Liquidation of partnerships.
We know that when a partner dies or leaves the firm, the partnership changes. Since it is no longer the same group of people, the partnership officially dissolves. This doesn't nmean that the business ends. The remaining partners may choose to continue the business as a "new" partnership. However, the death of a partner or other economic factors can serve as the trigger to liquidate the assets of the partnership and end the business.
Distribution of Assets or Debits
The partnership agreement should include details of how the firm will be liquidated. Often the firm is liquidated all at once and the assets are sold in one transaction for cash, with any gain or loss on the sale distributed among the partners in their profit and loss sharing ratio. The cash thus realized is used first to pay all debts to outside creditors and then to pay any loans from partners. Any remaining cash is then distributed to the partners according to their ending capital balances.
Occasionally the sale of the assets results in a loss so great that one of the partner's capital balance is insufficient to absorb his or her share of the loss. In that case, the partner must contribute enough cash to the partnership to eliminate any debit balance in his or her capital account. If the partner with the debit balance is personally insolvent, that balance must be distributed to the remaining partners in the remaining profit and loss ratio. (While those remaining partners now have a personal claim against the insolvent partner, they may experience some difficulty collecting on that claim!)
The journal entries necessary to record all of this activity are summarized in a statement of liquidation, which can be illustrated with the following example. Larry, Curly and Moe decide to liquidate their business on October 31, 1993. They have $6,000 cash, noncash assets of $446,000 and liabilities of $80,000. The partners' capital accounts have balances of $72,000, $180,000 and $120,000, respectively. The partners shared profits and losses in a 5:3:2 ratio and each is personally solvent.
The statement of liquidation is shown below, with the following activities identified by letter. The noncash assets are sold for $248,000 and the loss distributed to the partners (a). The liabilities are paid (b) and Larry contributes sufficient cash to cover his debit capital balance (c). The remaining cash is distributed to Curly and Moe (d).
If the loss on the asset sale is such that the entire partnership itself becomes insolvent and one or more of the partners are personally insolvent, the technique of marshalling of assets is used. This technique protects the interests of the personal creditors of the partners while identifying personal assets that partnership creditors may claim. Only those personal assets which exceed personal debts are available for contribution toward the liabilities of the partnership.
Making a Safe Payment
In the cases we've discussed so far, all assets are sold at one time. In some cases, a business can be liquidated over a protracted period of time. If the partners are unwilling to wait until the final sale to collect any proceeds from the firm, a safe payment can be calculated that will provide some cash to the partners while safeguarding sufficient funds for liabilities.
The safe payment is calculated with the following steps:
1. Assume that all noncash assets are worthless and distribute this hypothetical loss to the partners in the profit and loss sharing ratio.
2. Reserve enough cash to pay outside creditors and any anticipated liquidation expenses and distribute this hypothetical loss in a similar manner.
3. Distribute any partner's debit credit balance to the remaining partners in their remaining profit and loss ratio.
4. Any cash remaining may safely be distributed to the partners with credit capital balances up to the amount of that balance.
Suppose that Larry, Curly and Moe had decided to end their business at year end but wanted to withdraw as much cash as possible on October 31. Using the steps outlined above, there would be no safe payment, since all cash on hand must be reserved for the outside creditors.
It should now be obvious that the personal financial health of partners can significantly affect the final distribution of assets from a partnership that is closing its doors. The accountant may need access, therefore, not only to partnership records but to personal financial statements from each partner as well. Finally, consideration of each partner's need for or access to cash will affect whether immediate or protracted liquidation is a better choice. October Quiz
As you reflect on the details of this material, try your hand at the following example of a partnership liquidation.
Greenspan, Volker and Friedman are partners in a catalog shopping business who have decided to liquidate the business because of the uncertain economy. The partners share profits and losses in a 2:2:1 ratio and have capital balances of $360,000, $150,000 and $90,000, respectively. The business has cash assets of $240,000, noncash assets of $540,000 and liabilities of $180,000 as of September 30, 1993. Volker is personally insolvent.
The company will be officially liquidated on October 31, 1993, but the partners want to receive as much cash as possible by October 1. Compute the "safe payment" that can be made on October 1 and prepare the journal entry to record whatever payment is made.
On October 31, the noncash assets are sold for $100,000, with the loss distributed to the partners. All liabilities are paid. Prepare a statement of liquidation showing the final distribution to the partners and, from that, the appropriate journal entries to record the activities of the liquidation.
Answers will appear in next month's column.