essential characteristic of the partnership. The partnership relation
is a very personal one. It can be terminated in a number of ways, but
the death or retirement of any member automatically works a dissolution
of the firm, even though another man takes his place. The legal theory
is that the old partnership is dead and a new one, even though bearing
the same firm name, has come into existence. Thus a partnership cannot
be perpetual. The relationship between the partners is so intimate that
the success of the undertaking depends fundamentally on the good faith
and honor exercised by each partner towards the others, and therefore
any addition to the personnel of a partnership can be made only with
the consent of all members of the existing firm.
The partnership being the outgrowth of the sole proprietorship,
certain of the aspects of its earlier form still cling to it. For
suit at law it is looked upon as a collection of single owners, and
action on contract must usually be taken against the individual members
of the firm. Suit by or against the partnership cannot as a rule be
brought in the firm name. Some states, however, allow this under recent
enactments. Title to personalty can be held and transferred under the
firm name, but realty must be in the name of the individual members or
in the name of one member acting as trustee for the firm. Thus, while
in the view of the business community the copartnership is a business
entity under a firm name, in the sight of the law it is not an entity
but merely a collection of single owners. This legal view accounts
also for the full debt liability of every partner--except in a limited
partnership. In case the firm assets are insufficient to meet the
claims of creditors, any or all the partners’ private resources may be
levied upon.
Co-ownership of the profits of a business is another feature essential
to the copartnership. No sharing in the profits on any other basis than
that of co-ownership will constitute a partnership. When the question
comes before the courts, the intention of the parties governs, and
evidence showing that each acted as principal for himself and as agent
for the others, and has shared profits as profits, would be sufficient
to constitute the relationship.
=The Partnership Contract.=--A partnership being a contract
relationship, all the requirements governing legality of contracts,
such as agreement, consideration, lawful object, competency of
contracting parties, etc., apply to the copartnership. The contract
may be oral or in writing. In case of dispute an oral contract, on
account of the difficulty of proof, is of little force in regulating
the relations of the partners, and the general law of partnership
would usually govern. Inasmuch as there is so great an opportunity for
disputes in a relationship of this sort, it is imperative, if efficient
working relations are to be maintained, that very carefully drawn
articles of copartnership be agreed upon before active business is
begun. These articles should contain, at least, the following:
1. The name of the firm and of the partners.
2. The kind and place of business.
3. The duration of the partnership.
4. The method of terminating it.
5. A detailed statement of the relations between the
partners, such as duties and powers, capital
contributions, withdrawals of capital, salaries,
division of profits and losses, interest on
capital, and the time of closing the books to
secure a definite determination of the partners’
interests.
Even when the utmost care is exercised in drafting the articles
of partnership, it almost always happens that some portion is
not understood alike by all or that some contingency arises not
specifically provided for. Nevertheless, it is the only way in which a
comparative avoidance of misunderstanding and dispute can be obtained.
=Partnerships Classified.=--As to the scope of their business
operations, partnerships are usually classified into general and
special. The general class embraces those for the conduct of some
general or ordinary lines of business. The special class comprises
those formed to undertake a definite task or some particular line of
business. Joint ventures would come under this latter class.
As to the liability of their members, partnerships may be classified
as general and limited. The general partner has the full liability,
referred to above; the limited partner’s liability never exceeds the
amount of his investment. In a limited partnership one or more, but not
all, members may limit their liability. This class of partnership can
be formed only under direct authority of statute law. A limited partner
is not active in the management of the business, being more in the
nature of a lender of money to the firm, who gets his return in profits
instead of interest. Should he become active in the firm’s management,
he will constitute himself an ordinary partner with full liability. The
New York statute governing the formation of the limited partnership is
as follows:
Two or more persons may form a limited partnership which
shall consist of one or more persons of full age, called _general_
partners, and also of one or more persons of full age who contribute
in actual cash payments, a special sum as capital, to the common
stock--or fund--called _special_ partners, for the transaction
within this state of any lawful business, except banking and insurance
by making, severally signing and acknowledging and
causing to be filed and recorded in the clerk’s office in the county
where the principal place of business of such partnership is located,
a certificate in which is stated:
1. The name or firm under which such partnership is to
be conducted and the county wherein the principal
place of business is to be located.
2. The general nature of the business intended to be
transacted.
3. The names, and whether of full age, of all general
and special partners therein, distinguishing which
are general and which are special partners, and
their places of residence.
4. The amount of capital which each special partner
has contributed to the common stock--or fund.
5. The time at which the partnership is to begin and end.
Affidavit of the payment of capital must be made and a notice of
the formation of the partnership published in a paper of general
circulation. The limited partnership is thus hedged about with
safeguards for creditors, bankers, and other interested parties,
particularly by the rule that a limited partnership cannot exist unless
there are one or more general partners with full liability.
=The Joint-Stock Company.=--The joint-stock company is a partnership
or association in which ownership, voice in the management, and
profit-sharing ratio are evidenced by transferable shares of stock.
Control and management are exercised through a board of directors
chosen by the stockholders. If the company becomes bankrupt and the
firm assets are insufficient to satisfy creditors, the members are
personally liable to the full extent of their private property in the
same way as in a general partnership.
The mining partnership is a form of joint-stock company which operates
in mining communities. Usually the mining property itself is beyond the
scope of such a partnership, only the development of this property by
means of a lease being contemplated. Unlike the ordinary partnership,
the members of a mining partnership may assign their shares of
ownership. Upon their death or bankruptcy, their interests pass to
others who take their place in the partnership without the consent of
the remaining partners. Thus, the confidential relationship based on
the right of selection of its members, characteristic of the ordinary
partnership, is largely lacking in the mining partnership.
=Partners Classified.=--Finally, brief mention may be made of the
following terms applied to partners to indicate varying degrees of
activity within the ordinary partnership:
1. Ostensible partners--those who hold themselves out
and are known to be partners.
2. Nominal--those who are known as partners but who
have no real interest in the firm.
3. Dormant or silent--those who are not known to
outsiders as partners and who take no active
part in the management of the firm’s affairs.
4. Secret partners--those who are not known as
partners to outsiders but who have an interest and
take active part in managing the firm.
For more detailed information as to a partner’s rights, duties, and
responsibilities to his copartners and to outsiders, a standard legal
text on partnerships or business law should be consulted. The student
should also read Chapter II in connection with this chapter and the
next.
CHAPTER XXXIII
PARTNERSHIP FROM THE ACCOUNTING VIEWPOINT
From the fact that the law looks upon the partnership as a combination
or collection of sole owners, some of the accounting problems arising
out of the partnership form of organization are unique, and a partial
or full treatment of some of these problems will be given in this
chapter.
=Profit-Sharing in the Partnership.=--Of these problems perhaps the one
occurring most frequently is that concerning the division of profits.
Attention was called in Chapter XXXII to the need of explicit statement
on this point in the articles of copartnership under the head of the
intrapartnership relations. Since men combine their capitals for the
purpose of realizing profits, it would naturally be supposed that
all partnership agreements would be specific on that point. Yet it
very often happens that many contingencies relating to the matter of
profit-sharing have not been foreseen and as a result disputes arise.
The fundamental principles governing profit distribution may be stated
as follows:
1. Where the agreement is silent, the law provides that profits shall
be divided equally among the partners regardless of the amounts of
their respective investments of capital. Some partners may have made no
investments of money or property, setting up their particular skill and
aptitude or standing in the community as their share and contribution
to the profit-earning capacity of the organization. Unless it is
specifically agreed otherwise, these will share equally in any profits.
2. Where profits are to be shared in the same ratio as capital, the
agreement should specify whether the basis of division is to be the
original investments or the capitals as shown at the beginning of
each period, which would be the original investments plus profits
left in the business. This latter interpretation would usually result
in a changing ratio for succeeding periods, whereas under the former
interpretation the ratio of profit-sharing would be always the same.
3. Provision should be made, either in the original articles or at a
subsequent time, for a change in the profit-sharing ratio in the event
of a partner’s withdrawing some portion of his original investment if
such withdrawal is allowed. It may be stated here that an agreement
between the partners as to any ratio for division of profits can
be made at any time and will govern such ratio, but must be on a
determinable basis.
4. Where the articles are silent as to the division of losses, the
profit-sharing ratio governs. Where a different ratio is desired,
specific statement of it must be made. Of course, upon the inception
of an undertaking losses are not contemplated, but the experience of
others should cause provision to be made for apportionment of losses in
order to avoid possible difficulties or disputes.
5. Unless the articles--or subsequent agreements--provide for the
payment of salaries to any or all of the partners, none are allowed.
6. The conditions governing the partners’ drawings should be explicit
as to the amount to be drawn during a given period. It should be stated
explicitly whether excess drawings shall be regarded as a charge
against capital, or as the basis for an interest charge, or simply as
an excess drawing standing in the partner’s current account without
penalty other than a disallowance of future drawings until lapse of
time brings the total amount drawn within the agreed limitations.
7. The manner of handling undrawn profits should be made definite. Are
they to be transferred to the capital account and so be made a part
of capital, resulting in changing capital ratios; or are they to be
carried as open balances in the drawing accounts and thus take on the
nature of temporary loans subject to withdrawal at any time?
=Average Investment as a Basis for Profit-Sharing.=--Attention should
be called to a basis for profit-sharing sometimes employed for special
partnerships, entered into for the performance of a specific contract
or for doing any special work. In these cases the capital needed may
not be known at the start, or if known may not all be required then but
is to be furnished by whichever partner may have available funds at the
time of need. In such cases the basis of profit-sharing may be made the
amount of capital furnished by each partner and the length of time of
its use in the enterprise. Two methods of determining the ratio may be
employed.
FIRST METHOD. Each investment may be multiplied by the number of days
occurring between the date on which the investment was made and the
date of profit determination, giving a result which may be called
“day-dollars” of investment in a sense similar to the term foot-pound
in physics. From the total day-dollars of investment must be subtracted
the day-dollars of withdrawals, arrived at similarly, thus showing net
investment in terms of day-dollars. The sum of all the investments
in day-dollars becomes the basis on which to prorate profits, each
partner’s share being the part which his individual net investments
bear to this total net investment.
SECOND METHOD. The original investment of each partner may be
multiplied by the time it remains unchanged, i.e., until it is added
to or some portion is withdrawn. Similarly, this changed capital is
multiplied by the time it remains fixed, and so for every change. The
total of these items constitutes each partner’s net investment, from
which the profit-sharing ratio is determinable as above. In the problem
given below, for purposes of illustration the dates are so taken that
the calculation can be made on a month-dollar instead of a day-dollar
basis, thus shortening the operation. The capital accounts of the
partners, showing investments and withdrawals, are as follows:
A. B. CARD
=========================================
19— | 19—
Jan. 15 2,500.00 | Jan. 1 10,000.00
Apr. 1 4,500.00 | Mar. 15 7,500.00
June 15 1,500.00 | June 1 5,000.00
D. E. FOLWELL
=========================================
19— | 19—
Feb. 1 3,000.00 | Jan. 1 5,000.00
May 15 2,000.00 | 15 5,000.00
| Apr. 1 5,000.00
| June 15 2,500.00
Profits as on July 1, 19—, were $5,000. Determine each share.
