McGraw-Hill/Irwin© 2008 The McGraw-Hill Companies, Inc. All rights reserved. 16 Partnerships: Liquidation

16-2 Partnerships: Liquidation Because of the normal risks of doing business, the majority of partnerships begun in any one year fail within three years and require dissolution, and liquidation.

16-3 Overview of Partnership liquidations The major provisions of UPA 1997 have been adopted by most states. Dissociation is the legal description of the withdrawal of a partner including the following: –1. A partner’s death –2. A partner’s voluntary withdrawal –3. Judicial determination, including: a) The partner engaged in wrongful conduct that materially and negatively affected the partnership –[continued on next slide]

16-4 Overview of Partnership liquidations b) the partner willfully committed a material breach of the partnership agreement c) the partner became a debtor in bankruptcy d) an individual partner has become incapable of performing the partner’s duties under the partnership agreement. Not all dissociations result in a partnership liquidation.

16-5 Overview of Partnership liquidations Dissolution is the dissolving of a partnership: –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, the dissolution takes place when: (a) after a partner’s death or wrongful dissociation, (b) if all the partners agree to wind up the partnership business, and (c) it is not reasonably practicable to carry on the partnership business in conformity with the partnership agreement.

16-6 Overview of Partnership liquidations –3. An event that makes it unlawful to carry on a substantial part of the business. –4. A judicial determination that: a. The economic purpose of the partnership is unlikely to be achieved. b. A partner engaged in conduct relating to the partnership business that makes it impracticable to carry on the partnership business. c. It is not reasonable practicable to carry on the partnership in conformity with the partnership agreement.

16-7 Winding Up and Liquidation Winding up and liquidation of the partnership begins after dissolution of the partnership. Liabilities to partners or loans they made to the partnership have the same status as liabilities to the partnership’s third party creditors. As part of the liquidation process, each partner with a deficit in his or her capital account is required to make a contribution to the partnership to remedy that capital deficit.

16-8 Statement of Partnership Realization and Liquidation To guide and summarize the partnership liquidation process, a statement of partnership realization and liquidation may be prepared. The statement, often called a “statement of liquidation,” presents the effects of the liquidation on the balance sheet accounts of the partnership. Stated otherwise, the statement shows the conversion of assets into cash, the payment of liabilities, allocation of any gains or losses to the partners, and the distribution of cash to creditors and partner.

16-9 Lump-Sum Liquidations A lump-sum liquidation of a partnership is one in which all the assets are converted into cash within a very short time, creditors are paid, and a single, lump-sum payment is made to the partners for their capital interests. Admittedly, most partnership liquidations take place over an extended period.

16-10 Forced Liquidation “Forced liquidations” usually result in losses on the disposal of its assets. The assets of the partnership, including any receivables from the partners and any contributions required of partners to remedy their capital deficits, are applied to pay the partnership’s creditors.

16-11 Expenses of Liquidation The liquidation process usually begins with scheduling the partnership’s known assets and liabilities. The liquidation process also involves some expenses, such as additional legal and accounting costs as well as “liquidation sale” advertisements. These expenses are allocated to partners’ capital accounts in the profit and loss distribution ratio.

16-12 Installment Liquidations Installment liquidations involve the distribution of cash to partners before complete liquidation of the assets occurs. The accountant must be especially cautious when distributing available cash, because future events may change the amounts to be paid to each partner. For this reason, the practical guides (found on next slide) are used to assist the accountant in determining the “safe installment payments” to the partners.

16-13 RULES: Safe Installment Payments Distribute no cash to the partners until all liabilities and actual and potential liquidation expensed are paid or provided for by reserving the necessary cash.

16-14 RULES: Safe Installment Payments Anticipate the worst, or most restrictive, possible case before determining the amount of cash installment each partner receives: Assume that all remaining non-cash assets will be written off as a loss; that is, assume that nothing will be realized on asset disposals. Assume that deficits created in the capital accounts of partners will be distributed to the remaining partners; that is, assume that deficits will not be eliminated by additional partner capital contributions.

