Accounting: The Language of Business (Part 84)

With demands for special education or standardized test prep being shouted in their ears, public schools can't always hear a parent when he says: 'I want my child to be able to write contracts in Spanish,' or, 'I want my child to shake hands firmly,' or, 'I want my child to study statistics and accounting, not calculus.'

Amity Shlaes

Accounting for Partnerships and Limited Liability Corporations (Part E)

by

Charles Lamson

Liquidating Partnerships

When a partnership goes out of business, it usually sells the assets, pays the creditors, and distributes the remaining cash or other assets to the partners. This winding-up process is called the liquidation of the partnership. Although liquidating refers to the payment of liabilities, it often includes the entire winding-up process.

When the partnership goes out of business and the normal operations are discontinued, the accounts should be adjusted and closed. The only accounts remaining open will be the asset, contra asset, liability, and owner's equity accounts.

The sale of the assets is called realization. As cash is realized, it is used to pay the claims of creditors. After all liabilities have been paid, the remaining cash is distributed to the partners based on the balances in their capital accounts.

The liquidating process may extend over a long period of time as individual assets are sold. This delays the distribution of cash to partners but does not affect the amount each partner will receive.

To illustrate, assume that Farley, Greene, and Hall share income and losses in a ratio of 5:3:2 (5/10, 3/10, 2/10). On April 9, after discontinuing business operations of the partnership and closing the accounts, the following trial balance in summary form was prepared:

Based on these facts, we show the accounting for liquidating the partnership by using three different selling prices for the noncash assets. To simplify, we assume that all noncash assets are sold in a single transaction and that all liabilities are paid at one time. In addition, noncash assets and liabilities will be used as account titles in place of the various asset, contra asset, and liability accounts.

Gain on Realization

Between April 10 and April 31 of the current year, Farley, Greene, and Hall sell all noncash assets for $72,000. Thus, a gain of $8,000 ($72,000 - $64,000) is realized. The gain is divided among the capital accounts in the income-sharing ratio of 5:3:2. The liabilities are paid, and the remaining cash is distributed to the partners. The cash is distributed to the partners based on the balances in their capital accounts. A statement of partnership liquidation, which summarizes the liquidation process, is shown in Exhibit 5.

EXHIBIT 5 Gain on Realization

The journal entries to record the steps in the liquidating process are as follows:

Sale of assets:

Division of gain:

Payment of liabilities:

Distribution of cash to partners:

As shown in Exhibit 5, the cash is distributed to the partners based on the balances of their capital accounts. These balances are determined after the gain on realization that has been divided among the partners. The income-sharing ratio should not be used as a basis for distributing the cash to partners.

Loss on Realization

Assume that in the preceding example, Farley, Greene, and Hall disposed of noncash assets for $44,000. A loss of $20,000 ($64,000 - $44,000) is realized. The steps in liquidating the partnership are summarized in Exhibit 6.

EXHIBIT 6 Loss on Realization

The entries to liquidate the partnership are as follows:

Sale of assets:

Division of loss:

Payment of liabilities:

Distribution of cash to partners:

Loss on Realization---Capital Deficiency

In the preceding example, the capital account of each partner was large enough to absorb the partner's share of the loss from realization. The partners received cash to the extent of the remaining balances in their capital accounts. The share of loss on realization may exceed, however, the balance in the partner's capital account. the resulting debit balance in the capital account is called a deficiency. It represents a claim of the partnership against the partner.

To illustrate, assume that Farley, Greene, and Hall sell all of the noncash assets for $10,000. A loss of $54,000 ($64,000 - $10,000) is realized. The share of the loss allocated to Farley, $27,000 (50% of $54,000), exceeds the $22,000 balance in her capital account. The $5,000 deficiency represents an amount that Farley owes the partnership. Assuming that Farley pays the entire deficiency to the partnership, sufficient cash is available to distribute to the remaining partners according to their capital balances. The steps in liquidating the partnership in this case are summarized in Exhibit 7.

EXHIBIT 7 Loss on Realization---Capital Deficiency

The entries to record the liquidation are as follows:

Sale of assets:

Division of loss:

Payment of liabilities:

Receipt of deficiency:

Distribution of cash to Partners:

If cash is not collected from a deficient partner, the partnership cash will not be large enough to pay the other partners in full. Any uncollected deficiency becomes a loss to the partnership and is divided among the remaining partners' capital balances, based on their income-sharing ratio. The cash balance will then equal the sum of the capital account balances. Cash is then distributed to the remaining partners, based on the balances of their capital accounts.

Errors in Liquidation

The most common error that occurs in liquidating a partnership is making an improper distribution of cash to the partners. Such an error occurs because the distribution of cash to partners in liquidation is confused with the division of gains and losses on realization.

Gains and losses on realization result from the disposal of assets to Outsiders. Realized gains and losses should be divided among the partner capital accounts in the same manner as the net income or net loss from normal business operations---using the income sharing ratio. On the other hand, the distribution of cash (or other assets) to the partners in liquidation is not directly related to the income-sharing ratio. The distribution of assets to the partners in liquidation is the exact reverse of the contribution of assets by the partners at the time the partnership was established. The distribution of assets to partners in liquidation is equal to the credit balances in their capital accounts after all gains and losses on realization have been divided and allowances have been made for any partner deficiencies. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 531-536*

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