CHAPTER 16

Partnership Liquidation
BRIEF OUTLINE
16.1 Steps in the Liquidation Process 16.4 Installment Liquidation
16.2 Priorities of Partnership and Personal Creditors 16.5 Incorporation of a Partnership
16.3 Simple Liquidation Illustrated

INTRODUCTION

In the last chapter we discussed the different transactions which would affect a partnership’s equity. In
this chapter, we will discuss how partnerships are liquidated. While it might seem like a simple process to
turn all of the partnership’s assets to cash, to pay liabilities, and to distribute any remaining cash, it’s not
an easy task. It can sometimes take many months to finally liquidate the partnership.

CHAPTER OUTLINE

16.1 Steps in the Liquidation Process

A. Definitions
1. Liquidation – dissolutions of partnerships where the partnership is terminated
2. Sometimes referred to as “winding up the affairs”
B. Order of liquidation
1. The business should close
a. Compute income to date
b. Distribute income or loss to the partners in their residual profit and loss ratios
2. Noncash assets are converted to cash
a. Gains and losses are accumulated and then distributed to partners
b. Changes in asset values are part of business risk
c. Gains or losses in liquidation might be from over- or undervaluation of assets
d. Residual ratio is used because these gains and losses are from investing, not
operating
3. Distribute assets to creditors and partners
a. The UPA (Uniform Partnership Act) has a ranking of order of payment of liabilities
i. Those owing to creditors other than partners
ii. Those owing to partners other than for capital and profits, such as loans
iii. Those owing to partners in respect of capital
iv. Those owing to partners in respect of profit
b. The order of payment ranks the way assets are to be returned to partners, but there are
some alternatives
i. If a partner has a debit capital balance, any loans from that partner can be used to
decrease the deficit – this is called the right of offset
ii. If a partner has a deficit balance, that decreases the other partners’ access to
assets
iii. Payments to partners who might later owe the partnership money are eliminated
with the right of offset
iv. It’s very difficult to differentiate partner’s capital and reinvested profits, so
they’re usually added together
c. If partners take noncash assets, they must first be restated to their fair values
Study Guide to accompany Jeter and Chaney, Advanced Accounting

i. All partners should benefit from the increase or share in the decrease in value of
the noncash assets
ii. The partner who gets the asset should get the fair value of that asset
16.2 Priorities of Partnership and Personal Creditors
A. Partners are jointly and severally liable for the debts of the partnership
1. Jointly – all partners together are liable
2. Severally – each partner is individually liable also
B. Personal creditors of the partners can sometimes seek payment from partnership assets
C. Marshalling of assets – an order of how the creditors of the partners and of the partnership
make claims against assets
1. Partnership assets
a. First, to partnership creditors
b. Second, to personal creditors of partners whose claims are not settled by personal
assets
2. Personal assets
a. First, to personal creditors
b. Second, to partnership creditors not satisfied from partnership assets, regardless of
the capital balance of the partner
c. Finally, to the other partners to eliminate a deficit capital balance
16.3 Simple Liquidation Illustrated
A. Careful partnership records must be kept so the steps in liquidation can be completed
B. An illustration of the steps in the marshalling of assets:
Marshalling of Assets – Simple Liquidation
Noncash A, B, C,
Cash Assets Liabilities Capital Capital Capital
1. Sell noncash assets debit credit dr or cr dr or cr dr or cr
2. Pay creditors credit debit
3. Offset loan debit credit
4. Allocate deficit debit credit debit
5. Investment by partner debit credit
6. Payment to partners credit debit
1. When assets are sold for less than book value, the partners must absorb the loss; for more
than book value, the partners get the gain
2. When there’s enough cash, the creditors should be paid
3. The right of offset allows loans from partners to be added to their capital balances
4. If a partner has a deficit capital balance, he or she has two options
a. If the partner is personally bankrupt, the deficit balance must be allocated to the
remaining partners in their residual profit and loss ratio (4 above)
b. If the partner is personally solvent, the deficit is settled by a cash payment by the
partner (5 above)
c. After either option, that partner’s capital balance is zero
5. When there’s nothing left but cash and positive (credit) capital balances, the remaining
cash is distributed to owners
a. Remember – the cash is distributed based on the partner’s capital balances, not their
profit sharing ratios
b. After the last step is done, there are no balances in any accounts and the partnership
is liquidated
16.4 Installment Liquidation
A. Sometimes a simple liquidation forces the assets to be sold at far below their book values
1. It could be to the advantage of the partnership to sell the assets over time

