Chapter Fifteen Partnerships: Termination and Liquidation Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

15-2 Termination and Liquidation The liquidation of a partnership generally involves three important steps: 1. Non ‐ cash partnership assets are sold for cash, and gains and loss on the sales are allocated to the capital accounts of individual partners on the basis of the profit and loss ratios. 2. Partnership liabilities and expenses incurred during the liquidation are paid out of the partnership’s available cash. 3. Any partnership cash remaining after paying liabilities and liquidation expenses is distributed to the individual partners on the basis of their respective capital balances.

15-3 Termination & Liquidation The accountant summarizes and keeps track of the process in a statement of partnership liquidation. The liquidation of a partnership becomes complicated if: One or more partners have a negative (deficit) capital balance. The liquidation takes place over an extended period of time. The accountant can facilitate distribution of cash in installments by calculating the safe payments. The accountant might prepare a cash predistribution plan.

15-4 Learning Objective 15-1 Determine amounts to be paid to partners in a liquidation.

15-5 Termination & Liquidation Morgan & Houseman want to liquidate their partnership. The process calls for 1) Assets are converted into cash to pay business obligations and liquidation expenses. 2) Remaining assets are distributed to partners based on their final capital balances. 3) Partnership books are closed.

15-6 Termination & Liquidation - Example Morgan and Houseman allocate all profits and losses on a 6:4 basis. The partnership has $75,000 of noncash assets to be liquidated as seen on the 2015 Balance Sheet.

15-7 Learning Objective 15-2 Prepare journal entries to record the transactions incurred in the liquidation of a partnership.

15-8 Termination & Liquidation - Example On 6/1, the inventory is sold for $15,000. Note the loss on the sale of inventory of $7,000 is assigned $4,200 ($7,000 x 60%) to Morgan and $2,800 ($7,000 x 40%) to Houseman.

15-9 Termination & Liquidation - Example Assume that $9,000 of the Accounts Receivable are collected. The remaining accounts receivables are written off, and the loss is allocated between Morgan & Houseman. $3,000 x 60% = $1,800 $3,000 x 40% = $1,200

15-10 Termination & Liquidation - Example The fixed assets are sold for $29,000. The loss on fixed assets of $12,000 is allocated to Morgan & Houseman. $12,000 x 60% = $7,200 $12,000 x 40% = $4,800

15-11 Termination & Liquidation - Example Once all the assets are sold, accounts payable are paid off. Morgan & Houseman incur an additional $3,000 in liquidation expenses.

15-12 Termination & Liquidation - Example This schedule is used to determine the partners’ ending capital account balances and, thus, the appropriate distribution of the cash balance.

15-13 Termination & Liquidation - Example After the ending capital balances have been calculated, the remaining cash can be distributed to the partners to close out the financial records of the partnership.

15-14 Statement of Liquidation Transactions to date. Property still being held by the partnership. Liabilities remaining to be paid. Current cash and capital balances. A report can be prepared to disclose the progress of the liquidation to various interested parties.

15-15 Statement of Liquidation The process of liquidation can last over months, even years. Partners may experience deficit balances during the liquidation period. Partners may want cash distributions prior to the completion of the liquidation. Accountants distribute statements at each important juncture of the process.

15-16 Learning Objective 15-3 Determine the distribution of available cash when one or more partners have a deficit capital balance or become personally insolvent.

15-17 Deficit Capital Balance Deficit balances can be resolved two ways:  Deficit partner can make a contribution to cover deficit.  Remaining partners can absorb the deficit. (Deficit partner may pay later or can be sued for the amount.) Cash $20,000 Holland, Capital $ (6,000) Dozier, Capital ,000 Ross, Capital ,000 Total $ 20,000 Holland, Dozier, and Ross balances just prior to liquidation.

15-18 Deficit Capital Balance -- Contribution by Deficit Partner Holland legally is required to convey an additional $6,000 to the partnership to eliminate the deficit balance. This contribution raises the cash balance to $26,000, which allows a complete distribution to be made to Dozier ($15,000) and Ross ($11,000) in line with their capital accounts.

