Preferred Rtn in Equity Section

Partnership client is in disagreement with how we are accounting for his preferred return payments.

Below is client's definition of Preferred Return:
Preferred Return” means, with respect to a Class B Unit at any time, the amount accrued as of such time in respect of such Class B Unit (commencing on the date the Company issued such Class B Unit) at a simple rate of ten (10)% per annum on the unreturned initial capital contribution for such Class B Unit from time to time.

We are showing the payment of preferred dividends as a reduction of the partner's capital accounts. Is this correct?

He says since the preferred shares are to be paid on the unreturned initial capital, the Preferred partner's unreturned capital should not change on the balance sheet, until they are required to make payments to the unreturned capital.

If we are doing it correct by accounting as a reduction of partner capital, would the solution be just to keep an account balance "Partner Capital Contribution" and another "Partner Distributions" on the financials.

Thanks for any assistance and suggestions on this, including account descriptions.

He says since the preferred shares are to be paid on the unreturned initial capital, the Preferred partner's unreturned capital should not change on the balance sheet, until they are required to make payments to the unreturned capital.

I see his point and I’ve run into this before. Thus, this statement is largely true:

If we are doing it correct by accounting as a reduction of partner capital, would the solution be just to keep an account balance "Partner Capital Contribution" and another "Partner Distributions" on the financials.

I say “largely“ because if you think about the capital account makeup, it is (1) contributions (2) P/L allocations (3) distributions that are preferred returns “on” capital and (4) regular operating distributions. I’ve seen all of these things presented on a Balance Sheet in a situation like yours. But you and I both know that it’s not inconceivable to do things like you did them and then to keep track of one’s “unreturned initial capital contribution” on a spreadsheet.

I've only dealt with this a few times, but I always saw "preferred return" as an incentive for the investor that put extra capital in. So the preferred return was allocated to income until a distribution or return of extra capital was repaid. The idea was to incentivize the operators of the company to pay off the initial investors....usually until everyone had equal invested basis. If the operators didn't want to pay down the larger investors....that's fine the preferred return (allocation remains).

We would do this on debt also, there was "in ratio interest" or "out of ratio interest rate" on loans. The out-of-ratio interest rate was really high as an incentive to repay it promptly.

All that to say, that it makes sense that they want to keep track of that portion of capital separately. We had many spreadsheets and several heated debates over said spreadsheets.