PARTNERSHIP LIQUIDATION

Chapter 8

Dissolution

• Due to a change in the legal relationship among partners

• Typically due to– Admission of a new partner– Withdrawal of a partner– Death of a partner

Termination

• Partnership ceases normal business operations

Liquidation

• Occurs when the partnership sells its assets, pays its liabilities, and distributes remaining assets to partners

• May occur due to– Partnership fulfilling its business purpose– Partners desire to not continue the

business– Partnership is in financial difficulty

Liquidation (con’t)

• May be– Voluntary – the partners may choose to

liquidate– Involuntary – creditors force the

partnership to liquidate

Accountant’s Liquidation Responsibilities

• Manage liquidation to ensure the payment to creditors

• Manage liquidation that will result in an appropriate distribution to partners

Marshalling of Assets

• Keeping the partnership assets and liabilities separated from the partners’ personal assets and liabilities

• Partnership creditors and individual partner creditors can each have claims against partnership and partner assets but the priority of claims differ depending on source of payment

Partnership Creditors’ Claims

• Order of priority– By partnership creditors– By personal creditors if claim not fully

paid from partner personal assets (limited to partner’s capital balance)

Partner’s Personal Creditor Claims

• Order of priority– By personal creditors– By partnership creditors if claim not fully

paid from partnership assets (not limited to partner’s capital balance)

– By other partners if partner capital account has a deficit capital balance

Uniform Partnership Act Partnership Claims

• Partnership liabilities shall rank in the following order– Creditors other than partners– Partners other than for capital and profits– Partners in respect of capital– Partners in respect of profits

Uniform Partnership Act Partnership Claims (con’t)

• Partners’ three claims (i.e., loans to from partners, partners’ capital contributions, partners’ undistributed partnership income) are often combined into a single category in practice (e.g., right of offset)

• Partners’ capital contributions and undistributed income are often combined into one account

Uniform Partnership Act Partnership Claims (con’t)

• Right of offset importance is to ensure that payment is not made on a partner loan when there is a capital account deficit

• Right of offset requires an agreement in the Articles of Partnership because partnership loans have priority over partnership capital account balances in the distribution

Partnership Priority Claims

• Creditor claims does not mean that partnership creditors must be fully paid before partners can receive any distribution

• Creditor claims means that the accountant has the duty to ensure that sufficient funds will be available for creditors if partners receive any distribution

Liquidation Process

• Close books and allocate profit or loss to capital accounts

• Liquidate noncash assets, allocate gains and losses directly to capital accounts using residual profit and loss ratios

• Pay liabilities and distribute assets to partners

Partnership Distributions to Partners

• Lump-sum liquidation: all liabilities are paid and then a single (lump-sum) distribution is made to partners

• Installment liquidation: partner distributions are made while liabilities are still outstanding or noncash assets are still owned

• If distributions to partners are made and there are insufficient assets to pay creditors, the accountant may be liable to the creditors

Lump-Sum Liquidation

• Noncash assets generally sold in a relatively short period of time

• Liabilities are all paid• Remaining cash is distributed• Accountant’s duty is to search for

unrecognized liabilities and to unsure that priority of creditor claims are followed

Statement of Realization and Liquidation

• May be used as an alternative to journal entries to recognize liquidation events

• Trial balance before liquidation (balance sheet accounts only) are presented as column headings

• Loans to and from partners are collapsed into the respective partner’s capital account (right of offset)

Statement of Realization and Liquidation (con’t)

• Liquidation events (sale of assets, payment of expenses or liabilities) are posted directly to the columns with income statement items (e.g., gains, losses, expenses) posted directly to capital accounts using the residual profit and loss ratios

• Income statement accounts do not exist on the statement because they are only relevant to a going concern

Statement of Realization and Liquidation (con’t)

• Deficit capital accounts created during liquidation may occur due to the partner with the deficit– Having a large profit and loss residual

ratio– Having withdrawn a larger portion of

his/her profits

Statement of Realization and Liquidation (con’t)

• Removal of deficit partner balance– Additional contribution by partner with

deficit capital account desired– If additional contribution is not made,

deficit must be absorbed by other partners in proportion to their respective residual profit and loss ratios

Statement of Realization and Liquidation (con’t)

• Absorption of partner capital deficit by other partners in proportion to their respective residual profit and loss ratios

• Example 3Partner capital balances after item 4

(.45) (.35) (.20)Briscoe Johnson Mitchell55,250 (129,250) (6,000)

Statement of Realization and Liquidation

• Briscoe deficit allocation

(.35)(.20)

Johnson Mitchell

.35/(.35+.20) x $55,250 35,159

.20/(.35+.20) x $55,250 20,091

Statement of Realization and Liquidation

• Briscoe’s capital deficit means that the other partners will not receive the amount in their respective capital accounts

• Sum of the other capital balances exceeds the amount of cash available for distribution

• Allocation of deficit makes sum of remaining capital balances equal distributable cash

• Allocation may result in other capital deficits and further allocations

Installment Liquidation

• Issues to be considered when deciding when and how much to distribute to partners before the liquidation is complete include– amount still owed creditors– estimated remaining liquidation expenses– the inability of partners to make additional

contributions to eliminate capital deficits

Cash Distribution Plan

• Outlines order partners will receive cash during an installment liquidation

• No guarantee that any cash will be distributed

• Does not indicate when cash distributions will occur

Cash Distribution Plan (con’t)

• Focuses on – capital balances– loans to and from partners– residual profit and loss ratios

• to determine the relative ability of each partner’s capital account to absorb losses before becoming deficit

Loss Absorption Power

• Cash distribution plan component outlining the amount of liquidation– expenses– losses

• Indicates the relative risk of distributing cash a partner before the liquidation is completed

• necessary to reduce each partner’s respective capital account to $-0-

Loss Absorption Power

• Calculation

Loss Partner Residual Profit

Absorption = Capital and Loss

Power Balance Percentage

Example 4 (Johnson):

$577,000 = $201,950 / .35

Loss Absorption Power

• Losses and expenses of $577,000 would decrease Johnson’s capital account $201,950 = ($577,000 x .35)

• Cash distributions made first to the partner with the largest loss absorption power

• Each $1distribution decreases Johnson’s loss absorption power by $2.86 = ($1/.35)

Loss Absorption Power

• Distributions made until the receiving partner’s loss absorption power equals the next highest loss absorption power (i.e., risk of two capital accounts becoming $-0- is equal)

• Example 4 (con’t): Johnson’s first cash allocation ($577,000 - $240,000) .35 = $117,950

Loss Absorption Power

• Briscoe’s and Johnson’s loss absorption power now equals

• Next cash allocation to Briscoe and Johnson relative to profit and loss residual ratios

• Distribute cash to Briscoe and Johnson until their loss absorption powers equally Mitchell’s ($240,000 - $207,700) = $32,300

Loss Absorption Power

• Briscoe: $32,300 x .45 = $14,535• Johnson: $32,300 x .35 = 11,305• Any additional cash is allocated to all three

partners based on profit and loss residual ratios

Schedule of Safe Payments

• Must be prepared when cash distribution plan does not provide a useable foundation for distribution allocation, i.e., when profit residual ratio is not the same as loss residual ratio

• May be prepared for any liquidation

Schedule of Safe Payments• Schedule calculated distribution under the

presumptions that– All remaining non cash assets are

worthless– Partners cannot make contributions to

eliminate deficit capital balances• Resulting distribution allocates cash to least

risky partner(s) under most conservative assumptions