SOLUTION
(Using the second method)
Amount Months Month-Dollars
A. B. CARD:
$10,000 × ½ $ 5,000
7,500 × 2 15,000
15,000 × ½ 7,500
10,500 × 2 21,000
15,500 × ½ 7,750
14,000 × ½ 7,000
------ ----- -------
6 $63,250
D. E. FOLWELL:
$ 5,000 × ½ $ 2,500
10,000 × ½ 5,000
7,000 × 2 14,000
12,000 × 1½ 18,000
10,000 × 1 10,000
12,500 × ½ 6,250
----- -------
6 55,750
--------
Total investment in month-dollars $119,000
--------
63,250
Card’s share of the profit: -------- of $5,000 = $2,657.56
119,000
55,750
Folwell’s share: ------- of $5,000 = $2,342.44
119,000
The first method will, of course, give identical results. The second
method has the slight advantage that the Investment Months column will
always total the same as the length of the fiscal period, provided each
partner makes his initial investment at the first of the period—which
is not always the case—and acts as a check on the accuracy of that part
of the calculation.
=Interest on Partners’ Investments.=—A second problem of importance in
connection with partnership accounting is the interest on partners’
investments. The purpose of allowing such interest is twofold: First,
it may serve as an indication of the excess of the profits in this
enterprise over the return on the investment of a like amount in the
money market, thus dividing the partnership profits into two parts,
interest and management earnings; and second, it may serve as a method
of distributing profits up to a certain amount on the basis of capital
investments, where the agreed-on ratio is different from the capital
ratio, thus distributing the period’s profits on two different bases or
ratios.
This is done sometimes to equalize somewhat the comparatively
smaller-ratio profits of the partners who have made the larger
investments. This problem, however, will be treated more fully in a
later chapter where the methods of booking the interest, its treatment
in case of a loss instead of a profit, and the computation of
interest on drawings as well as on investments will be discussed and
illustrated. Suffice it to say here that disputes frequently occur in
connection with these problems and that detailed provision as to their
handling should be made in the partnership agreement.
=Valuation and Correct Booking of Original Investments.=—A third
matter of importance is the valuation and correct booking of the
original investments other than cash. In the case of the sole
proprietor this is of comparatively little importance because he will
always reap the entire gain and therefore suffer no harm ultimately
from present undervaluation of his property investments. In the
partnership, however, where separate investment and personal accounts
must be kept with each member, the correct valuation of the assets is
of importance, inasmuch as the property of the partnership is the joint
property of all partners and all will share ultimately in the effect of
any under-or over-valuation at the time of investment. The partners’
accounts are set up for the purpose of showing their respective
interests in the enterprise, and after investments are once brought
onto the books these accounts govern the equities of the various
partners.
=Distinction between Buying Out an Interest and Making an Investment to
Secure an Interest.=—The taking in of a partner by a sole proprietor
or his admission as a new member to an existing partnership raises
a point about which there must be a very definite understanding. A
distinction must be made between purchasing from the owners an interest
in the business as it stands at any given time and making an investment
in a business to secure such an interest. The first transaction is
of a personal nature between the owners and a third party who is
a purchaser; in the other transaction the third party, who is an
investor, puts in money to acquire an interest and his investment
becomes the common property of all the owners of whom he is now one. In
the one case the capital of the business is not increased, in the other
case it is increased by the amount of the new investment. For example,
if a balance sheet shows:
Cash $ 5,000.00 Liabilities $ 6,000.00
Other Assets 15,000.00 A. Jackson, Capital 14,000.00
and Jackson sells a half-interest to B. Killian for a given
consideration, the new balance sheet becomes:
Cash $ 5,000.00 Liabilities $ 6,000.00
Other Assets 15,000.00 A. Jackson, Capital 7,000.00
B. Killian, Capital 7,000.00
In this case no new capital has come into the business because the
purchase price does not go to the business as such but to A. Jackson as
a private individual.
If, however, Killian is admitted as a half-interest partner by making a
cash investment equal to the amount of Jackson’s interest on the basis
of book values, the balance sheet of Jackson and Killian will read:
Cash $19,000.00 Liabilities $ 6,000.00
Other Assets 15,000.00 A. Jackson, Capital 14,000.00
B. Killian, Capital 14,000.00
showing an investment of double the capital in the original Jackson
business.
The question of good-will which frequently comes up when an interest in
a going business is secured will be treated in Chapter XXXV, where also
the manner of closing the books of the old business and opening those
of the new firm will be shown.
=Final Considerations.=—From the foregoing discussion it is evident
that the partnership relation gives rise to some of the most vexing
questions which confront the accountant and the lawyer. It is a
truism, therefore, that in drawing up the partnership agreement, all
eventualities should be foreseen as nearly as possible and that they
should be carefully provided for. As a final safeguard it is well to
provide for the submission to arbitrators of disputes subsequently
arising, the decision to be binding upon all the partners. This will
avoid endless, expensive, and usually unsatisfactory actions at law
and will more nearly secure justice to all. As a step in the same
direction, it is suggested that provision be made for the drawing up of
correct balance sheets and profit and loss statements, that sufficient
time be allowed each partner to examine them as to their correctness
and, if satisfied, that each be compelled to subscribe to them. This
will localize any dissatisfaction within a limited time period and
secure its adjustment while all salient points are still fresh in the
minds of the interested parties.
CHAPTER XXXIV
CAPITALIZATION OF THE PARTNERSHIP
=Sources of Capital.=—From an accounting viewpoint, the capital of any
business enterprise is the excess of its assets over its liabilities.
Usually, the main fund of capital is secured by original contribution.
In a partnership, the partners’ investments provide the common
partnership fund. Thereafter, additions to the capital may be secured
in several ways:
1. Profits may be left in the business instead of
being withdrawn.
2. Specific contributions may be made by the partners,
which are either to be considered as additions to
their capital investment, or are to be treated as
more or less temporary loans to the business.
3. A new partner may be taken in, his contribution
increasing the partnership capital.
The present chapter deals with original investments and with the
first two types of additional capital mentioned above, while the next
chapter discusses the admission of new members and the consolidation of
partnerships.
=Original Contributions.=—It sometimes happens that the partnership
agreement does not state specifically how much each partner shall
invest in the business. For example, the agreement may state that
partner A is to contribute certain properties, i.e., place of business
and equipment; that B is to contribute a stock of goods, and that the
investments of the remaining partners are to consist of cash, the exact
amount of which is not stated because it depends upon the valuation to
be placed upon the property and merchandise invested by A and B.
After such a valuation has been made and the amounts of the cash
contributions have been determined, it may be found that the total
investment is more than the business requires; or it may develop that
some of the partners do not have sufficient funds available to pay
their shares, while others may be able to contribute more than their
respective shares. It thus happens that the partnership agreement is
not always rigidly enforced, some partners contributing more, and
others less, than the agreed amounts. At the time this is looked
upon as a temporary arrangement, but it often results in a permanent
condition. The partnership agreement should contain provision for such
a contingency. If it does not, a later agreement should be made to
regulate the relations between the partners.
=Adjustment of Capital Contributions.=—Whenever a partner contributes
more than his agreed share, it is customary to allow him interest on
the excess amount, and other partners whose investment may be less than
the agreed amount are usually charged with interest. This is obviously
an equitable method of meeting the situation.
As a rule, these interest adjustments are handled through the Profit
and Loss account, i.e., the partners who invest less than the agreed
share are considered to owe interest to the partnership, and those who
invest more have an interest claim against the business—not against
the other partners individually. The debit or credit balance in the
Profit and Loss account resulting from these adjustments is in turn
distributed among _all_ the partners in the profit-or-loss-sharing
ratios. It should be clearly understood, however, that although these
adjustments are made through the Profit and Loss account, there is no
element of business profit or expense involved. For this reason, these
interest entries should be made direct in the appropriation section of
the Profit and Loss, and should never be booked in the regular Interest
accounts.
The following illustrations will bring out the different methods of
adjustment:
PROBLEM. A, B, and C are equal partners under
an agreement to contribute each $15,000. Provision
is made that excess contributions are to be credited
with interest at 6% and that deficits are to be
charged at the same rate. The records show that actual
contributions were: A, $18,000; B, $13,000; and C,
$11,000.
Three methods of adjustment will be shown.
FIRST METHOD
A’s excess is $3,000, interest on which is $180.
B’s deficit is $2,000, interest on which is $120.
C’s deficit is $4,000, interest on which is $240.
These three interest amounts are brought upon the books
by the following journal entries:
Profit and Loss 180.00
A 180.00
B 120.00
C 240.00
Profit and Loss 360.00
The Profit and Loss account then shows a credit balance
of $180, which is distributed as follows:
Profit and Loss 180.00
A 60.00
B 60.00
C 60.00
The net effect of these adjustments is a credit to
A of $240, and debits to B and C of $60 and $180
respectively.
Note that A is credited with $180 for his excess of
$3,000, and Profit and Loss is debited with the same
amount, because it is the business that owes him this
interest. If this Profit and Loss debit is distributed
separately, A’s share of it is $60, so that his real
credit on his $3,000 excess is not $180 but $120. On
the other hand, the combined debits to B and C result
in a credit to Profit and Loss of $360, and if this
item is distributed as such, A’s share of it is $120,
thus making his total credit on the complete adjustment
$240. A similar explanation applies to the adjustments
for B and C.
SECOND METHOD. The first method was based on
a consideration of the respective excesses or deficits
on capital investments, but the same result may be
obtained by comparing all contributions with the amount
of the smallest investment, viz., $11,000 by C. This
would show A’s excess over C as $7,000, and B’s excess
over C as $2,000, and these two amounts may be treated
as loans to the business. The result is that A is
credited with 6% on $7,000, and B with 6% on $2,000, as
follows:
Profit and Loss 540.00
A 420.00
B 120.00
The debit to Profit and Loss is charged in equal shares
to the three partners as follows:
A 180.00
B 180.00
C 180.00
Profit and Loss 540.00
The final result shows a net credit to A of $240, a net
debit of $60 to B, and a net debit of $180 to C, the
same as by the first method.
