Henry Rand Hatfield.

Modern accounting, its principles and some of its problems online

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principle at stake.

The first class of difficulties arises in connection with
the establishment of the firm. When an individual first
opens a set of books there either is no difficulty in know-
ing how much capital he contributes, or if there be a doubt
it is of no particular moment so far as it concerns ultimate
distribution of wealth. If A begins business with $5,000
cash and certain real estate he should, of course, attempt

316



PARTNERSHIP ACCOUNTS



317



to place correct valuation on the latter in estimating his
net wealth. But if he fails to do so it evidently does him-
self no injury. But if two persons join in a partnership,
one furnishing cash and the other real estate, it is neces-
sary to know what value is placed on the latter. To be
sure the original entry is the same whether it be in the
books of a single trader or those of a partnership, as in
either case Real Estate is debited and the Capital account
of the one contributing it is credited. This may be illus-
trated by assuming the following opening:



Dr.



FORM 119.
Balance Sheet.



Cr.



Cash $5,000

Real Estate. 5,000

$10,000



A, Capital Account $5,000

B, Capital Account 5,000

$10,000



in which the cash is contributed by A and the real estate
by B. Any other valuation of the real estate would not,
in itself affect the credit of A's Capital account; nor
would it, in the absence of special agreement, affect the
division of profits, B being entitled to half of the profits
whatever the value of his contribution. But the value at
which the contributed property is admitted is, neverthe-
less, of vital importance in a partnership for having once
been accepted by the firm any subsequent shrinkage in the
value of the real estate is a loss to be divided between the
two partners, and not one to be borne by the contributing
partner alone. Conversely a sale of the real estate for $10,-
000 gives to A as well as to B one half of the appreciation,
$2,500. It is evident then that it is essential in account-
ing to understand the nature of the contribution which
each partner makes, to interpret accurately the terms of
the partnership agreement, for " in the absence of special



318



MODEEN ACCOUNTING



agreement the rise or fall in the value of fixed plant or
real estate belonging to a partnership is as much profit or
loss of the partnership as anything else." (Robinson v.
Ashton, L. R. 20 Eq. 28 (1875)).

In this connection it is necessary to distinguish between
the division of profits and a share in the partnership.
This may be illustrated by the case where a single trader
whose Balance Sheet shows:



Dr.



FORM 120.

Balance Sheet.



Cr.



Merchandise $5,000 Capital Account



$5,000



and who agrees to admit B and give him one half of the
profits if he contributes $6,000. This done the Balance
Sheet shows:

FORM 121.
Dr. Balance Sheet of A and B. Cr.



Merchandise $5,000

Cash 6,000

$11,000



A, Capital Account $5,000

B, Capital Account 6,000

$11,000



The basis of the division of the profits here differs from
the proportion of capital contributed by each, which is
legal and not uncommon in practice. But had the agree-
ment been that the contribution of $6,000 by B entitled
him to a half interest in the business the accounts would
need different treatment. The half interest being secured
by a contribution of $6,000 it implies that A too has a
similar interest of $6,000 and consequently, accepting the
valuation of the goods at $5,000 as correct, that he is con-
strued as contributing Goodwill of $1,000 as well as the
merchandise, thus giving:



PARTNERSHIP ACCOUNTS



319



Dr.



FORM 122.

Balance Sheet of A and B.



Cr.



Merchandise $5,000

Goodwill 1,000

Cash 6,000

$12,000



A, Capital Account $6,000

B, Capital Account 6,000



$12,000



If desired the same relationship can be represented with
Goodwill eliminated as follows :



Dr.



FORM 123.
Balance Sheet of A and B.



Cr.



Merchandise $5,000

Cash 6,000

$11,000



A, Capital Account $5,500

B, Capital Account 5,500

$11,000



Similarly if the arrangement specifies that B's contribu-
tion of $6,000 gives him a three fifths interest in the busi-
ness, not merely three fifths of the profits, and the mer-
chandise still being accepted as worth $5,000, B must be
construed as bringing into the firm business connections,
or other elements of Goodwill, to such a value that his
total contribution represents one and a half times the value
of A's merchandise, or:



Dr.



FORM 124.
Balance Sheet of A and B.



Cr.



Merchandise $5,000

Goodwill 1,500

Cash 6,000

$12,500



A, Capital Account $5,000

B, Capital Account 7,500



$12,500



or again eliminating the Goodwill:



320



MODERN ACCOUNTING



Dr.



FORM 125.
Balance Sheet of A and B.



Cr.



