ages is often lost sight of. No doubt this oversight not infrequently causes errors of judgment. Opinions and decisions are founded upon what seem to be facts shown by the percentage items, whereas, a closer investigation would have shown that the latter were not universally applicable.

"Moreover, when accounts are presented in the comparative form of related percentages in different periods, an imperfect understanding of the nature and uses thereof is especially likely to lead to misunderstanding and faulty conclusions.

"In order to exhibit in an elementary way a few of the principles involved and to induce those unfamiliar with the subject to devote some attention to it, the following summarized comparative trading and profit and loss account, with relative percentages, has been prepared:

Comparative Trading and Profit and Loss Account

"The first point to note in connection with the trading account is that it is equational in form. The sum of the elements on the debit side of the accounts, A, B, C, and D, equals the amount of the credit item E. The percentage items, of course, have the same relation to each other as the basic figures expressed in dollars, and therefore appear also as an equation.

"The equational form arises from the fact that the trading statement is prepared on the principle of double entry and is usually extracted from books kept upon that principle.

"As a consequence of the employment of this form, any changes made in the figures of any element of the account must be offset by changes of equal amount in some other element on either or both sides of the account in order to maintain the equation.

"The percentages are usually calculated by taking some one element of the account as a basis; the total net sales for the period is a common base. Consequently, any changes in this basic figure alter the percentage relations of the other elements of the account to the same extent as the change in the base. In brief, changes in the figures expressed in dollars on either side of the account affect the relative percentage amounts.

"This may be seen in the illustrative account, wherein the total expenses in 1916 although exactly the same in amount as those in 1915, have increased from 10 per cent of the sales to 15 per cent thereof, an increase of expenses of 50 per cent, apparently, in one year.

"This apparent increase is, however, merely a relative increase due to the increased amount of sales. If the percentages were calculated on the cost of goods sold the relative increase in percentage would be still greater.

"The necessity of bearing in mind that the percentage figures computed on the basis of the accumulated figures of a period are average figures, is very clearly seen when the percentages of one period are applied to bases of a similar kind in other periods.

"Referring again, for example, to the percentage of total expenses to the net sales in 1915, namely, 10 per cent and using the net sales during 1916 as a basis, it is found that the actual percentage in the latter year of total expenses to sales is no less than 50 per cent more than if it had been calculated upon the percentage of the previous year.

"Variations of this nature would be still more noticeable if computed over shorter periods say, monthly or quarterly, as neither expenses nor sales generally accrue regularly throughout a fiscal period.

"It is evident, then, that estimates or forecasts based on percentages or averages may be very untrustworthy unless all the conditions and circumstances in which the transactions took place are taken into consideration.

"Yours truly,

"Wм. W. McClellan, C. P. A.”

One more letter deserves attention on account of the very prevalent confusion that exists in many minds in regard to the principles involved:

"Dear Sir:

"Billings, Mont.

"In accordance with your suggestion for JOURNAL readers to send in problems arising in their own experience, I enclose the following:

"A, B and C form a partnership to carry on a business. A and B have no money nor property to invest. C has, say, $15,000 cash, sufficient to buy goods and start the business going. It is agreed that each partner is to have one-third interest in the business. C lends the $15,000 to the partnership, and all of them (A, B and C) sign a note for $15,000 to the order of C (payee), which C holds. It is further agreed that C is to be repaid his $15,000, by receiving three-fourths of the annual profits before A and B are entitled to any profits. A and B to receive the other one-fourth. C is also to receive 8 per cent interest on the full amount of the note. Assuming that there are sufficient profits to pay the note in full, and that the note is accordingly paid, how do the partners stand? The business is continued.

"This is an actual case that came before me a year ago.

"Of course, one might criticize the parties, and say that they should have done things a little differently. But that is not the point. The fact is they did things just as I have stated above, and the question must be solved, not from what they should have done, but from what they actually did.

"The point which interests me is: Has C any interest in the business when the note is paid? The possibility of C's ultimate elimination from the business never occurred to any of the partners, nor to their attorney. It appears to me that the whole transaction is predicated upon the loan of $15,000, evidenced by the promissory note for that amount. If A, B and Chad each contributed $5,000, the division of the profits would have been equal (one-third to each). But C puts up the full amount, which includes $10,000 for A and B. A and B then proceed to establish their capital interest, by depriving themselves of the difference between_onethird and one-eighth of the profits, and paying that difference to C. C also receives the interest on the note, as previously stated, which of course includes interest on his own one-third of the total investment. It would be proper for C to receive back $10,000 as due from A and B, but if he exceeds this amount, and receives the full $15,000, has he not been paid back all of the capital which he invested, and in consequence, would not

his financial interest, as a partner, cease? In other words, if he is to continue with a one-third capital interest, can it be based upon anything other than bonus? It is important to know this, in order to show who are the proprietors of the business.

"I would like to know what JOURNAL readers think of this.

"Yours very truly,

ANSWER

"GEO. T. WATTS."

