Partnerships: Liquidation

Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Chapter 16

Partnerships: Liquidation

16-2

Learning Objective 16-1

Understand and explain terms associated with

partnership liquidations.

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Overview of Partnership Liquidations

The Uniform Partnership Act of 1997 includes seven sections which deal specifically with the dissolution and winding up of a partnership. Creditors have first claim to the partnership’s

assets. After the creditors are fully satisfied, any

remaining assets are distributed to the partners based on the balances in their capital accounts.

16-4


Dissociation The legal description of the withdrawal of a

partner, including the following:

1. A partner’s death.

2. A partner’s voluntary withdrawal.

3. A judicial determination.

Not all dissociations result in a partnership liquidation.

16-5


Dissolution The dissolving of a partnership Events that cause dissolution and winding up:

1. In a partnership at will, a partner’s express notice to leave the partnership.

2. In a partnership for a definite term or specific undertaking:a) When after a partner’s death or wrongful dissociation, at

least half of the remaining partners decide to wind up the partnership business.

b) When all of the partners agree to wind up the business .

c) When the term or specific undertaking has expired or been completed.

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Events that cause dissolution and winding up:

An event that makes it unlawful to carry on a substantial part of the partnership business.

A judicial determination.

On dissolution, the partnership begins the winding up of the partnership’s business.

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Winding up and liquidation begins after the dissolution of the partnership. The partnership continues for the limited

purpose of winding up the business and completing work in process.

Winding up process includes the transactions necessary to liquidate the partnership.

Some partnerships change to the liquidation basis of accounting once they no longer consider the business to be a going concern.

16-8


Loans to/from partners According to the UPA 1997, liabilities to partners

for loans the partners made to the partnership generally have the same status as liabilities to the partnerships’ third party creditors.

These loans have no priority for payment. Receivables from partners for loans or other

advances made by the partnership to partners have the same status as other assets of the partnership.

16-9


Deficits in partners’ capital accounts Generally, a partner with a deficit in his or her

capital account must make a contribution to the partnership to remedy that capital deficit.

Liquidating distributions, in cash, are made to each partner with a capital credit balance.

If a partner fails to remedy his or her capital deficit, all other partners must contribute, in the proportion to which those partners share partnership losses, the additional amount necessary to pay the partnership’s obligations.

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Statement of partnership realization and liquidation May be prepared to guide and summarize the

partnership liquidation process. Often called a “statement of liquidation.” It presents, in worksheet form, the effects of the

liquidation on the partnership balance sheet accounts.

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Practice Quiz Question #1

The difference between disassociation and dissolution is:

a. Dissolution relates to adding a powder to a liquid.

b. Disassociation relates to the withdrawal of a partner and dissolution relates to the winding up of a partnership.

c. Dissolution relates to the dissolving of a partner’s personal assets.

d. Dissolution relates to the withdrawal of a partner and disassociation relates to the winding up of a partnership.

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Make calculations related to lump-sum partnership

liquidations.

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The Liquidation Process

1. Non-cash assets converted to cash.

2. Creditors paid to the extent possible.

3. Remaining funds (if any) distributed to partners.

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Group Exercise 1: Lump-sum Liquidation

Partners Larry, Curly, and Moe share profits and losses in the ratio of 3:2:1, respectively. The partners voted to liquidate the partnership when its assets, liabilities, and capital were as follows:

Cash $ 7,000 Liabilities $24,000Non-cash assets 90,000 Loan, Larry 5,000

Loan, Moe 10,000Capital, Larry 22,000Capital, Curly 27,000

__________ Capital, Moe 9,000Total Assets $97,000 Total Liabilities & Equity $97,000

Assume that all the noncash assets were sold for $42,000 and that all cash was distributed to outside creditors and partners.

REQUIRED

Prepare a statement of realization and liquidation.

16-15

Group Exercise 1: Lump-sum Liquidation

Partners Larry, Curly, and Moe share profits and losses in the ratio of 3:2:1, respectively. The partners voted to liquidate the partnership when its assets, liabilities, and capital were as follows:

Cash $ 7,000 Liabilities $24,000Non-cash assets 90,000 Loan, Larry 5,000

Loan, Moe 10,000Capital, Larry 22,000Capital, Curly 27,000

__________ Capital, Moe 9,000Total Assets $97,000 Total Liabilities & Equity $97,000

Assume that all the noncash assets were sold for $42,000 and that all cash was distributed to outside creditors and partners.

