DISSOLUTION WITH LIQUIDATION A partnership is liquidated when its business operations are completely terminated or ended. The partnership assets are sold, the partnership creditors are paid, and the remaining assets, if any, are distributed to the partners as return of their investments. Partnership dissolution with liquidation may be caused by any of the following factors: 1. The accomplishment of the purpose for which the partnership was organized. 2. The termination of the term/period covered by the partnership contract. 3. The bankruptcy of the firm. 4. The mutual agreement among the partners to close the business. Accounting problems involved in the liquidation of a partnership include: 1. Determination of the profit or loss from the beginning of the accounting period to the date of liquidation and the distribution of such profit or loss. 2. Closing of the partnership books; 3. Correction of accounting errors in prior periods like overstatement or understatement of inventories, excessive depreciation charges, and failure to provide adequately for doubtful accounts; and 4. Liquidation of the business. At the point of partnership liquidation, the assets and liabilities of the partnership are directly intertwined with those of the individual partners' personal assets and liabilities because of the unlimited liability of each partner. The priorities for creditors' claims against the assets available to pay the partnership liabilities involve two concepts: the marshaling of assets and the right of offset. Marshaling of assets involves the order of creditors' rights against the partnership's assets and the personal assets of the individual partners. The order in which claims against the partnership's assets will be marshaled is as follows: 1. Partnership creditors other than partners . 2. Partners' claims other than capital and profits, such as loans payable and accrued interest payable. 3. Partners' claim to capital or profits, to the extent of credit balances in capital accounts. The order of claims against the personal assets of the individual partners is as follows: 1. Personal creditors of individual partners. 2. Partnership creditors on unpaid partnership liabilities regardless of a partner's capital balance in the partnership. Right of offset involves offsetting a deficit in a partner's capital (debit balance in the capital account of a partner) against the loan payable to that partner. The loan payable to a partner has a higher priority in liquidation than a partner's capital balance but a lower priority than liabilities to outside creditors. DEFINITION OF TERMS Dissolution - the termination of a partnership as a going concern; it is the termination of the life of partnership. Winding up - the process of settling the business or partnership affairs; it is synonymous to liquidation. Termination - the point in time when all partnership affairs are ended. Liquidation - the interval of time between dissolution and termination of partnership affairs; it is also the process of winding up a business which normally consists of conversion of assets into cash, payment of liabilities and distribution of remaining cash among the partners.
Page 2 Realization - the process of converting non-cash assets into cash. Gain on realization - the excess of the selling price over the cost or book value of the assets disposed or sold through realization. Loss on realization - the excess of the cost or book value over the selling price of the assets disposed or sold through realization. Capital deficiency - the excess of a partner's share on losses over his capital. Deficient partner - a partner with a debit balance in his capital account after receiving his share on the loss on realization. Right of offset - the legal right to apply part or all of the amount owing to a partner on a loan balance against deficiency in his capital account resulting from losses in the process of liquidation. Partner's interest - the sum of a partner's capital, loan balance and advances to the partnership.
TYPES OF LIQUIDATION 1. Lump-sum liquidation or liquidation by totals. This is a type of liquidation whereby the distribution of cash to the partners is done only after all the non-cash assets have been realized, the total amount of gain or loss on realization is known, and all liabilities have been paid. 2. Liquidation by installment or piece-meal liquidation. This is a type of liquidation whereby assets are realized on a piecemeal basis and cash is distributed to partners on a periodic basis as it becomes available, that is even before all non-assets are converted into cash. PROCEDURES IN LUMP-SUM LIQUIDATION When a partnership is to be liquidated, the books should be adjusted and balances of nominal accounts are closed. The resulting net income or loss for the period is transferred to the partners' capital account. Advances and withdrawals are closed to capital accounts since cash settlement shall be based on the partners' capital account balances. The partnership is then ready to proceed with liquidation as follows: 1. Sale of non-cash assets and distribution or allocation of gain or loss on realization among the partners according to their residual profit and loss ratios (salary and interest factors disregarded) unless liquidation ratios are specified in the partnership agreement. 2. Distribution of cash to the creditors and partners. In this procedure, the provisions of the marshaling of assets and the exercise of the right of offset are applied. Liquidation expenses may be incurred to facilitate the immediate realization of non-cash assets. Payment of liquidation expenses reduces cash and is recorded as a deduction from partners' capital based on the partners' profit and loss ratios. When realization of assets in the course of liquidation results in a loss, the loss is carried to the capital accounts of the partners as a deduction. If the partner's capital account results in a debit balance, called capital deficiency, after the distribution of loss on realization, such can be offset against any loan balance of the partner to the partnership. The amount offset shall be the amount of the loan or the amount of the deficiency , whichever is lower.
