The effect of an omission to charge interest on capital is as follows : (1) If the capital contributed by partners is equal, and if the shares in the profits are unequal, the partner entitled to the smaller share will lose. (2) If profits are shared equally by partners, but if their capital contribution is unequal, the partner with the larger amount invested will lose.
6. When interest on capital should not be charged to profit-and-loss account.—When interest is allowed on all of the capital accounts, it should not be charged to the profit-and-loss account as an expense of the business unless the articles so provide. The reason is that the charge for interest provided for under this agreement is not a charge for borrowed money. It is a method of equalizing the share of the respective partners in the profits by allowing to invested capi tal a fair rate of return and considering that the re mainder of the profits, after provision has been made for the earnings of capital as an investment, will be the profit for risk taking.
Therefore, this provision really constitutes a method of distributing a portion of the profits. The charge for interest should be disposed of in the same man ner as the remainder of the profits are distributed. The profits from operation, exclusive of the interest charge, will first be determined, then distributed, part in the form of an interest allowance and the remainder upon the agreed ratio. The case is different if in terest is allowed upon excess capital, which a partner has allowed to remain in the business as a loan. The case is also different when interest is charged on a deficiency of capital contribution. In the first place, interest allowed to a partner on excess capital is really interest on borrowed money, and therefore con stitutes a proper charge against the income account of the business in the same manner as interest on a bank loan. In the second case, where a partner has failed to contribute the amount he agreed upon, or has allowed his capital account to fall below the agreed amount, the firm would probably be compelled to borrow money at interest for the purposes of the busi ness, and, therefore, the interest charge made against this partner would be credited to the regular interest account of the business.
When an agreement provides that interest shall be allowed on the capital account of all the partners, the entry must nevertheless be made, even though in doing so the profit-and-loss account would show a debit balance. Thus, in a case where the profits to be distributed were not equal to the aggregate charge for interest allowed on all the capital, the difference between the net profits and the allowance for inter est would be charged against the capital account of the respective partners in the ratio in which they were to share profits and losses.
7. Adjusting interest on capital turn the part ners' accounts direct.—Another method might have been employed in handling the interest on capital in Forms 16 and 17. This method consists of an ad justment between the partners' accounts direct, elim inating any entries either thru the interest or profit and-loss accounts. For example, in Form 16, the profit-and-loss-sharing ratio was equal and the capital ratio unequal. The total capital invested was $6,000. The average capital was $2,000. Z, in his capital ac count would receive a credit of $60 for interest on his excess of $1,000 over the average capital, and X would be charged with $60 for interest on $1,000, representing the difference between his capital and the average capital. The entry to accomplish this is : X $60.00 To Z $60.00 In Form 17, the profit-and-loss-sharing ratio was 1: 2: 3. The total capital was $6,000. X, who con tributed one-third of the capital, received one-sixth of the profits. Or, expressed in another way, X, who contributed one-third of the capital, would be charged with one-sixth of the losses. His capital account, therefore, is credited with interest on $1,000, the ex cess of his capital over the average of $1,000 ( one sixth of $6,000) Y's capital was one-third of the total and he re ceived one-third of the profits or would be charged with one-third of the losses. Hence no adjustment would be necessary in his case. Z, whose capital was one-third of the total, but who was entitled to receive one-half of the profits, or be charged with one-half of the losses, would be charged with interest on the excess of his capital of $1,000 over the average of one sixth, or with an amount of $60. The adjustment between the partners, expressed in the form of, an entry, is as follows: 8. Comparison of the two differ ence between the two methods may be briefly stated as follows: the first method not only attempts to ad just the differences between the partners in respect to capital but also attempts to apportion profits as between the part that is representative of a fair rate of return on capital and the profit from business opera tion. The second method serves merely to adjust the differences between the partners in respect to capital contribution.