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2. If the sale of assets takes time, the partners will want their money before the liquidation is
complete
3. If the assets are distributed early, special care must be taken not to give assets to a partner
who might later owe money to the partnership
B. Safe payment approach
1. Each time cash is distributed there are still noncash assets, which might or might not be
sold at book value
2. The most conservative approach would make three assumptions
a. Loans from partners are added to their capital balances
b. No more cash will be received from the remaining noncash assets, and their book
value is treated as a loss – minimizes the partners’ capital balances
c. Each partner is personally insolvent – can’t pay a deficit balance
3. Computation of safe payment before each distribution
a. See detailed example in text
b. When adequate cash is accumulated, the first step is to pay creditors
c. After every sale of assets the safe payment of the available cash is determined again
i. All partners maintain an equity balance
Safe Payment Plan
A, Capital B, Capital C, Capital
Starting capital balances credit credit credit
Balance of noncash assets (debit) (debit) (debit)
Safe payment credit credit credit
ii. One or more partners has a deficit
Safe Payment Plan
A, Capital B, Capital C, Capital
Starting capital balances credit credit credit
Balance of noncash assets (debit) (debit) (debit)
Partners’ adjusted balances credit debit credit
Partner’s deficit allocated (debit) credit (debit)
Safe payment credit -0- credit
d. The safe payment calculation would be repeated periodically until all noncash assets
are liquidated
4. Additional losses, discovery of liabilities, and liquidation expense
a. In an installment liquidation, it is possible that some additional liabilities will be
discovered during the course of the liquidation
b. Usually there are liquidation expenses which might not be paid at the time of the safe
payment
c. An “allowance” can be created which deducts contingent debt and estimated
liquidation expenses as if they had actually been incurred
d. A balance of cash will then be retained to be used for additional costs
C. Advanced plan for the distribution of cash
1. The safe payment plan above can be very time consuming and is definitely repetitive
2. A second technique anticipates the safe payment plan and creates an advance schedule of
payments to partners
a. It shows the order and amount each partner will receive
b. It allows partners’ individual creditors to anticipate potential payments to them
3. Advance plan for distribution of cash can be found in your book on pages 782-786
a. Step 1 – Determine the partners’ capital balances including loan balances and
residual profit and loss ratios
b. Step 2 – Determine how much partnership loss each partner could absorb before his
or her capital balance is absorbed

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i. Capital balance/profit and loss ratio = loss absorption potential (LAP)

ii. The LAPs are ranked from highest to lowest
iii. The partner with the highest LAP will get cash first
c. Step 3 – the LAP is used to determine the amount of, and the order of distribution
i. We reduce the largest LAP to the second largest, then take that amount times the
first partner’s profit and loss ratio to get the first cash payment
ii. We reduce the LAPs of the first and second partners to the third LAP, and take
the difference by the two partner’s proportional profit and loss ratios to get the
second cash payment
iii. When all the partners’ LAPs are the same, their remaining equities are in their
profit and loss ratios so any further cash payments are in their residual profit and
loss ratios
4. The advantage of this plan is that it’s very easy to distribute cash as the partnership
continues to sell assets
5. The advance plan is practical only if the partners use the same ratio to share losses as
profits. Otherwise, the distribution has to be recalculated every time.
16.6 Incorporation of a Partnership
A. Just as proprietorships can evolve into partnerships, partnerships often evolve into
corporations
B. Partnership books can be transferred to the corporation or new books can be established
1. Retention of partnership books by corporation
a. Adjust assets and liabilities to fair value, generally using a valuation account
To adjust assets and liabilities to fair value
Inventory
Land
Equipment (credit if FV is lower than BV)
Accounts Receivable
Valuation Adjustment
b. Close the valuation account to the partners’ capital accounts
To close the valuation account
Valuation Adjustment
A, Capital
B, Capital
c. Close the partners’ capital accounts and issue stock, using additional paid-in
capital if necessary
To close the partners’ capital accounts to corporate equity
A, Capital
B, Capital
Common Stock
Additional Paid-in Capital
2. New books established by the corporation
a. Partnership books must be closed – the balancing amount will be a debit to the
common stock account
To close partnership assets and liabilities
Common Stock (to balance)
Accounts Payable
Notes Payable
Cash
Accounts Receivable
Inventory
Equipment

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Land
b. The capital accounts are then closed with the common stock account created
To close the partnership capital accounts
A, Capital
B, Capital
Common Stock (from Corporation)

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MULTIPLE CHOICE QUESTIONS

Choose the BEST answer for the following questions.