THIRD METHOD. The total capital contributed
is $42,000. To be equal partners under the agreement,
each should have contributed one-third of the common
fund, or $14,000. Actually, A’s investment is $4,000
in excess of this, while B’s is $1,000 less, and C’s
$3,000 less. The excess contribution of A, $4,000, may
be looked upon as a loan to B and C as individuals,
bringing their shares up to the $14,000; viz., $1,000
to B and $3,000 to C. Instead of making the adjustment
through the Profit and Loss account as in the first
two methods, the interest is now adjusted between
the three partners as private persons, the entries
affecting only the partners’ personal accounts. This
adjustment results in a credit to A and a debit to B
for $60, A having loaned B $1,000; and in a credit to
A and a debit to C for $180, A having loaned C $3,000.
A’s total credit is $240, and B’s and C’s debits are
respectively $60 and $180, the same as by the other two
methods.
Thus it is seen that any of the three methods employed leads to the
same results. It will be observed, however, that in the example given
the contemplated investments are to be equal for the three partners
($15,000), and the profit and loss is to be shared on the same basis.
The three different methods of adjusting interest lead to the same
result only when the profit-sharing ratio is identical with the ratio
between the contemplated investments.
=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.
CHAPTER XXXV
OTHER PARTNERSHIP PROBLEMS
=Admission of a New Partner.=—In Chapter XXXIII a distinction was made
between buying out an interest in a business and making an investment
in a business. In the former case no new capital is acquired, while in
the latter the capital of the firm is increased by the amount of the
new partner’s contribution.
When a new partner is admitted he usually acquires not merely the right
to share in the profits, but he also obtains a share in the net worth
(often called “net assets”) of the enterprise. For this reason it is
necessary that all the partners, including the new member, agree on the
value of the net assets, and in this connection any of the following
possibilities may arise:
1. Upon admission of the new partner the book accounts
may be considered to represent the true status of
the business. A balance sheet is drawn up and the
new partner is admitted on the basis of the net
worth it shows.
2. It may be agreed that the assets are not worth the
amount at which they are carried on the books and
that a new valuation be placed upon them.
3. The business may be considered to be worth more
than the amount shown by the balance sheet.
=First Case.=—In the first case little difficulty is met in making the
opening entry admitting the new partner. For instance, if the balance
sheet shows a net worth of $30,000, and the new partner wishes to make
an investment in order to secure a one-fourth interest in the firm, the
amount to be contributed is manifestly $10,000. Assuming that he makes
a cash investment of $10,000, the following entry meets all accounting
requirements:
Cash 10,000.00
A, Capital 10,000.00
As a result of this cash investment of $10,000, the net worth of the
new firm is increased to $40,000 and the one-fourth interest belonging
to A is evidenced by his capital account at $10,000. The new firm may
now continue the old records and no further adjustments need be made.
=Second Case.=—In the second case it is necessary to place a new
valuation upon the assets of the old firm and the accounts of the old
partners must be adjusted accordingly. For instance, suppose A and B
are equal partners and the financial status of the firm is shown by the
following balance sheet:
BALANCE SHEET OF A & B
Cash $ 1,000.00 Notes Payable $ 3,000.00
Accounts Receivable 10,000.00 Accounts Payable 5,000.00
Merchandise 6,000.00 Mortgage on Bldg 4,000.00
Building and Equipment 16,000.00 A, Capital 10,500.00
B, Capital 10,500.00
---------- ----------
$33,000.00 $33,000.00
========== ==========
More capital is needed and C is invited to make an investment.
Upon investigation he finds that there are included under Accounts
Receivable many old items, of which it is estimated $1,000 will be
uncollectible; that the merchandise is overvalued to the amount of
$500; and that the building and equipment are worth $1,500 less than
is shown on the books. He offers to make an investment to secure a
one-fourth interest and his offer is accepted.
As a result of the new valuations placed upon the assets, the net
worth of the firm is now $18,000, against the old showing of $21,000.
Consequently, the capital accounts of A and B are reduced from $10,500
to $9,000 each. The new partner is to invest a certain sum sufficient
to acquire a one-fourth interest in the new business. Hence the
combined capital of A and B, amounting to $18,000, will represent
three-fourths of the new capital, and consequently the amount to be
invested by C is $6,000. Thus the new capital of the firm will amount
to $24,000, one-fourth of which, or $6,000, is credited to C’s capital
account.
The balance sheet of the new firm will show:
BALANCE SHEET OF A, B & C
Cash $ 7,000.00 Notes Payable $ 3,000.00
Accounts Rec. $10,000 Accounts Payable 5,000.00
Less—Reserve 1,000 9,000.00 Mortgage on Bldg 4,000.00
------- A, Capital 9,000.00
Merchandise 5,500.00 B, Capital 9,000.00
Building and Equipment 14,500.00 C, Capital 6,000.00
---------- ----------
$36,000.00 $36,000.00
========== ==========
The firm has thus secured $6,000 additional capital, on a basis
somewhat unfavorable for the present, but inasmuch as the books now
show conservative values, no real injustice results.
=Third Case.=—The third case shows the firm in a position to demand
something more than book values as the basis for admission of the new
partner. The presumption is that the old firm is favorably known, has
an established trade and patronage, built by fair dealing and judicious
advertising, by its favorable location, and the numerous other ways
in which a substantial business may be developed. Its standing in the
community is a factor of value to the firm because it brings trade to
its doors. Other conditions being equal, a firm which enjoys a good
reputation is worth more than a new venture. Such a reputation is
known as “good-will” and constitutes an exceedingly valuable though an
intangible asset. The essence of good-will is the ability to produce
more than normal profits, i.e., profits above the average in that line.
Consequently, whenever the members of a firm consider the admission
of a new partner, good-will is regarded as one of the _assets_ of the
existing enterprise, thereby increasing its net worth.
The valuation of good-will, however, is a difficult matter and it is
a well-established principle that good accounting will not allow the
asset good-will to be set up on the books of a concern unless it has
come into possession of it by purchase or unless a part of its own
good-will is sold to a new partner. In this case the price received for
the portion sold represents an outsider’s valuation and may therefore
become the basis for valuing the whole of it.
The following case will serve as an illustration:
PROBLEM. Assume that X has a one-half interest
in a firm, and Y and Z a one-fourth interest each, the
balance sheet showing the following summarized facts:
BALANCE SHEET OF X, Y & Z
Cash $ 2,000.00 Liabilities $10,000.00
Other Assets 48,000.00 X, Capital 20,000.00
Y, Capital 10,000.00
Z, Capital 10,000.00
---------- ----------
$50,000.00 $50,000.00
========== ==========
An outsider, R, is now to be admitted to a one-fifth
interest by making an investment in the business. The
relative shares of the others are to remain as before.
Hence, after R’s admission, X will have two-fifths,
and Y, Z, and R one-fifth interest each. It is further
assumed that no revaluation of the tangible assets is
necessary.
The net worth of the old firm, according to the books,
is $40,000, and if this were taken as the basis
for admitting R, an investment of $10,000 would be
sufficient to acquire a one-fifth interest in the new
firm. However the business is considered to be worth
$10,000 more than the $40,000 shown in the balance
sheet, and for this reason, instead of paying $10,000,
R is required to invest $12,500. The excess of $2,500
is paid by R as an offset to the shares of the others
in the good-will of the firm.
There are three ways of treating this good-will element, viz.:
FIRST METHOD. Debit the Good-Will account for the amount actually
paid for it by R, viz., $2,500, and credit the capital accounts of the
old partners in proportion to their shares in the profits:
Good-Will 2,500.00
X, Capital 1,250.00
Y, Capital 625.00
Z, Capital 625.00
As a result of this entry, the capital account of X is
$21,250, and those of Y and Z $10,625 each. The capital
account of R, however, shows a credit of $12,500. In
other words, R’s interest in the net assets—although
not in the profits—of the business as shown by his
account is _larger_ than that of Y and Z, while
as a matter of fact he is to have an equal share. For
this reason, this method of treating good-will is not
satisfactory.
SECOND METHOD. This method regards the matter
from a different standpoint. Taking book values as a
basis, the share bought by R is worth only $10,000.
However, on account of good-will, the real value of
this share is considered to be higher and R is required
to pay $12,500 for it. Hence, in order that the books
may show actual values, the good-will item must be
added to the assets of the old firm, at the same time
increasing the capital accounts of X, Y, and Z in
proportion to their shares in the profits. The entry is:
Good-Will 10,000.00
X, Capital 5,000.00
Y, Capital 2,500.00
Z, Capital 2,500.00
As a result of this adjustment the capital of the
old firm is shown as $50,000. R now invests $12,500,
and the capital is thereby increased to $62,500. The
capital accounts of the four partners now show $25,000,
or two-fifths for X, and $12,500 or one-fifth each for
Y, Z, and R.
THIRD METHOD. Under this method of handling
good-will, the extra $2,500 invested by R is treated as
a bonus for distribution among the members of the old
firm, their capital interests in the new firm remaining
the same as in the old and R’s appearing at $10,000.
There is no objection to this method if R is satisfied.
Of the three methods, the second usually proves the most satisfactory.
A similar problem involving the handling of good-will is encountered
when a member of an existing firm sells out his interest, including
a share of the good-will, to one who takes his place in the firm.
Here the transaction may be looked upon as a private deal between
buyer and seller, in which case the buyer merely succeeds to the
seller’s interest in the firm, his capital appearing on the books at
the same amount as the seller’s former capital figure even though the
new partner pays more for it; or the good-will may be brought onto
the books and the capitals of all the partners be shown at increased
figures, as under the second method discussed above.
=Consolidation of Partnerships.=—There are various reasons why the
consolidation of partnerships may be of mutual advantage to the
individual firms concerned. When two or more firms consolidate, the
competition which formerly existed between them is eliminated and
co-operation takes its place. Also by uniting their businesses, many
of the operations which were formerly performed separately are now
amalgamated with resulting savings. Many other advantages may result
from such consolidations.
From the standpoint of the accountant, the consolidation of
partnerships is essentially the same as the admission of new partners,
the same principles applying to both. Before actual consolidation
takes place, it is necessary for each of the partnerships to place a
new valuation upon its assets and for all concerned to agree upon the
new figures. In almost all cases good-will is an important factor. The
valuation of good-will requires an investigation of the profits and
profit-earning capacity of the member firms. Conditions affecting the
profits of the various firms must be equalized as nearly as possible
so that the earning capacity of each can be compared on an equitable
basis. Such questions as the way in which partners’ salaries, interest
on capitals, withdrawals, and loans have been handled; the relation of
outside sources of income, if any, to the profit of any of the member
firms; and whether the consolidation contemplates taking over such
source of profits—these and similar questions must be considered and
treated equitably for all concerned.