Merchandise $5,000

Cash 6,000

$11,000



A, Capital Account $4,400

B, Capital Account 6,600

$11,000



The first point in partnership accounting to be ascertained
is then what is the exact nature of the partnership agree-
ment ; what is actually contributed ; what is the division of
interests between the partners.

It is also necessary to distinguish between one who
buys, say, a third interest in a firm from the members of
the firm and one who enters the partnership with a third
interest. Thus if A and B are in business together with
the following showing:

FORM 126.
Dr. Balance Sheet of A and B. Cr.



Miscellaneous assets $60,000



$60,000



A, Capital Account $20,000

B, Capital Account 40,000

$60,000



C might, if it were mutually agreed on, buy a third inter-
est in the firm from B, paying therefor $20,000, which
would give as the Balance Sheet of the new firm:



Dr.



FORM 127.
Balance Sheet of A, B, and C.



Cr.



Miscellaneous assets $60,000



$60,000



A, Capital Account $20,000

B, Capital Account 20,000

C, Capital Account 20,000

$60,000



But if he were admitted to the firm with a one third inter-



PAKTNEKSHIP ACCOUNTS



321



est the showing, provided he contributed the book value of
his share in the business, would have to be as follows:



Dr.



FORM 128.
Balance Sheet of A, B, and C.



Cr.



Miscellaneous Assets $60,000

Cash 30,000



$90,000



A, Capital Account $20,000

B, Capital Account 40,000

C, Capital Account 30,000

$90,000



This important distinction has not always been observed
by writers, as may be seen even in Dicksee's work on
Goodwill.

The allowance of interest on partners' capital furnishes
opportunity for disagreement, principally when the exact
nature of the allowance is not definitely stated in the arti-
cles. If interest is to be allowed on the entire capital the
matter is simple. Thus assuming partners who contribute
as follows : A $100,000, B $60,000 and C $50,000, interest
at 5 per cent, to be allowed and profits shared equally, the
several accounts concerned will be as in Form 129.

The same net results, so far as the partners' balances
are concerned, may be secured by crediting or debiting
interest on the excess or deficit which each partner's con-
tribution shows in relation to the average capital. The
three partners have together furnished $210,000, of which
the average is one third or $70,000. A receives interest
on an excess of $30,000, B is charged on a deficit of $10,000
and G on $20,000, which gives the same balances to the
credit of the several partners as those in Form 129, but
without passing the charge through the interest or profit
and loss account. The correct booking in this case could
be secured by the following journal entry:



B.
C..



$500

1,000

To A $1,500



322



MODEKN ACCOUNTING



Dr.



FORM 129.
A, Capital Account.



Or.



of interest allowed. . .
Balance



. . $3,500
. . 101,500



$105,000



Cash $100,000

Interest on $100,000 at

5% 5,000

$105,000



Balance $101,500



Dr.



B, Capital Account.



Cr.



$ of interest allowed.
Balance. .



$3,500
59,500

$63,000



Cash $60,000

Interest on $60,000 at

5% 3,000

$63,000



Balance $59,500



Dr.



C, Capital Account.



Cr.



J of interest allowed.
Balance



$3,500
49,000

$52,500



Cash $50,000

Interest on $50,000 at

5% 2,500

$52,500



Balance $49,000



Dr.



Interest Account.



Cr.



Allowed on partners'
capital:

A $5,000

B 3,000

C 2,500 $10,500

$10,500



By A $3,500

' r B 3,500

" C 3,500



$10,500



NOTE. As these accounts are to show only the effect of the interest
transactions the Interest Account has been closed directly into the
Capital Accounts instead of being carried to the Profit and Loss account
and appearing indirectly in the balance of Profit and Loss carried to the
partners



PARTNERSHIP ACCOUNTS 323

It is to be noted that had the basis of profit sharing
not been one third to each but in some other proportion,
say, 2:1:1, the basis of comparison, by which excess con-
tributions are measured, would be correspondingly modi-
fied. Thus A's contribution being compared with two
fourths of $210,000 or $105,000 he is charged with interest
on $5,000 or $250; B showing an excess of $7,500 over
$52,500 (i. e., one fourth of $210,000) receives $375; and
C pays $125. These entries produce the same results as
though the entire capital had been credited with interest
and the total interest, $10,500, had been divided in the
proportion last named.

If profits are divide^! in proportion to capital contrib-
uted by the several partners, interest may be reckoned for
the purpose of distinguishing the business profits from
those derived from invested capital, but the amounts cred-
ited to each partner is not thereby altered. Hence, while
it may be desirable to make allowance for interest even
though profits are proportionate to capital, this is useless
unless put through the interest account in full.