Priorities• What to do with the loss on sale of non-cash assets?• Pay outside debt.• Pay inside debt.• Distribute remainder to partners

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Group Exercise 1: Solution

Larry, Curly, and MoeStatement of Realization and Liquidation

Assets Outside Partners' Loans Partners' CapitalCash Noncash Liabilities Larry Moe Larry Curly Moe

Beginning Balance 7,000) 90,000) 24,000) 5,000) 10,000) 22,000) 27,000) 9,000)

= + ++ = + + + + +

Proceeds )

Book Value

Loss

Larry (3/6) Curly (2/6) Moe (1/6)

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Larry, Curly, and MoeStatement of Realization and Liquidation

Assets Outside Partners' Loans Partners' CapitalCash Noncash Liabilities Larry Moe Larry Curly Moe

Beginning Balance

Asset sale & loss allocation

Subtotal

Right to setoff

Outside Distributions

Outside Loans

Partners' LoansPartners' CapitalEnding Balance

16-18

Sharing of Gains & Losses During Liquidation

Gains and losses incurred on the realization of noncash assets during liquidation are allocated among the partners in the

profit-and-loss sharing ratio (such as 4:3:1).

unless agreed to otherwise by the partners.

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Consequences of a Partner Being Personally Insolvent

A partner having a capital account deficit may be able to eliminate the deficit by capital contribution. setoff (against loans to the

partnership).

A deficit that cannot be eliminated is allocated to the remaining partners who have

positive capital balances (using their P/L sharing ratio).

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Consequences of a Partner Being Personally Insolvent

A partner that winds up absorbing some or all of another partner’s capital deficit has legal recourse against that

partner. because that partner has

broken the terms of the partnership agreement.

16-21

Sharing Profits and Losses: In The Ratio of Capital Balances

Sharing profits and losses in the ratio of capital balances is one of the most important safeguards used in

partnership agreements. results in no partner ever having a capital

account deficit balance until the losses incurred in liquidation exceed the total partnership capital. Thus, all partners go into a deficit position

simultaneously.

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The Rule of Setoff

A deficit balance in a partner’s capital account can be eliminated to the extent that such partner has a loan to the partnership.

Note Payable to Jones

Capital, Jones

Balances before setoff $30,000) $(11,000)

Apply rule of setoff (11,000) 11,000)Balances after setoff $19,000) $0)

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How to Know You’ve Done it Right?

If you allocate losses correctly, the remaining cash balances at the end should be exactly enough to pay back partners’ capital balances.

=

Capital

16-24

Group Exercise 2: Lump-sum Liquidation—Insolvent

Partners Huey, Dewey, and Louie share profits and losses in the ratio of 3:3:2, respectively. The partners voted to liquidate the partnership when its assets, liabilities, and capital were as follows:

Cash $ 2,000 Liabilities $35,000NR from Louie 4,000 Loan, Dewey 17,000Non-cash assets 82,000 Capital, Huey 11,000

Capital, Dewey 13,000Capital, Louie 12,000

Total Assets $88,000 Total Liabilities & Equity $88,000

• All the noncash assets of $82,000 were sold for $46,000.• Louie was personally insolvent and unable to contribute any cash.• Huey and Dewey were both personally solvent and able to eliminate any

deficits in their capital accounts through setoff or contribution.• All cash was distributed to outside creditors and partners.

REQUIREDPrepare a statement of realization and liquidation.

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Huey, Dewey, and LouieStatement of Realization and Liquidation

Assets Outside Part Loan Partners' CapitalCash Noncash Liabilities Dewey Huey Dewey Louie

Beginning Balance 2,000) 86,000 35,000) 17,000) 11,000) 13,000) 12,000)


= + ++ = + + + +

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Beginning Balance 2,000) 86,000 35,000) 17,000) 11,000) 13,000) 12,000)NR Write-off (4,000) (4,000)


= + ++ = + + + +

Proceeds

Book Value

Loss

Huey (3/8) Dewey (3/8) Louie (2/8)

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Beginning BalanceNR Write-offAsset sale & loss allocation

SubtotalWrite off Louie

SubtotalRight to setoffHuey contribution

Outside Distributions

Outside LoansPartners' LoansEnding Balance


16-28


Which of the following statements is true about a lump-sum partnership liquidation?

a. Lump-sum liquidations take place over an extended period of time.

b. Lump-sum liquidations can only take place when the partnership has two partners.

c. Lump-sum liquidations relate mainly to corporations.

d. Lump-sum liquidations take place all at once or over a short period of time .

