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Chapter 16. Partnerships: Liquidation. Learning Objective 16-1. Understand and explain terms associated with partnership liquidations. Overview of Partnership Liquidations.

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learning objective 16 1
Learning Objective 16-1

Understand and explain terms associated with partnership liquidations.

overview of partnership liquidations
Overview of Partnership Liquidations
  • The Uniform Partnership Act of 1997 includes seven 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.
overview of partnership liquidations1
Overview of Partnership Liquidations
  • Dissociation
    • The legal description of the withdrawal of a partner, including the following:
      • A partner’s death.
      • A partner’s voluntary withdrawal.
      • A judicial determination.
    • Not all dissociations result in a partnership liquidation.
overview of partnership liquidations2
Overview of Partnership Liquidations
  • Dissolution
    • The dissolving of a partnership
    • Events that cause dissolution and winding up:
      • In a partnership at will, a partner’s express notice to leave the partnership.
      • In a partnership for a definite term or specific undertaking:
        • When after a partner’s death or wrongful dissociation, at least half of the remaining partners decide to wind up the partnership business.
        • When all of the partners agree to wind up the business .
        • When the term or specific undertaking has expired or been completed.
overview of partnership liquidations3
Overview of Partnership Liquidations
  • Events that cause dissolution and winding up:
    • An event that makes it unlawful to carry on a substantial part of the partnership business.
    • A judicial determination.
  • On dissolution, the partnership begins the winding up of the partnership’s business.
overview of partnership liquidations4
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.
overview of partnership liquidations5
Overview of Partnership Liquidations
  • Loans to/from partners
    • According to the UPA 1997, liabilities to partners for loans the partners made to the partnership generally 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.
overview of partnership liquidations6
Overview of Partnership Liquidations
  • Deficits in partners’ capital accounts
    • Generally, a 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.
overview of partnership liquidations7
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 worksheet form, the effects of the liquidation on the partnership balance sheet accounts.
practice quiz question 1
Practice Quiz Question #1

The difference between disassociation and dissolution is:

a. Dissolution relates to adding a powder to a liquid.

b. Disassociation relates to the withdrawal of a partner and dissolution relates to the winding up of a partnership.

c. Dissolution relates to the dissolving of a partner’s personal assets.

d. Dissolution relates to the withdrawal of a partner and disassociation relates to the winding up of a partnership.

learning objective 16 2
Learning Objective 16-2

Make calculations related to lump-sum partnership liquidations.

the liquidation process
Non-cash assets converted to cash.

Creditors paid to the extent possible.

Remaining funds (if any) distributed to partners.

The Liquidation Process
group exercise 1 lump sum liquidation
Group Exercise 1: Lump-sum Liquidation

Partners Larry, Curly, and Moe share profits and losses in the ratio of 3:2:1, respectively. The partners voted to liquidate the partnership when its assets, liabilities, and capital were as follows:

Cash $ 7,000 Liabilities $24,000

Non-cash assets 90,000 Loan, Larry 5,000

Loan, Moe 10,000

Capital, Larry 22,000

Capital, Curly 27,000

__________ Capital, Moe 9,000

Total Assets $97,000 Total Liabilities & Equity $97,000

Assume that all the noncash assets were sold for $42,000 and that all cash was distributed to outside creditors and partners.

REQUIRED

Prepare a statement of realization and liquidation.

group exercise 1 lump sum liquidation1
Group Exercise 1: Lump-sum Liquidation

Partners Larry, Curly, and Moe share profits and losses in the ratio of 3:2:1, respectively. The partners voted to liquidate the partnership when its assets, liabilities, and capital were as follows:

Cash $ 7,000 Liabilities $24,000

Non-cash assets 90,000 Loan, Larry 5,000

Loan, Moe 10,000

Capital, Larry 22,000

Capital, Curly 27,000

__________ Capital, Moe 9,000

Total Assets $97,000 Total Liabilities & Equity $97,000

Assume that all the noncash assets were sold for $42,000 and that all cash was distributed to outside creditors and partners.

  • Priorities
  • What to do with the loss on sale of non-cash assets?
  • Pay outside debt.
  • Pay inside debt.
  • Distribute remainder to partners
group exercise 1 solution
Group Exercise 1: Solution

=

+

+

+

=

+

+

+

+

+

Larry (3/6)

Curly (2/6)

Moe (1/6)

sharing of gains losses during liquidation
Gains and losses incurred on the realization of noncash assets during liquidation are

allocated among the partners in the profit-and-loss sharing ratio (such as 4:3:1).

unless agreed to otherwise by the partners.