_____ 1. How does a partnership liquidate?

a. The business closes, the noncash assets are liquidated, the creditors are paid, and the
remaining cash is distributed to the partners
b. The partners take what cash there is and then declare bankruptcy
c. The partners pay the bills and split up the assets
d. One of the partners sells his or her share of the partnership to another partner

_____ 2. What is the UPA’s order of payment?

a. To creditors other than partners, to partners in respect of capital, in respect of profits, and
in respect of liabilities
b. To partners in respect of profits, in respect of liabilities, in respect of capital, and to other
creditors
c. To creditors other than partners, and to partners in respect of liabilities, in respect of
capital, and in respect of profits
d. To creditors other than partners, and to partners in respect of profits, in respect of
liabilities and in respect of capital

_____ 3. Marshalling of assets is

a. an order of how the personal creditors of the partners seek payment
b. an order of how the partnership creditors seek payment
c. an order of how the partnership and personal creditors of the partners seek payment
d. when the partnership is bankrupt and its assets are taken by the court

_____ 4. In a liquidation, when assets are sold for less than book value, what disposition is made of the
loss?
a. The loss is divided among the partners in their capital balance ratio
b. The loss is divided among the partners in their profit and loss ratio
c. The loss is subtracted from the partner with the highest capital balance
d. The loss decreases the next year’s income

_____ 5. What is the purpose of an installment liquidation?

a. To spread the sale of assets out to maximize the return on the sales
b. To distribute the cash to creditors and then partners as quickly as possible
c. To create a schedule of safe payments
d. All of these

_____ 6. What is the loss absorption potential?

a. The amount of loss a partnership can sustain and still have more equity than liabilities
b. The amount of loss the partners can sustain before their capital balances are dissipated
c. An amount used in a simple liquidation to determine cash payments
d. The amount of cash paid to each partner in a safe payment plan

_____ 7. The purpose of a safe payment plan is to

a. pay creditors
b. keep an amount of cash on hand for contingencies
c. make sure assets are sold for enough cash to pay the bills
d. make sure no money is paid to partners who later might owe money to the partnership

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_____ 8. What is an advance plan for the distribution of cash?

a. An organized way to determine how cash should be allocated over time
b. An organized way to minimize the payments to creditors
c. An organized way to minimize the possibility for bankruptcy
d. An organized way to maximize returns to partners

_____ 9. If partners are jointly and severally liable for a partnership debt, it means the creditor
a. must name all partners in a lawsuit but each partner is only liable for a proportional
amount
b. must name all partners in a lawsuit and each partner is liable for the entire debt
c. may name any or all partners in a lawsuit but each partner is only liable for a proportional
amount
d. may name any or all partners in a lawsuit and each partner is liable for the entire amount

_____10. What is the difference between simple liquidation and installment liquidation?
a. Simple liquidation is when the partnership is easy to liquidate and installment liquidation
is when it is difficult
b. Simple liquidation is when there are only two partners; installment when there are more
than two partners
c. Simple liquidation waits to distribute money until all the assets are sold and liabilities are
paid; installment pays money over time
d. Simple liquidation pays money overtime; installment liquidation makes payments to
creditors over time

_____11. When a partnership incorporates, the partners

a. must sell all the assets of the partnership
b. transfer their ownership capital to stockholders’ equity
c. sell the partnership to another company
d. cannot keep the partnership books

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MATCHING

Match the terms in the list to the definitions below. Each term may be used only once.

A. Liquidation F. Severally liable

B. Simple liquidation G. Safe payment plan
C. Installment liquidation H. Loss absorption potential
D. Marshalling of assets I. Advance payment plan
E. Jointly liable J. Winding up the affairs

_____ 1. The amount of loss the partner can absorb and still have no deficit

_____ 2. A system where the order of payment to creditors and partners is very carefully followed

_____ 3. Another term for liquidation

_____ 4. A partnership dissolution where the partnership ceases to exist

_____ 5. A partner is responsible along with the other partners for the partnership’s debts

_____ 6. A system to determine how much money each partner can get as money comes in from the
sale of assets

_____ 7. A plan where all the assets are sold, all the bills are paid, and the rest of the money is given to
the partners

_____ 8. A partner is responsible on his own for the partnership’s debts

_____ 9. A system to allow the partnership to sell assets over time to maximize return on those assets

_____10. A system to make sure money is never paid to a partner who might later owe money to the
partnership

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EXERCISES

1. The partnership of Xavier, Yarnell and Zablicki have decided to liquidate their partnership. At the
time, the partners share income and loss in the ratio of 2:2:6. No partner can make any payments into
the partnership. The partnership sold the noncash assets for $20,000.
A. Complete the liquidation schedule below
Marshalling of Assets – Simple Liquidation
Noncash Y, X, Y, Z,
Cash Assets Liabilities Loan Capital Capital Capital
Beginning balances $5,000 $40,000 $15,000 $2,000 $12,000 $1,000 $15,000