15-19 Deficit Capital Balance - Remaining Partners Absorb Deficit If the partner resists, the loss will be written off against the capital accounts of Dozier and Ross. Allocation of Potential $6,000 Loss Dozier ⁄3 of $(6,000) $(4,000) Ross ⁄3 of $(6,000) $(2,000) Allocation of the loss is based on the relative profit and loss ratio specified in the articles of partnership. Dozier and Ross are credited with 40 percent and 20 percent of partnership income, respectively. The 40:20 ratio equates to a 2:1 relationship (or 2⁄3:1⁄3) between the two.

15-20 Deficit Capital Balance - Remaining Partners Absorb Deficit Capital balances after distribution of Holland’s loss: Holland Dozier Ross Capital Balances $ (6,000) $ 15,000 $ 11,000 Allocation of Holland’s deficit balance 6,000 (4,000) (2,000) Capital Balances $ - $ 11,000 $ 9,000 A safe payment of $11,000 may be made to Dozier that reduces that partner’s capital account from $15,000 to the minimum $4,000 level. A $9,000 payment to Ross decreases the $11,000 capital balance to the $2,000 limit. Thus, $11,000 and $9,000 are the safe payments that can be distributed to the partners without creating new deficits.

15-21 Schedule of Liquidation - Interim Cash Distributions Prior to making interim cash distributions to the partners, assume: 1. All noncash assets will be complete losses. 2. All liabilities will be paid. 3. All deficit partners will be written off. Even though assumptions #1 and #3 may be unrealistic, they allow the computation of “safe” balances.

15-22 Schedule of Liquidation - Interim Cash Distributions Transactions in the partnership liquidation summarized

15-23 Learning Objective 15-4 Prepare a proposed schedule of liquidation from safe capital balances to determine an equitable preliminary distribution of available partnership assets.

15-24 Preliminary Distribution of Assets Debts owed to personal creditors. Debts owed to partnership creditors. Debts owed to the other partners. Under the Uniform Partnership Act, a priority ranking of creditors having claims against individual partners is recognized:

15-25 Claims Against the Partnership  Individual partner’s creditors can make a claim against the assets of the partnership.  All partnership creditors must be satisfied first.  The creditors can only assert claims to the extent of the specific partner’s positive capital balance.  Each partner is liable for ALL the debts of the partnership.  Partners are NEVER liable for the personal debts of the other partners.

15-26 Learning Objective 15-5 Develop a predistribution plan to guide the distribution of assets in a partnership liquidation.

15-27 Predistribution Plan At the start of a liquidation, accountants produce a single predistribution plan to serve as a guide for all future payments. Whenever cash becomes available, the plan indicates the appropriate recipient(s) without drawing up ever- changing proposed schedules of liquidation. The plan is developed by simulating a series of losses, each of which is just large enough to eliminate, one at a time, all of the partners’ claims to partnership property.

15-28 Predistribution Plan Assume the following partnership is to be liquidated Assume the income sharing percentage is Rubens 50%, Smith 20%, and Trice 30%. Partnership capital reported totals $121,000. Differing losses would reduce each partner’s current capital balance to zero. As a prerequisite to developing a predistribution plan, the sensitivity to losses exhibited by each of these capital accounts must be measured.

15-29 Predistribution Plan First, determine the maximum loss that each partner can absorb. Divide each partner’s capital balance by their respective income sharing percent.

15-30 Predistribution Plan Since Rubens can ONLY absorb a partnership loss of $60,000, new balances are computed assuming that the partnership has a $60,000 loss. With Rubens wiped out, continue calculating maximum absorbable losses using income sharing percentages of Smith, 20% (2/5) and Trice 30% (3/5).

15-31 Predistribution Plan According to the schedule, a total loss of $115,000 ($60,000 from Step 1 plus $55,000 from Step 2) leaves capital of only $6,000, a balance attributed entirely to Smith.

15-32 Predistribution Plan To inform all parties of the pattern by which available cash will be disbursed, the predistribution plan should be formally prepared in a schedule format prior to beginning liquidation. Liquidation expenses have been estimated.