Partnership Dissolution

Introduction A partnership may dissolve due to disagreement among the partners, poor performance of the firm or being taken over by another business. The assets of the partnership will be realized to pay off the liabilities. The sales proceeds should be applied in the following order, as required by the Hong Kong Ordinance: Pay off creditors first, then the partners’ advances, and Finally the partners’ capital

Realization Account In the partnership dissolution, an account named as ‘Realization Account’ will be opened to compute the profit or loss from realization which should be shared among the partners according to the profit or loss sharing ratio

Nature of partnership dissolution Dissolution where the assets are sold separately Dissolution where partnership is sold as a whole

Dissolution where Assets are sold separately

Procedures of Dissolution All assets will be sold to other persons or taken over by partners Settle the liabilities of the partnership to outsider or partners Transfer any ‘profit or loss on realization’ to each partner’s capital accounts in profit/loss sharing ratio Merge the balances in the partners’ current accounts to their capital accounts

Any credit balance in each partner’s capital account represents the amount which can be withdrawn from the partnership to each partner; any debit balance in a partner’s capital account represents additional cash to be injected by that partners

Transactions Accounting entries Close all asset accounts with net book value to the realization account (except cash and bank because these assets need not be disposed of) Dr Realization Cr Assets Cost of dissolution or any losses or expenses incurred on realization Cr Bank Proceeds from the disposal of assets Dr Bank Cr Realization Assets taken over by a partner without payment Dr Capital

Transactions Accounting entries Asset taken over by partners as a gift No entries required Creditors taken over by a partner Dr Creditors Cr Capitals Payment to creditors with discounts received Cr Realization – discount Cr Bank Profit or loss on realization to be shared among the partners according to the profit-sharing ratio Dr Realization – profit or Dr Capital Cr Realization - loss

Transactions Accounting entries Repayment of loan to an partner Dr Loan from partner Cr Bank Repayment of loan to an outsider ( creditors) Dr Loan from outsider Transfer any balances in partners’ current accounts Dr Current (for credit balance) Cr Capitals Or Dr Capital Cr Current (for debit balance) Repayment of remaining capital to partners

Example 1

John, Peter and Tom were partners sharing profits and losses in the ratio 1:1:3. The balance sheet as at 31 December 1996 was as follows: Balance Sheet as at 31 December 1996 Fixed Assets Cost Dep NBV Premises 180000 10000 170000 Motor Vehicles 27500 5500 22000 207500 15500 192000 Current assets Stock 68250 Debtors 172500 Less: provision for bad debt 1265 171235 Bank 26065 265550 Less: Current Liabilities Creditors 60000 Working Capital 205550 397550

Capital: John 100000 Peter 40000 Tom 160000 300000 Current: John 30000 Peter (10000) Tom 70000 90000 Long – term liabilities Loan from Tom 7550 397550 Assets and liabilities were disposed of as follows: 1. The premises were sold at $ 200000 and legal charges from the sale amount to $10000 2. Tom took over the stock and motor vehicles at book value 3. Except for $2500, all debts were collected 4. The creditors were discharged for $56000 5. Realization expenses of $10000 were paid Required: Prepare the realization, Bank, Capital and Current account for the dissolution of partnership

Realization Premises 170000 Premises Prov. for depreciation 10000 Bal b/f 180000 Realization 170000 180000 180000 Provision for depreciation Premises 10000 Bal b/f 10000

Realization Premises 170000 Motor Vehicles 22000 Motor Vehicles Prov. for depreciation 5500 Bal b/f 27500 Realization 22000 27500 27500 Provision for depreciation Motor Vehicles 5500 Bal b/f 5500

Realization Premises 170000 Motor Vehicles 22000 Debtors 171235 Debtors Prov. for bad debts 1265 Bal b/f 172500 Realization 171235 172500 172500 Provision for Bad Debts Motor Vehicles 1265 Bal b/f 1265

Realization Premises 170000 Motor Vehicles 22000 Debtors 171235 Stock 68250 Stock Bal b/f 68250 Realization 68250