16-15 RULES: Safe Installment Payments After the accountant has assumed the worst possible cases, the remaining credit balances in capital accounts represent safe distributions of cash that may be distributed to partners in those amounts.

16-16 Cash Distribution Plan At the beginning of the liquidation process, it is common for accountants to prepare a cash distribution plan, which gives the partners an idea of the installment cash payments each will receive as cash becomes available to the partnership. The cash distribution plan is a pro forma projection of the application of cash as it becomes available.

16-17 Loss Absorption Power A basic concept of the cash distribution plan at the beginning of the liquidation process is loss absorption power (LAP). An individual partner’s LAP is defined as the maximum loss that can be realized by the partnership before that partner’s capital account balance is extinguished.

16-18 LAP Example On May 1, 2005, Alt has a capital account credit balance of $34,000 and a 40 percent share in the losses of ABC Partnership. Alt’s LAP is $85,000 (i.e., LAP = $34,000/.40 = $85,000). This means that $85,000 in losses on disposing of noncash assets or from additional liquidation expenses would eliminate the credit balance in Alt’s capital account given that $85,000 x.40 = $34,000.

16-19 Incorporation of a Partnership As a partnership continues to grow, the partners may decide to incorporate the business in order to: Have access to additional equity financing Limit their personal liability Obtain selected tax advantages Achieve other sound business purposes

16-20 Incorporation of a Partnership At the time of incorporation, the partnership is terminated, and the assets and liabilities are revalued to their market values. The gain or loss on revaluation is allocated to the partners’ capital accounts in the profit and loss sharing ratio. Capital stock in the new corporation is then distributed in proportion to each partner’s capital accounts.

16-21 Personal Financial Statements At beginning of the liquidation process, partners are usually asked for personal financial statements in order to determine each partner’s personal solvency.

16-22 Personal Financial Statements Personal financial statements include: Statement of financial condition, or personal balance sheet, which presents the fair value of the person’s assets and liabilities at a point in time. Statement of changes in net worth, or personal income statement, which presents the primary sources of changes in the person’s net worth.

16-23 Personal Financial Statements In addition to presenting a person’s assets and liabilities, the statement of financial condition should include an estimate of the income taxes incurred as if all the assets were converted and the liabilities extinguished. The person’s net worth would then be computed as assets less liabilities less estimated taxes.

16-24 Personal Financial Statements In general, the accrual basis of accounting should be used to determine the person’s assets and liabilities, and comparative statements are usually provided.

16-25 Personal Financial Statements Unlike a balance sheet of a business that is based on historical cost, the assets in the personal statement of financial condition are stated at their estimated current values. The liabilities are stated at the lower of the discounted value of future cash payments or the current cash settlement amount.

16-26 Personal Financial Statements Included immediately below the liabilities are the estimated taxes that would be paid if all the assets were converted to cash and all the liabilities were paid. Assets and liabilities are presented in their order of liquidity and maturity, not as current and noncurrent.

16-27 Personal Financial Statements The statement of changes in net worth presents the major sources of income. Both realized and unrealized income are recognized in the statement of changes in net worth. A commercial business’s income statement may not recognize holding gains on some marketable securities, but such gains are recognized on an individual’s statement of changes in net worth.

16-28 Personal Financial Statements Sufficient footnote disclosures should accompany the two personal financial statements. The footnotes should describe the following: –The methods used to value the major assets. –The names and nature of business in which the person has major investments. [Continued on next slide]

16-29 Personal Financial Statements –The methods and assumptions used to compute the estimated tax bases and a statement that the tax provision in an actual liquidation will probably differ from the estimated because the actual tax burden will then be based on actual realizations determined by market values at the point of liquidation. –Maturities, interest rates, and other details of any receivables and debt. –Any other information needed to present fully the person’s net worth.