Advanced Accounting Chapter 10

Deficit Capital Balance- Remaining Partners Absorb Deficit

If the partner resists, the loss will be written off against the capital accounts of Dozier and Ross. Allocation of Potential $6,000 Loss Dozier: 2/3 of $(6,000)=$(4,000) Ross: 1/3 of $(6,000)=$(2,000) Allocation of the loss is based on the relative profit and loss ratio specified in the articles of partnership. Dozier and Ross are credited with 40 percent and 20 percent of partnership income, respectively. The 40:20 ratio equates to a 2:1 relationship (or 2/3:1/3) between the two. Capital balances after distribution of Holland's loss: Holland: Capital Balance=($6,000), Allocation of Holland's deficit balance=6,000, Capital balances=0. Dozier: Capital Balance=$15,000, Allocation of Holland's deficit balance=(4,000), Capital Balances=$11,000. Ross: Capital Balance=$11,000, Allocation of Holland's deficit balance=(2,000), Capital Balances=$9,000. A safe payment of $11,000 may be made to Dozier that reduces that partner's capital account from $15,000 to the minimum $4,000 level. A $9,000 payment to Ross decreases the $11,000 capital balance to the $2,000 limit. Thus, $11,000 and $9,000 are the safe payments that can be distributed to the partners without creating new deficits.

Termination and Liquidation 1

Morgan and Houseman want to liquidate their partnership. The process calls for 1) Assets are converted into cash to pay business obligations and liquidation expenses 2)Remaining assets are distributed to partners based on their final capital balances 3)Partnership books are closed. (Partnership assets are converted into cash that is then used to pay business obligations as well as liquidation expenses. Any remaining assets are distributed to the individual partners based on their final capital balances. Once assets have been distributed, the partnership's books are permanently closed. If each partner has a capital balance large enough to absorb all liquidation losses, the accountant should experience little difficulty in recording this series of transactions.

Termination and Liquidation Journal Example Journal Entries

On 6/1, the inventory is sold for $15,000. Note the loss on the sale of inventory of $7,000 is assigned $4,200 ($7,000 x 60%) to Morgan and $2,800 ($7,000 x 40%) to Houseman. D: Cash 15,000 D: Morgan, Capital (60% of loss) 4,200 D: Houseman, Capital (40% of loss) 2,800 C: Inventory 22,000 To record sale of partnership inventory at a $7,000 loss. Assume that $9,000 of the Accounts Receivable are collected. The remaining accounts receivables are written off, and the loss is allocated between Morgan and Houseman. $3,000 x 60%=$1,800 $3,000 X 40%=$1,200 D: Cash 9,000 D: Morgan, Capital 1,800 D: Houseman, Capital 1,200 C: Accounts Receivable 12,000 To record collection of accounts receivable with write-off of remaining $3,000 in accounts as bad debts. The fixed assets are sold for $29,000. The loss on fixed assets of $12,000 is allocated to Morgan and Houseman. $12,000 x 60%=$7,200 $12,000 x 40%=$4,800 D: Cash 29,000 D: Morgan, Capital 7,200 D: Houseman, Capital 4,800 C: Land, Building, and Equipment (net) 41,000 To record sale of fixed assets and allocation of $12,000 loss. Once all the assets are sold, accounts payable are paid off. Morgan and Houseman incur an additional $3,000 in liquidation expenses. D: Liabilities 32,000 C: Cash 32,000 To record payment made to settle the liabilities of the partnership. D: Morgan, Capital 1,800 D: Houseman, Capital 1,200 C: Cash 3,000 To record payment of liquidation expenses with the amounts recorded as direct reductions to the partners' capital accounts.

Predistribution Plan

At the start of a liquidation, accountants produce a single predistribution plan to serve as a guide for all future payments. Whenever cash becomes available, the plan indicates the appropriate recipient(s) without drawing up ever-changing proposed schedules of liquidation. The plan is developed by simulating a series of losses, each of which is just large enough to eliminate, one at a time, all of the partners' claims to partnership property.

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.

Termination and Liquidation

The liquidation of a partnership generally involves three important steps: 1. Non-cash partnership assets are sold for cash, and gains and loss on the sales are allocated to the capital accounts of individual partners on the basis of the profit and loss ratios. 2. Partnership liabilities and expenses incurred during the liquidation are paid out of the partnership's available cash. 3. Any partnership cash remaining after paying liabilities and liquidation expenses is distributed to the individual partners on the basis of their representative capital balances. The accountant summarizes and keeps track of the process in a statement of partnership liquidation. The liquidation of a partnership becomes complicated if: one or more partners have a negative (deficit) capital balance and the liquidation takes place over an extended period of time. The accountant can facilitate distribution of cash in installments by calculating the safe payments. The accountant might prepare a cash predistribution plan.

