As the chapter on bankruptcy discussed, accounting for the termination and liquidation of a business can prove to be a delicate task. Losses are commonly incurred. For example,
“[f]ormer partners in Keck, Mahin and Cate have pledged to pay slightly over $3 million to gen- eral unsecured creditors to settle the bankrupt firm’s debts . . . this figure represents about 36 per- cent of the money owed.”6Here, both the partners and the creditors suffered heavy losses.
Other partnerships have experienced a similar fate.
In 1990, prior to the advent of limited-liability partnerships, the accounting firm of Laventhol &
Horwath filed for Chapter 11 bankruptcy-court protection, in part due to lawsuits over question- able accounting. The firm’s assets were insufficient to cover the claims of creditors and litigants.
Under a plan negotiated with the firm’s creditors, the 360 partners and former partners who had spent time at the firm since 1984 were required to dig into their own pockets to share a $46 million liability. Under a formula hammered out by partner Jacob Brandzel, now an executive at American Express Co. in Chicago, they were obligated to contribute between about $5,000 and $450,000, depending on factors including seniority. Managers were levied a 5 percent to 10 percent surcharge on top. Everyone was given 10 years to pay.7
Consequently, throughout any liquidation, both creditors and partners demand continuous accounting information that enables them to monitor and assess their financial risks. In gen- erating these data for a partnership, the accountant must record the following:
• The conversion of partnership assets into cash.
• The allocation of the resulting gains and losses.
• The payment of liabilities and expenses.
• Any remaining unpaid debts to be settled or the distribution of any remaining assets to the partners based on their final capital balances.
Beyond the goal of merely reporting these transactions, the accountant must work to ensure the equitable treatment of all parties involved in the liquidation. The accounting records, for example, are the basis for allocating available assets to creditors and to the individual partners. If assets are limited, the accountant also may have to make recommendations as to the appropriate method for distributing any remaining funds. Protecting the interests of partnership creditors is an especially significant duty because the Uniform Partnership Act specifies that they have first priority to the assets held by the business at dissolution. The accountant’s desire for an
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Partnerships: Termination and Liquidation 637
equitable settlement is enhanced, no doubt, in that any party to a liquidation who is not treated fairly can seek legal recovery from the responsible party.
Not only the creditors but also the partners themselves have a great interest in the financial data produced during the period of liquidation. They must be concerned, as indicated, by the possibility of incurring substantial monetary losses. The potential for loss is especially signif- icant because of the unlimited liability to which the partners are exposed.
Even the new legal formats that have been developed do not necessarily provide safety.
Because it is unclear how much protection the LLP structure will provide Andersen partners, part- nership and bankruptcy lawyers are expected to be following the matter closely. “As far as I know, there has never been a litigation test of the extent of the LLP shield, and there have been very few LLP cases about liability at all,” said Larry Ribstein, a law professor at George Mason University.8 As long as a partnership can meet all of its obligations, a partner’s risk is normally no more than that of a corporate stockholder. However, should the partnership become insolvent, each partner faces the possibility of having to satisfy allremaining obligations personally. Although any partner suffering more than a proportionate share of these losses can seek legal retribution from the other partners, this process is not always an effective remedy. The other partners may themselves be insolvent, or anticipated legal costs might discourage the damaged party from seeking recovery. Therefore, each partner usually has a keen interest in monitoring the progress of a liquidation as it transpires.
Termination and Liquidation Procedures Illustrated
The procedures involved in terminating and liquidating a partnership are basically mechani- cal. 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.
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 prof- its and losses on a 6:4 basis, respectively. On May 1, 2011, 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.
Following is a balance sheet for the partnership of Morgan and Houseman as of the termi- nation date. 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.
MORGAN AND HOUSEMAN Balance Sheet
May 1, 2011
Assets Liabilities and Capital
Cash . . . . $ 45,000 Liabilities . . . . $ 32,000 Accounts receivable . . . . 12,000 Morgan, capital . . . . 50,000 Inventory . . . . 22,000 Houseman, capital . . . . 38,000 Land, building, and
equipment (net) . . . . 41,000
Total assets . . . . $120,000 Total liabilities and capital . . . . $120,000
8Ibid.
LO1
Determine amounts to be paid to partners in a liquidation.
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We assume here that the liquidation of Morgan and Houseman proceeds in an orderly fash- ion through the following events:
2011
June 1 The inventory is sold at auction for $15,000.
