Chapter 15_Partnerships: Termination and Liquidation

Insolvent Partnership

*Can occur if losses, partner drawings, or litigation depletes the operation's working capital *A bankruptcy petition could follow if the partnership cannot meet its debts as they come due

How is a negative capital balance generally incurred?

incurred in disposing of assets

Why are liquidation gains and losses usually recorded as direct adjustments to the partners' capital accounts?

-During liquidation, monitoring partner capital account balance is most important. -It indicates cash received or owed by partners -So, recording gains and losses directly enhances the informational value of the accounts -*Net income is less important since operations have ceased

The Uniform Partnership Act explains what to do with:

-remaining deficit capital balances -what order to settle claims during liquidation (1st- claims of partnership creditors)

How is a proposed schedule of liquidation developed?

Developed based upon simulating the accounting recognition that would be required by a possible series of transactions: assets are sold, expenses are paid, etc. a) These events are simulated with the anticipation of maximum losses in each case ["conservative presumption"] b) Noncash assets are assumed to have no resale value; maximum possible liquidation expenses are included; all partners are considered personally insolvent; etc.

How are safe capital balances calculated? (Simple answer)

by projecting maximum losses

Any deficit that is not recovered from the deficit partner must be charged to the remaining partners based on their relative...

profit and loss ratio

According to the Uniform Partnership Act, what events SHOULD occur if a partner incurs a negative capital balance during the liquidation process?

The partner with a deficit contributes enough assets to offset the deficit balance *Should they fail to pay, the remaining partners must absorb the deficit for now based on P/L ratio *Usually due to the disposal of non-cash assets resulting in material losses

T/F: Even a financially sound partnership can become insolvent if it incurs material losses during a voluntary liquidation.

True

*Unless it's been agreed otherwise, the final allocation of business assets will be distributed to the partners according to the...

final capital account balances

Liquidation Made in Installments

*Drawn out, piecemeal fashion with cash flowing into the company on occasion because in practice, complete losses are not likely to occur

Safe Capital Balances

the amounts that could be immediately paid to each partner without jeopardizing future payments a) The ending potential capital balances that remain on a proposed schedule of liquidation b) Indicates that the partner will still have a sufficient interest in the partnership to absorb all potential losses even after a preliminary distribution

A Proposed Schedule of Liquidation is developed based on...

the underlying assumption that all future events will result in total losses **Because all potential losses have been recognized at this point, the remaining $XX,XXX capital is a safe balance that should be paid to Dixon

Whose assets can a creditor go after in a partnership (even if the creditor is only directly linked to Partner C)?

all or ANY one of the partners (if one in particular is better off)

Predistribution Plan: Schedules (of Maximum Losses) a.k.a. "Steps [of Maximum Losses]"

*As a prerequisite to developing a predistribution plan, the SENSITIVITY to losses exhibited by each of these capital accounts must be measured: Partner: Capital Balance / Loss Allocation = Maximum Loss That Can Be Absorbed *Loss Allocation= P/L Ratio, then alt. P/L ratio with fractions

How is a predistribution plan created for a partnership liquidation?

*Assume a series of losses 1. Information for the plan is generated by assuming the occurrence of a series of losses, each just large enough to eliminate one partner's claim to any partnership property 2. Once a series of losses has been simulated that would eliminate the capital balances of all partners, the actual plan is developed by measuring the effects that occur if the losses do not materialize 3. By working backwards through this series of possible losses, a predistribution plan can be produced that serves as a guide for all payments made during the liquidation

Other than a direct capital contribution, how else could a partner provide cash to the business and better guarentee being paid back?

*Consider it a loan, i.e. Rizzoli, Loan $25,000 *Now the partner is also considered a creditor, and therefore applies to the Uniform Partnership Act's proclamation that creditor are first to be paid **To follow common practice, this TB accounts for a loan from a partner in liquidation as if the balance were a component of the partner's capital

T/F: The balance in each partner's capital account measures that partner's interest in the market value of the Business Net Assets

*False, the capital accounts are based on book value [historical costs]

*According to the Uniform Partnership Act, in a liquidation, partnership assets should be used to first settle whose claims? [*Previously Misunderstood Problem*]

partnership creditors, including those partners who are also creditors What They Should Do: *first repay claims of partners who are creditors [Rizzoli loaning $ to the partnership] before distributing any cash to said partners based on their capital balances What They Actually Do: in practice, the loan is merged with partner's capital account to minimize the chance of a negative balance occurring ^May result in less money, but the partners are better protected. (Could be grounds for a lawsuit- they aren't getting their due money up front)

What is the purpose of a statement of liquidation? What information does it convey to its readers?

