Liquidation of a partnership means winding up the business usually by selling the assets, paying the liabilities, and distributing the rem aining cash to the partners. A business which in the process of converting its assets into cash and making settlement with creditors is said to be in liquidation. A term which is always used by a business that is in the process of liquidation is realization, which means the sale of assets.

In this page, emphasis will be placed on the accountin g problems and procedures involved in the winding up (liquidation) of the partnerships affairs - from the dissolution to the effective termination of partnership operations. When the business is to be liquidated, the accounts must be adjusted and closed, and the resulting income or loss in the final period is transferred to the capital accounts of the partners.

In the process of partnership liquidation, it often become necessary to examine each partner's personal assets and liabilities in conjunction with his capital account. A partner may have a deficiency in his personal assets, in his partnership capital account, or in both.



LUMP-SUM LIQUIDATION

Realization of Assets. Typically a partnership will experience losses on the sale of its assets. A partnership may have a "Going Out of Business" sale in which its inventory is marked down well below normal selling price to incourage immediate sale. The partnership fixed assets may also be offered at a reduced price. The accounts receivable are usually collected by the partnership. Sometimes the partnership offers a large cash discount for the prompt payment of any remaining receivables whose collection may otherwise delay the termination of the partnership. Alternatively, the receivables may be sold to a factor. A factor is a business that specializes in aquiring account receivables and immediately paying cash to the seller of the receivables. The partnership records the sale of the receivables, as it would any other asset.

Before any distribution may be made to the partners, either liabilities to outside creditors must be paid in full or the necessary funds may be placed in an escrow account. The escrow agent, usually a bank, uses the funds only for payment of the partnrship liabilities.

Expenses of Liquidation. During the liquidation process, expenses are usually incurred, such as legal and acounting expenses and advertising cost of selling the assets. These expenses are allocated to the partners' capital accounts in their profit and loss ratio.

Liquidation Procedure. The following procedure may be used in lump-sum liquidation.

  1. Realization of assets and distribution of gain or loss on realization among the partners based on the profit and loss ratio.
  2. Payment of expenses.
  3. Payment of liabilities.
  4. Elimination of partner's capital deficiencies. If after the distribution of loss on realization a partner incurs a capital deficiency (i.e., partner's share of realization loss exceeds his capital credit), this deficiency must be eliminated by using one of the following methods in order of priority.
    1. If the deficient partner has a loan balance, exerise the right of offset.
    2. If the deficient partner is solvent, make him invest cash to eliminate his deficiency.
    3. If the deficient partner is insolvent, let the other partners absorb the deficiency
  5. Payment to partners (in order of priority):
    1. Loan accounts
    2. Capital accounts
INSTALLMENT LIQUIDATION

An existing partnership may admit a new partner with the consent of all the partners. When a new partner is admitted, the partnership is dissolved and a new partnership is formed. Upon the admission of a new partner, a new agreement covering partners' interests, profit and loss sharing and other consideration should be drawn because the dissolution of the original partnership cancels the old agreement.

Frequently, aprtnership assets are not realized through an instantaneous sale but in a piecemeal fashion. In other words, the liquidation of some business may extend over several months. When this happens the partners may prefer to receive the amounts due to them in a series of installments rather than wait until all assets have been converted to cash. Installment payments to partners are proper provided that measures are taken to insure that all creditors are paid in full and that there is no overdistribution to one or more of the partners.

Installment liquidation involves the selling of some assets, paying the liabilities of the partnership, dividing the available cash to the partners, selling additional assets and making further payments to partners. This process continues until all the assets have been sold and all cash has been distributed to the creditors and to the partners.

Procedures for Liquidation by Installment. The following are the accounting procedures that may be followed in liquidating a partnership by installments.

  1. Record the realization of assets and distribute the realized gains or losses among the partners using the profit and loss ratio.
  2. Pay liquidation expenses and unrecorded liabilities, if there are any, and distribute these among the partners using the profit and loss ratio.
  3. Pay the liabilities to outsiders.
  4. Distribute cash to the partners after possible future losses have been apportioned to partners or in accordance with an advance distribution plan.
Note: Eliminate any capital deficiency only before final payments to partners.


PERIODIC COMPUTATION OF SAFE PAYMENTS TO PARTNERS

An existing partnership may admit a new partner with the consent of all the partners. When a new partner is admitted, the partnership is dissolved and a new partnership is formed. Upon the admission of a new partner, a new agreement covering partners' interests, profit and loss sharing and other consideration should be drawn because the dissolution of the original partnership cancels the old agreement.

In installment, cash distributions to the partners are authorized even before all the losses that may be incurred and charged against the aprtners are known. Considerable care is therefore, required to insure an equitable distribution of cash to the partners.

The Statement of Partnership Liquidation is usually supported by a schedule of safe installment payments to partners, simply called Schedule of Safe Payments, prepared periodically. According to the schedule, each installment of cash is ditributed as if no more cash is forthcoming, either from sale of assets or from collection of deficiencies from partners. Cash is, therefore, distributed to a partner only if he has an excess credit balance in his partnership interest (i.e., capital account or capital and loan accounts combined) after absorption of his share of the maximum possible loss that may occur. The possible loss (hypothetical loss) consists of the following:

  1. Total value of remaining non-cash assets. These assets are assumed unrealizable, i.e., they cannot be sold, hence, they are considered loss chargeable to the partners.
  2. Cash withheld to pay for anticipated liquidation expenses and unrecorded liabilities that may arise. The said expenses and liabilities represent possible loss to the partners because upon their payment, the amont paid is to be correspondingly absorbed by the partners.

Additional loss may also accrue to the partners when a debit balance in any of the capital accounts results from the foregoing allocations of possible loss. The deficiency of any of the partners is absorbed by the other partners as additional possible loss to them because he is presumed unable to pay anything to the firm.

Payment to partners based on periodic computation of safe payments bring, at some point of liquidation, the partnrs' capital to the profit and loss ratio. The absence of any partner's deficiency after distribution of the possible loss signifies that the ratio of the capital balances are in the profit and loss ratio. Preparation of schedules of safe payments in subsequent periods are no longer necessary because all subsequent payments can be made based solely on the profit and loss ratio. Each partner's capital is adequate to absorb his share of the maximum remaining possible loss.

CASH WITHHELD

An existing partnership may admit a new partner with the consent of all the partners. When a new partner is admitted, the partnership is dissolved and a new partnership is formed. Upon the admission of a new partner, a new agreement covering partners' interests, profit and loss sharing and other consideration should be drawn because the dissolution of the original partnership cancels the old agreement.

The cash set aside in a separate fund is not a factor in computing possible loss. It is the cash set aside to insure payments of potential liquidation expenses which may be incurred, and unrecorded liabilities which may be discovered. This cash withheld is added to the total value of the remaining non-cash assets to obtain the maximum posibble loss needed in the computation of safe installment payments. Also, cash available for distribution to the partners for the period is net with the cash withheld.

Unrecorded liabilities are obligations which are discovered or incurred during the liquidation. These are allocable to the partners according to their profit and loss sharing agreement.


References:
Guerrero, Pedro and Peralta, Jose.   Advanced Accounting Volume 1, Sixth Edition (1998).

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