Realization Bank – premises (200000-10000) 190000 - Debtors (172500-2500) 170000 Premises 170000 Motor Vehicles 22000 Debtors 171235 Creditors – discount received 4000 Stock 68250 Bank- realization expenses 10000 Loan from Tom Bank 7550 Bal b/f 7550 Bank Bal b/f 26065 Realization - expenses 10000 Realization – premises 190000 - debtors 170000 Creditors 56000 Loan from Tom 7550 Creditors Bank 56000 Bal b/f 60000 Realization – discount received 4000 60000 60000

Realization Bank – premises (200000-10000) 190000 - Debtors (172500-2500) 170000 Premises 170000 Motor Vehicles 22000 Debtors 171235 Creditors – discount received 4000 Stock 68250 Tom – stock 68250 - MV 22000 Bank- realization expenses 10000 Gain on realization: John 1/5 2553 Peter 1/5 2553 Tom 3/5 7659 12765 454250 454250 Capital John Peter Tom John Peter Tom Realization: Stock 68250 MV 22000 Bal b/f 100000 40000 160000 Gain on realizaiton 2553 2553 7659

Capital John Peter Tom John Peter Tom Realization: Stock 68250 MV 22000 Bal b/f 100000 40000 160000 Gain on realizaiton 2553 2553 7659 Current 30000 70000 Current 10000 Bank 132553 32553 147409 132553 32553 147409 132553 32553 147409 Current John Peter Tom John Peter Tom Bal b/f 10000 Bal b/f 30000 - 70000 Capital 30000 70000 Capital 10000 30000 10000 70000 30000 10000 70000 Bank Bal b/f 26065 Realization - expenses 10000 Realization – premises 190000 - debtors 170000 Creditors 56000 Loan from Tom 7550 Capital: John 132553 Peter 32553 Tom 147409 386065 386065

Dissolution where partnership is sold as a whole

Purchase consideration The purchase consideration is to be discharged by the limited company (buyer) to partners(seller) to take over the business Goodwill = Purchase consideration – ( assets at take-over value – liabilities at take-over value)

Transactions Accounting entries For dissolution of Old partnership (seller) Close all asset accounts with net book value to the realization account (Bank and cash may be taken over) Dr Realization Cr Assets Cost of dissolution or any losses or expenses incurred on realization Cr Bank Proceeds from sale of the business (purchase consideration) Dr Vendee (buyer) Cr Realization

Transactions Accounting entries Liabilities taken over by the buyer Dr Liabilities Cr Realization The purchase consideration settled by cheque, shares and debentures Dr Bank/ Shares/ debentures in purchaser’s company Cr Bank Repayment of remaining capital to partners Dr capital Cr Bank/ shares/ debentures in purchaser’s company

Transactions Accounting entries For opening entries of New Company (buyer) Assets taken over Dr Assets Cr Business Purchase Liabilities taken over Dr Business Purchase Cr Liabilities The purchase consideration offered Cr Vendor (seller) The purchase consideration settled by cheques, shares and debentures Dr Vendor (seller) Cr Bank/Shares/Debentures

Example 2

John, Peter and Tom were partners sharing profits and losses in the ratio 1:1:3. The balance sheet as at 31 December 1996 was as follows: Balance Sheet as at 31 December 1996 Fixed Assets Cost Dep NBV Premises 180000 10000 170000 Motor Vehicles 27500 5500 22000 207500 15500 192000 Current assets Stock 68250 Debtors 172500 Less: provision for bad debt 1265 171235 Bank 26065 265550 Less: Current Liabilities Creditors 60000 Working Capital 205550 397550

Capital: John 100000 Peter 40000 Tom 160000 300000 Current: John 30000 Peter (10000) Tom 70000 90000 Long – term liabilities Loan from Tom 7550 397550 On 31 December 1996, they incorporated a limited company, Fortune limited, to take over the partnership business. Fortune Limited had an authorized capital of $500000 ordinary shares of $1 each.

