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.