The following illustration is given to indicate the bookkeeping
problems incident to consolidations:
PROBLEM. A and B, equal partners in an
established business, consolidate with C and D, equal
owners of an allied business. A and B are each to have
a one-third, and C and D each a one-sixth interest in
the new firm. The following balance sheets show their
financial positions:
BALANCE SHEET OF A & B
Cash $ 2,500.00 Notes Payable $ 5,000.00
Notes Receivable 1,000.00 Accounts Payable 8,000.00
Accounts Receivable 22,000.00 Mortgage on Real
Merchandise 10,000.00 Estate 4,000.00
Furniture and Fixtures 2,500.00 A, Capital 16,000.00
Delivery Equipment 1,500.00 B, Capital 16,000.00
Real Estate 9,500.00
---------- ----------
$49,000.00 $49,000.00
========== ==========
BALANCE SHEET OF C & D
Cash $ 5,000.00 Notes Payable $ 5,000.00
Accounts Receivable 15,000.00 Accounts Payable 7,750.00
Merchandise 8,000.00 C, Capital 9,000.00
Furniture & Fixtures 2,000.00 D, Capital 9,000.00
Horse & Wagon 750.00
---------- ----------
$30,750.00 $30,750.00
========== ==========
A careful valuation of the various properties shows
the figures of the balance sheet of C & D to be
conservatively estimated. In regard to A & B’s
figures, however, it is decided to allow $2,000 for
possible bad debts, and to value their merchandise at
$9,000, delivery equipment at $1,000, and real estate
at $9,000. Furthermore, it is agreed that C & D’s
good-will is to be valued at $5,000, and A & B’s at $10,000.
After the adjustments the new balance sheets appear as follows:
BALANCE SHEET OF A & B
Cash $2,500.00 Notes Payable $5,000.00
Notes Receivable 1,000.00 Accounts Payable 8,000.00
Accounts ” $22,000 Mortgage on Real
_Less_—Reserve 2,000 20,000.00 Estate 4,000.00
Merchandise 9,000.00 A, Capital 19,000.00
Furniture and Fixtures 2,500.00 B, Capital 19,000.00
Delivery Equipment 1,000.00
Real Estate 9,000.00
Good-Will 10,000.00
$55,000.00 $55,000.00
========== ==========
BALANCE SHEET OF C & D
Cash $ 5,000.00 Notes Payable $ 5,000.00
Accounts Receivable 15,000.00 Accounts Payable 7,750.00
Merchandise 8,000.00 C, Capital 11,500.00
Furniture and Fixtures 2,000.00 D, Capital 11,500.00
Horse and Wagon 750.00
Good-Will 5,000.00
---------- ----------
$35,750.00 $35,750.00
========== ==========
It is agreed that C and D’s capitals are each to be
taken as representing one-sixth of the capitalization
of the new firm, and A and B are each to contribute
$4,000 in cash to bring their capitals up to the
required amounts.
The opening balance sheet of the consolidated firm will
then read as follows:
BALANCE SHEET OF A, B, C & D
Cash $15,500.00 Notes Payable $10,000.00
Notes Receivable 1,000.00 Accounts Payable 15,750.00
Accounts Mortgage on Real
Receivable $37,000 Estate 4,000.00
_Less_—Reserve 2,000 35,000.00 A, Capital 23,000.00
Merchandise ------- 17,000.00 B, Capital 23,000.00
Furniture and Fixtures 4,500.00 C, Capital 11,500.00
Delivery Equipment 1,750.00 D, Capital 11,500.00
Real Estate 9,000.00
Good-Will 15,000.00
---------- ----------
$98,750.00 $98,750.00
========== ==========
CHAPTER XXXVI
PARTNERSHIP PROFITS
=Ambiguity of Definition of Profits.=—The term “profits” as applied
to business is perhaps used with as little uniformity as any term met
with. When a concern speaks of its profits, it is difficult to know
exactly what is intended, because the meaning of the term depends very
largely on the methods of accounting of that particular concern. The
reported profits of different firms are not, therefore, a true basis
for judging their relative worths. For instance, although the net
profits of a single proprietorship and of a partnership are usually
determined in the same manner, there is nevertheless variation in the
treatment of some items such as salaries, drawings, interest on capital
invested, etc. The partnership form, like the single proprietorship,
contemplates an investment on the part of the owners not only of
capital but also of time and effort. This is one of the differences
in working organization between these forms of business and the
corporation. Investment in the corporation is of capital only. If
services are employed by the corporation, they are paid for and charged
as services, salaries, etc.
=Compensation for Time and Services.=—In the partnership form of
organization, the active and direct management of the business is
usually vested in the owners. Where this is not the situation, as in
a limited partnership, or whenever one or more of the partners does
not take an active part in the management of the business, his share
of the profit is usually curtailed by the allowance of salaries to the
managing partners before any distribution of profits in the agreed
ratio is made to the partners. Thus, partnership profits include not
only the salaries of the owners but, in general, a recompense for the
time and ability of the proprietors. The man who makes an investment in
a partnership does so usually because he desires to invest his time as
well as his capital. He expects, therefore, to receive not only a fair
rate of interest on his money but also pay for the services he renders.
=Interest on Investment.=—The rate paid for the use of money is
dependent both on the money market and on the element of risk involved
in the particular investment. In mining ventures, for instance, where
there is frequently considerable uncertainty as to the return of the
principal, the interest rate is sufficiently high to offset, during
the life of the loan, the possible loss of the principal at the end.
So an investor in a partnership, because of the greater element of
risk in comparison with other and safer investments, requires a higher
rate of return in interest than he would ordinarily secure through the
investment of his capital in sound securities.
=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.
=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.
CHAPTER XXXVII
PARTNERSHIP DISSOLUTION
=Temporary Nature of Partnership.=—Because of its personal character, a
partnership has necessarily a limited duration. It must look forward to
the time when its business will have to be closed up. The chief causes
leading to a dissolution are briefly reviewed here.
=Causes of Dissolution=
1. The withdrawal of any partner. Under ordinary circumstances a
partner cannot be held to a specific performance of his contract. If
he becomes dissatisfied, suspicious, or desires for other reasons to
withdraw from his contract before its expiration, he has that power.
Such withdrawal cannot be looked upon as a right but only as a power
to be exercised under unusual circumstances. If his withdrawal before
the agreement terminates results in damage to his copartners, they
have a lawful claim against him for the amount of the damage. Under
extraordinary conditions, specific performance of the contract might be
decreed, i.e., the partner would not be allowed to withdraw.
Withdrawal does not relieve a partner from liability for partnership
debts incurred while he was a member of the firm. Any creditors not
paid by the firm may hold the withdrawing partner liable for the
debts. To be relieved from the liability on debts arising _after_ his
withdrawal, personal notice of withdrawal must be given to all the
firms with which the partnership has been dealing; a published notice
being considered sufficient for the parties not dealing with the firm
until after withdrawal.
2. Sale of a partner’s interest or admission of a new partner. When a
partner, with the consent of his copartners, sells his interest in the
firm to another, or when a new member is admitted to the partnership,
in the eyes of the law the old partnership has ceased to exist and a
new one has taken its place.
3. Limitations in the partnership agreement. The agreement may specify
the period for which the partnership is to exist. If it is a special
partnership, the object it is to accomplish may be stated and the law
considers the firm automatically dissolved as soon as that object is
attained.
4. Mutual consent of the partners. Whether or not the partnership
period is limited by the agreement, the partners may at any time
rescind their contract by mutual consent.
5. Misconduct, insanity, death, assignment, or bankruptcy of a partner.
The happening of any of these contingencies effects a dissolution.
By misconduct may be understood a member’s failure to pay the agreed
contribution of capital, failure to perform his duties, his acting in
bad faith towards his copartners, etc.
6. Illegal object. A partnership entered into for the pursuit of an
object which later becomes illegal is automatically dissolved.
7. War between nations of which partners are citizens. This dissolves
the partnership, though such dissolution may be more in the nature of a
suspension, inasmuch as the relation may be resumed upon cessation of
hostilities.
8. Bankruptcy of the firm. This results in the firm’s assets being sold
to satisfy the claims of its creditors and the firm as such ceases to
exist.
9. Sale or transfer. A firm may sell out to another firm or change its
form of organization to that of a corporation. The old firm, therefore,
no longer exists.
=Problems Incident to Dissolution.=—It is purposed to consider some of
the problems involved in winding up the affairs of a partnership. From
the schedule of causes of dissolution given above it will be seen that
a firm may be either solvent or insolvent at dissolution. The three
statements sometimes set up in the case of insolvency—the Statement of
Affairs, the Deficiency Account, and the Realization and Liquidation
Statement—will not be explained here but results obtained through them
will be taken into account. These statements are seldom met in practice
and are not standardized either as to form or content. Their treatment
is deferred to the work of the second year.
=Partnership Provisions Covering Liquidation.=—Because of the certainty
of final dissolution, it is not unusual for the partnership agreement
to make definite regulations concerning the method of liquidation. The
appointment of one of the members as liquidating partner, the manner
of distributing the proceeds from liquidation whether by instalments
or otherwise, the manner of paying the liquidator for his services—all
these contingencies should be provided for.
Where dissolution is forced by the death of one of the partners, to
determine the interest of his heirs it is necessary to take inventory
and make appraisal of the firm’s assets. To avoid this inconvenience
to the business, provision is sometimes made in the agreement that the
remaining partners shall continue the business until the end of the
regular fiscal period. The deceased partner’s share in the profits
for the current period up to the date of his death is determined by
prorating the year’s profit over the period in which the deceased had
an interest. The method of calculating the firm’s good-will is usually
provided for in the partnership agreement so that the estate of the
deceased partner will share in it also. Usually interest is allowed the
estate of the deceased partner from the date of his death until the
settlement of his share.
=Partners’ Rights and Procedure During Liquidation.=—When dissolution
is accompanied by liquidation, as happens in many instances, all the
partners have an equal right to share in the work of liquidation.
Since the work usually does not require the time of all the partners,
a customary procedure is to appoint one member—or an outsider—as
the liquidator. Notice of the dissolution, in which the name of the
liquidator is given, is published in the leading newspapers. If
liquidation is necessary because of the death of a partner, great
responsibility rests upon the liquidator. He must act in strict good
faith and endeavor to realize the best price possible for the assets of
the firm in the interest of the deceased partner’s estate. A similar
responsibility rests upon him when liquidation is carried on in the
interest of absent members.
The expenses and losses incident to liquidation must be borne by all
in the profit and loss ratio. The liquidator may be paid either by
means of a commission on the sums realized or by a salary. If the
liquidator is a partner, settlement may take place privately between
the partners but usually his commission or salary is charged to the
firm’s liquidation expenses.
Liquidation may proceed by sale of the assets in regular order and may
even permit the purchase of additional goods where necessary to fulfil
existing contracts or to complete partly manufactured goods, or where
stock on hand can be disposed of to better advantage by the addition of
side lines or specialties.
=Distribution of Proceeds.=—Upon the realization of the assets,
application of the proceeds must be made in the following order: First,
the claims of outside creditors must be met in full or by compromise
where not fully recognized. Second, the claims of the partners on
account of loans or advances made to the firm must be satisfied.