Assets and liabilities were disposed of as follows: John took over the stock at book value. Tom collected all the debts except $2500 The company took over the premises at a valuation of $200000, motor vehicles at $25000, cash at bank and all the liabilities. Goodwill was valued at $70000 for the purpose of the takeover The purchase consideration was to be discharged by the issue to the partners of 150000 ordinary shares at $1.2 each, according to the profit-sharing ratio, and the balance was to be in cash The company also issued 50000 ordinary shares at $1.2 for cash to outsiders Required: Prepare the realization, Capital and the opening balance sheet for the new company

Fortune Ltd – purchase consideration [(200000+25000+26065-7550-60000) Realization Liabilities taken over by Ltd. Co. Creditors 60000 Loan from Tom 7550 Premises 170000 MV 22000 Stock 68250 Debtors 171235 Bank 26065 Tom: debtors (172500-2500) 170000 John: stock 68250 Bank be taken over Fortune Ltd – purchase consideration [(200000+25000+26065-7550-60000) +70000] 253515 Capital: John 20353 Peter 20353 Tom 61059 101765 559315 559315 Purchase consideration=Asset-liabilities +goodwill

John Peter Tom John Peter Tom Current 10000 Capital John Peter Tom John Peter Tom Current 10000 Bal b/f 100000 40000 160000 Realization Stock 68250 Debtors 170000 Current 30000 70000 Realization -profit 20353 20353 61059 Shares in Fortune Ltd 36000 36000 108000 Bank 46103 14353 13059 (Bal. fig.) 150353 60353 291059 150353 60353 291059 Shares in Fortune Ltd. 150000*1.2 = 180000 John 1/5 36000 Peter 1/5 36000 Tom 3/5 108000 180000

Fortune Limited Balance sheet as at 1 Jan 1996 Fixed Assets Goodwill 70000 Premises 200000 MV 25000 295000 Current Assets Bank [26065 + (50000*1.2) –(46103+14353+13059)] 12550 Less: Current liabilities Creditors 60000 Working Capital (47450) 247550 Share Capital Ordinary Shares (150000*$1+50000*$1) 200000 Share Premium (150000*$0.2+150000*$0.2) 40000 240000 Long-term liabilities Loan from Tom 7550 247550

Cash distribution among partners

Cash Distribution Among Partners With the application of the Garner vs. Murray rule When cash is to be distributed as soon as possible ( Piecemeal realization)

With the application of Garner vs. Murray rule

With the application of Garner vs. Murray rule Any CREDIT balance in each partner’s capital account represents the amount which can be withdrawn from the partnership to each partner Any DEBIT balance in a partner’s capital account represents additional cash to be injected by that partner. If he is insolvency to repay the amount, the solvency partners will be shared the amount in: Profit & loss sharing ratio Any agreed ratio given in the examination question GARNER vs. MURRAY rule may be applied

What is Garner vs. Murray rule?

Garner vs. Murray rule Under the rule, a partner is required to contribute cash to eliminate the debit balance in his capital account In the court case of Garner vs. Murray (1904), it was held that subject to any agreement to the contrary, such a debit balance deficiency was to be shared by the other partner not in their profit and loss sharing ratio but “ the ratio of their last agreed capitals”

If one partner is insolvent, his capital deficiency will be shared by other partners according to the ‘last agreed capital ratio’ (the ratio of the balances in the capital accounts before the dissolution, in the absence of any agreement to the contrary

Example 3

Au, Chow and Lee were partners sharing profits and losses in the ratio 2:2:1. The balance sheet as at 31 December 1996 was as follows: Balance Sheet as at 31 December 1996 Fixed Assets Cost Dep NBV Goodwill 100000 100000 Land 150000 150000 Plant & Machinery 133000 55800 77200 Fixture & Fittings 30000 13000 17000 Motor Vehicles 32000 24000 8000 445000 92800 352200 Current assets Stock 64000 Debtors 65000 Less: provision for bad debt 6000 59000 Cash 160 123160 Less: Current Liabilities Creditors 57000 Bank Overdraft 128360 Working Capital 62200 290000

