Chapter Fifteen

Partnerships: Termination and Liquidation

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

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Reasons for Termination

Personality disputes between partners Retirement Death Changed business environment Other opportunities Low profits Bankruptcy (either of the business or an individual partner)

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Termination & Liquidation

When the partners wish to terminate the business: Convert all assets to cash. Allocate all gains or losses to the partner capital balances. Pay all liabilities. Distribute remaining cash to partners.

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Termination & Liquidation Example

Morgan & Houseman want to liquidate their partnership. Balances at 5/1/11 are:
Morgan & Houseman Balance Sheet 5/1/2011 Assets

Cash $ A/R Inventory Land, Bldg, & Equip. Total $

45,000 12,000 22,000 41,000 120,000

Liabilities and Capital Liabilities $ 32,000 Morgan,Capital 50,000 Houseman,Capital 38,000 Total $ 120,000

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Termination & Liquidation Example

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.
Description Debit Credit

Date

Cash Morgan, Capital Houseman, Capital Inventory

15,000 4,200 2,800 22,000

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Termination & Liquidation Example

The balances after selling the inventory were:
Morgan & Houseman Balance Sheet 6/1/2011 Assets

Cash $ 60,000 A/R 12,000 Land, Bldg, & Equip. 41,000 Total $ 113,000

Liabilities and Capital Liabilities $ 32,000 Morgan,Cap. 45,800 Houseman,Cap. 35,200 Total $ 113,000

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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

Date Description Debit Credit

Cash Morgan, Capital Houseman, Capital Accounts Receivable

9,000 1,800 1,200 12,000

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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

Description Debit Credit

Date

Cash Morgan, Capital Houseman, Capital Land, Bldg & Equip.(net)

29,000 7,200 4,800 41,000

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Termination & Liquidation Example

Once all the assets are sold, the accounts payable are paid off. Morgan & Houseman incur an additional $3,000 in liquidation expenses.
Date Description Debit Credit

Accounts Payable Cash Morgan, Capital Houseman, Capital Cash

32,000 32,000 1,800 1,200 3,000

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Termination & Liquidation Example

The pre-distribution balances are:
Morgan & Houseman Balance Sheet 10/15/2011 Assets

Cash Total

$ $

63,000 63,000

Liabilities and Capital Morgan, Cap. $ 35,000 Houseman,Cap 28,000 Total $ 63,000

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Termination & Liquidation Example

Once the remaining cash is distributed, the partnership is considered terminated.

Date

Description

Debit

Credit

Morgan, Capital Houseman, Capital Cash

35,000 28,000 63,000

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Schedule of Liquidation
Because the various parties want to be updated on the progress of the liquidation, a report can be prepared to disclose: Transactions to date. Liabilities remaining to be paid.

Property still being held by the partnership.

Current cash and capital balances.

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Schedule of Liquidation
The process of liquidation can take time. Partners may experience deficit balances during the liquidation period. Partners may want cash distributions prior to the completion of the liquidation.

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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.)

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Deficit Capital Balance -Contribution by Deficit Partner

Contributions made by the deficit partner(s) are distributed to the nondeficit partners based on their relative profit sharing percentages. Any payments by Sabaka will be split 4/5 to Loup and 1/5 to Lobo.

Partner Loup Lobo Sabaka

Capital Profit & Loss Balance Ratio $ 100,000 40% $ 86,000 10% $ (25,000) 50%

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Deficit Capital Balance Remaining Partners Absorb Deficit

Hund, Chien and Cano have the following balances just prior to liquidation.
Hund, Chien & Cano Balance Sheet 6/30/2008 Cash Inventory Assets $ 30,000 75,000 Liabilities and Capital Accts. Payable $ 35,000 Hund, Capital 25,000 Chien, Capital 40,000 Cano, Capital 5,000 Total $ 105,000

Total

$ 105,000

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Deficit Capital Balance Remaining Partners Absorb Deficit

Hund, Chien and Cano share profits 35:25:40. On 7/5/08, the inventory is sold for $25,000, a $50,000 loss. Prepare the entry.
Date Description Debit Credit

Cash Hund, Capital Chien, Capital Cano, Capital Inventory

25,000 17,500 12,500 20,000 75,000

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Deficit Capital Balance Remaining Partners Absorb Deficit

With a 40% share of the $50,000 loss, Canos capital account moves to a deficit balance of $(15,000).
Date Description

Cano Capital 5,000 20,000 (15,000)

Debit

Credit

Cash Hund, Capital Chien, Capital Cano, Capital Inventory

25,000 17,500 12,500 20,000 75,000

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Deficit Capital Balance Remaining Partners Absorb Deficit

How will the remaining $20,000 be distributed?
Debit Credit

The $25,000 for the inventory sale, increases the cash balance to $55,000. $35,000 must be kept to pay off the accounts payable.
Date Description

