16

Partnerships: Liquidation

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc. All rights reserved.

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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
dissolution, and liquidation.
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Overview of Partnership liquidations

• The major provisions of UPA 1997 have been

adopted by most states.
• Dissociation is the legal description of the
withdrawal of a partner including the following:
– 1. A partner’s death
– 2. A partner’s voluntary withdrawal
– 3. Judicial determination, including:
• a) The partner engaged in wrongful conduct that
materially and negatively affected the partnership
– [continued on next slide]
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Overview of Partnership liquidations

• b) the partner willfully committed a material breach

of the partnership agreement
• c) the partner became a debtor in bankruptcy
• d) an individual partner has become incapable of
performing the partner’s duties under the
partnership agreement.
• Not all dissociations result in a partnership
liquidation.
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Overview of Partnership liquidations

• Dissolution is the dissolving of a partnership:

– 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, the dissolution takes place when:
(a) after a partner’s death or wrongful dissociation, (b)
if all the partners agree to wind up the partnership
business, and (c) it is not reasonably practicable to
carry on the partnership business in conformity with
the partnership agreement.
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Overview of Partnership liquidations

– 3. An event that makes it unlawful to carry on a

substantial part of the business.
– 4. A judicial determination that:
• a. The economic purpose of the partnership is
unlikely to be achieved.
• b. A partner engaged in conduct relating to the
partnership business that makes it impracticable to
carry on the partnership business.
• c. It is not reasonable practicable to carry on the
partnership in conformity with the partnership
agreement.
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Winding Up and Liquidation

• Winding up and liquidation of the partnership

begins after dissolution of the partnership.
• Liabilities to partners or loans they made to the
partnership have the same status as liabilities to
the partnership’s third party creditors.
• As part of the liquidation process, each partner
with a deficit in his or her capital account is
required to make a contribution to the
partnership to remedy that capital deficit.
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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 payment of liabilities, 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, 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.
• The assets of the partnership, including any
receivables from the partners and any
contributions required of partners to remedy
their capital deficits, are applied to pay the
partnership’s creditors.
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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 capital accounts represent safe distributions of
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 account
balance is extinguished.
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LAP Example

• On May 1, 2005, Alt has a capital account credit

balance of $34,000 and a 40 percent share in
the 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
revalued to their market values.
• The gain or loss on revaluation is allocated to
the partners’ capital accounts in the profit and
loss sharing ratio.
• Capital stock in the new corporation is then
distributed in proportion to each partner’s capital
accounts.
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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.
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Personal Financial Statements

• Personal financial statements include:

• Statement of financial condition, or personal
balance sheet, which presents the fair value of
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 sources 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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Personal Financial Statements

• Sufficient footnote disclosures should

accompany the two personal financial
statements.
• The footnotes should describe the following:
– The methods used to value the major assets.
– The names and nature of business in which the
person has major investments.

• [Continued on next slide]

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Personal Financial Statements

– The methods and assumptions used to compute

the estimated tax bases and a statement that the
tax provision in an actual liquidation will probably
differ from the estimated because the actual tax
burden will then be based on actual realizations
determined by market values at the point of
liquidation.
– Maturities, interest rates, and other details of any
receivables and debt.
– Any other information needed to present fully the
person’s net worth.