Third, the partners share in the remainder, by first taking out their
respective capital contributions and then, if there is a balance, by
sharing it in their profit and loss ratios. If there is a loss, this
must be shared in the profit and loss ratio before withdrawal of any
capital contributions. The remainder, if any, is divided among the
partners in the ratio of their capitals as diminished by the loss.
Whether the net assets are either more or less than the total amount
of the capitals, the difference is shared in the profit and loss
ratio, and what remains is shared in the capital ratio. If a careful
accounting is made of the profit or loss at the time of the sale of
each piece of property and these profits and losses together with the
dissolution expenses are summarized and distributed to the partners’
capital accounts, those accounts will of course show the claims of the
various partners on the net assets of the business after all assets
have been converted into cash and all liabilities paid.
Instead of a complete liquidation of the firm’s assets, certain of the
assets may, by mutual consent, be taken over by each partner at agreed
values and applied toward the satisfaction of his capital and loan
interests. Such use of assets is spoken of as a _conversion_ to that
particular purpose. It must be distinctly understood that this is not a
right which any partner can demand, but only a privilege granted by the
mutual agreement of the partners. Any partner can demand that all the
assets be sold and that the proceeds be applied in satisfaction of the
interests concerned.
=Sharing Losses.=—In the case of insolvency, the partners are compelled
to share the losses in the profit and loss ratio, not in capital ratio,
and these losses are chargeable against their capital accounts. If the
capital account of any of the partners is not large enough to satisfy
his share in the losses, a deficit in that partner’s interest results,
which is represented by the debit balance in his capital account.
This shows the amount which he must contribute to the firm in order
that all claims may be satisfied. The rule that profits and losses in
liquidation cannot be shared in the same ratio as capitals, unless this
ratio is also the profit and loss ratio, is responsible for the fact
that upon dissolution one or more partners may have to make additional
contributions, while others may not be obliged to do so. This duty
of contributing to make up a deficit is inherent in the partnership
relation and can be enforced by the copartners.
A few illustrations will set forth the main problems in connection
with the liquidation of partners’ capitals:
=1. Sharing Losses Equally=
BALANCE SHEET OF A, B & C
Cash $10,000.00 Liabilities $10,000.00
Other Assets 60,000.00 A, Capital 15,000.00
B, Capital 20,000.00
C, Capital 25,000.00
---------- ----------
$70,000.00 $70,000.00
========== ==========
A, B, and C share profits and losses equally.
The above balance sheet shows, in summary form, the condition of the
firm previous to liquidation, and also indicates the shares of the
partners in the net assets as on that date, i.e., the partners share
in the net assets in the ratio 15:20:25 or 3:4:5. Dissolution becomes
necessary and in the course of liquidation the expenses and losses
incurred amount to $15,000. After the net loss of $15,000 is divided
equally among the partners, the capitals will amount to, A $10,000,
B $15,000, and C $20,000. The result is that the capital ratio has
changed from 3:4:5 to 10:15:20, or 2:3:4, and the net assets of $45,000
are to be shared in this new ratio.
=2. Capital Deficit=
BALANCE SHEET OF JONES & SMITH
Cash $10,000.00 Jones, Capital $20,000.00
Losses in Liquidation 15,000.00 Smith, Capital 5,000.00
---------- ----------
$25,000.00 $25,000.00
========== ==========
Jones and Smith share profits and losses equally.
The above balance sheet shows the condition of the firm after
liquidation. It is necessary, first, to distribute the liquidation
losses among the partners, after which they share in the net assets
according to capital ratios. Accordingly, each capital account is
debited with an equal share in the loss of $15,000, after which Jones’
capital is $12,500 and Smith’s account shows a debit balance of $2,500.
This means that Jones not only gets the entire cash of $10,000, but
Smith must contribute $2,500 to the firm and this also goes to Jones.
=3. Personal Insolvency of One Partner=
BALANCE SHEET OF SMITH, JONES & GREEN
Cash $16,000.00 Smith, Capital $15,000.00
Jones, Capital 9,000.00 Green, Capital 10,000.00
---------- ----------
$25,000.00 $25,000.00
========== ==========
Smith and Jones each have a ⅖ share and Green a ⅕ share in profits and
losses.
The above balance sheet shows the financial condition of the firm after
taking into consideration the losses incident to liquidation. From
this it is seen that Jones owes the business $9,000. Assume that he
is personally insolvent and cannot contribute the share due from him.
The net assets available for distribution consist of $16,000 in cash.
Inasmuch as Jones’ interest is entirely wiped out and a contribution
is due from him which he cannot pay, the amount of that contribution
is an additional loss to be borne by the two remaining partners. Their
respective shares in this loss are determined by their original profit
and loss ratios ⅖ and ⅕, so that as between themselves Smith must bear
⅔ of the loss or $6,000, and Green ⅓ or $3,000; after which Smith’s
capital and share in the net assets is $9,000, and Green’s $7,000.
Where a partner, in his private capacity, and the firm of which he is
a member are both bankrupt, his personal creditors have first claim on
his personal estate and the firm’s creditors on the assets of the firm.
=Distribution by Instalments.=—Where the liquidation is of long
duration, the partners may desire to receive what is due them by
instalments rather than wait to receive their respective shares in
one amount. Where the capital ratio differs from the profit and loss
ratio, it is difficult to determine the proper ratio in which the
instalments should be paid, due to the fact that expenses and losses
have not yet been determined. Consequently it is impossible to tell
what the ultimate ratios will be in which the partners are to share
the net assets. As the payment of instalments on an arbitrary basis
might result ultimately in an overpayment of some partners and an
underpayment of others, the only safe method of handling the situation
is to pay the first instalments to those partners whose capital ratios
are in excess of their profit and loss ratios until their capitals are
reduced to the point where the capital ratios of all the partners are
the same as their profit and loss ratios. As soon as this point is
reached, the proceeds of the assets may be distributed to the partners
on the basis of their profit and loss ratios, because these are now
identical with their capital ratios. A more complete treatment of this
problem will be found on pages 650 to 654 of the author’s second volume.
=Treatment of Good-Will upon Liquidation by Sale.=—When dissolution is
brought about by the sale of the entire business, it may happen that
the amount realized on the assets is smaller than their book value,
and the difference must be treated as a loss in accordance with the
principles previously stated. Similarly, where the assets are sold
and the price realized is larger than their book value, the excess
constitutes a profit and must be distributed among the partners in
profit and loss ratio. Usually such an excess is treated as a receipt
on account of good-will, and two standard methods of booking it are
employed. When good-will is mentioned in the sale contract and its
value has been determined, it is brought on the books as an asset and
transferred immediately to the partners’ accounts. Thus, if the value
is $15,000 and the profit and loss ratio is ⅖ to A, ⅖ to B, and ⅕ to C,
the entry is:
Good-Will 15,000.00
A, Capital 6,000.00
B, Capital 6,000.00
C, Capital 3,000.00
Good-will is now shown as an asset, and the entry closing it off is the
same as for the sale of the other assets, viz., a debit to Cash and a
credit to Good-Will.
On the other hand, when good-will is not specified as such in the sale
contract, but the amount realized on the sale of the assets is larger
than their book values, this excess may be credited to Good-Will, which
is then treated not as an asset account (as in the case given above)
but as a profit and loss account. The balance of this account is closed
out to the partners’ accounts in profit-sharing ratios in the same way
as above. The ultimate result is the same in either case; the first
method is a little more complete since it shows the value of the asset
good-will previous to its sale.
The formal entries by which the sale of any business is recorded on
its books, whether single proprietorship, partnership, or corporation,
are treated in Chapter XXXIX under corporations.
CHAPTER XXXVIII
THE CORPORATION
=Definition.=—The definition of a corporation, given by former Chief
Justice Marshall as “an artificial being, invisible, intangible,
and existing only in contemplation of the law,” sets forth its
fundamental characteristics, viz., artificial personality and creation
by the law. Blackstone says, “A corporation is an artificial person
created for preserving in perpetual succession certain rights which
being conferred on natural persons only would fail in the process
of time.” Blackstone’s definition lays particular emphasis on a
characteristic not specifically mentioned by Marshall, that of
perpetuity of succession. It is apparent that the corporation within
the limits prescribed by statute has most of the attributes and
powers of a person—it can sue and be sued, can hold and pass title to
property, real and personal, can carry on business in its own name, is
responsible to the extent of its entire property for the payment of its
debts, etc.
=Growth of the Corporate Form of Organization.=—The corporate form
of organization is being increasingly utilized for the conduct of
business of almost every kind. It offers a much more attractive field
to the investor who desires to place his surplus funds in productive
enterprises and share in their profits without having the burdens
of active management or the risk of losing his private fortune to
satisfy the claims of business creditors should the undertaking prove
unsuccessful. Just as the partnership is an advance over the sole
proprietorship in point of business organization, efficiency, and
ability to cope with larger undertakings, so the corporation in some of
its forms represents an advance over the partnership form of business
organization. Its advantages and disadvantages in comparison with the
partnership will be reviewed briefly.
=Advantages.=—Some of its advantages are:
1. Limited liability. Only corporation property can be
levied on to satisfy the claims of creditors; the
private fortunes of the individual stockholders
cannot be touched.
2. Continued existence. The death, withdrawal, or
bankruptcy of any of its members does not interfere
with its existence. Its life may be terminated by
voluntary dissolution, insolvency, expiration of
charter life, forfeiture of charter to the state
for misuse, non-use, or abuse of its privileges.
3. Transferability of its shares, and their use as
collateral for private loans without injury to the
credit of the corporation.
4. Larger capital. A partnership becomes unwieldy and
inefficient if the number of partners becomes too
large. The number of stockholders in a corporation
is not limited and varies from one to many
thousands in the larger corporations. Accordingly
much more extensive fields of endeavor are open to
the corporation because it can bring together and
use advantageously the combined capitals of many persons.
5. Centralized control. Its method of internal organization
is such that one man can be made the responsible head
instead of the many heads of the partnership.
=Disadvantages.=—The chief disadvantages of the corporation may be
summarized thus:
1. Comparative absence of personal interest of the
managing officer. This is largely a theoretical
drawback, inasmuch as it is usually required that
the managing officer be a stockholder.
2. As a creature of the state, the corporation is
subject to state legislative control. It is taxable
by the state and is required to make periodic reports.
3. Its credit is dependent on the amount of its net assets
and not on the fortunes of its individual owners.
4. Corporations are sometimes restricted as to the
character of their business. In some states certain
lines of business cannot be carried on by corporations.
5. In some states it is illegal for corporations to
hold stock in other corporations.
In spite of these and other disadvantages, most of which are not
serious, the advantages of the corporate form of organization far
surpass those of the sole proprietorship or partnership.
=The Formation of a Corporation.=—Formerly a corporation could be
brought into existence only by a special act of the legislature.