16-29


Make calculations related to installment partnership

liquidations.

16-30

Installment Liquidations: Priority In Distributing Cash

What is an installment liquidation? Assets are sold over time. Cash is distributed throughout the liquidation

process. Who gets priority in each round?

No cash distributions are made to partners until outside creditors have been paid in full. This holds true for both:

Lump-sum liquidations. Installment liquidations.

16-31

The Statement of Realization and Liquidation

The statement of realization and liquidation is an historical statement. portrays what actually happened in the past

(during the liquidation process). is usually prepared in a lump-sum liquidation

(or as a “look back” at an installment liquidation).

16-32

The Schedule of Safe Payments

The schedule of safe payment is a pro forma (what if) statement for

installment liquidations. portrays what could happen in the future

—on a worst-case basis.

Must prepare a new schedule for each $ distribution

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Cash Distribution Plan

The cash distribution plan is a pro forma (what if) statement for

installment liquidations. is only prepared once at the beginning

of the winding up process.

16-34

Installment Liquidations: “Inside” versus “Outside” Loans

Some people seem to have a “fixation” on “equality” between “inside” and “outside” debt.

Strictly speaking, the UPA of 1997 says they are equal. In practice, partners frequently need to subordinate their debt

to existing “outside” debt. We will assume subordination in all in-class examples.

It makes sense to make payments in the following order: Outside debt Inside debt Capital

However, this order can result in inequities. Partner gets payment for loan and spends it. Partner can’t make up deficit balance. Other partners have to cover the deficit.

The legal doctrine of setoff effectively treats loans as additional capital investments to avoid inequities.

16-35

Thoughts on Installment Liquidations

Don’t sell everything at once … BE PATIENT!

You can’t just start handing out cash!

You need a plan to ensure FAIRNESS!

Two types of “plans” for distributing cash:

1. Cash Distribution Plan (beginning of the process)

2. Schedule of Safe Payments (with each distribution)

Ensures that no one gets too much cash too soon.

16-36

Group Exercise 3: Distributing Available $ to Partners

The partnership of Snap, Crackle, and Pop is in the process of being liquidated. The trial balance immediately after the sale of a portion of the noncash assets and full payment to outside creditors is as follows:

Cash $27,000NR from Crackle 13,000Non-cash assets 42,000

Loan, Snap $12,000Capital, Snap 10,000

Capital, Crackle 19,000Capital, Pop __________ 41,000

Totals $82,000 $82,000

Snap wants the available cash distributed to her to pay off her loan—she cites Section 807 of the UPA, which states that partners’ loans have priority over partners’ capital. Pop wants the cash distributed to him because he has the largest capital investment. Crackle believes that it should be distributed equally, which is how profits and losses are shared.

REQUIRED1. Evaluate the position of each partner.2. Who should receive the $27,000 available cash?3. Optional: If subsequent to the cash distribution of $27,000, noncash assets having a

book value of $30,000 are sold for $9,000, who receives the $9,000?

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PART 1

Snap quotes the UPA properly but does not consider the rule of setoff, which essentially treats a partner’s loan as a capital contribution in determining how cash should be distributed to partners.

Pop’s position indirectly states that he is most able to bear losses and the cash should be distributed considering this ability. This general approach is used in distributing cash to partners.

Crackle’s position is without merit. The distribution of cash in liquidation is not related to the manner of sharing profits and losses.

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Schedule of Safe Payments

No cash to partners until AFTER all outside creditors are paid in full.

Before any cash goes to the partners, consider two hypothetical worst-case scenarios. All non-cash assets worthless (distribute losses) Assume partners absorb any deficits

Cash only goes to partners with positive balances. It means they have enough excess invested to absorb

even the worst possible scenarios!