July 15 Of the total accounts receivable, the partnership collected $9,000 and wrote off the remainder as bad debts.
Aug. 20 The fixed assets are sold for a total of $29,000.
Aug. 25 All partnership liabilities are paid.
Sept. 10 A total of $3,000 in liquidation expenses is paid to cover costs such as accounting and legal fees as well as the commissions incurred in disposing of partnership property.
Oct. 15 All remaining cash is distributed to the owners based on their final capital account balances.
Accordingly, the partnership of Morgan and Houseman incurred a number of losses in liq- uidating its property. Such losses are almost anticipated because the need for immediate sale usually holds a high priority in a liquidation. Furthermore, a portion of the assets used by any business, such as its equipment and buildings, could have a utility that is strictly limited to a particular type of operation. If the property is not easily adaptable, disposal at any reasonable price often proves to be a problem.
To record the liquidation of Morgan and Houseman, the following journal entries would be made. Rather than report specific income and expense balances, gains and losses are tradi- tionally recorded directly to the partners’ capital accounts. Because operations have ceased, determination of a separate net income figure for this period would provide little informational value. Instead, a primary concern of the parties involved in any liquidation is the continuing changes in each partner’s capital balance.
6/1/11 Cash . . . . 15,000 Morgan, Capital (60% of loss) . . . . 4,200 Houseman, Capital (40% of loss) . . . . 2,800
Inventory . . . . 22,000 To record sale of partnership inventory at a $7,000 loss.
7/15/11 Cash . . . . 9,000 Morgan, Capital . . . . 1,800 Houseman, Capital . . . . 1,200
Accounts Receivable . . . . 12,000 To record collection of accounts receivable with write-off of
remaining $3,000 in accounts as bad debts.
8/20/11 Cash . . . . 29,000 Morgan, Capital . . . . 7,200 Houseman, Capital . . . . 4,800
Land, Building, and Equipment (net) . . . . 41,000 To record sale of fixed assets and allocation of $12,000 loss.
8/25/11 Liabilities . . . . 32,000
Cash . . . . 32,000 To record payment made to settle the liabilities of the
partnership.
9/10/11 Morgan, Capital . . . . 1,800 Houseman, Capital . . . . 1,200
Cash . . . . 3,000 To record payment of liquidation expenses with the amounts
recorded as direct reductions to the partners’ capital accounts.
638 Chapter 15
LO2
Prepare journal entries to record the transactions incurred in the liquidation of a partnership.
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Partnerships: Termination and Liquidation 639
After liquidating the partnership assets and paying off all obligations, the 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 distribu- tion for this final payment:
Cash and Capital Account Balances
Morgan, Houseman,
Cash Capital Capital
Beginning balances* . . . $ 45,000 $50,000 $38,000 Sold inventory . . . 15,000 (4,200) (2,800) Collected accounts receivable . . . 9,000 (1,800) (1,200) Sold fixed assets . . . 29,000 (7,200) (4,800) Paid liabilities . . . (32,000) –0– –0–
Paid liquidation expenses . . . (3,000) (1,800) (1,200) Final totals . . . $ 63,000 $35,000 $28,000
* Because of the presence of other assets as well as liabilities, the beginning balances in Cash and in the capital accounts are not equal.
After the ending capital balances have been calculated, the remaining cash can be distrib- uted to the partners to close out the financial records of the partnership:
10/15/11 Morgan, Capital . . . . 35,000 Houseman, Capital . . . . 28,000
Cash . . . . 63,000 To record distribution of cash to partners in accordance with
final capital balances.
Schedule of Liquidation
Liquidation can take a considerable length of time to complete. Because the various parties involved seek continually updated financial information, the accountant should produce fre- quent reports summarizing the transactions as they occur. Consequently, a statement (often referred to as the schedule of liquidation) can be prepared at periodic intervals to disclose
• Transactions to date.
• Property still being held by the partnership.
• Liabilities remaining to be paid.
• Current cash and capital balances.
Although the preceding Morgan and Houseman example has been condensed into a few events occurring during a relatively brief period of time, partnership liquidations usually re- quire numerous transactions that transpire over months and, perhaps, even years. By receiving frequent schedules of liquidation, both the creditors and the partners are able to stay apprised of the results of this lengthy process.