Cash Hund, Capital Chien, Capital Cano, Capital Inventory

25,000 17,500 12,500 20,000 75,000

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Deficit Capital Balance Remaining Partners Absorb Deficit

Capital Balances

Hund Chien Cano $ 7,500 $ 27,500 $ (15,000)

Allocation of Cano's deficit balance (8,750) (6,250) 15,000 Capital Balances $ (1,250) $ 21,250 $ Notice that, after Canos deficit has been Allocation of Hund's basis of 35:25, there is now allocated on the a deficit deficit balance balance in Hunds account! 1,250 (1,250)

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Deficit Capital Balance Remaining Partners Absorb Deficit

Hund Chien Cano $ 7,500 $ 27,500 $ (15,000)

Capital Balances

Allocation of Cano's deficit balance (8,750) (6,250) Capital Balances $ (1,250) $ 21,250 $ Allocation of Hund's deficit balance 1,250 (1,250) Capital Balances $ - $ 20,000

15,000 -

After allocating Hunds deficit to Chien, the $20,000 can be distributed to Chien.

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Schedule of Liquidation Interim Cash Distributions

Prior to making an interim cash distribution 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.

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Marshaling of Assets
Under the Uniform Partnership Act, a Marshaling of Assets is a priority ranking of creditors having claims against individual partners: Debts owed to separate creditors. Debts owed to partnership creditors. Debts owed to the other partners.

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Claims Against the Partnership

Individual partners 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 partners 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.

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Predistribution Plan
Used by accountants to guide the distribution of cash resulting from the liquidation process. Examine the Balance Sheet below. Assume the income sharing % is Hund Hund, Chien & Cano 10%, Chien 40%, and Cano 50%. Balance Sheet
6/30/2008 Cash Inventory Assets $ 30,000 75,000 Liabilities and Capital Accts. Payable $ 35,000 Hund, Capital 25,000 Chien, Capital 40,000 Cano, Capital 5,000 Total $ 105,000

Total

$ 105,000

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Predistribution Plan
First, determine the maximum loss that each partner can absorb. Divide each partners capital balance by their respective income sharing %.
Maximum Loss That Can Be Absorbed $ 250,000 $ 100,000 $ 10,000

Partner Hund Chien Cano

Capital Balance $ 25,000 40,000 5,000

Income Sharing % 10% 40% 50%

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Predistribution Plan
Maximum Loss That Can Be Absorbed $ 250,000 $ 100,000 $ 10,000

Partner Hund Chien Cano

Capital Balance $ 25,000 40,000 5,000

Income Sharing % 10% 40% 50%

Since Cano can ONLY absorb a partnership loss of $10,000, we will first compute new balances assuming that the partnership has a $10,000 loss.

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Predistribution Plan
Hund, Cano, Capital Chien, Capital (10%) Capital (40%) (50%) $ 25,000 $ 40,000 $ 5,000 (1,000) (4,000) (5,000) $ 24,000 $ 36,000 $ -

Beginning Balances Assume a $10,000 loss Remaining Balances

With Cano wiped out, we will proceed with determining maximum absorbable losses using income sharing percentages of Hund 20% (1/5) and Chien 80% (4/5).

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Predistribution Plan
As earlier, we will compute the maximum absorbable loss by dividing the capital balances by the relative income sharing %.
Maximum Loss That Can Be Absorbed $ 120,000 $ 45,000

Partner Hund Chien

Capital Balance $ 24,000 36,000

Income Sharing % 20% 80%

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Predistribution Plan
Maximum Loss That Can Be Absorbed $ 120,000 $ 45,000

Partner Hund Chien

Capital Balance $ 24,000 36,000

Income Sharing % 20% 80%

As we can see above, Chien can only absorb a loss of $45,000. Lets determine new capital balances for a loss of $45,000.

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Predistribution Plan
Hund, Capital Chien, (20%) Capital (80%) $ 24,000 $ 36,000 (9,000) (36,000) $ 15,000 $ Cano, Capital (50%) N/A N/A N/A

Beginning Balances Assume a $45,000 loss Remaining Balances

With Cano and Chien both wiped out, and Hund remaining as the only partner, we can now determine the predistribution plan.

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Predistribution Plan
Hund, Chien & Cano Predistribution Plan Available Cash First $35,000 Next $15,000 Next $45,000 All other cash benefits Recipient Creditors Hund Hund(20%) and Chien(80%) Hund(10%), Chien(40%) and Cano(50%)

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Summary

Partnerships may be terminated for a variety of reasons. When terminated, partnership assets must be systematically liquidated. Actual liquidation can require an extended period to accomplish. This promotes the use of proposed schedules of liquidation. Marshaling of assets may be necessary when one or more partners have negative capital balances.

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Possible Criticisms

Development of predistribution plans and schedules of liquidation may involve speculation. Some critics feel that this violates the traditionally conservative role of accountants.

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