Cash and Capital Account Balances (Termination and Liquidation Example)

This schedule is used to determine the partners' ending capital account balances and, thus, the appropriate distribution of the cash balance. (pg.470) After liquidating the partnership assets and paying off all obligations, the $63,000 cash that remains can be divided between Morgan and Houseman personally. The following schedule is utilized to determine the partners' ending capital account balances and, thus, the appropriate distribution of the cash balance. After the ending capital balances have been calculated, the remaining cash can be distributed to the partners to close out the financial records of the partnership. D: Morgan, Capital 35,000 D: Houseman, Capital 28,000 C: Cash 63,000 To record distribution of cash to partners in accordance with final capital balances. (Once the remaining cash is distributed, the partnership is considered terminated.)

Deficit Capital Balance

Deficit balances can be resolved two ways: 1) Deficit partner can make a contribution to cover deficit 2)Remaining partners can absorb the deficit. (Deficit partner may pay later or can be sued for the amount.) Holland, Dozier, and Ross balances just prior to liquidation D: Cash $20,000 C: Holland,Capital $(6,000) C: Dozier, Capital 15,000 C: Ross, Capital 11,000 C: Total $20,000

Predistribution Plan Example

Assume the following partnership is to be liquidated. Assume the income sharing percentage is Rubens 50%, Smith 20%, and Trice 30%. (pg.482). Partnership capital reported totals $121,000. Differing losses would reduce each partner's current capital balance to zero. As a prerequisite to developing a predistribution plan, the sensitivity to losses exhibited by each of these capital accounts must be measured. However, the individual balances for the partners range from $30,000 to $51,000 and profits and losses are assigned according to three different percentages. First, determine the maximum loss that each partner can absorb. Divide each partner's capital balance by their respective income sharing percent. (pg. 482). According to the initial computation, Rubens is the partner in the most vulnerable position at the present time. Based on the 50% share of income, a loss of only $60,000 would reduce this partner's capital account to a zero balance. If the partnership does incur a loss of this amount, Rubens can no longer hope to recover any funds from the liquidation process. Since Rubens can ONLY absorb a partnership loss of $60,000, new balances are computed assuming that the partnership has a $60,000 loss. With Rubens wiped out, continue calculating maximum absorbable losses using income sharing percentages of Smith, 20% (2/5) and Trice 30% (3/5). (pg. 483) According to the schedule, a total loss of $115,000 ($60,000 from Step 1 plus $55,000 from Step 2) leaves capital of only $6,000, a balance attributed entirely to Smith. (pg. 483). At this final point in the simulation, an additional loss of this amount also ends Smith's right to receive any funds from the liquidation process. Having the sole positive capital balance remaining, this partner would have to absorb the entire amount of the final loss. 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. Liquidation expenses have been estimated. (pg. 484). To complete this illustration, liquidation expense of $12,000 have been estimated. Because these expenses have the same effect on the capital accounts as losses, they do not change the sequential pattern by which assets eventually will be distributed.

Schedule of Liquidation- Interim Cash Distributions

Prior to making interim cash distributions 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. (pg.476)

Statement of Liquidation

A report can be prepared to disclose the progress of the liquidation to various interested parties. Will disclose: transactions to date, liabilities remaining to be paid, property still being held by the partnership, current cash and capital balances. 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.

Termination and Liquidation Example

Morgan and Houseman allocate all profits and losses on a 6:4 basis. The partnership has $75,000 of noncash assets to be liquidated as seen on the 2015 Balance Sheet. To illustrate the typical process, assume that Morgan and Houseman have been operating an art gallery as a partnership for a number of years. Morgan and Houseman allocate all profits and losses on a 6:4 basis, respectively. On May 1, 2015, the partners decide to terminate business activities, liquidate all noncash assets, and dissolve their partnership. Although they give no specific explanation for this action, any number of reasons could exist. The partners, for example, could have come to a disagreement so that they no longer believe they can work together. Another possibility is that business profits have become inadequate to warrant the continuing investment of their time and capital. The partnership has $75,000 of noncash assets to be liquidated. The revenue, expense, and drawing accounts have been closed as a preliminary step in terminating the business. A separate reporting of the gains and losses that occur during the final winding-down process will subsequently be made. (pg. 469)

Preliminary Distribution of Assets

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 personal creditors, debts owed to the other partners.

Deficit Capital Balance- Contribution by Deficit Partner

Hollan legally is required to convey an additional $6,000 to the partnership to eliminate the deficit balance. This contribution raises the cash balance to $26,000, which allows a complete distribution to be made to Dozier ($15,000) and Ross ($11,000) in line with their capital accounts. D: Cash 6,000 C: Holland, Capital 6,000 To record contribution made by Holland to extinguish negative capital balance. D: Dozier, Capital 15,000 D: Ross, Capital 11,000 C: Cash 26,000 To record distribution of remaining cash to partners in accordance with their ending characteristics.