As this method proved cumbersome and was subject to much abuse, it
gave place in all states to general corporation statutes or enabling
acts whereby an application in due form and according to statutory
provisions is all that is necessary for organizing a corporation.
Though the statutes differ for each state, they are uniform in the main
points. The method of formation under the New York statute will be
explained.
=Certificate of Incorporation—New York State.=—The form of
application for a charter to do business as a corporation is known
as a “certificate of incorporation.” This document must be prepared
by at least three natural persons, two-thirds of which number
must be citizens of the United States and at least one of whom
must be a citizen of New York State. These persons are called the
“incorporators.” Their certificate must be made out in the English
language, signed by each incorporator, acknowledged before a notary
public, and must contain:
1. The name of the corporation, in the English
language. This must be different from the name of
any other domestic or foreign corporation doing
business in the state and must not contain in its
title the words, “bank, trust, insurance, etc.”
2. The purpose or purposes for which it is created.
There is practically no limitation as to the
lines of endeavor the corporation may declare
itself desirous of following, with the exception
that banks, trust, transportation, and insurance
companies, etc., come under special laws.
3. The amount of capital stock of the corporation,
common and preferred if both are to be issued.
Preferred stock of various classes may be
authorized after incorporation. The minimum amount
of capital required by the New York law is $500.
One-half of the capital must be paid in within one
year from the date of incorporation. The
certificate must state also the amount of capital
to be paid in before the corporation can commence
business and this must not be less than $500. No
debts can be contracted before that amount is paid in.
4. The number of shares into which the authorized
capital is divided and the par value of each.
This must not be less than $5 nor more than $100,
although more recently capital stock has been
authorized with no named par value.
5. The place in which the principal office is to be
located, which must be within the state.
6. The contemplated duration of its life. This may be
made perpetual.
7. The number of directors, which must not be less
than three.
8. The names and post-office addresses of the
directors for the first year. Directors usually
are stockholders and at least one-fourth of the
directors are subject to election annually.
9. The names and post-office addresses of the
subscribers to the certificate of incorporation,
and the number of shares in the corporation
subscribed by each.
=Filing the Certificate—New York State.=—The certificate of
incorporation is usually made out in triplicate. The original must
be filed and recorded in the office of the Secretary of State; the
duplicate certified by the Secretary must be filed with the clerk of
the county in which the principal business office is to be located;
and the certified triplicate is retained by the corporation in its own
files. The fees for filing the certificate with the Secretary of State
are $10, and for recording 15 cents per folio. The county clerk’s fees
are 6 cents per folio for filing.
=Organization Tax—New York State.=—Before the filing of the
certificate, an organization tax of 1/20th of 1% of the authorized
capital stock must be paid to the State Treasurer. Record of this
payment is forwarded to the Secretary’s office.
=Initial Acts of Corporation.=—When the corporation is ready to
commence business, its first act is usually to call a meeting of
the incorporators and directors for the purpose of adopting a set
of by-laws—although this matter may be delegated to the board of
directors. This meeting also authorizes the issue of stock at or above
par in exchange for cash, labor, or property.
=State Control.=—The outside control of the corporation is vested
in the state. The state constitution, the general corporation law,
the statutes relating to business organizations in general, and the
specific contract between the corporation and state embodied in its
charter or certificate of incorporation—these form the basis for state
control and the limits within which the corporation may act as an
authorized person. If the corporation does an interstate business,
it is subject also to the regulations of the Interstate Commerce
Commission.
=Working Organization and Management.=—The corporation’s owners, that
is, the stockholders, are the source of all authority and control.
Unlike the partnership where control and voice in the management are
equally shared by the partners regardless of any inequality in their
investments, the corporation ownership is evidenced by shares of stock
and each share is given one vote. Thus each owner’s authority and
voting power are dependent upon the amount of his ownership of stock.
He has, however, the right to delegate this power to another person by
“power of attorney,” and in this way it frequently happens that one
stockholder exercises a power far beyond the amount of shares owned
by him. Delegation of voting power frequently occurs when the stock
is widely distributed geographically and is owned in small lots. In
theory the agent or attorney entrusted with the voting power of others
is simply carrying out the will of his principal, the real owner of the
stock.
=Annual Election of Directors.=—Because of the number of stockholders
and because many of them are engaged in other pursuits, one of the
characteristics of the corporate form of management is that the owners
frequently do not have direct control of their enterprise. Accordingly,
at regular times, usually annually, the stockholders elect directors to
whom are delegated the general oversight and control of the business.
The board of directors thus elected stands in the place of the
stockholders during the period between the annual meetings at which it
renders account of its management.
=Officers.=—The board of directors elects officers of the
company—usually a president, vice-president, treasurer, and
secretary—to undertake the active management of the business; or the
directors may appoint a general manager or superintendent on whom rests
the active management and who is the executive head of the corporation.
Thus the chief characteristic of the working organization of the
corporation is the delegation of authority to a responsible head. The
accountability of the officers to the board of directors, and of the
directors to the stockholders, has so far proved the most efficient
method of conducting modern business.
=The Showing of Proprietorship.=—The chief difference, from an
accounting viewpoint, between the corporate form and other forms of
business organization is in the showing of proprietorship. Vested
proprietorship in a sole owner or partnership business is carried under
the title of the different owners’ capital accounts, and credit is
extended by the public to such owners, not on the basis of what the
particular business is worth, but on the reputation of the owners and
what they are known to be worth outside the business as well as in
the business. On the other hand, the law has relieved the owners of a
corporation of individual liability for the debts of the corporation.
Only the corporate property can be held liable for the satisfaction
of creditors’ claims. For their protection, the corporation is not
allowed to impair its capital stock by the payment of any portion of
it in dividends to the owners or to change the amount of its capital
stock without special authority. The outstanding capital stock, in
theory, represents to the prospective creditor the minimum value of the
corporation assets which are supposed to be sufficient to meet in full
the claims of creditors. Accordingly, the portion of the capital of a
corporation represented by its capital stock is a fixed amount, and
the increments or decrements of proprietorship are usually shown in a
separate account called Surplus. This account must always be read with
the Capital Stock account to ascertain the current or present capital
as distinguished from the original.
The Surplus account is sometimes divided and shown under such titles
as Profits, Reserves, Undivided Profits, Working Capital, etc. To
ascertain full proprietorship or net worth, all such accounts must be
included.
RECORDS PECULIAR TO A CORPORATION
=The Subscription Book and Subscription Ledger.=—Upon the proper filing
and acceptance of the certificate of incorporation, authority is
given the incorporators to secure subscriptions to the capital stock.
Subscription books or blanks may then be opened, which usually contain
a form of agreement somewhat as follows:
We, the undersigned, do hereby subscribe for and agree
to take the number of shares of the capital stock of
the Blank Company, par value ........ set opposite our
names and pay for the same, ........ per centum down,
the remainder subject to the call of the board of
directors.
Where the number of subscribers is large and especially if record must
be made of the payment of calls, a Subscription Ledger or Instalment
Book is used. This ledger has no set form but usually carries columns
showing when the calls are to be made, when actually made, when paid,
and the balance still due. A controlling account called “Subscribers”
or “Subscription” is carried on the general ledger, with a special
column in the cash book to gather the totals for posting.
=The Stock Certificate Book and Stock Ledger.=—A subscriber is,
as such, a stockholder in the corporation even though his stock
certificate may not yet have been issued to him. The stock certificate
is merely evidence of ownership. It is usually issued from a book with
perforated leaves similar to a check book, with stub to carry the
essential data of the certificate. Directly from this stub, or through
the medium of a stock journal, postings are made to the individual
accounts in the stock ledger. This ledger which, in turn, is controlled
by the Capital Stock account or accounts on the general ledger, carries
the detailed information as to the number of shares issued, shares
canceled, and balances held by each owner.
=The Stock Transfer Book.=—In the state of New York a stock transfer
book must be kept, showing all the data in connection with transfers
of shares, such as old and new stock certificate numbers, names of the
parties, etc.
=The Minute Book.=—To preserve a record of the meetings of the
directors and stockholders, and the business transacted thereat,
use is made of a minute book kept by the secretary. This book, as
the source of authority for all the important acts and policies of
the corporation, is a most important record. The record should be a
complete history of the corporation from its organization through the
entire period of its existence.
=Other Records.=—When the stock is sold on the instalment plan, formal
receipt of the payment of each instalment is sometimes made by means of
an “Instalment Scrip Book,” whose certificates or receipts are issued
upon payment of each instalment. When full payment has been made, the
instalment certificates are exchanged for the regular certificates
of stock. A dividend book for recording the payment of dividends is
sometimes kept, though the need for such a record has been largely
eliminated through the use of dividend checks.
CHAPTER XXXIX
OPENING THE CORPORATION BOOKS
=Corporation Accounting Records.=—The method of recording the ordinary
business transactions of a corporation is essentially the same as in
the types of business organization previously discussed. The opening
and closing of corporation accounts, however, as also the method of
making the periodic summarization, call for the special treatment given
in this chapter and the next.
=Proprietorship and Capital Stock.=—As stated before, the members of
a stock corporation have their ownership evidenced by certificates
of stock. The proprietorship or net worth of a corporation, as of
the single proprietorship and partnership, is the excess of its
assets over its liabilities. This excess is shown in the books by two
accounts or two groups of accounts, viz., the Capital Stock account—or
accounts—which represents the amount of outstanding shares; and
the Surplus account—subdivided and carried under other titles, if
desirable—which represents the excess of the proprietorship over the
amount of capital stock. Each stockholder’s share in the corporation is
determined by the number of shares he possesses.
=Common and Preferred Stock.=—There may be various classes of stock.
If only one kind is authorized at the beginning, the subsequent
creation of other kinds requires an amendment of the charter. The usual
classes of stock are common and preferred. As its name indicates,
preferred stock has some kind of preference over the common or ordinary
stock. This preference may be only in regard to dividends, or it
may include preference as to ownership in the net assets in case of
dissolution. Preferred stock usually carries a fixed dividend, payable
before any dividend can be paid to the common stockholders.
Preferred stock is classified as cumulative and non-cumulative. The
terms apply to the dividend liability of the corporation in the event
that the continuity of dividend declarations is broken. The dividend
on cumulative preferred stock accumulates and becomes a preferred
claim for the amount accumulated since the time of the last dividend
declaration. That is, the common shareholders are not entitled to
receive any dividend until the preferred shareholders have received the
amount of the accumulated total. Preferred stock that is non-cumulative
does not possess this feature. A dividend once passed on such stock is
not a preferred claim to profits as compared with the dividend rights
of common stockholders, but lapses completely. Preferred stock is
cumulative unless specified to the contrary.
