Chapter 16

Partnerships:
Liquidation

McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
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.

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 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.

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 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.

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 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.

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 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.

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Overview of Partnership Liquidations

• There are four basic liquidation provisions:

• Dissociation
• Dissolution
• Termination
• Liquidation

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 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.

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 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.

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 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.

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 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.

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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.]
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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.

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 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.

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 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.

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 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.

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 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.
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 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.
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 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.

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 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.

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 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.
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 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.

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 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.

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 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.
15-24
 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.
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 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.
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 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.

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 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.
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 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.
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 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.
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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.

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 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.

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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.

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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.

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 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.
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 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.

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 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

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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.
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 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

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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.

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 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.

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 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.

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 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.

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 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.

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 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.
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 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!

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 Chapter 16

End of Chapter

McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.