Sharing of Gains & Losses During Liquidation
consequences of a partner being personally insolvent
A partner having a capital account deficit may be able to eliminate the deficit by

capital contribution.

setoff (against loans to the partnership).

A deficit that cannot be eliminated is allocated to

the remaining partners who have positive capital balances (using their P/L sharing ratio).

Consequences of a Partner Being Personally Insolvent
consequences of a partner being personally insolvent1
Consequences of a Partner Being Personally Insolvent
  • A partner that winds up absorbing some or all of another partner’s capital deficit has
    • legal recourse against that partner.
    • because that partner has broken the terms of the partnership agreement.
sharing profits and losses in the ratio of capital balances
Sharing Profits and Losses: In The Ratio of Capital Balances
  • Sharing profits and losses in the ratio of capital balances
    • is one of the most important safeguards used in partnership agreements.
    • results in no partner ever having a capital account deficit balance until the losses incurred in liquidation exceed the total partnership capital.
      • Thus, all partners go into a deficit position simultaneously.
the rule of setoff
The Rule of Setoff

A deficit balance in a partner’s capital account can be eliminated to the extent that such partner has a loan to the partnership.

how to know you ve done it right
How to Know You’ve Done it Right?

If you allocate losses correctly, the remaining cash balances at the end should be exactly enough to pay back partners’ capital balances.

Capital

=

group exercise 2 lump sum liquidation insolvent
Group Exercise 2: Lump-sum Liquidation—Insolvent

Partners Huey, Dewey, and Louie share profits and losses in the ratio of 3:3:2, respectively. The partners voted to liquidate the partnership when its assets, liabilities, and capital were as follows:

Cash $ 2,000 Liabilities $35,000

NR from Louie4,000Loan, Dewey 17,000

Non-cash assets 82,000 Capital, Huey 11,000

Capital, Dewey 13,000

Capital, Louie 12,000

Total Assets $88,000 Total Liabilities & Equity $88,000

  • All the noncash assets of $82,000 were sold for $46,000.
  • Louie was personally insolventand unable to contribute any cash.
  • Huey and Dewey were both personally solvent and able to eliminate any deficits in their capital accounts through setoff or contribution.
  • All cash was distributed to outside creditors and partners.

REQUIRED

Prepare a statement of realization and liquidation.

group exercise 2 solution1
Group Exercise 2: Solution

=

+

+

+

=

+

+

+

+

Huey (3/8)

Dewey (3/8)

Louie (2/8)

practice quiz question 2
Practice Quiz Question #2

Which of the following statements is true about a lump-sum partnership liquidation?

Lump-sum liquidations take place over an extended period of time.

Lump-sum liquidations can only take place when the partnership has two partners.

Lump-sum liquidations relate mainly to corporations.

Lump-sum liquidations take place all at once or over a short period of time .

learning objective 16 3
Learning Objective 16-3

Make calculations related to installment partnership liquidations.

installment liquidations priority in distributing cash
What is an installment liquidation?

Assets are sold over time.

Cash is distributed throughout the liquidation process.

Who gets priority in each round?

No cash distributions are made to partners until outside creditors have been paid in full.

This holds true for both:

Lump-sum liquidations.

Installment liquidations.

Installment Liquidations: Priority In Distributing Cash
the statement of realization and liquidation
The Statement of Realization and Liquidation
  • The statement of realization and liquidation
    • is an historical statement.
    • portrays what actually happened in the past (during the liquidation process).
    • is usually prepared in a lump-sum liquidation (or as a “look back” at an installment liquidation).
the schedule of safe payments
The schedule of safe payment

is a pro forma (what if) statement for installment liquidations.

portrays what could happen in the future—on a worst-case basis.

Must prepare a new schedule for each $ distribution

The Schedule of Safe Payments
cash distribution plan
Cash Distribution Plan
  • The cash distribution plan
    • is a pro forma (what if) statement for installment liquidations.
    • is only prepared once at the beginning of the winding up process.
installment liquidations inside versus outside loans
Some people seem to have a “fixation” on “equality” between “inside” and “outside” debt.

Strictly speaking, the UPA of 1997 says they are equal.

In practice, partners frequently need to subordinate their debt to existing “outside” debt.

We will assume subordination in all in-class examples.

It makes sense to make payments in the following order:

Outside debt

Inside debt

Capital

However, this order can result in inequities.

Partner gets payment for loan and spends it.

Partner can’t make up deficit balance.

Other partners have to cover the deficit.

The legal doctrine of setoff effectively treats loans as additional capital investments to avoid inequities.