The issue of No-par-value stock is authorized by thirteen different
states. Very often in a corporation whose stock carries a stated par
value, there is little real relationship between the actual value of
the stock as indicated by the net assets of the corporation and its
stated par value. The law requires that par-value stock be carried on
the books at its stated par. If such stock has been sold or exchanged
for assets of a lesser value, there is always the temptation to inflate
the value of the assets in order to maintain it at the par of the
stock issued for them. This tendency is not met in the use of stock
carrying no par value. Such stock appears on the books at exactly the
amount of the assets received in exchange for it. A purchaser of such
stock, because of the fact that it carries no stated par value, is at
once put on notice to investigate the values back of it. No-par-value
stock may be either preferred or common. In the former instance, if the
preference relates to the assets at the time of dissolution, each such
share must state the amount of assets applicable to each share in case
of liquidation of the corporation. This constitutes a preference claim,
not over the creditors of the corporation, but only over the common
stockholders.
Thus it is seen that there may be different classes of ownership of a
corporation, the owners of one class having some advantages over the
owners of the other classes. It should be understood, of course, that
within each class the rights and duties of the owners are the same.
=Opening the Books of a Corporation.=—The opening entries of a
corporation have to do with a correct treatment of capital stock,
subscriptions, calls and instalments, payments by cash and by property,
etc.
The charter to do business, granted a corporation by the state, gives
it the right to sell shares of stock. These shares have no value in
themselves and are worth only what the corporation can exchange them
for, either in cash or other assets. There is, therefore, no reason
for making a record on the books of account as distinguished from
the corporation’s minute book, of the corporation’s right to issue
stock and of the amount of the stock which it has a right to issue.
Until the stock has been paid or subscribed for, no formal entry
need be made on the books of account. Of course, full record of all
deliberations and resolutions as to procedure and policy up to the time
of the actual sale of the stock is carried in the minute book, and a
concise narrative statement of the organization of the corporation, its
purposes, the authorized capital stock issue, the number of shares,
the par value of each share, if par value stock, and so forth, should
always precede the formal opening entries in the journal. This record
and that in the minute book should give all the information of this
sort needed. There is a too prevalent tendency among bookkeepers
to make all sorts of memorandum entries on the books of account. A
memorandum entry is an entry which has no financial significance and is
made merely as a reminder that transactions of financial significance
may arise from that source.
Before a corporation can secure its charter it is necessary to
make certain expenditures. These usually consist of fees paid to
a lawyer for his services in assisting in drawing up the charter;
fees for filing the certificate; the organization tax; the cost of
the certificates of stock and stock records; and so forth. These
expenditures must be met by the incorporators from their private funds
but they are reimbursed from the funds received upon sale of the stock.
It is, accordingly, customary in opening the books of a corporation to
show first the sale of the stock before showing the expenditures for
organization.
A number of different methods of opening the books are employed. The
first of these does not make use of the memorandum entries referred
to above, whereas the other two do use memorandum entries. The three
methods will be illustrated by means of the problem given below. The
entries are shown in journal form. It will be understood, of course,
that those entries which involve cash will appear in the cash book
only. All the other entries appear in the general journal.
PROBLEM 1. The Smith-Brown Company is
incorporated with an authorized capital stock of
$250,000, of which $150,000 is subscribed and paid for
at par; the balance remains unissued for the present.
The organization expenses are $1,000.
FIRST METHOD
THE SMITH-BROWN COMPANY
A corporation organized under the State of New York,
with an authorized capital stock of Two Hundred and
Fifty Thousand dollars ($250,000), divided into Two
Thousand, Five Hundred (2,500) shares of the par value
of One Hundred dollars ($100) each, with all powers
necessary to carry on the business of manufacturing,
selling, and distributing motors of all kinds.
Case 1. Where the subscription and payment are not
simultaneous:
(a) Subscribers 150,000.00
Capital Stock Subscriptions 150,000.00
To record subscriptions to the capital
stock as follows:
A shares
B ”
C ”
Etc.
(b) Cash 150,000.00
Subscribers 150,000.00
To credit subscribers for the payment
of their subscriptions.
(c) Capital Stock Subscriptions 150,000.00
Capital Stock 150,000.00
To record the issue of stock to all
subscribers who have paid in full.
(d) Organization Expense 1,000.00
Cash 1,000.00
To record the payment of the costs of
organizing the corporation.
Entry (a) sets up the claim under subscription
contracts against the subscribers as an asset of the
corporation, and is offset by the proprietorship
account, carried under the title “Capital Stock
Subscriptions,” until payment has been made and
the certificates of stock actually issued to the
stockholders.
Entry (b) is self-explanatory.
Entry (c) shows the issue of the certificates and
therefore transfers the proprietorship from Capital
Stock Subscriptions to Capital Stock.
Case 2. Where the subscription and payment are
simultaneous:
(a) Cash 150,000.00
Capital Stock 150,000.00
(b) Organization Expense 1,000.00
Cash 1,000.00
In a small corporation where a cash investment
constitutes the entire original capital, the entries
shown in case 1 above are sometimes abbreviated as
here indicated. In such a case there is often no
formal subscription contract entered into and there is
therefore no need to set up accounts with Subscribers
and Capital Stock Subscriptions.
SECOND METHOD. This method makes use of the
memorandum accounts, Unissued Capital Stock and Capital
Stock Authorized. Omitting the narrative statement of
organization, the explanatory matter after the various
entries, and the organization expense entry, which are
common to all methods, the other necessary entries are
as follows:
(a) Unissued Capital Stock 250,000.00
Capital Stock Authorized 250,000.00
(b) Subscribers 150,000.00
Capital Stock Subscriptions 150,000.00
(c) Cash 150,000.00
Subscribers 150,000.00
(d) Capital Stock Subscriptions 150,000.00
Capital Stock 150,000.00
(e) Capital Stock Authorized 150,000.00
Unissued Capital Stock 150,000.00
Entry (a) is a memorandum entry recording the amount of
capital stock authorized by the corporation’s charter.
This entry has little or no financial significance. Not
until stock is sold does the corporation have any real
assets.
Entry (b) shows that of the stock which was unissued
under entry (a), $150,000, has been subscribed for,
thus giving the corporation a legally enforcible
claim—an asset—for that amount.
Entry (c) is self-explanatory.
Entry (d) shows the issue of the stock when the
subscriptions are paid.
Entry (e) adjusts the memorandum entry (a), to show
the present amount of authorized stock still unissued,
viz., $100,000. Both accounts under (a) continue as
memoranda only, and as they exactly offset each other,
they will not appear on the balance sheet.
THIRD METHOD. This method also makes use of
memorandum accounts before the sale of the stock. The
difference between this and the second method should be
noted. It will be seen that the credit of entry (a) is
here Capital Stock instead of Capital Stock Authorized.
This is theoretically incorrect because as yet the
corporation has no proprietorship. The best that can be
said for it is that the debit represents a contingent
asset and the credit a contingent proprietorship item.
The other entries are self-explanatory.
(a) Unissued Capital Stock 250,000.00
Capital Stock 250,000.00
(b) Subscribers 150,000.00
Subscriptions 150,000.00
(c) Cash 150,000.00
Subscribers 150,000.00
(d) Subscriptions 150,000.00
Unissued Capital Stock 150,000.00
=Premium or Discount on Stock.=—The law requires that when stock
of par value is issued, the Capital Stock account must be carried
always at par. When stock is sold at a premium or at a discount, it
necessitates, therefore, the use of supplementary proprietorship
accounts to make the proper record. In the state of New York, a
corporation cannot sell its stock at a discount, but in states where
this is allowed the amount of such discounts should be charged to a
“Discount on Stock” or some similar account. Sometimes the charge
is made to “Organization Expense.” The use of Organization Expense
account for this purpose is contrary to the principle that the account
title should show the exact nature of the items recorded under it. It
is misleading and sometimes reprehensible. A full discussion of this
matter is given in Volume II. When stock is sold above par, the amount
of the premium is recorded in the account “Premium on Stock,” which
as usually handled constitutes a part of the permanent capital of the
corporation. Premiums on stock sales should not be credited to Surplus
account. The following illustration will show the kind of entries
required:
PROBLEM 2. Of the $100,000 unissued stock
of Problem 1, we will assume that $50,000 is later
subscribed for at 98, and $50,000 at 102.
Entries to make the record according to the first
method, Problem 1, are as follows:
(a) Covering stock subscribed for at a discount:
Subscribers 49,000.00
Discount on Capital Stock 1,000.00
Capital Stock Subscriptions 50,000.00
(b) For stock subscribed for at 102:
Subscribers 51,000.00
Premium on Capital Stock 1,000.00
Capital Stock Subscriptions 50,000.00
Entries for payment of the subscription and issue of
the stock follow the method of entry already shown on
page 342. It will be observed that the Capital Stock
Subscription and the Capital Stock accounts are always
shown at par value.
=Capital Stock on the Balance Sheet.=—The net worth section of the
balance sheet of a corporation will usually appear somewhat as follows
for the capital stock items. Often, however, more detail is shown in
connection with the surplus item. The student should note how full
information is given concerning the capital stock.
(1) _Net Worth_
Represented by:
Capital Stock:
Authorized $250,000.00
Unissued 100,000.00
-----------
Issued and Outstanding $150,000.00
Premium on Capital Stock 5,000.00
Surplus 60,000.00
-----------
Total Net Worth $215,000.00
===========
Where the discount on stock has not been charged off against Surplus
either because sufficient profits have not been reserved, or because,
although sufficient profits have been reserved, it is deemed desirable
to build up a larger balance of Surplus before charging off the
discount, the net worth section will appear as follows:
(2) _Net Worth_
Represented by:
Capital Stock:
Authorized $250,000.00
Unissued 100,000.00
-----------
Issued and Outstanding $150,000.00
Surplus 10,000.00
-----------
$160,000.00
Discount on Capital Stock 15,000.00
-----------
Total Net Worth $145,000.00
===========
Discount on capital stock should usually be shown as above, although
one sometimes finds it listed among the assets on a balance sheet. This
is not wholly objectionable unless it is set up under a title which
does not indicate its true nature.
=Instalments.=—The subscription contract sometimes provides for
payment by instalments. The corporation usually issues to all such
subscribers a “call,” i.e., a notice that an instalment payment will
come due at a given time. The subscriber is not considered delinquent
until the call has been made and he has not responded. The accounts
must therefore reflect the difference in status brought about by a
“call.” This is accomplished by transferring the claim against the
subscriber carried in Subscribers account to a new claim against him
carried under Call account. The illustrations below show the accounts
required and their handling.
PROBLEM 3. Assume that the $50,000 of stock
subscribed for at 102 is to be paid for one-half in
cash and the remainder in two equal instalments at the
end of successive three-month periods.
For the one-half cash payment the entry is as follows:
Cash 25,500.00
Subscribers 25,500.00
At the end of the first three months, the record is:
Call No. 1 12,750.00
Subscribers 12,750.00
To show the call issued.
Cash 12,750.00
Call No. 1 12,750.00
To record payment of the first call.