It is seen therefore that interest on the partners' cap-
ital may be estimated either on the whole contributed
capital, in which case the entries must go through the
Interest Account, or by figuring it merely on deficiencies
and excesses (relative to the proportion in which profits
are divided). In the former case the entries must go
through the Interest Account; in the latter the entries are
made direct to the proprietors' Capital accounts and do
not appear in the Interest Account. The former method
not only serves to adjust differences- between the partners,
but at the same time, serves to distinguish between the
profits supposedly arising from investment of capital at
the normal rate of interest and the profits of the business
operations. The second method merely adjusts differences
between partners.
23



324



MODERN ACCOUNTING



Where the agreement does not call for interest on the
whole capital but only on excesses and deficits relative to
the amount agreed on the treatment is quite similar. Tims
if the partners had agreed to contribute as follows: A
$100,000, B $60,000, and C $50,000, but in fact paid
$70,000, $73,000 and $25,000 respectively, profits to be
shared equally, the Interest Account would show:



Dr.



FORM 130.

A, Capital Account.



Cr.



Interest on $30,000 $1,500

Balance 69,200

$70,700



Cash $70,000

of interest received 700

$70,700



Balance $69,200



Dr.



B, Capital Account.



Cr



Balance $74,350



$74,350



Cash

Interest on $13,000. .
J of interest received .



$73,000
650
700

$74,350



Balance $74,350



Dr.



C, Capital Account.



Cr.



Interest on $25,000 $1 ,250

Balance 24,450

$25,700



Cash $25,000

J of interest received 700



$25,700
Balance $24,450



Dr.



Interest Account.



Cr.



To Bon $13,000 $650

Balance to partners:

A $7*00

B 700

G 700 2,100

$2,750



On A's deficit.
On C's deficit.



$1,500
1,250



$2,750



PAKTKEKSHIP ACCOUNTS



325



Had profits been shared in proportion to the agreed
on contributions of capital (i.e., in ratio of 10:6:5 in
this example) the accounts would show:



Dr.



FORM 131.
A, Capital Account.



Cr.



Interest on $30,000 deficit $1,500
Balance 69,500

$71,000



Cash $70,000

\% of interest received 1,000

$71,000



Balance $69,500



Dr.



B, Capital Account.



Cr.



Balance $74,250



$74,250



Cash $73,000

Interest on $13,000 excess 650
^V of interest received. . . . 600

$74,250



Balance $74,250



Dr.



C, Capital Account.



Cr.



Interest on $25,000 deficit $1 ,250
Balance 24,250

$25,500



Cash $25,000

t of interest received 500

$25,500



Balance $24,250



Dr.



Interest Account.



Cr.



To Bon $13,000 $650

Balance to partners :
A,W $1,000

B, A- 600

C, &. 500 2,100

$2,750



On A's deficit $1,500

On C's deficit 1,250



$2,750



326



MODERN" ACCOUNTING



But in the latter case the adjustment could have been
more simply made by entries made directly in the Capital
Accounts, without passing through the Interest Account.
But where this shorter method is used, the amount, on
which interest is charged or credited to each partner, again
is not determined by comparing his contribution with the
amount which he agreed to furnish ; but the amount which
he contributes is compared with the proportion of the total
contributed capital corresponding to his share in the
profits. Thus in the above example A's actual contribu-
tion of $70,000 is compared, not with the amount agreed
on, namely, $100,000, but with f (the ratio in which he
shares profits) of the total contributed capital, $168,000,
i. e., with $80,000, showing a deficit of $10,000, B's actual



Dr.



FORM 132.
A, Capital Account.



Cr.



Interest on $10,000 deficit $500
Balance 69,500

$70,000



Cash $70,000

$70,000



Balance $69,500



Dr.


B, Capital Account. Cr.


Balance


$74,250


Cash $73,000




$74,250


Interest on $25,000 excess 1 ,250


$74,250




Balance $74,250





Dr.



C, Capital Account.



Cr.



Interest on $1 5,000 deficit $750
Balance 24,250

$25,000



Cash $25,000



$25,000
Balance $24,250



PARTNERSHIP ACCOUNTS



327



contribution is compared with ^ of $168,000 or $48,000,
showing an excess of $25,000, and C's with -^ or $40,000,
showing a deficit of $15,000. The accounts would there-
fore appear as in Form 132.

