Loss account, thereby showing in it the proper distribution of profits as salary.

Profits Determination upon Admitting a New Partner.—Particular care should be taken to determine as nearly as possible the correct net profit at the time of any change in the partners’ relations. Upon the admission of a new partner, failure to make entry in the old partners’ accounts of any profit rightfully belonging to them leads to its being shared with the new partner and consequently results in a loss to the old partners. In like manner the deferring of an expense charge—rightfully belonging to the period before the admission of the new partner—to the period after the admission, results in a wrongful charge to the new partner. Similarly, when a partner is admitted on a changing profit ratio basis (as when, for example, he is to receive a one-fourth share for three years, at the end of which time he is to have a one-third share), an incorrect determination of profits at the end of the three-year period may mean a loss either to him or to the old partners. So long as the same partnership and the same profit and loss-sharing ratios continue, no injustice results through failure to include some such items in their proper periods, as they are cumulative and their effect will be recorded in later periods. However, this is no excuse for the inaccurate determination of profits at any time.