Installment Liquidations: “Inside” versus “Outside” Loans
thoughts on installment liquidations
Thoughts on Installment Liquidations
  • Don’t sell everything at once … BE PATIENT!
  • You can’t just start handing out cash!
  • You need a plan to ensure FAIRNESS!
  • Two types of “plans” for distributing cash:
  • Cash Distribution Plan (beginning of the process)
  • Schedule of Safe Payments (with each distribution)
  • Ensures that no one gets too much cash too soon.
group exercise 3 distributing available to partners
Group Exercise 3: Distributing Available $ to Partners

The partnership of Snap, Crackle, and Pop is in the process of being liquidated. The trial balance immediately after the sale of a portion of the noncash assets and full payment to outside creditors is as follows:

Cash $27,000

NR from Crackle 13,000

Non-cash assets 42,000

Loan, Snap $12,000

Capital, Snap 10,000

Capital, Crackle 19,000

Capital, Pop __________ 41,000

Totals $82,000 $82,000

Snap wants the available cash distributed to her to pay off her loan—she cites Section 807 of the UPA, which states that partners’ loans have priority over partners’ capital. Pop wants the cash distributed to him because he has the largest capital investment. Crackle believes that it should be distributed equally, which is how profits and losses are shared.

REQUIRED

  • Evaluate the position of each partner.
  • Who should receive the $27,000 available cash?
  • Optional: If subsequent to the cash distribution of $27,000, noncash assets having a book value of $30,000 are sold for $9,000, who receives the $9,000?
group exercise 3 solution
Group Exercise 3: Solution

PART 1

  • Snap quotes the UPA properly but does not consider the rule of setoff, which essentially treats a partner’s loan as a capital contributionin determining how cash should be distributed to partners.
  • Pop’s position indirectly states that he is most able to bear lossesand the cash should be distributed considering this ability. This general approach is used in distributing cash to partners.
  • Crackle’s position is without merit. The distribution of cash in liquidation is not related to the manner of sharing profits and losses.
schedule of safe payments
Schedule of Safe Payments
  • No cash to partners until AFTER all outside creditors are paid in full.
  • Before any cash goes to the partners, consider two hypotheticalworst-case scenarios.
    • All non-cash assets worthless (distribute losses)
    • Assume partners absorb any deficits
  • Cash only goes to partners with positive balances.
    • It means they have enough excess invested to absorb even the worst possible scenarios!
group exercise 3 continued schedule of safe payments
Group Exercise 3 Continued: Schedule of Safe Payments

The partnership of Snap, Crackle, and Pop is in the process of being liquidated. The trial balance immediately after the sale of a portion of the noncash assets and full payment to outside creditors is as follows:

Cash $27,000

NR from Crackle 13,000

Non-cash assets 42,000

Loan, Snap $12,000

Capital, Snap 10,000

Capital, Crackle 19,000

Capital, Pop __________ 41,000

Totals $82,000 $82,000

Snap wants the available cash distributed to her to pay off her loan—she cites Section 807 of the UPA, which states that partners’ loans have priority over partners’ capital. Pop wants the cash distributed to him because he has the largest capital investment. Crackle believes that it should be distributed equally, which is how profits and losses are shared.

REQUIRED

  • Evaluate the position of each partner.
  • Who should receive the $27,000 available cash?
  • Optional: If subsequent to the cash distribution of $27,000, noncash assets having a book value of $30,000 are sold for $9,000, who receives the $9,000?
group exercise 3 solution1
Group Exercise 3: Solution

PART 2

  • The two worst-case assumptions are needed to determine who gets the cash. A schedule of safe payments follows:
group exercise 3 continued schedule of safe payments1
Group Exercise 3 Continued: Schedule of Safe Payments

The partnership of Snap, Crackle, and Pop is in the process of being liquidated. The trial balance immediately after the sale of a portion of the noncash assets and full payment to outside creditors is as follows:

Cash $ 9,000

NR from Crackle 13,000

Non-cash assets 12,000

Loan, Snap $ 8,000

Capital, Snap 3,000

Capital, Crackle 12,000

Capital, Pop __________ 11,000

Totals $34,000 $34,000

Snap wants the available cash distributed to her to pay off her loan—she cites Section 807 of the UPA, which states that partners’ loans have priority over partners’ capital. Pop wants the cash distributed to him because he has the largest capital investment. Crackle believes that it should be distributed equally, which is how profits and losses are shared.