To sum up : When interest is allowed on the total cap-
ital, entries may be through the Interest Account, or the
adjustment may be made directly between the Capital Ac-
counts by allowing interest on excesses and deficits relative
to the proportion of total contributed capital correspond-
ing to the individual partner 's share of profits. But where
interest is allowed only on excesses and deficits, the shorter
method can be used only where profits and assumed capital
contributions are proportionate. Otherwise the adjust-
ment of excesses must be made by the longer form of put-
ting entries through the interest or other similar account.

A third problem relates to the final distribution of as-
sets in case of liquidation. Here great confusion exists,
even in the decisions of courts. To illustrate, there may be
taken a partnership between A and B in which A fur-
nishes $2,000 and B $500, profits to be shared equally. But
losses having been suffered, the total assets amount to only
$1,000, the balance sheet showing :



Dr.



FORM 133.

Balance Sheet.



Cr.



Cash $1,000

Deficit 1,500

$2,500



A, Capital Account $2,000

B, Capital Account 500

$2,500



It has been variously claimed that in such a case the avail-
able cash is to be divided either on the basis of the divi-
sion of the profits, i. e., $500 to each ; or on the basis of con-
tributed capital, i. e., $800 to A and $200 to B. Neither of
these is correct from the accounting viewpoint. The loss



328



MODERN ACCOUNTING



of $1,500 by the terms of the agreement being divisible
equally, the accounts should show :



Dr.



FORM 134.
Balance Sheet.



Cr.



Cash $1,000

B, deficit 250

$1,250



A, Capital Account $1,250



$1,250



so that A is entitled not only to the cash but has a valid
claim against B for $250. A moment's glance will show
that in no other way can losses be shared equally, and this
is the doctrine of Nowell v. Nowell (,L. R. 7 Eq. 538
(1869)).

Somewhat more complicated, but similar in principle
is a case where three partners whose statement is :



Dr.



FORM 135.
Balance Sheet of A, B, and C.



Cr.



Cash $2,200

Deficit 4,800



$7,000



A, Capital Account $2,000

B, Capital Account 500

C, Capital Account. 4,500

$7,000



Dividing the deficit gives :



Dr.



FORM 136.
Balance Sheet.



Cr.



Cash $2,200

B, deficit 1,100

$3,300



A, Capital Account $400

C, Capital Account 2,900

$3,300



If now, B is found to be insolvent and the claim against
him worthless, a great variety of opinions are given as to



PARTNERSHIP ACCOUNTS



329



the proper division of the remaining assets between A and
C. Thus it has been claimed that A is entitled to one half
of the cash, or $1,000, others say to or 676.92, and still
other claims, whose reasoning need not be given here, but
which may perhaps be worked out by the curious reader,
give him $1,661.54, $2,113.04, and $266.66.

To the accountant the solution is simple and clear.
There being only $2,200 cash with which to pay the $3,300
due to A and C, the two together are to suffer a further
loss of $1,100 which according to the terms of the agree-
ment is to be borne equally. Hence, charging the worth-
less claim against B equally to A and C gives :



Dr.



FORM 137.
Balance Sheet.



Cr.



Cash $2,200

A, deficit 150

$2,350



C $2,350



$2,3.50



whereby A, instead of receiving anywhere from $676.92 to
$2,113.04, is compelled to pay C $150.

While the correctness of the principle involved in this
solution is recognized by accountants, the courts have not
been so uniform. However, it is most fully set forth, with
illustrative examples in the case of Raymond v. Putnam

(44 N. H. 160 (1862)'), and has been more recently vouched
for in Whitcomb v. Converse (119 Mass. 38 (1875)) and
confirmed in Woelfel v. Thompson (173 Mass. 301 (1899) ).
Unfortunately a recent English ease (Garner v. Murray

[1904] 1 Ch. 57), relying pn the phraseology of the statute,
sanctions another solution. 1

1 The decision in Garner v. Murray has been much discussed by
accountants. A series of interesting communications on the subject
may be found in the Accountant for 1904. It is also discussed in



330 MODERN ACCOUNTING

The foregoing discussion shows the futility of the ques-
tion frequently raised as to the basis on which assets are
to be divided, the ratio in which losses are shared being
already given. Such a question involves a misconception
or else is purely gratuitous. If all losses are shared accord-
ing to the agreed proportion, the capital accounts of the
several partners show the amounts which they are sev-
erally to receive or pay. Evidently a firm starting with an
equality of assets and capital will, by the most elementary
principle of bookkeeping, have assets still equaling the
balances of the Capital Accounts if all shrinkages are de-
ducted from the original credits. One needs not estimate
proportions, the absolute amounts must appear in the Capi-
tal Accounts themselves. To determine the final distribu-
tion of assets it is necessary only to determine profits and
losses, to divide these in the agreed proportion, and to
discharge the remaining capital balances, collecting from
the debtor, and paying to the creditor partners.

