Averaging Investments.—In temporary partnerships, organized for carrying out a particular undertaking, the amount of capital needed is often not known and may vary at different stages of the undertaking. Here the partners usually contribute as need arises, and withdraw when funds not needed in the business become free. Under such conditions, the partnership agreement should always state the manner in which the partners’ interests are to be adjusted. A common method, as explained and illustrated in [Chapter XXXIII], is to compute the average investment of each partner and to use these amounts as the basis for profit-sharing. In this way the problem of interest adjustment as such is completely eliminated.
Accretions of Capital through Profits.—At the close of the fiscal period, when results are summarized, the net profits are transferred to the partners’ accounts. As the amount of profit left in the business usually differs for different partners, it is evident that the partners’ capital accounts at the end of the period will show a different ratio from that existing at the beginning. Assume that a given partnership consists of two members, A investing $2,000 and B $1,000, and that profits are to be shared in the same ratio as these original investments, i.e., 2:1; assume further that A withdraws the greater part of his profits while B allows his share to accumulate, and that at the end of a number of years the capital ratios have completely changed, the capitals being, say, $8,000 for A and $24,000 for B. Obviously, under such circumstances it would not be just for A still to receive twice as much profit as B on the basis of the original investment ratio of 2:1.
Whenever it is intended that profits are to be shared on the basis of investments, the profit-sharing ratio should be changed from time to time in order to correspond with actual investments, and this should be plainly stated in the partnership agreement; or increments to capital through the accretion of profits should be treated as temporary loans subject to withdrawals and bearing interest until withdrawn. It should be the policy of the firm to offer an incentive to its members to leave their surplus profits in the business and so prevent the need of borrowing from outside.
Finally, it may be said that in the event of dissolution, accretions through profits constitute claims against the firm ranking before the partners’ capitals. Such accretions partake of the nature of loans and for this reason they are sometimes carried in partners’ loan accounts, to keep them separate from the original capital investments, or are left in the “Personal” accounts which are not then closed into the “Capital” accounts.
Additional Contributions and Loans.—When contributions are made by partners there should be a specific understanding as to whether such funds are to be considered as additional capital or as loans to the partnership. In the first case the items should be shown in the capital accounts of the partners, thus requiring a reconsideration of the profit-sharing ratio—although a change is not always made; in the second case they should be entered in the partner’s loan accounts with corresponding interest adjustments, as has been explained.
Loans by partners may be evidenced by firm notes signed by all the partners. However, these notes should not be carried in the regular Notes Payable account because that account represents the firm’s liability to outsiders, which must ordinarily be met promptly according to the terms of the instrument. At common law a partner may not bring suit against the firm of which he is a member; hence there is an essential difference between these two kinds of notes. For this reason a new account is opened entitled “Partners’ Notes Payable,” which is credited whenever the firm issues a promissory note to any of its members. Where the loan is not evidenced by a formal note, record should be in the partner’s loan account. As stated on [page 324], any loans made by partners to the business rank before regular capital claims, and this priority is not changed when such loans are evidenced by promissory notes.
Partners’ Loans in Relation to Firm Credit.—Loans made by partners to the business may be viewed in two very different ways, depending upon the credit rating of the firm. If there is distrust as to the partners’ standing and financial condition, the fact that they themselves, who know the real condition better than any outsider, are willing to put additional capital into the business, is the best evidence that the firm is not so badly off. Consequently, loans made by partners under such conditions help to increase the firm’s credit.
On the other hand, if the integrity of any member of the firm is questionable, his loans to the business do not necessarily increase the credit of the firm; for in case of financial trouble he may attempt secretly to withdraw part of the assets from the business and to conceal the true condition of affairs from the creditors. Being on the inside, he is in a position to do this before outsiders can even scent trouble. Normally, however, the loan of a partner makes a better impression than a loan from an outsider, since in case of insolvency and dissolution the partner’s loan ranks after the claims of outside creditors.
It sometimes happens that in a partnership one or more of its members lends the firm comparatively large amounts of money and accepts demand notes as evidence of such loans. If the partner holding such a note is unscrupulous, he may present it for payment at an unfavorable time and, if the business is unable to pay, may demand an “accounting.” He may even go so far as to cause its dissolution, repurchase the business at much less than its true value and so “freeze out” his partners.
Borrowed Capital.—It may happen that a firm is obliged to borrow funds from outside in order to increase its working capital. For instance, the partners may have no available private funds for further investment and yet may not desire to admit new capital on a profit-and-loss-sharing basis. Such loans usually are on a long-time basis, and should not be included in the Notes Payable account. A special account should be opened, e.g., Notes Payable Special, Mortgage, or some other title plainly indicating the nature of the loan. Sharp distinction should be made between funds borrowed for the purpose of increasing the permanent capital, and money borrowed for current needs. The need for additional current funds usually results from seasonal fluctuations in business, slow collection of customers’ accounts, or slow movement of stock, and is met by current borrowing at a bank; while the need for increased capital is caused by the original capital investment being insufficient to meet present conditions.