Mr. White (invested $20,000) and Mr. Black (invested $10,000) are in a partnership to run a marketing firm. They share profits and losses in the ratio of 2:1, which is also the ratio of their initial investment in the business. Mr. White manages the office but Mr. Black gets all of the contracts for the firm. It is his high profile that gets the contracts for the firm. At the end of the year, the firm has reported net income of $300,000, which was allocated in the ratio of 2:1, ($200,000 for Mr. White, and $100,000 for Mr. Black). On Dec 31, 20XX, Mr. White’s capital balance was $150,000 and Mr. Black’s capital balance was $100,000. Mr. White has withdrawn more cash from the business than his partner Mr. Black.

On Jan 15th, Mr. White discovered that the net income for the previous year was understated by $60,000. Mr. Black tells Mr. White that this net income of $60,000 should be shared in the proportion of their current capital balances. (Mr. White = 150,000/$250,000 = 60% = $36,000; Mr. Black = $100,000/$250,000 = 40% = $24,000). But Mr. White feels that the additional income should be shared in the ratio of 2:1 ($60,000 x 2/3 = $40,000 Mr. White; $60,000 x 1/3 = $20,000 Mr. Black).

Who is correct? Why?

To determine who is correct, we need to assess how the net income should be allocated and compare the approaches of Mr. Black and Mr. White.

First, let's understand the basis on which the net income is usually allocated. In this case, the partners have agreed to share profits and losses in the ratio of their initial investments (2:1). This means that if the partnership's net income is $300,000, it should be divided into two parts: $200,000 for Mr. White and $100,000 for Mr. Black.

However, the problem arises because Mr. White's capital balance is $150,000 and Mr. Black's balance is $100,000. These balances do not reflect the agreed-upon ratio or their initial investments. This means the incorrect allocation of income has already occurred.

Mr. Black's approach is to rectify this by sharing the additional income of $60,000 in proportion to their current capital balances. According to his calculation, Mr. White should receive $36,000 (60%) and Mr. Black should receive $24,000 (40%).

On the other hand, Mr. White believes that the additional income should be allocated based on the original ratio of their initial investments, which is 2:1. According to his calculation, Mr. White should receive $40,000 (2/3 of $60,000) and Mr. Black should receive $20,000 (1/3 of $60,000).

Now, let's evaluate who is correct.

Based on the information provided, there is no explicit agreement or mention of changing the profit-sharing ratio based on the partners' capital balances. The agreed-upon ratio was 2:1 for both initial investment and profit-sharing. Therefore, Mr. White's argument aligns with the initial agreement and seems fair.

Mr. Black's proposition to allocate the additional income in proportion to their current capital balances may seem reasonable to rectify the imbalance caused by the incorrect allocation of the initial net income. However, capital balances can fluctuate due to various factors such as withdrawals, additional investments, or changes in profit-sharing agreements. It is not advisable to base the allocation of additional income solely on the current capital balances, as these balances may not accurately reflect the agreed-upon distribution.

In conclusion, based on the initial agreement and the absence of any explicit mention to change the profit-sharing ratio based on capital balances, Mr. White's approach of allocating the additional income in a 2:1 ratio is more justifiable and aligns with the original agreement.