In one set of circumstances there is, however, a problem
of division of assets apparently distinct from that of appor-
tionment of losses. This occurs where a liquidation takes
place and it is desired to distribute the assets in install-
ments as quickly as they are realized, and hence before the
net loss is ascertained. The aim is to distribute the assets
in such proportions that in any contingency no one part-

Dicksee's " Advanced Accounting," 2d ed., p. 66. Dicksee favors the
solution here given, but in attempting to work out a solution corre-
sponding to the decision of the court he seems to have misunderstood
the latter.

The court records furnish many other interesting illustrations of the
difficulty which the legal mind finds in solving problems requiring ac-
counting knowledge. Aside from mere arithmetical errors, which are
surprisingly common, many of the decisions involve errors in principle.
Cases in point are: Gunnell v. Bird, 10 Wall. 304; Oakley v. Cokalete,
41 N. Y. Supp. 1124; Schulte v. Anderson, 13 Jones & Sp. 489; Butler
v. Ballard, 43 N. Y. Sup. Ct. 191. The last named is quoted anrf
criticised by W. C. Jaudon in Banking Law Journal, XI, 342.



331



ner will be paid more than his share. This may be illus-
trated by taking the case of a partnership in which the
profits and losses are to be divided as follows : 50 per cent,
to A, 30 per cent, to B, and 20 per cent, to C, the balance
sheet before liquidation begins being:



Dr.



FORM 138.
Balance Sheet of A, B, and C.



Cr.



Assets $25,000

Deficit 5,000



$30,000



A, Capital Account $10,000

B, Capital Account 10,000

C, Capital Account 10,000

$30,000



Oil the principle already discussed the deficit is appor-
tioned among the partners, leaving the claims of A, B, and
C at $7,500, $8,500, and $9,000 respectively. If the assets
were all in ready cash the problem of distribution would
be removed. But assuming that the assets are only grad-
ually sold and converted into cash, the yield in successive
installments being $10,000, $8,000, and $6,000, after which
nothing remains, there is a real problem as to the proper
distribution of each installment. When the first installment
of $10,000 is received how should it be divided ? It should
not be divided in proportion to the original contributions
of capital, that is, in thirds ; nor in the same proportion as
profits were divisible, that is, in the ratio of 5:3:2; nor
in proportion to the capital then standing on the books,
that is, in the ratio of 75 : 85 : 90. The correct method is
as follows: It being impossible to know beforehand how
much the remaining assets will yield, it is necessary to
equalize the status of the partners so that if no more cash
is received the actual losses will be in the predetermined
ratio. If nothing had been realized the net loss of each
of the partners would have been $7,500, $8,500, and $9,000



332 MODERN ACCOUNTING

respectively. But if A loses $7,500, B should, by the part-
nership agreement, lose only $4,500 and C only $3,000.
Before paying anything more to A $4,000 should therefore
be paid to B and $6,000 to C. The $10,000 cash should
accordingly be divided on this basis. The illustration is
here made simple by assuming a first installment just suf-
ficient to equalize the status of the three partners and by
omitting all consideration of expenses and interest. But
similar reasoning would determine the distribution had
some smaller sum been available for dividends.

The adjustment between partners having once been
made, all further installments are to be divided in propor-
tion to the division of losses. This is not because the divi-
sion of assets is at all the same as the division of profits
or of losses, but because this method of treating all un-
realized assets as potential losses prevents any one of the
partners being overpaid. After the distribution of the
three installments the accounts will appear as in Form
139. If the assets fail to produce more the losses are still
properly divided according to the agreed ratio. 1

The discussion in the present chapter does not profess
to treat any problems save those which seem peculiar to
the status of partnership. "While in the keeping of part-
nership accounts questions will arise as to the most con-
venient method of booking certain transactions, these are
ordinarily mere questions of general bookkeeping technic
and not peculiar to partnership. Or problems may arise
such as the amount of profits to be divided, but these are
all matters of accounting principles elsewhere discussed,
say under valuation, depreciation, or profits; questions all

1 The problems involving the principle discussed above are given in
Dicksee's "Advanced Accounting " (p. 69) and in Breaker and Chap-
man's "American Accountants' Manual." The solution given in the
former is correct, but in the latter, the authors, while apparently
recognizing the correct method, fail rigorously to apply it so that the


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Online LibraryHenry Rand HatfieldModern accounting, its principles and some of its problems → online text (page 24 of 27)