1. McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 16 Partnerships: Liquidation

2. 15-2 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 termination of a partnership’s business. The termination of a partnership’s business is often an emotional event for the partners.

3. 15-3 Partnerships: Liquidation The partners may have had high expectations for the business when it began and invested a large amount of personal resources and time in the business. The end of the partnership often is the end of these business dreams.

4. 15-4 Partnerships: Liquidation Accountants usually assist in the liquidation process and must recognize the legitimate rights of many parties involved in the partnership: individual partners, creditors of the partnership and the individual partners, customers, and others doing business with the partnership.

5. 15-5 Partnerships: Liquidation The Uniform Partnership Act of 1914 has 45 sections, 16 of which deal specifically with the termination and dissolution of the partnership. Most of these sections discuss the specific rights of third-party creditors who have extended credit to the partnership.

6. 15-6 Partnerships: Liquidation Outside creditors have first claim to the partnership’s assets and, because of the unlimited liability of each partner, may have claims against individual partners’ personal assets. This chapter presents the concepts that accountants must know if they offer professional services to partnerships undergoing liquidation.

7. 15-7 Overview of Partnership Liquidations There are four basic liquidation provisions: Dissociation Dissolution Termination Liquidation

8. 15-8 Dissociation Dissociation is the legal description of the withdrawal of a partner because of death, retirement, and either voluntary or involuntary withdrawal. A partner may be given the consent of the other partners to leave the partnership, or there are certain illegal acts that result in dissociation of a partner such as a material breach of the partnership agreement.

9. 15-9 Dissociation Not all dissociations result in a dissolution of the partnership. Many dissociations involve just a buyout of the withdrawing partner’s interest rather than a termination and winding up of the partnership’s business.

10. 15-10 Dissolution Dissolution is the dissolving of a partnership due to at the expiration of the partnership’s term of purpose; or by written consent of all partners. Dissolution also includes the change in the relation of the partners as a result of a new partner’s entering the partnership.

11. 15-11 Termination & Liquidation Termination is the end of the normal business function of the partnership. The partnership is no longer a going concern at the point of termination. Liquidation is the sale of the partnership assets, payment of the partnership’s liabilities, and distribution of any remaining assets to the individual partners.

12. 15-12 Major Causes of a Dissolution A new partner is admitted or a partner withdraws. The specified term or task of the partnership has been completed. All partners agree to dissolve the partnership. The partnership or an individual partner is bankrupt. [Continued on next slide.]

13. 15-13 Major Causes of a Dissolution By court decree: –A partner is declared insane. –A partner seriously breaches the partnership agreement. –The court determines that a partnership may be operated only at a loss.

14. 15-14 Dissolution versus Going Concern The dissolution of a partnership does not necessarily mean the partnership must stop doing business, close its doors, and liquidate. As discussed in Chapter 15, many partnerships go through legal dissolution without any effect on their day-to-day operations. For example, the admission of a new partner requires the legal dissolution of the old partnership and the creation of a new partnership.

15. 15-15 Termination & Liquidation Avoidance In most instances of a dissociation of a partner or the dissolution of a partnership, a partnership may easily avoid termination and liquidation by including provisions in the partnership agreement for the continuation of business.

16. 15-16 Immediate Termination Certain dissolutions, however, require the termination of business regardless of provisions in the partnership agreement. For example, A partnership must immediately terminate its activities if: A court so decrees. The partnership is bankrupt. The partnership’s business becomes illegal.

17. 15-17 Continuation Provisions The partnership agreement should include the necessary continuation provisions if the partners wish to avoid termination in other than the preceding three required instances. The partnership agreement should also specify if a special liquidation profit and loss sharing ratio is to be used in lieu of the normal profit and loss sharing ratio. If the partnership agreement does not provide for a special liquidation sharing ratio, then the same ratio used to distribute the operating profit or loss is used during liquidation.

18. 15-18 The Liquidation Phase-Out Process The liquidation of a partnership may take place over a period of several months after the date of termination. The partners may seek the best possible prices for the partnership’s assets and may not wish to accept a forced sale price (i.e., the price at a public auction). This phase-out period requires accounting for the liquidation activities of the partnership. In addition, the legal rights of the partners and creditors must be fully protected.