Similar entries at the end of the second three months are:
Call No. 2. 12,750.00
Subscribers 12,750.00
Cash 12,750.00
Call No. 2 12,750.00
If the call is not paid in full at balance sheet time,
the debit balance in the “Call” accounts constitutes an
asset, i.e., the amount of unpaid instalments due from
subscribers. Upon full payment of all subscriptions,
certificates of stock are issued and recorded as shown
on pages 341, 342.
=Entries for Common and Preferred Stock.=—Where more than one
kind of stock is issued, such as common and one or more kinds of
preferred, separate capital stock accounts—and usually other related
accounts—should be kept for each class, as illustrated below:
PROBLEM 4. Assume that the stock of a
corporation is $200,000 common and $50,000 preferred,
and that $100,000 common and $50,000 preferred have
been subscribed for. The entries necessary to record
the subscription in accordance with the first method
explained above, are:
Subscribers—Capital Stock Common 100,000.00
Capital Stock Common, Subscriptions 100,000.00
Subscribers—Capital Stock Preferred 50,000.00
Capital Stock Preferred, Subscriptions 50,000.00
The other entries for payment of subscriptions and
issue of stock are essentially the same as explained
above, but the record of the transactions affecting
common and preferred stock should always be kept
distinct and separate.
=Entries for No-Par Stock.=—When a corporation issues no-par stock,
the amount of proprietorship resulting from its sale is exactly what
the stock brings and is so recorded; there is neither discount nor
premium. Booking it is, therefore, simple. The amount of capital so
secured, i.e., secured from its sale, should, however, never be mixed
with the accretions to capital from reserved profits or other sources.
Such items constitute the Surplus just as in the case of stock of par
value, and the legal requirement that these amounts be kept separate
from the capital stock are just as strict. This is necessary so that
the records will clearly show that dividends have not encroached
upon the capital. Since the value at which no-par stock is carried
on the books bears no relation to the number of shares issued, it is
customary to carry on the balance sheet information as to the number
of shares outstanding. The net worth section of the balance sheet of a
corporation issuing no-par stock should appear as follows:
_Net Worth_
Represented by:
Capital Stock—No Par:
Authorized 10,000 shares
Unissued 3,000 ”
------
Issued and Outstanding 7,000 ” $369,465.00
Surplus 125,479.00
-----------
Total Net Worth $494,944.00
===========
=Payment of Subscriptions by Property.=—When payment of subscriptions
is by property instead of by cash, the value at which such property
shall be brought onto the books is entirely at the discretion of
the corporation’s directors, and unless fraud can be shown, their
valuations are final. No difficulties are involved in recording such
a payment; the paid properties are debited under suitable account
titles, and the Subscribers account is credited. The following problem
illustrates the change from a partnership to a corporation, at the
same time showing how the payment of subscriptions by property must be
treated.
=Change from Partnership to Corporation=
PROBLEM 5. A and B, partners, incorporate
as the American Baking Company. The authorized
capitalization is $250,000. Each partner subscribes
for an amount of stock equal to his interest in the
partnership, and C, an outsider, subscribes for
the remainder of the stock at par. The corporation
purchases the assets and assumes the liabilities of the
partnership, paying therefor with stock as above. C
pays his subscription in cash. The balance sheet of the
partnership on that date was as follows:
BALANCE SHEET OF A & B
Cash $ 20,000.00 Accounts Payable $ 45,000.00
Accounts Receivable 150,000.00 Mortgage Payable 80,000.00
Merchandise 50,000.00 A, Capital 125,000.00
Plant 130,000.00 B, Capital 100,000.00
----------- -----------
$350,000.00 $350,000.00
Make the opening entries for the new corporation and
also close the books of the partnership.
1. The entries to open the corporation’s books:
(a) Subscribers 250,000.00
Capital Stock Subscriptions 250,000.00
To record subscriptions to
the capital stock as follows:
A 125,000
B 100,000
C 25,000
(b) Cash 20,000.00
Accounts Receivable 150,000.00
Merchandise 50,000.00
Plant 130,000.00
A & B, Vendors 350,000.00
To record the purchase from
A & B of their partnership assets.
(c) A & B, Vendors 125,000.00
Accounts Payable 45,000.00
Mortgage Payable 80,000.00
To record partial payment to A & B for
their assets by the assumption of their
liabilities.
(d) A & B, Vendors 225,000.00
Subscribers 225,000.00
To record full payment to A & B for the
balance due them, by the cancellation
of their subscription indebtedness.
(e) Cash 25,000.00
Subscribers 25,000.00
To record payment by C of his
subscription contract.
(f) Capital Stock Subscriptions 250,000.00
Capital Stock 250,000.00
To record the issue of stock to
all subscribers, who have paid in full.
Entries (b), (c), and (d) are sometimes combined in the
following compound entry:
Cash 20,000.00
Accounts Receivable 150,000.00
Merchandise 50,000.00
Plant 130,000.00
Accounts Payable 45,000.00
Mortgage Payable 80,000.00
Subscribers 225,000.00
Although this accomplishes the same result so far as
the ultimate showing is concerned, it does not present
the various steps of the transactions so clearly as
the separate entries. The “A & B, Vendors” account in
entry (b) indicates the liability of the corporation to
A & B, arising from the purchase of their partnership
properties. Entries (c) and (d) show the manner
in which A and B are paid for this purchase, with
consequent cancellation of that liability.
2. The entries to close the books of the partnership of A & B are:
(a) American Baking Company 350,000.00
Cash 20,000.00
Accounts Receivable 150,000.00
Merchandise 50,000.00
Plant 130,000.00
To charge the American Baking Company
with the assets purchased under
contract of (date).
(b) Accounts Payable 45,000.00
Mortgage Payable 80,000.00
American Baking Company 125,000.00
To credit the American Baking Company
under their purchase contract for
the taking over of the firm’s
liabilities.
(c) American Baking Company Stock 225,000.00
American Baking Company 225,000.00
To credit the American Baking Company
for the payment of the balance due
by the issue of its stock at par
to the firm.
(d) A, Capital 125,000.00
B, Capital 100,000.00
American Baking Company Stock 225,000.00
To show the distribution of
the stock.
Where the stock is issued to each partner directly
(instead of to the firm and then distributed to the
vendors), sometimes the issue is not shown on the
partnership books, entry (c) above carrying debits to
the partner’s capital accounts in place of the debit
to American Baking Company Stock. Whether the actual
transaction follows one course or the other, entries as
shown above seem to meet either requirement.
The student should make sure that the effect of the
entries under (a) and (b) is thoroughly understood.
It may be further noted that if good-will or shrinkage
of values enters into the sale of a partnership, the
necessary adjustments should be made in the partners’
accounts before the sale takes place, after which the
closing entries are as shown above.
CHAPTER XL
CURRENT AND CLOSING ENTRIES FOR THE CORPORATION
=Relation between the Corporation and Its Owners.=—It should be noted
that the owners of a corporation are on a somewhat different basis in
their relationships and activities to the business than are the owners
of a partnership or single proprietorship business. The legal theory
that the corporation is an entity, a person, separate and apart from
its owners, necessitates a change in the status of accounts with owners
as compared with similar accounts in the other types of organization.
A charge against a stockholder as a customer of the corporation is on
the same basis as a charge against any other customer. A stockholder
may become a creditor of the corporation in exactly the same way as any
other person. In a partnership, on the other hand, charges against a
partner and credits to his account are looked upon as charges against
and credits to his proprietary interest in the event of liquidation of
the firm. This is not true in the case of a corporation, stockholders
in such dealings being considered “outside” parties.
=Current Record on Corporation Books.=—After the corporation has
been organized and the opening entries made on its books, the record
of current transactions proceeds on practically the same basis as
in all other types of business organization. Sales, purchases, cash
receipts and disbursements, notes receivable and payable, and all the
transactions arising out of them, are recorded currently in the same
types of books and in the same manner as the similar transactions of a
single proprietorship or a partnership.
While the record of current transactions is practically the same for
all types of business organizations, there are some kinds of current
transactions of a corporation which differ somewhat from those of the
other types. They arise out of the nature of the corporation and are
recorded under account titles peculiar to the corporate form. Some
of these transactions and other accounting records will be discussed
briefly.
=Treasury Stock.=—In some classes of enterprise and also under some
methods of organizing and financing the corporation, no provision is
made for the securing of a fund of working capital, all of the original
capital being tied up in fixed assets—as a mine or some other plant.
A similar condition is sometimes encountered even after a corporation
has been operating for a number of years. Lack of business judgment
and financial foresight sometimes brings about a condition in which
the company has allowed an undue proportion of its current assets, and
therefore its working capital, to become tied up in plant extensions.
In both such cases a frequent method of raising working capital is
for the stockholders to donate to the corporation a pro rata portion
of their holdings of stock to enable it to secure the needed working
capital by selling the stock. When such stock comes back into the
company’s treasury, it is termed “treasury stock.” Having once been
issued and presumably fully paid for, it has this characteristic which
does not attach to the original shares before their issue, viz., that
it can be sold at a discount without the purchasers being liable to
creditors, in case of bankruptcy, for the amount of the discount.
Par-value stock which is originally sold at a discount or which is
being sold on the instalment plan and has not therefore been paid
for in full is subject to levy for the unpaid amount in the event of
bankruptcy of the corporation. Thus, the man who buys a $100 share of
original stock for $90, is subject to a $10 levy in the event that the
assets of the corporation are not sufficient to pay its debts.
Accordingly, in financing highly speculative ventures such as mining,
oil, and other similar companies, it is customary to issue the entire
capital stock of the company to the owner or owners of the mining
or oil property taken over by the corporation as the basis for its
operations. Inasmuch as the value of the properties taken over is not
determinable, it is usually impossible to show that the stock issued
for them does not represent their true value. Accordingly, such stock
is legally fully paid stock and not subject to the liability for
additional assessment which attaches to stock sold at a discount.
Working capital is provided through the donation of a portion of the
capital stock to the treasury of the corporation, which is then in a
position to sell to others the stock now fully paid and non-assessable.
It is easier to find purchasers for this stock because it can be sold
at whatever discount is necessary to dispose of it and carries with it
no liability for future assessment.
Treasury stock may arise also through repurchase by the company. It
may sometimes be desirable for a company to buy back some of its own
stock. This is not allowed in all states but where allowed such stock
repurchased becomes treasury stock.
The student should distinguish carefully between treasury stock and
unissued stock.
=Accounting for Treasury Stock.=—The record of treasury stock
transactions is not complicated. They are discussed under three heads
as follows:
1. RECORD AT TIME OF ACQUISITION. Only the acquisition through donation
will be explained here. Acquisition through purchase usually involves
an adjustment of purchase price to par value and the vexed problem of
valuation. This problem will be found discussed on page 18, Volume II.