See Exhibit 15.1 for the final schedule of liquidation for the partnership of Morgan and Houseman. The accountant should have distributed previous statements at each important juncture of this liquidation to meet the informational needs of the parties involved. The example here demonstrates the stair-step approach incorporated in preparing a schedule of liquidation. The effects of each transaction (or group of transactions) are outlined in a horizontal fashion so that current account balances and all prior transactions are evident.
This structuring also facilitates the preparation of future statements: A new layer sum- marizing recent events can simply be added at the bottom each time a new schedule is to be produced.
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Deficit Capital Balance—Contribution by Partner
In Exhibit 15.1, the liquidation process ended with both partners continuing to report pos- itive capital balances. Thus, each partner was able to share in the remaining $63,000 cash.
Unfortunately, such an outcome is not always possible. At the end of a liquidation, one or more partners could have a negative capital account, or the partnership could be unable to generate even enough cash to satisfy all of its creditors’ claims. Such deficits are most likely to occur when the partnership is already insolvent at the start of the liquidation or when the disposal of noncash assets results in material losses. Under these circumstances, the accounting procedures to be applied depend on legal regulations as well as the individ- ual actions of the partners.
To illustrate, assume that the partnership of Holland, Dozier, and Ross was dissolved at the beginning of the current year. Business activities were terminated and all noncash assets were subsequently converted into cash. During the liquidation process, the partnership incurred a number of large losses that have been allocated to the partners’ capital accounts on a 4:4:2 basis, respectively. A portion of the resulting cash is then used to pay all partnership liabilities and liquidation expenses.
Following these transactions, assume that only the following four account balances remain open within the partnership’s records:
Cash . . . $20,000 Holland, Capital . . . $ (6,000) Dozier, Capital . . . 15,000 Ross, Capital . . . 11,000 Total . . . $20,000 Holland has a negative capital balance of $6,000; the assigned share of partnership losses has exceeded this partner’s net contribution. In such cases, the Uniform Partnership Act (Sec- tion 807[b]) stipulates that the partner “shall contribute to the partnership an amount equal to any excess charges over the credits in the partner’s account . . .” Therefore, Holland legally is
640 Chapter 15
EXHIBIT 15.1
MORGAN AND HOUSEMAN Schedule of Partnership Liquidation
Final Balances
Morgan, Houseman,
Noncash Capital Capital
Cash Assets Liabilities (60%) (40%)
Beginning balances, 5/1/11 . . . . $ 45,000 $ 75,000 $ 32,000 $ 50,000 $ 38,000 Sold inventory, 6/1/11 . . . . 15,000 (22,000) –0– (4,200) (2,800)
Updated balances . . . . 60,000 53,000 32,000 45,800 35,200
Collected receivables, 7/15/11 . . . . 9,000 (12,000) –0– (1,800) (1,200)
Updated balances . . . . 69,000 41,000 32,000 44,000 34,000 Sold fixed assets, 8/20/11 . . . . 29,000 (41,000) –0– (7,200) (4,800)
Updated balances . . . . 98,000 –0– 32,000 36,800 29,200
Paid liabilities, 8/25/11 . . . . (32,000) (32,000) –0– –0–
Updated balances . . . . 66,000 –0– –0– 36,800 29,200
Paid liquidation expenses, 9/10/11 . . . . (3,000) (1,800) (1,200)
Updated balances . . . . 63,000 –0– –0– 35,000 28,000
Distributed remaining cash, 10/15/11 . . . . (63,000) (35,000) (28,000)
Closing balances . . . . –0– –0– –0– –0– –0–
LO3
Determine the distribution of available cash when one or more partners have a deficit capital balance or become personally insolvent.
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Partnerships: Termination and Liquidation 641
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. The jour- nal entry for this final payment closes out the partnership records:
Cash . . . . 6,000
Holland, Capital . . . . 6,000 To record contribution made by Holland to extinguish negative capital
balance.
Dozier, Capital . . . . 15,000 Ross, Capital . . . . 11,000
Cash . . . . 26,000 To record distribution of remaining cash to partners in accordance with
their ending capital balances.
Deficit Capital Balance—Loss to Remaining Partners
Unfortunately, an alternative scenario can easily be conceived for the previous partnership liq- uidation. Although Holland’s capital account shows a $6,000 deficit balance, this partner could resist any attempt to force an additional investment, especially because the business is in the process of being terminated. The possibility of such recalcitrance is enhanced if the in- dividual is having personal financial difficulties. Thus, the remaining partners may eventually have to resort to formal litigation to gain Holland’s contribution. Until that legal action is con- cluded, the partnership records remain open although inactive.