19. 15-19 Priority of Claims At the point of partnership liquidation, the assets and liabilities of the partnership are directly intertwined with those of the general partners’ personal assets and liabilities because of the unlimited liability of each partner.

20. 15-20 Priority of Claims The Uniform Partnership Act establishes the priorities for creditors’ claims against the assets available to pay the partnership’s liabilities. Two concepts are important here: The marshaling of assets. The right of offset.

21. 15-21 Marshaling of Assets The order in which claims against the partnership’s assets will be marshaled, or satisfied, is as follows: Partnership creditors other than partners. Partners’ claims other than capital and profits, such as loans payable and accrued interest payable. Partners’ claims to capital or profits, to the extent of credit balances in capital accounts.

22. 15-22 Marshaling of Assets The order of claims against the personal assets of general partners is as follows: Personal creditors of individual partners. Partnership creditors for unpaid partnership liabilities, regardless of a partner’s capital balance in the partnership.

23. 15-23 Right of Offset Loans payable to a partner have a higher priority in liquidation than partners’ capital balances, but a lower priority than liabilities to outside creditors. However, the legal right of offset allows a deficit in a partner’s capital account to be offset by a loan payable to that partner.

24. 15-24 Right of Offset Assume that partnership has a $4,000, 12 percent interest-bearing loan payable to partner Cha. If Cha had a $2,000 deficit in her capital account at the end of the liquidation process, $2,000 of the loan payable to her would be offset against the deficit. The remaining $2,000 loan payable to partner Cha is then paid to Cha.

25. 15-25 Cautions about Offsetting Partners’ Loans and Capital It is important to maintain specific identification of a loan payable (or receivable) between the partnership and a partner: If the loan payable (or receivable) continues to be interest-bearing during the liquidation process. If the loan is secured by a property interest. Actual offsetting of receivables from partners against partners’ capitals may be considered a cancellation of the receivable.

26. 15-26 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 allocation of any gains or losses to the partners, and the distribution of cash to creditors and partner.

27. 15-27 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, outside 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.

28. 15-28 Forced Liquidation “Forced liquidations” usually result in losses on the disposal of its assets. Before any distributions of assets may be made to the partners, either liabilities to outside creditors must be paid in full or the necessary funds may be placed in an escrow account. The escrow agent, usually a bank, uses the funds only for payment of the partnership’s liablities.

29. 15-29 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.

30. 15-30 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.

31. 15-31 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.

32. 15-32 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.

33. 15-33 RULES: Safe Installment Payments After the accountant has assumed the worst possible cases, the remaining credit balances in loan and capital accounts represent safe distributions of assets and cash that may be distributed to partners in those amounts.

34. 15-34 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.

35. 15-35 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 and loan account balances are extinguished. For planning purpose, loan accounts are fully offset against the capital accounts before a partner’s LAP is computed.

36. 15-36 LAP Example Alt has a capital account credit balance of $34,000 and a 40 percent share in the profits and 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.

37. 15-37 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

38. 15-38 Incorporation of a Partnership At the time of incorporation, the partnership is terminated, and the assets and liabilities are revalues to their market values. The gain or loss on revaluation is allocated to the partner’s capital accounts in the profit and loss sharing ratio. Capital stock in the new corporation is then distributed in proportion to the capital accounts of the partners.

39. 15-39 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. Guidelines for preparing personal financial statements are found in Statement of Position 82-1

40. 15-40 Personal Financial Statements Personal financial statements include: Statement of financial condition, or personal balance sheet, which presents 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.

41. 15-41 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.

42. 15-42 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.

43. 15-43 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.

44. 15-44 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.

45. 15-45 Personal Financial Statements The statement of changes in net worth presents the major source 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.

46. 15-46 You Will Survive This Chapter !!! DANGER: If you (the accountant) pay cash to partners before creditors are satisfied, you may have to “chip in” for the benefit of the creditors!

47. McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 16 End of Chapter