McGraw-Hill/Irwin

Partnerships: Liquidation

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Copyright © 2009 The McGraw-Hill Companies, Inc. All rights reserved.

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Overview of Partnership Liquidations

• The Uniform Partnership Act of 1997 includes 7 sections which deal specifically with the dissolution and winding up of a partnership

– Creditors have first claim to the partnership’s assets

– After the creditors are fully satisfied, any remaining assets are distributed to the partners based on the balances in their capital accounts

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Overview of Partnership Liquidations

• Dissociation– The legal description of the withdrawal of a

partner, including the following:1. A partner’s death

2. A partner’s voluntary withdrawal

3. A judicial determination

– Not all dissociations result in a partnership liquidation

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Overview of Partnership Liquidations

• Dissolution– The dissolving of a partnership– Events that cause dissolution and winding up:

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:a) When after a partner’s death or wrongful dissociation,

at least half of the remaining partners decide to wind up the partnership business

b) When all of the partners agree to wind up the business c) When the term or specific undertaking has expired or

been completed

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Overview of Partnership Liquidations

– Events that cause dissolution and winding up: 3. An event that makes it unlawful to carry on a

substantial part of the partnership business

4. A judicial determination

– On dissolution, the partnership begins the winding up of the partnership’s business

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Overview of Partnership Liquidations

• Winding up and liquidation begins after the dissolution of the partnership

– The partnership continues for the limited purpose of winding up the business and completing work in process

– Winding up process includes the transactions necessary to liquidate the partnership

– Some partnerships change to the liquidation basis of accounting once they no longer consider the business to be a going concern

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Overview of Partnership Liquidations

• Loans with partners– Liabilities to partners for loans the partners

made to the partnership have the same status as liabilities to the partnerships’ third party creditors

– These loans have no priority for payment

– Receivables from partners for loans or other advances made by the partnership to partners have the same status as other assets of the partnership

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Overview of Partnership Liquidations

• Deficits in partners’ capital accounts – Each partner with a deficit in his or her capital

account must make a contribution to the partnership to remedy that capital deficit

– Liquidating distributions, in cash, are made to each partner with a capital credit balance

– If a partner fails to remedy his or her capital deficit, all other partners must contribute, in the proportion to which those partners share partnership losses, the additional amount necessary to pay the partnership’s obligations

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Overview of Partnership Liquidations

• Statement of partnership realization and liquidation

– May be prepared to guide and summarize the partnership liquidation process

– Often called a “statement of liquidation”

– It presents, in workpaper form, the effects of the liquidation on the partnership balance sheet accounts

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Lump-Sum Liquidations

• All 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

– Most partnership liquidations take place over an extended period

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Lump-Sum Liquidations

• Realization of assets– Typically, a partnership experiences losses on

the disposal of its assets

– “Going out of Business” sale

– Goodwill on the books is generally written off

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Lump-Sum Liquidations

• Realization of assets– The partnership attempts to collect its

accounts receivable

– Large cash discounts may be offered for the prompt payment

– The receivables may also be sold to a factor, a business that specializes in acquiring accounts receivables and immediately paying cash to the seller of the receivables

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Lump-Sum Liquidations

• Expenses of liquidation– The liquidation process also involves some

expenses, such as additional legal and accounting costs

– They may also incur costs of disposing of the business, such as special advertising and costs of locating specialized equipment dealers

– These expenses are allocated to partners’ capital accounts in the profit and loss ratio

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Lump-Sum Liquidations

– A deficit in a partner’s capital account can occur if the credit balance of that capital account is too low to absorb his or her share of losses

– This may be remedied in one of the following ways:• The partner invests cash or other assets to eliminate the

capital deficit• The partner’s capital deficit is distributed to the other

partners in their resulting loss-sharing ratio

– The approach used depends on the solvency of the partner with the capital deficit

Case: Partnership Solvent and Deficit Created in Partner’s Capital Account

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Lump-Sum Liquidations

– A partnership is insolvent when existing cash and cash generated by the sale of the assets is not sufficient to pay the partnership’s liabilities

– In this case, the individual partners are liable for the remaining unpaid partnership liabilities

Case: Partnership Is Insolvent and Deficit Created in Partner’s Capital Account

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Installment Liquidations

• Installment liquidation – Requires several months to complete and

includes periodic payments to the partners during the liquidation period

– Most partnership liquidations take place over an extended period in order to obtain the largest possible amount from the realization of the assets

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Installment Liquidations

– Some partnerships using installment liquidations prepare a Plan of Liquidation and Dissolution prior to the beginning of the liquidation

– Some adopt the liquidation basis of accounting• These partnerships may prepare a Statement of

Net Assets in Liquidation and a Statement of Changes in Net Assets in Liquidation

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Installment Liquidations

– Those partnerships using GAAP apply FASB 144 to value their long-lived assets to be disposed of by sale

– FASB 144 states that these assets are to be classified separately and valued at the lower of carrying amount or fair value less costs to sell

– FASB 146 requires that costs associated with an exit activity be recognized and measured at fair value in the period in which the liability is incurred, not in earlier periods

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Installment Liquidations

– Most partnerships use the Statement of Partnership Realization and Liquidation during the installment liquidation process and recognize gains or losses from the liquidation events

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Installment Liquidations

• Determining safe installment payments:– Distribute no cash to the partners until all liabilities

and actual plus potential liquidation expenses have been paid or provided for by reserving the necessary cash

– Anticipate the worst possible case before determining the amount of cash installment each partner receives:• Assume that all remaining noncash assets will be written

off as a loss• Assume that deficits created in the partners’ capital

accounts will be distributed to the remaining partners

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Installment Liquidations

• Determining 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

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Installment Liquidations

• Cash distribution plan– Prepared at the beginning of the liquidation

process

– Gives the partners an idea of the installment cash payments each will receive

– The actual installment distributions are determined using the statement of realization and liquidation, supplemented with the schedule of safe payments to partners

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Installment Liquidations

• Loss absorption power– An individual partner’s LAP is defined as the

maximum loss that the partnership can realize before that partner’s capital account balance is extinguished

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Additional Considerations

• Incorporation of a partnership– As a partnership continues to grow, the

partners may decide to incorporate the business

– At the incorporation, the partnership is terminated, and the assets and liabilities are revalued to their fair values

– The gain or loss on revaluation is allocated to the partners’ capital accounts in the profit and loss–sharing ratio

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Additional Considerations

• Incorporation of a partnership– Capital stock in the new corporation is then

distributed in proportion to the partners’ capital accounts

– The separate business entity of the partnership should now close its accounting records and the corporation, as a new business entity, should open its own new accounting records to record the issuance of its capital stock to the prior partners