CHAPTER
22
PARTNERSHIPS:
LIQUIDATIONS
FOCUS OF CHAPTER 22
• Fundamental Procedures in
Liquidation
• Lump-Sum Liquidations
• Installment Liquidations
Sharing of Gains & Losses
During Liquidation
• Gains and losses incurred on the
realization of noncash assets during
liquidation are:
– Allocated among the partners in the
profit-and-loss sharing ratio (such as
4:3:1).
– UNLESS agreed to otherwise by the
partners.
Consequences of A Partner
Being Personally Insolvent
• A partner having a capital account deficit
may be able to eliminate the deficit by:
– Capital contribution.
– Setoff.
• A deficit that cannot be eliminated, is
allocated to:
– The remaining partners who have
POSITIVE capital balances (using their
P/L sharing ratio).
Consequences of A Partner
Being Personally Insolvent
• A partner that winds up absorbing some
or all of another partner’s capital deficit
has:
– Legal recourse against that partner.
– Because that partner has broken the
terms of the partnership agreement.
Sharing Profits and Losses:
In The Ratio of Capital Balances
• Sharing profits and losses in the ratio of capital
balances:
– Is one of the most important safeguards
used in partnership agreements.
– Results in no partner EVER having a capital
account deficit balance until the losses
incurred in liquidation exceed the TOTAL
partnership capital.
• Thus ALL partners go into a deficit
position SIMULTANEOUSLY.
The Rule of Setoff
• A deficit balance in a partner’s capital
account can be eliminated to the extent that
such partner has a loan to the partnership.
Note Payable
to Jones
Balances before setoff....... $30,000
Apply rule of setoff........ (11,000)
Balances after setoff....….. $19,000
Capital,
Jones
$(11,000)
11,000
$ -0-
No More “Marshaling of
Assets”
• In liquidation:
– PARTNERSHIP CREDITORS have first
priority as to PARTNERSHIP ASSETS.
– PERSONAL CREDITORS of an
insolvent partner do NOT have first
priority as to PERSONAL ASSETS of
that partner.
• They share on a pro rata basis with
partnership creditors.
Installment Liquidations:
Priority In Distributing Cash
• No cash distributions are made to partners
until creditors have been paid in full
(100%).
– This holds true for BOTH:
• Lump-sum liquidations.
• Installment liquidations.
Installment Liquidations:
Different Strokes For Different Folks
• The amount to be distributed to each partner
at any point in time can be determined by
preparing either of the following items:
#1 – Schedules of safe payments at each
cash distribution date.
• Will have to be done several times.
#2 – A cash distribution plan at the beginning
of the liquidation process.
• Need be done only once.
Installment Liquidations
• The EFFECT of distributing cash to
partners based on either (a) schedules of
safe payments or (b) cash distribution
plans, is to:
– Bring the capital balances into the
profit-and-loss sharing ratio.
“CONVERGENCE”
Installment Liquidations:
Loss Absorption Potentials
• Conceptually, the first cash distribution to
partners goes to that partner who has:
– THE HIGHEST LOSS ABSORPTION
POTENTIAL.
• This is NOT necessarily the partner
that has the highest capital balance.
Installment Liquidations:
Loss Absorption Potentials—Calculating
• The loss absorption potential of each partner
is calculated by:
– Dividing the partner’s capital balance by his
or her profit-and-loss sharing percentage.
Capital balance of Jones............
Jones’ P/L sharing percentage..
$80,000
20%
= $400,000
Loss
Absorption
Potential
Installment Liquidations:
Loss Absorption Potentials—Implications
• Consequences of Having the Highest
Loss Absorption Potential: He or she
will be:
– The first partner to receive cash.
– The partner that could suffer the
greatest inequity in relation to his or
her capital balance.
It is NOT a good thing to have
the highest loss absorption potential.
Installment Liquidations:
Loss Absorption Potentials—Loans “To”
• In calculating a partner’s loss absorption
potential, a partner’s loan to the partnership is
ADDED TO the partner’s capital balance.
Capital balance, Jones................ $80,000
PLUS
Note payable to Jones...............
10,000
Total.......................................... $90,000
= $450,000
Jones’ P/L sharing percentage...
20%
Loss
Absorption
Potential
Installment Liquidations:
Loss Absorption Potentials—Loans “From”
• In calculating a partner’s loss absorption
potential, a partner’s loan from the partnership
is SUBTRACTED FROM the partner’s capital
balance.
Capital balance, Jones................ $80,000
Note receivable from Jones......
(5,000) MINUS
Total.......................................... $75,000
= $375,000
Jones’ P/L sharing percentage...
20%
Loss
Absorption
Potential
The Statement of Realization
and Liquidation
• The STATEMENT OF REALIZATION AND
LIQUIDATION is
– A historical statement.
– It portrays what actually happened in the
past (during the liquidation process).
– Income statements are not prepared
during this period.
The Schedule of Safe
Payments
• In contrast to the Statement of
Realization and Liquidation, the
SCHEDULE OF SAFE PAYMENTS is
– A pro forma (what if) statement.
– It portrays what could happen in the
future—on a worst-case basis.
Review Question #1
In liquidation, cash distributions to partners
are determined based on:
A. Who has the highest capital balance.
B. How profits and losses are shared.
C. Partners’ loans to the partnership having
priority over partners’ capital balances.
D. The marshalling of assets principle.
E. The rule of setoff.
F. None of the above.
Review Question #1
With Answer
In liquidation, cash distributions to partners
are determined based on:
A. Who has the highest capital balance.
B. How profits and losses are shared.
C. Partners’ loans to the partnership having
priority over partners’ capital balances.
D. The marshalling of assets principle.
E. The rule of setoff.
F. None of the above. (Loss absorption
potential)
Review Question #2
In liquidation, Kelly (who shares in 25% of
profits and losses) was given equipment
having a carrying value of $10,000 and a fair
value of $14,000. Kelly’s capital account is
debited:
A. $10,000
B. $11,000
C. $13,000
D. $14,000
E. $15,000
Review Question #2
With Answer
In liquidation, Kelly (who shares in 25% of
profits and losses) was given equipment
having a carrying value of $10,000 and a fair
value of $14,000. Kelly’s capital account is
debited:
A. $10,000
B. $11,000
C. $13,000 ($14,000 - [$4,000 x 25%])
D. $14,000
E. $15,000
End of Chapter 22
Time to Clear Things Up—Any
Questions?