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Group Exercise 3 Continued: Schedule of Safe Payments





Totals $82,000 $82,000


REQUIRED1. Evaluate the position of each partner.2. Who should receive the $27,000 available cash?3. Optional: If subsequent to the cash distribution of $27,000, noncash assets having

a book value of $30,000 are sold for $9,000, who receives the $9,000?

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PART 2

The two worst-case assumptions are needed to determine who gets the cash. A schedule of safe payments follows:

Schedule of Safe Payments to PartnersPartner

Snap Crackle PopPreliquidation loan balancePreliquidation capital balancePreliquidation loan from partnership

First worst-case assumption:Assume full loss of all non-cash assets SubtotalSecond worst-case assumption:

Assume Crackle's deficit is absorbed by other partners

Cash to be distributed to Snap and Pop

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Cash $ 9,000NR from Crackle 13,000Non-cash assets 12,000

Loan, Snap $ 8,000Capital, Snap 3,000


Totals $34,000 $34,000


REQUIRED1. Evaluate the position of each partner.2. Who should receive the $27,000 available cash?3. Optional: If subsequent to the cash distribution of $27,000, noncash assets

having a book value of $30,000 are sold for $9,000, who receives the $9,000?

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PART 3

Snap Snap Crackle PopLoan Capital Capital Capital

Beginning Balances $12,000) $10,000) $19,000) $41,000)

First Cash Distribution

Updated Balances

Allocation of loss on sale

Updated Balances

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Totals $34,000 $34,000




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PART 3

Schedule of Safe Payments to Partners Beginning Balances are after the above cash distribution of $27,000 and

after the $21,000 loss on the sale of noncash assets for $9,000.

Schedule of Safe Payments to PartnersPartner

Snap Crackle PopPreliquidation loan balancePreliquidation capital balancePreliquidation loan from partnership

First worst-case assumption:Assume full loss of all non-cash assets SubtotalSecond worst-case assumption:Assume Crackle's deficit is absorbed by other partnersCash to be distributed to Snap and Pop

16-45

Installment Liquidations: Different Strokes For Different Folks

The amount to be distributed to each partner at any point in time can be determined by preparing either of the following items: Schedules of safe payments at each cash

distribution date. Will have to be done several times.

A cash distribution plan at the beginning of the liquidation process. Need be done only once.

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Installment Liquidations

The effect of distributing cash to partners based on either

(a) schedules of safe payments or

(b) cash distribution plans

is to bring the capital balances into the profit-and-loss sharing ratio.

16-47

Installment Liquidations: Loss Absorption Potential

Conceptually, the first cash distribution to partners goes to that partner who has the highest loss absorption potential (LAP). This is not necessarily the partner who has the

highest capital balance.

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Installment Liquidations: Loss Absorption Potential—Calculating

The loss absorption potential (LAP) of each partner is calculated by dividing the partner’s capital balance by his or

her profit-and-loss sharing percentage.

Capital balance, Jones $80,000= $400,000

Jones’ P/L sharing percentage 20%Loss

Absorption Potential

16-49

Installment Liquidations: Loss Absorption Potential—Loans “To”

In calculating a partner’s loss absorption potential, a partner’s loan to the partnership is added to the partner’s capital balance.

Capital balance, Jones $80,000PLUS

Note payable to Jones 10,000

Total $90,000= $450,000



16-50

Installment Liquidations: Loss Absorption Potential—Loans “From”

In calculating a partner’s loss absorption potential, a partner’s loan from the partnership is subtracted from the partner’s capital balance.

Capital balance, Jones $80,000MINUS

Note payable from Jones (5,000)

Total $75,000= $375,000



16-51

Installment Liquidations: Loss Absorption Potential—Implications

Consequences of Having the Highest Loss Absorption Potential:

He or she will be: The first partner to receive cash. The partner that could suffer the greatest inequity

in relation to his or her capital balance.

It is NOT a good thing to have the highest loss absorption potential.

16-52

Group Practice: Loss Absorption Potential





Totals $82,000 $82,000

REQUIRED Calculate the loss absorption potential for Snap, Crackle, and Pop.

16-53


Snap Crackle Pop

Capital $10,000) $19,000) $41,000)

Loan to (from) partnership

Profit/loss sharing ratio

Loss absorption potential

Based on these calculations, who should receive cash first?