Distribution of Safe Payments
While awaiting the final resolution of this matter, no compelling reason exists for the partner- ship to continue holding $20,000 in cash. These funds will eventually be paid to Dozier and Ross regardless of any action that Holland takes. An immediate transfer should be made to these two partners to allow them the use of their money. However, because Dozier has a
$15,000 capital account balance and Ross currently reports $11,000, a complete distribution is not possible. A method must be devised, therefore, to allow for a fair allocation of the avail- able $20,000.
To ensure the equitable treatment of all parties, this initial distribution is based on the as- sumption that the $6,000 capital deficit will prove to be a total loss to the partnership.Holland may, for example, be completely insolvent so that no additional payment will ever be forth- coming. By making this conservative presumption, the accountant is able to calculate the lowest possible amounts (or safe balances) that Dozier and Ross must retain in their capital accounts to be able to absorb all future losses.
Should Holland’s $6,000 deficit (or any portion of it) prove uncollectible, the loss will be written off against the capital accounts of Dozier and Ross. Allocation of this amount is based on the relative profit and loss ratio specified in the articles of partnership. According to the information provided, Dozier and Ross are credited with 40 percent and 20 percent of all part- nership income, respectively. This 40:20 ratio equates to a 2:1 relationship (or 2⁄3:1⁄3) between the two. Thus, if no part of the $6,000 deficit balance is ever recovered from Holland, $4,000 (two-thirds) of the loss will be assigned to Dozier and $2,000 (one-third) to Ross:
Allocation of Potential $6,000 Loss
Dozier . . . .2⁄3of $(6,000) $(4,000) Ross . . . .1⁄3of $(6,000) $(2,000)
These amounts 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
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$4,000 loss, and Ross’s capital account could decrease by as much as $2,000. These balances must therefore remain in the respective capital accounts until the issue is resolved. Hence, Dozier is entitled to receive $11,000 in cash at the present time; this distribution reduces that partner’s 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 $11,000 and $9,000 amounts represent safe payments that can be distributed to the partners without fear of creating new deficits in the future.
Dozier, Capital . . . . 11,000 Ross, Capital . . . . 9,000
Cash . . . . 20,000 To record distribution of cash to Dozier and Ross based on safe capital
balances, using the assumption that Holland will not contribute further to the partnership.
After this $20,000 cash distribution, only a few other events can occur during the remain- ing life of the partnership. Holland, either voluntarily or through legal persuasion, may con- tribute the entire $6,000 needed to eradicate the capital deficit. If so, the money should be immediately turned over to Dozier ($4,000) and Ross ($2,000) based on their remaining cap- ital balances. This final distribution effectively closes the partnership records.
A second possibility is that Dozier and Ross could be unable to recover any part of the deficit from Holland. These two remaining partners must then absorb the $6,000 loss them- selves. Because adequate safe capital balances have been maintained, recording a complete de- fault by Holland serves to close out the partnership books.
Dozier, Capital (2⁄3of loss) . . . . 4,000 Ross, Capital (1⁄3of loss) . . . . 2,000
Holland, Capital . . . . 6,000 To record allocation of deficit capital balance of insolvent partner.
Deficit Is Partly Collectible
One other ending to this partnership liquidation is conceivable. The partnership could recover a portion of the $6,000 from Holland, but the remainder could prove to be uncollectible. This partner could become bankrupt, or the other partners could simply give up trying to collect.
The partners could also negotiate this settlement to avoid protracted legal actions.
To illustrate, assume that Holland manages to contribute $3,600 to the partnership but sub- sequently files for relief under the provisions of the bankruptcy laws. In a later legal arrange- ment, $1,000 additional cash goes to the partnership, but the final $1,400 will never be collected. This series of events creates the following effects within the liquidation process:
1. The $3,600 contribution is distributed to Dozier and Ross based on a new computation of their safe capital balances.
2. The $1,400 default is charged against the two positive capital balances in accordance with the relative profit and loss ratio.
3. The final $1,000 contribution is then paid to Dozier and Ross in amounts equal to their ending capital accounts, a transaction that closes the partnership’s financial records.
The distribution of the first $3,600 depends on a recalculation of the minimum capital balances that Dozier and Ross must maintain to absorb all potential losses. Each of these computations is necessary because of a basic realization: Holland’s remaining deficit bal- ance ($2,400 at this time) could prove to be a total loss. This approach guarantees that the
642 Chapter 15
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