REQUIRED

  • Evaluate the position of each partner.
  • Who should receive the $27,000 available cash?
  • Optional: If subsequent to the cash distribution of $27,000, noncash assets having a book value of $30,000 are sold for $9,000, who receives the $9,000?
group exercise 3 continued schedule of safe payments2
Group Exercise 3 Continued: Schedule of Safe Payments

The partnership of Snap, Crackle, and Pop is in the process of being liquidated. The trial balance immediately after the sale of a portion of the noncash assets and full payment to outside creditors is as follows:

Cash $ 9,000

NR from Crackle 13,000

Non-cash assets 12,000

Loan, Snap $ 8,000

Capital, Snap 3,000

Capital, Crackle 12,000

Capital, Pop __________ 11,000

Totals $34,000 $34,000

Snap wants the available cash distributed to her to pay off her loan—she cites Section 807 of the UPA, which states that partners’ loans have priority over partners’ capital. Pop wants the cash distributed to him because he has the largest capital investment. Crackle believes that it should be distributed equally, which is how profits and losses are shared.

REQUIRED

  • Evaluate the position of each partner.
  • Who should receive the $27,000 available cash?
  • Optional: If subsequent to the cash distribution of $27,000, noncash assets having a book value of $30,000 are sold for $9,000, who receives the $9,000?
group exercise 3 solution3
Group Exercise 3: Solution

PART 3

Schedule of Safe Payments to Partners

  • Beginning Balances are after the above cash distribution of $27,000 and after the $21,000 loss on the sale of noncash assets for $9,000.
installment liquidations different strokes for different folks
Installment Liquidations: Different Strokes For Different Folks
  • The amount to be distributed to each partner at any point in time can be determined by preparing either of the following items:
    • Schedules of safe payments at each cash distribution date.
      • Will have to be done several times.
    • A cash distribution plan at the beginning of the liquidation process.
      • Need be done only once.
installment liquidations
Installment Liquidations
  • The effect of distributing cash to partners based on either

(a) schedules of safe payments or

(b) cash distribution plans

is to bring the capital balances into the profit-and-loss sharing ratio.

installment liquidations loss absorption potential
Installment Liquidations: Loss Absorption Potential
  • Conceptually, the first cash distribution to partners goes to that partner who has the highest loss absorption potential (LAP).
    • This is not necessarily the partner who has the highest capital balance.
installment liquidations loss absorption potential calculating
Installment Liquidations: Loss Absorption Potential—Calculating
  • The loss absorption potential (LAP) of each partner is calculated by
    • dividing the partner’s capital balance by his or her profit-and-loss sharing percentage.
installment liquidations loss absorption potential loans to
Installment Liquidations: Loss Absorption Potential—Loans “To”
  • In calculating a partner’s loss absorption potential, a partner’s loan to the partnership is added to the partner’s capital balance.
installment liquidations loss absorption potential loans from
Installment Liquidations: Loss Absorption Potential—Loans “From”
  • In calculating a partner’s loss absorption potential, a partner’s loan from the partnership is subtracted from the partner’s capital balance.
installment liquidations loss absorption potential implications
Installment Liquidations: Loss Absorption Potential—Implications
  • Consequences of Having the Highest Loss Absorption Potential:

He or she will be:

    • The first partner to receive cash.
    • The partner that could suffer the greatest inequity in relation to his or her capital balance.

It is NOT a good thing to have

the highest loss absorption potential.

group practice loss absorption potential
Group Practice: Loss Absorption Potential

The partnership of Snap, Crackle, and Pop is in the process of being liquidated. The trial balance immediately after the sale of a portion of the noncash assets and full payment to outside creditors is as follows:

Cash $27,000

NR from Crackle 13,000

Non-cash assets 42,000

Loan, Snap $12,000

Capital, Snap 10,000

Capital, Crackle 19,000

Capital, Pop __________ 41,000

Totals $82,000 $82,000

REQUIRED

  • Calculate the loss absorption potential for Snap, Crackle, and Pop.
group practice loss absorption potential1
Group Practice: Loss Absorption Potential

Based on these calculations, who should receive cash first?

practice quiz question 3
Practice Quiz Question #3

In liquidation, cash distributions to partners are determined based on:

Who has the highest capital balance.

How profits and losses are shared.

Partners’ loans to the partnership having priority over partners’ capital balances.

The marshalling of assets principle.

The rule of setoff.

None of the above.

group exercise 3 continued cash distribution plan
Group Exercise 3 Continued: Cash Distribution Plan

The partnership of Snap, Crackle, and Pop is in the process of being liquidated. The trial balance immediately after the sale of a portion of the noncash assets and full payment to outside creditors is as follows:

Cash $27,000

NR from Crackle 13,000

Non-cash assets 42,000

Loan, Snap 12,000

Capital, Snap 10,000

Capital, Crackle 19,000

Capital, Pop __________ 41,000

Totals $82,000 $82,000

Snap wants the available cash distributed to her to pay off her loan—she cites Section 807 of the UPA, which states that partners’ loans have priority over partners’ capital. Pop wants the cash distributed to him because he has the largest capital investment. Crackle believes that it should be distributed equally, which is how profits and losses are shared.