The apparent confusion in this case arises from a wrong use of language. C does not receive three-fourths of the profits in payment of his note, as the problem states. He receives three-fourths of the money provided by the profits, which is a very different proposition. A and B are to receive the other fourth, that is, they are allowed to draw the other fourth, but must leave their share of the three-fourths in the business, so that it may be paid to C. It is exactly the same with C. He must leave $5,000.00 of his profits in the business to provide for his share of the note, and he can draw in cash the same amount as A and B each do.

The mistake of mixing accounting principles with financial considerations has already been pointed out in this department. The division of the profits and the resultant accumulation of capital in the accounts of A, B and C have not the remotest relation to the payment of the note held by C. In fact, the possession of the note by C has nothing to do with the matter. The money might just as well have been borrowed from X, Y or Z. The firm owes the note, they do not owe C. On the other hand, C is just as much a member of the firm as are the other two, and has exactly the same rights to his share of the profits, except that he apparently has waived the right to draw any of them out in cash.

Looking at the accounting principles only, it is plain that A, B and C have entered into an equal partnership, and that neither of them has paid in any capital. To provide the money with which to carry on the business, they have borrowed $15,000.00 from some one-from whom is entirely immaterial, since they all signed the note. To provide for the payment of the note, they have agreed to leave all their profits in the business, except one-eighth each that A and B are entitled to draw out. When their combined accumulations of profits in their capital accounts amount to $15,000.00, the note will have been repaid to the holder of it, whoever he may happen to be, and their capital accounts will not be affected by the payment. To say that, because C is said to receive three-fourths of the profits in payment, it means that the profits are to be charged with the payment of the note is so plain a confusion of accounting principles with financial transactions as hardly to need explanation. There is a very prevalent idea, however, among those who do not analyze very closely that in some way the payment of a legitimate recorded debt decreases the net worth of the payer. In this case, C does not receive three-quarters of the profits in payment of his note, but he does receive three-quarters of the money provided by the profits. As each of the

partners has an equal interest, each one must receive credit for one-third of the net profits in his capital account. Whether he then draws part of it out or not is entirely a matter of financial arrangement between the partners, and has nothing to do with the accounting principle that in an equal partnership, each partner must be credited with an equal share of the profits.

In this case it is necessary that the accumulated profits shall have amounted to $20,000.00 in addition to the interest on the note, before the note can be paid. To avoid complications, we will assume that the interest has been paid and that the books have been closed as far as the operating accounts are concerned, but that no division of profits has been made among the partners. Also that no partial payments have been made on the note, and that the money is on hand to pay the note. The books would then show the following condition :

At this point it would require a more expert juggler of figures than the editor of this department professes to be to pay the note out of profits in the sense of charging it to profit and loss. It would be a little difficult to find a credit to offset that debit. Of course, what would be done would be to debit notes payable and credit cash, when the money was paid. Profit and loss would then be closed out into the partners' capital accounts by this entry

If C claimed that his having only a third interest in the business meant that each of the other's capital should be equal to his, and A and B could not pay in enough to make up the amounts, they would have had to wait until they had accumulated $24,000.00 of profits, of which A and B would have drawn one-eighth, or $3,000.00 each. To equalize, C would also have to draw the same amount. The net balance of each would then be $5,000.00, which would have provided the money with which to pay the note.

So much space would not have been given to this very simple proposition, if it had not been for the fact that it is an excellent example of the faulty reasoning of those who insist upon completely identifying a business with the man who finances it. Our correspondent says: "But C puts up the full amount, which includes $10,000.00 for A and B." C did nothing of the kind. What he did do was to lend $15,000.00 to the firm of which he was a member. If he had put up the capital for A and B, he would have lent each of them $5,000.00, or the two jointly $10,000.00, taking their notes therefor. A and B would place the money to the credit of their capital accounts, and as far as the books of the business are concerned, there would be no record of the notes at all. Of course, C would have had to pay in the other $5,000.00 to the credit of his own capital account. A and B would have had to pay the interest on their notes to C and would also have had to use three-fourths of their credits for profits by drawing out the money and paying it to C, while C himself would have drawn out all his profits in money to repay his own capital out of the three-fourths of his profits and to offset the one-fourth each drawn by A and B. The result would have been the same in the final outcome, but it would have been reached in an entirely different manner from that stated in the problem.

The whole difficulty disappears if we can once bring ourselves to realize that C, in lending the money to the business, is in an accounting sense distinct from C, the man who has a one-third interest in the business, and also that it is possible for C, the partner in the firm, to owe C, the man that lends the money. In other words, a man may act in a dual capacity and in one of those capacities can owe himself in the other capacity. The sooner accountants learn that fundamental truth, the sooner they will begin to think clearly in regard to such points as are involved in this question.

THE LAST WORD ON CAPITAL AS A LIABILITY

Mr. C. M. Van Cleve has written a rejoinder to the article in the October number, which is too long to quote in full in the space at the disposal of this department. At the risk of wearing out the patience of the reader, the salient points only will be briefly discussed.

In answer to the question "If the credit in A's capital account on the books of A & Co. is not a liability of A & Co., what is it?" he says, "It is a part of the net capital of the firm, a part of the excess of assets over liabilities."