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.