REQUIRED

  • Evaluate the position of each partner.
  • Who should receive the $27,000 available cash?
  • Optional: If subsequent to the cash distribution of $27,000, noncash assets having a book value of $30,000 are sold for $9,000, who receives the $9,000?
group exercise 4 installment liquidation
Group Exercise 4: Installment Liquidation

Partners Potter, Granger, and Weasley share profits and losses in the ratio 2:1:1, respectively. The partners voted to liquidate the partnership when its assets, liabilities, and capital were as follows:

Cash $ 25,000

NR from Potter 15,000

Other assets 210,000

Liabilities $ 70,000

Loan, Granger 18,000

Capital, Potter 44,000

Capital, Granger 10,000

Capital, Weasley __________ 108,000

Totals $250,000 $250,000

The partnership will be liquidated over a long period of time. Cash will be distributed to the partners as it becomes available. The first sale of noncash assets having a book value of $110,000 realized $80,000.

REQUIRED

  • Determine how the available cash should be distributed to the partners after this first sale.
group exercise 3 continued schedule of safe payments3
Group Exercise 3 Continued: Schedule of Safe Payments

The partnership of Snap, Crackle, and Pop is in the process of being liquidated. The trial balance immediately after the sale of a portion of the noncash assets and full payment to outside creditors is as follows:

Cash $ 9,000

NR from Crackle 13,000

Non-cash assets 12,000

Loan, Snap $ 8,000

Capital, Snap 3,000

Capital, Crackle 12,000

Capital, Pop __________ 11,000

Totals $34,000 $34,000

Snap wants the available cash distributed to her to pay off her loan—she cites Section 807 of the UPA, which states that partners’ loans have priority over partners’ capital. Pop wants the cash distributed to him because he has the largest capital investment. Crackle believes that it should be distributed equally, which is how profits and losses are shared.

REQUIRED

  • Evaluate the position of each partner.
  • Who should receive the $27,000 available cash?
  • Optional: If subsequent to the cash distribution of $27,000, noncash assets having a book value of $30,000 are sold for $9,000, who receives the $9,000?
group exercise 4 installment liquidation1
Group Exercise 4: Installment Liquidation

Partners Potter, Granger, and Weasley share profits and losses in the ratio 2:1:1, respectively. The partners voted to liquidate the partnership when its assets, liabilities, and capital were as follows:

Cash $ 25,000

NR from Potter 15,000

Other assets 210,000

Liabilities $ 70,000

Loan, Granger 18,000

Capital, Potter 44,000

Capital, Granger 10,000

Capital, Weasley __________ 108,000

Totals $250,000 $250,000

The partnership will be liquidated over a long period of time. Cash will be distributed to the partners as it becomes available. As of this date no assets have been liquidated.

REQUIRED

  • Compute the Loss Absorption Potential for each partner as of the day the partners decided to liquidate the partnership.
group practice loss absorption potential2
Group Practice: Loss Absorption Potential

Based on these calculations, who should receive cash first?

group exercise 4 installment liquidation2
Group Exercise 4: Installment Liquidation

Partners Potter, Granger, and Weasley share profits and losses in the ratio 2:1:1, respectively. The partners voted to liquidate the partnership when its assets, liabilities, and capital were as follows:

Cash $ 25,000

NR from Potter 15,000

Other assets 210,000

Liabilities $ 70,000

Loan, Granger 18,000

Capital, Potter 44,000

Capital, Granger 10,000

Capital, Weasley __________ 108,000

Totals $250,000 $250,000

The partnership will be liquidated over a long period of time. Cash will be distributed to the partners as it becomes available. As of this date no assets have been liquidated.

REQUIRED

  • Prepare a Cash Distribution Plan as of the day the partners decided to liquidate the firm. This plan should show how cash will be distributed to the partners as it becomes available (after all outside liabilities have been paid).
practice quiz question 4
Practice Quiz Question #4

Which of the following is NOT true about the schedule of safe payments and cash distribution plans?

a. Cash distribution plans are prepared multiple times during the liquidation as cash comes in.

b. Cash distribution plans are prepared at the beginning of the liquidation.

c. Schedules of safe payments are prepared multiple times during the liquidation as cash comes in.

d. The allocation of assets to partners is the same under the cash distribution plan and schedule of safe payments.

conclusion
Conclusion

The End

16-67