16-54


In liquidation, cash distributions to partners are determined based on:

a. Who has the highest capital balance.b. How profits and losses are shared.c. Partners’ loans to the partnership

having priority over partners’ capital balances.

d. The marshalling of assets principle.e. The rule of setoff.f. None of the above.

16-55

Group Exercise 3 Continued: Cash Distribution Plan



Loan, Snap 12,000Capital, Snap 10,000


Totals $82,000 $82,000




16-56

Cash Distribution Plan: Snap, Crackle, and Pop

Cash Distribution PlanLoss Absorption Potential Snap Snap Crackle PopSnap Crackle Pop Loan Capital Capital Capital

12,000 10,000 6,000 41,000 )

Loss absorption potential 66,000 18,000 123,000

Cash distributed to Pop

Cash distributed to Pop/ Snap

First $27,000 DistributionSnap Pop $ 27,000)

Next $9,000 DistributionSnap Pop $ 9,000)

Priorities:

16-57

Group Exercise 4: Installment Liquidation

Partners Potter, Granger, and Weasley share profits and losses in the ratio 2:1:1, respectively. The partners voted to liquidate the partnership when its assets, liabilities, and capital were as follows:

Cash $ 25,000NR from Potter 15,000Other assets 210,000

Liabilities $ 70,000Loan, Granger 18,000Capital, Potter 44,000

Capital, Granger 10,000Capital, Weasley __________ 108,000

Totals $250,000 $250,000The partnership will be liquidated over a long period of time. Cash will be distributed to the partners as it becomes available. The first sale of noncash assets having a book value of $110,000 realized $80,000.

REQUIRED Determine how the available cash should be distributed to the partners after this

first sale.

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Group Exercise 4: Schedule of Safe Payments

Step 2: Payment of Outside LiabilitiesOriginal cash on hand

+ Sale proceeds

Total cash available for debt payment

Payment of outside liabilities

Cash available for distribution to partners

Step 1: Sale of Non-cash AssetsProceeds

Book Value, non-cash assets sold

Realized loss

Remaining non-cash assets

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Step 3: Update Capital Balances

Potter Granger Weasley

Original balance 44,000) 10,000) 108,000)

Loss allocation from asset sale

Updated Balance

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Totals $34,000 $34,000




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Schedule of Safe Payments to Partners


Loan to partnership

Pre-distribution capital balance

Loan from partnership

Equivalent Capital

First worst-case assumption:

Assume full loss of all non-cash assets

Subtotal

Second worst-case assumption:

Assume deficits are absorbed by Weasley

Cash to be distributed to Weasley

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Totals $250,000 $250,000The partnership will be liquidated over a long period of time. Cash will be distributed to the partners as it becomes available. As of this date no assets have been liquidated.

REQUIRED1. Compute the Loss Absorption Potential for each partner as of the day the

partners decided to liquidate the partnership.

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Capital $44,000) $10,000) $108,000)

Loan to (from) partnership

Profit/loss sharing ratio

Loss absorption potential

Based on these calculations, who should receive cash first?

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Totals $250,000 $250,000The partnership will be liquidated over a long period of time. Cash will be distributed to the partners as it becomes available. As of this date no assets have been liquidated.

REQUIRED2. Prepare a Cash Distribution Plan as of the day the partners decided to liquidate

the firm. This plan should show how cash will be distributed to the partners as it becomes available (after all outside liabilities have been paid).

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Group Exercise 4: Cash Distribution Pl

Cash Distribution Plan50% 25% 25%

Loss Absorption Potential Granger Potter Granger WeasleyPotter Granger Weasley Loan Capital Capital Capital

18,000 29,000 10,000 108,000 )

Loss absorption potential 58,000 112,000 432,000

Cash distributed to Weasley

Cash distributed to Weasley and Granger

First $35,000 DistributionPotter Granger Weasley $ 35,000)

Priorities:

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Which of the following is NOT true about the schedule of safe payments and cash distribution plans?

a. Cash distribution plans are prepared multiple times during the liquidation as cash comes in.

b. Cash distribution plans are prepared at the beginning of the liquidation.

c. Schedules of safe payments are prepared multiple times during the liquidation as cash comes in.

d. The allocation of assets to partners is the same under the cash distribution plan and schedule of safe payments.

Conclusion

The End

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Partnerships: Liquidation

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