Capital: Au 120000 Chow 80000 Lee 30000 230000 Current: Au 20000 Chow 20000 40000 Long – term liabilities Bank loan 20000 290000 On 31 December 1996 the partners agreed to dissolve the partnership due to a disagreement between the partners. Assets were to be realized, outstanding debts to be paid and the remainder to be shared by the partners in an equitable manner. Distributions of cash were to be made as soon as possible. January Provision was made for dissolution expenses of $2400 Land was sold for $200000 The cash available was utilized to settle in full the bank overdraft, the bank overdraft, the bank loan and all creditors after receiving discounts

March Stock which had originally costed $40000 was sold for $32000 $15000 was received form debtors April Plant & Machinery were sold for $51000 after paying carriage of $2000 Fixtures and fittings were sold for $12000 May All the outstanding debtors, with the exception of a customer who owed $4000 settled their accounts Motor vehicles were sold for $25000 The remaining stock was sold for $22000 Dissolution expenses amounted to $2100 Prepare distribution statement of cash at each stage

Distribution Statement Total Au Chow Lee $ $ $ $ Capital accounts 230000 120000 80000 30000 Current accounts 40000 20000 20000 270000 140000 100000 30000 1st Distribution: Cash available (w1) ( 47000) Maximum possible loss (2:2:1) 223000 89200 89200 44600 50800 10800 (14600) Lee’s capital deficiency shared by Au And Chow in the last agreed capital ratio (120000:80000) (8760) (5840) 14600 Cash distributed 42040 4960 0 2nd Distribution: Capital balance 223000 97960 95040 30000 Cash available (51000+12000) (63000) Maximum possible loss (2:2:1) 160000 64000 64000 32000 140000-42040 33960 31040 (2000) Lee’s capital deficiency shared by Au And Chow in the last agreed capital ratio (120000:80000) (1200) (800) 2000 Cash distributed 32760 30240 0

97960-32760 3rd Distribution: Capital balance 160000 65200 64800 30000 Cash available (W2) (93300) Maximum possible loss (2:2:1) 66700 26680 26680 13340 Cash distributed 38520 38120 16660 97960-32760

=> no cash distribution to partners on January W1 Cash available for 1st distribution: January Opening balance 160 Receipt from land 200000 200160 Less: Payment Assumed dissolution expenses 2400 (i.e. not actual expenses) Bank overdraft 128360 Bank loan 20000 Creditors (Bal. Fig.) 49400 200160 ‘Settle in full’ means no more payment will be paid. => the difference between 57000 and 49400 is discount received => no cash distribution to partners on January March Receipts: Stock 32000 Debtors 15000 First cash distributed to partners 47000 Back

Notes: Very often no cash is distributed to partners at first or second month since outstanding debts must be repaid first and then the remaining cash can then be distributed to partners. Even though the questions have not mentioned to repay outstanding debts, you should make sure to keep some cash to prepare to repay debts and could not be distributed it to partners

Back W3 Cash available for 3rd distribution: May Receipts Surplus in dissolution expenses(2400-2100) 300 Collection remaining debtors balance (65000-15000-400) 46000 Receipts from MV 25000 Receipts from remaining stock 22000 93300 Back

Realization Goodwill 100000 Land 150000 Plant & Machinery 77200 Fixtures & fittings 17000 Motor Vehicles 8000 Stock 64000 Debtors 59000 Cash: Land 200000 Stock (32000+22000) 54000 Debtors (15000+46000) 61000 Plant & machinery 51000 Fixture & fittings 12000 Motor vehicles 25000 Creditors – discount rececived (57000-49400) 7600 Cash - dissolution expenses 2100 Capital: Au (2/5) 26680 Chow (2/5) 26680 Lee (1/5) 13340 66700 477300 477300

Capital Au Chow Lee Au Chow Lee Cash in March 40240 4960 In April 32760 30240 in May 38520 38120 16660 Bal b/f 120000 80000 30000 Current 20000 20000 Realization -loss 26680 26680 26680 140000 100000 30000 140000 100000 30000