Termination and Liquidation Chapter Ten Partnerships: Termination and Liquidation McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Reasons for Termination Termination of business activities followed by liquidation of partnership property occurs for a variety of reasons: Personality disputes between partners Retirement Death Changed business environment Other opportunities Low profits Bankruptcy (either the business or a partner) 10-2

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 and expenses. Distribute remaining cash to partners. 10-3

Termination & Liquidation - Example LO 1 Morgan & Houseman want to liquidate their partnership. Balances at 5/1/13 are: 10-4

Termination & Liquidation - Example LO 2 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. 10-5

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 10-6

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 10-7

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. 10-8

Termination & Liquidation - Example The pre-distribution balances are: 10-9

Termination & Liquidation - Example Once the remaining cash is distributed, the partnership is considered terminated. 10-10

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. Property still being held by the partnership. Liabilities remaining to be paid. Current cash and capital balances. 10-11

Schedule of Liquidation The process of liquidation can last over months, even years. Partners may experience deficit balances during the liquidation period. Partners may want cash distributions prior to the completion of the liquidation. Accountants distribute statements at each important juncture of the process. 10-12

Deficit Capital Balance LO 3 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.) 10-13

Deficit Capital Balance - Remaining Partners Absorb Deficit Holland, Dozier, and Ross have the following balances just prior to liquidation. 10-14

Deficit Capital Balance -- Contribution by Deficit Partner Contributions made by the deficit partner(s) are distributed to the non-deficit partners based on their relative profit sharing percentages. Any payments by Holland will be split 2/3 to Dozier and 1/3 to Ross. 10-15

Deficit Capital Balance - Remaining Partners Absorb Deficit If Holland’s loss proves to be uncollectible, the Dozier and Ross would be forced to absorb the loss as follows: Allocation of Potential $6,000 Loss Dozier . . . . . . . . . . . . . 2⁄3 of $(6,000) $(4,000) Ross . . . . . . . . . . . . . . .1⁄3 of $(6,000) $(2,000) These represent the maximum potential reductions that the two remaining partners could still incur. Depending on Holland’s actions, Dozier could be forced to absorb an additional $4,000 loss, and Ross’s capital account could decrease by $2,000. 10-16

Deficit Capital Balance - Remaining Partners Absorb Deficit Capital balances after distribution of Holland’s loss: 10-17

Deficit Capital Balance - Remaining Partners Absorb Deficit Dozier’s distribution of $11,000 cash reduces his capital account from $15,000 to the minimum $4,000 level. Likewise, a $9,000 payment to Ross decreases the $11,000 capital balance to the $2,000 limit. These safe payments can be distributed without fear of creating new deficits in the future. 10-18

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. 10-19

Preliminary Distribution of Assets LO 4 Under the Uniform Partnership Act, a priority ranking of creditors having claims against individual partners is recognized: Debts owed to partnership creditors. Debts owed to the other partners. Debts owed to personal creditors. 10-20

Claims Against the Partnership Individual partner’s 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 partner’s 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. 10-21

Predistribution Plan LO 5 Used by accountants to guide the distribution of cash resulting from the liquidation process. Examine the Balance Sheet below. Assume the income sharing % is Rubens 50%, Smith 20%, and Trice 30%. 10-22

Predistribution Plan First, determine the maximum loss that each partner can absorb. Divide each partner’s capital balance by their respective income sharing %. 10-23

Predistribution Plan Since Rubens can ONLY absorb a partnership loss of $60,000, new balances are computed assuming that the partnership has a $60,000 loss. 10-24

Predistribution Plan With Rubens wiped out, continue calculating maximum absorbable losses using income sharing percentages of Smith, 20% (2/5) and Trice 30% (3/5). 10-25

Predistribution Plan As earlier, compute the maximum absorbable loss by dividing the capital balances by the relative income sharing %. 10-26

Predistribution Plan Trice can only absorb a loss of $55,000. Now determine new capital balances for a loss of $55,000. 10-27

Predistribution Plan With Rubens and Trice both wiped out, and Smith left as the only remaining partner, the predistribution plan can be prepared. 10-28

Predistribution Plan To inform all parties of the pattern by which available cash will be disbursed, the predistribution plan should be formally prepared in a schedule format prior to beginning liquidation. 10-29

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. Predistribution plans may be necessary when one or more partners have negative capital balances. 10-30