Sell noncash assets

Pay creditors

Offset loan

Allocated deficit

Payment to partners
B. Now assume the noncash assets were sold for $16,000. Complete the liquidation schedule below
Marshalling of Assets – Simple Liquidation
Noncash Y, X, Y, Z,
Cash Assets Liabilities Loan Capital Capital Capital
Beginning balances $5,000 $40,000 $15,000 $2,000 $12,000 $1,000 $15,000
Sell noncash assets

Pay creditors

Offset loan

Allocated deficit

Payment to partners

2. Kelly, Layman, Miller and Nott are partners with capital balances of $15,450, $20,550,
$16,500, and $13,500, respectively. Miller also holds a partnership note for $3,000. Net
income and loss are shared 3:2:4:1. After the assets are sold and creditors are paid, the
partnership has $18,000 in cash. Assume that no partner can make any payment into the
partnership. Determine how the partnership cash should be allocated.
M, Loan K, Capital L, Capital M, Capital N, Capital

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3. Charlie, Jake and Goober have a pet sitting service which is no longer profitable. They have tried to
sell the business intact, but have no buyers. The partnership balance sheet is listed below.

Cash $ 30,000 Liabilities $ 20,000

Other assets 90,000 C, Capital 25,000
J, Capital 35,000
______ _ G, Capital 40,000
$120,000 $120,000
Charlie, Jake and Goober share income and loss in a 2:5:3 ratio. During January 2013, $15,000 of the
other assets were sold for $10,000. The creditors were paid and the remaining cash was distributed to
the partners.
A. Prepare a schedule of safe payments and determine cash distribution
Safe Payment Plan
C, Capital J, Capital G, Capital

B. If $25,000 of remaining other assets were sold in February 2013, for $10,000, how much cash
would you distribute to each partner?
Safe Payment Plan
C, Capital J, Capital G, Capital

4. The MDS partnership has decided to liquidate. At the time, the profit and loss ratios for Murphy,
Donnelly and Sullivan were 1:1:3. The balance sheet is below.
Cash $ 30,000 Liabilities $ 20,000
Other assets 170,000 M, Capital 50,000
D, Capital 70,000
S, Capital 60,000
$200,000 $200,000

A. Using the loss absorption potential system, determine how the partners will share in the
distribution of cash
Loss Absorption Potential
M D S
Capital
P & L ratio
LAP (capital/P&L)

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Loss Absorption Potential Asset Distribution

M D S M D S
P & L ratio
LAP
Net capital interest
Distribution to D
(100 × 0.2)

Distribution to M & D
(150 × 0.2)

B. Prepare an advance plan for the distribution of cash

Advance Cash Distribution Plan
Order of cash distribution Liabilities M D S

5. Hayes and Bullet is growing and has decided to incorporate. The partners currently share their income
and loss in a 4:1 ratio. They will issue 10,000 shares of $10 par value common stock for their existing
capital balances. The balance sheet on the date the corporation will be formed is below.

Cash $ 10,000 Accounts pay. $ 40,000

Accounts rec. (net) 30,000
Land 100,000 Hayes, Capital 100,000
Building (net) 60,000 Bullet, Capital _ 60,000
$200,000 $200,000

The fair values of the assets and liabilities are equal to their book values except for land (FV =
$110,000) and building (FV = $20,000). Prepare the journal entries for the partnership, assuming

A. The partnership books are to be retained by the corporation

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B. The partnership books are to be closed and new books are to be started by the corporation

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SOLUTIONS

MULTIPLE CHOICE

1. A 4. B 7. D 10. C
2. C 5. D 8. A 11. B
3. C 6. B 9. D

MATCHING

1. H 4. A 7. B 10. G
2. D 5. E 8. F
3. J 6. I 9. C

EXERCISES

1. A.
Marshalling of Assets – Simple Liquidation
Noncash Y, X, Y, Z,
Cash Assets Liabilities Loan Capital Capital Capital
Beginning balances $5,000 $40,000 $15,000 $2,000 $12,000 $1,000 $15,000
Sell noncash assets 20,000 (40,000) _______ ________ (4,000) (4,000) (12,000)
25,000 -0- 15,000 2,000 8,000 (3,000) 3,000
Pay creditors (15,000) (15,000) ______ ______ ______ ______
10,000 -0- 2,000 8,000 (3,000) 3,000
Offset loan ______ (2,000) ______ 2,000 ______
10,000 -0- 8,000 (1,000) 3,000
Allocated deficit ______ (250) 1,000 (750)
10,000 7,750 -0- 2,250
Payment to partners (10,000) (7,750) (2,250)

