Termination and Liquidation 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.

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. 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 their 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.

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. The accountant can summarize and keep track of these steps in a statement of partnership liquidation. The liquidation of a partnership becomes more complicated when:  One or more partners have a negative (deficit) capital balance. A deficit (debit) capital balance can exist either at the beginning of the liquidation process or can arise during the liquidation as partners’ capital balances absorb losses from non‐cash asset sales. In some cases, a partner with a deficit capital balance will have sufficient personal assets to be able to make a contribution to the partnership to eliminate the deficit. In other cases, a partner will be personally insolvent and the other partners will have to absorb the deficit through reductions in their capital accounts.  The liquidation takes place over an extended period of time. In this case, the partners are likely to request that cash be distributed to them as it becomes available through the liquidation of partnership assets. The accountant can facilitate the distribution of cash in installments by calculating the safe payments that can be made without running the risk that an individual partner will incur a deficit capital balance. The accountant might choose to prepare a cash predistribution plan in advance of any sales of non‐cash assets to guide the distribution of installment payments during the course of the partnership liquidation.

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

Termination & Liquidation To liquidate a partnership, the process calls for: 1) Assets converted into cash to pay business obligations and liquidation expenses. 2) Remaining assets distributed to partners based on their final capital balances. 3) Partnership books closed. The procedures involved in terminating and liquidating a partnership are basically mechanical. Partnership assets are converted into cash that is then used to pay business obligations as well as liquidation expenses. Any remaining assets are distributed to the individual partners based on their final capital balances. Once assets have been distributed, the partnership’s books are permanently closed. If each partner has a capital balance large enough to absorb all liquidation losses, the accountant should experience little difficulty in recording this series of transactions. 15-5

Prepare journal entries to record the transactions Learning Objective 15-2 Prepare journal entries to record the transactions incurred in the liquidation of a partnership. 15-6

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

Termination & Liquidation - Example $9,000 of the Accounts Receivable are collected. Remaining accounts receivables are written off, and the loss is allocated between Morgan (60%, $1,800) & Houseman (40%, $1,200). Fixed assets are sold for $29,000. The loss of $12,000 is allocated to Morgan (60%, $7,200) & Houseman (40%, $4,800). 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

Termination & Liquidation - Example Once assets are sold and accounts payable paid, the partnership incurs an additional $3,000 in liquidation expenses. After calculating ending capital balances, the remaining cash is distributed to the partners to close out the financial records. Once all the assets are sold, the accounts payable are paid off. Morgan & Houseman incur an additional $3,000 in liquidation expenses. 15-9

Learning Objective 15-3 Determine the distribution of available cash when one or more partners have a deficit capital balance or become personally insolvent. Determine the distribution of available cash when one or more partners have a deficit capital balance or become personally insolvent. 15-10

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. Allocation of the loss is based on the relative profit and loss ratio specified in the articles of partnership. A safe payment may be made to partners that reduces that partner’s capital account to the minimum dollar level. safe payments can be distributed to the partners without creating new deficits. Deficit Capital Balance Deficit balances can be resolved two ways: The deficit partner can make a contribution to make up the deficit. The remaining partners can absorb the deficit. (The deficit partner may pay later or can be sued for the deficit amount.) 15-11

Learning Objective 15-4 Prepare a proposed schedule of liquidation from safe capital balances to determine an equitable preliminary distribution of available partnership assets. Prepare a proposed schedule of liquidation from safe capital balances to determine an equitable preliminary distribution of available partnership assets. 15-12

Preliminary Distribution of Assets Under the Uniform Partnership Act, a priority ranking of creditors having claims against individual partners is recognized: 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: Debts owed to partnership creditors, Debts owed to the other partners, and Debts owed to personal creditors. Debts owed to personal creditors. 15-13

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. 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. 15-14

Learning Objective 15-5 Develop a predistribution plan to guide the distribution of assets in a partnership liquidation. Prepare a proposed schedule of liquidation from safe capital balances to determine an equitable preliminary distribution of available partnership assets. 15-15

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. 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. 15-16

Predistribution Plan As a prerequisite to developing a predistribution plan, the sensitivity to losses exhibited by each of these capital accounts must be measured. Determine the maximum loss that each partner can absorb. Divide each partner’s capital balance by their respective income sharing percent. Once a partner’s maximum loss is absorbed, new balances are computed until all losses are absorbed. Assume the following partnership is to be liquidated Assume the income sharing percentage is Rubens 50%, Smith 20%, and Trice 30%. The partnership capital reported by this organization totals $121,000. However, the individual balances for the partners range from $30,000 to $51,000, and profits and losses are assigned according to three different percentages. Thus, 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: 15-17

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. 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. To complete this illustration, liquidation expenses of $12,000 have been estimated. Because these expenses have the same effect on the capital accounts as losses, they do not change the sequential pattern by which assets eventually will be distributed. 15-18