*Periodically summarizes transactions as they occur during the Liquidation progress -Provides the financial data for the liquidation as it has progressed to date -A Stmt. of Liquidation should be produced periodically by the accountant to disclose: A) Transactions to date B) Assets still held by the partnership C) Liabilities remaining to be paid D) Current capital balances *USING the stair-step approach (the various schedules) *A new layer summarizing recent events can simply be added at the bottom each time a new statement is to be produced [Look at the dates- months to years apart]

The Liquidation Process: [Also, Sections of the Stmt. of Partnership Liquidation]

A) Disposal of noncash assets B) Payment of liabilities C) Payment of liquidation expenses D) Distribution of any remaining cash to the partners based on their final capital balances

Negative of proposed schedule of liquidation: a newly revised schedule must be prepared each time a distribution of cash to partners is contemplated What is the solution?

Solution: produce a single predistribution plan at the start of liquidation to provide guidance for all payments made to the partners throughout this process ^Thereafter, whenever cash becomes available, this plan indicates the appropriate recipeint(s) without necessity of drawing up everchainging Proposed Schedules of Liquidation *Positive- by receiving frequent statements of liquidation, both the creditors and the partners are able to stay apprised of the results of this lengthy process

What is the objective in making any type of preliminary distribution?

To ensure that the partnership maintains enough capital to absorb all future losses

Under what circumstance would Partner A (30%), who currently has a deficit balance of $ 5,500, still be expected to compensate the partnership when writing off a different Partner B's (40%) deficit balance of $3,700? There is a Partner C (30%) that is fully solvent.

*If Partner A is personally solvent and Partner B's personal financial condition does not allow for any further contribution DR A, Capital (3/6 of loss) ... 1,850 DR C, Capital (3/6 of loss) ... 1,850 CR B, Capital .................................. 3,700 *To record write-off of deficit capital balance of insolvent partner [B] *When Partner A eventually contributes enough assets to eliminate the negative capital balance it will be for both his own personal deficit DR Cash .............. 7,350 CR A, Capital .... 7,350 *To record contribution from solvent partner necessitated by negative capital balance *To be summarized in the Statement of Partnership Liquidation

Why are losses often expected? To the point of needing to project maximum losses?

*The need for immediate sale usually holds a high priority in a liquidation *A portion of the assets, i.e. building or equipment, may have value that is strictly limited to a particular type of operation *Assets may not be easily adaptable "Conservative Presumption"- to ensure equitable treatment of all parties, safe cash distributions will assume that deficits will prove to be a total loss (Applies other projected maximum losses)

Safe Cash

*When the partnership terminates activity, or during the course of the liquidation, more cash may be available than the amount needed to extinguish all potential liabilities and liquidation expenses

Predistribution Plan

*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 *recognizes that the individual capital accounts exhibit differing degrees of sensitivity to losses [i.e. Schedule 1] *Creating the plan will require working backward through the preceding final schedule to determine the effects that will result if the assumed losses do not occur

Why would the members of a partnership elect to terminate business operations and liquidate all noncash assets?

-Withdrawal of a partner -Retirement of a partner -Death of a partner -Bankruptcy of either an individual partner or the partnership as a whole -Partners find that they are incompatible and wish to go their separate ways

If a partner incurs a negative capital balance during the liquidation process and is expected to contribute enough assets to offset this deficit balance, however, it'll be 2-3 months from now. What happens in the meantime for the other two partners?

1. Safe payments of cash to individual partners are determined based on safe capital balances, the amounts that will remain in the individual capital accounts even if all deficits and other assets prove to be complete losses that must be absorbed by the remaining partners. 2. If a portion (or all) of a deficit is subsequently recovered from a partner, a further distribution to the other partners is made based on newly computed safe capital balances. 3. Any deficit that is not recovered from a partner must be charged to the remaining partners based on their relative profit and loss ratio *Any capital that remains can be distributed accordingly

The Important Role of the Accountant

A. Provides timely financial information B. Works to ensure an equitable settlement of all claims (for all parties) C. Protect the interests of partnership creditors due to Uniform Partnership Act- partnership creditors have first priority to the assets held by the business at dissolution

What is the purpose of a proposed schedule of liquidation? And what is it based on?

Determines the equitable distribution of [safe] cash amounts that become available *Based on presumed losses to produce safe capital balances

What is the difference between the dissolution of a partnership and the liquidation of partnership property?

Dissolution of a Partnership: *change in partnership composition a) Cessation of partnership: (usually to transfer property to new partnership) b) A partner may withdraw, retire, die c) To make way for a new partner d) *Operations generally continue without being disturbed Liquidation of a Partnership: a) Cease operations (actual business activities) b) Property is sold, cash is distributed to creditors and partners