B.
Marshalling of Assets – Simple Liquidation
Noncash Y, X, Y, Z,
Cash Assets Liabilities Loan Capital Capital Capital
Beginning balances $5,000 $40,000 $15,000 $2,000 $12,000 $1,000 $15,000
Sell noncash assets 16,000 (40,000) _ _____ ______ (4,800) (4,800) (14,400)
21,000 -0- 15,000 2,000 7,200 (3,800) 600
Pay creditors (15,000) (15,000) ______ _ _____ ______ ______
6,000 -0- 2,000 7,200 (3,800) 600
Offset loan ______ (2,000) ______ 2,000 ______
6,000 -0- 7,200 (1,800) 600
Allocated deficit ______ (450) 1,800 (1,350)
6,000 6,750 -0- (750)
Allocate deficit ______ (750) 750
6,000 -0-
Payment to partners (6,000) (6,000)

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2.
M, Loan K, Capital L, Capital M, Capital N, Capital
Balances $ 3,000 $15,450 $20,550 $16,500 $13,500
Loss ($51,000) ______ (15,300) (10,200) (20,400) (5,100)
3,000 150 10,350 (3,900) 8,400
Offset (3,000) ____________ 3,000 ______
-0- 150 10,350 (900) 8,400
Allocate deficit (450) (300) 900 (150)
(300) 10,050 -0- 8,250
Allocate deficit 300 (200) (100)
-0- 9,850 8,150
Cash payment (9,850) (8,150)

3. A.
Safe Payment Plan
C, Capital J, Capital G, Capital
Capital balances, 1/1 $25,000 $35,000 $40,000
Loss on asset sale (1,000) (2,500) (1,500)
24,000 32,500 38,500
Allocation of potential loss (15,000) (37,500) (22,500)
9,000 (5,000) 16,000
Allocation of J’s deficit (2,000) 5,000 (3,000)
Safe payments 7,000 -0- 13,000
B.
Safe Payment Plan
C, Capital J, Capital G, Capital
Capital balances, 2/1 $24,000 $32,500 $38,500
Payments to partners (7,000) ___ (13,000)
17,000 32,500 25,500
Loss on asset sale (3,000) (7,500) (4,500)
14,000 25,000 21,000
Allocation of potential loss (10,000) (25,000) (15,000)
Safe payments 4,000 -0- 6,000

4. A.
Loss Absorption Potential
M D S
Capital $50,000 $70,000 $60,000
P & L ratio .2 .2 .6
LAP (capital/P&L) $250,000 $350,000 $100,000

Loss Absorption Potential Asset Distribution

M D S M D S
P & L ratio 0.2 0.2 0.6 0.2 0.2 0.6
LAP $250,000 $350,000 $100,000
Net capital interest $50,000 $70,000 $60,000
Distribution to D (100 × 0.2) ______ (100,000) ______ ______ (20,000) ______
250,000 250,000 100,000 50,000 50,000 60,000
Distribution to M & D (150 × 0.2) (150,000) (150,000) ______ (30,000) (30,000) ______
$100,000 $100,000 $100,000 $20,000 $20,000 $60,000

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B.
Advance Cash Distribution Plan
Order of cash distribution Liabilities M D S
1. First $20,000 100%
2. Next $20,000 100%
3. Next $60,000 50% 50%
4. Remainder 20% 20% 60%

5. A.
To adjust assets an liabilities to fair value
Land 10,000
Valuation Adjustment 30,000
Building (net) 40,000
To distribute valuation adjustment to partners
H, Capital 24,000
B, Capital 6,000
Valuation Adjustment 30,000
To close partners’ capital accounts and open capital stock account
H, Capital 76,000
B, Capital 54,000
Common Stock, $10 par ($10 × 10,000) 100,000
Additional Paid-in Capital 30,000

B.
To adjust assets an liabilities to fair value
Land 10,000
Valuation Adjustment 30,000
Building (net) 40,000
To distribute the valuation adjustment to partners
H, Capital 24,000
B, Capital 6,000
Valuation Adjustment 30,000
To close partnership asset and liability accounts
Common Stock (from corporation to balance) 130,000
Accounts Payable 40,000
Cash 10,000
Accounts Receivable 30,000
Land (new balance) 110,000
Building (new balance) 20,000
To close partnership books
H, Capital 76,000
B, Capital 54,000
Common Stock (from corporation) 130,000

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