Page 3 Cash can be distributed to partners before or after the elimination of the deficiency. If cash is distributed after the elimination of the deficiency, 1. Capital deficiency is eliminated by a. Making additional cash investment, if the deficient partner is solvent. b. Charging the deficiency as additional loss to the remaining partners, if the deficient partner is insolvent. 2. Cash available for distribution is then paid to partners to apply first on loan then on capital. Note that the final distribution of cash to partners is made based on partners' capital balances and not on any ratio. If cash is distributed to partners before eliminating the deficiency: 1. Cash available for distribution is paid to partners based on an accompanying schedule to determine amounts to be paid to partners. 2. Deficient partners may (a) If solvent, make additional cash investment; to be paid to partners as second cash distribution, or the deficient partner may make direct cash settlement to the other partners. (b) If insolvent, the deficiency shall be absorbed by the other partners as additional loss according to their profit and loss ratio. The personal status of partners (that is, personal assets and personal liabilities) is sometimes provided in the problem to indicate that a partner is solvent or insolvent. When personal assets exceed personal liabilities, the partner is solvent to the extent of the excess. When personal assets are less than personal liabilities, the partner is insolvent. STATEMENT OF LIQUIDATION The statement of liquidation is a statement prepared to summarize the liquidation process. It is the basis of the journal entries made to record liquidation. This statement presents in working paper form the effect of the liquidation on the statement of financial position. It shows the conversion of assets into cash, the allocation of gain or loss on realization, and the distribution of cash to creditors and partners. Illustrative Problem A: Henson, Domingo and Diaz Statement of Financial Position December 1, 2015 Assets Cash Other Assets
P
8,000 136,000
144,000
Case
Liabities and Equity Liabilities P 44,800 Domingo, Loan 2,000 Diaz, Loan 3,200 Henson, Capital 38,000 Domingo, Capital 24,000 Diaz, Capital 32,000 Total Liab & Equity P 144,000
(1) The other assets were sold for P140,000. (2) The other assets were sold for P100,000. (3) The other assets were sold for P74,000.
Instructions: 1. Prepare a statement of liquidation for each of the cases. For each case, prepare a schedule of cash distribution. 2. Present journal entries to record the liquidation process. Points of emphasis in the preparation of the statement of liquidation 1. Make sure that the balances before liquidation show equlaity of debits and credits. This will always be true after each liquidation transaction. 2. Maintain two columns only for the debits. These are cash and other assets regardless of whether the assets were given itemized like cash, receivables, inventory, supplies, equipment, etc. Non-pcash assets are classified as "other assets." 3. Gain on realization increases capital while loss on relaization decreases capital. 4. Figures in parenthesis for each liquidation transaction represent reduction in the account. 5. Double rule when all columns are brought to zero balance.
Case 1 - The other assets were sold for P140,000. (Gain on realization, no capital deficiency)
Cash Profit & Loss ratio Balances before liquidation Sales of assets and distribution of gain Balances Payment of liabilities Balances Payment to partners
8,000
Other Assets
136,000
140,000 (136,000) 148,000 0 (44,800) 103,200 (103,200)
0 0
Henson, Domingo and Diaz Statement of Liquidation December 1 - 31, 2015 (all in Pesos P) Loan Liabilities Domingo Diaz
44,800
2,000
44,800
2,000
(44,800) 0 0
2,000 (2,000)
Capital Henson Domingo 2(40%) 2(40%)
Diaz 1(20%)
3,200
38,000
24,000
32,000
3,200
1,600 39,600
1,600 25,600
800 32,800
3,200 39,600 25,600 32,800 (3,200) (39,600) (25,600) (32,800)
The other assets with a book value of P136,000 were sold for P140,000 resulting in a P4,000 gain on realization distributed among the partners in their 2:2:1 ratio. The entries to record the liquidation process are: (a) Realization of assets and distribution of gain on realization, 2:2:1 Cash
140,000 Other Assets Henson, Capital (4,000 x 2/5) Domingo, Capital (4,000 x 2/5)
136,000 1,600 1,600
Diaz, Capital (4,000 x 1/5)
800
(b) Payment of liabilities Liabilities
44,800 Cash
(c ) Payment to partners Domingo, Loan Diaz, Loan Henson, Capital Domingo, Capital Diaz, Capital Cash
44,800
2,000 3,200 39,600 25,600 32,800 103,200
Case 2 - The other assets were sold for P100,000. (Loss on realization, no capital deficiency)
Cash
Henson, Domingo and Diaz Statement of Liquidation December 1 - 31, 2015 (all in Pesos P) Loan Liabilities Domingo Diaz
Other Assets
Profit & Loss ratio Balances before liquidation Sales of assets and distribution of loss Balances
8,000
136,000
100,000 108,000
(136,000) 0
44,800
2,000
Payment of liabilities Balances Payment to partners
(44,800) 63,200 (63,200)
0 0
(44,800) 0 0
2,000 (2,000)
44,800
2,000
3,200
3,200
Capital Henson Domingo Diaz 2(40%) 2(40%) 1(20%) 38,000
24,000
32,000
(14,400) (14,400) 23,600 9,600
(7,200) 24,800
3,200 23,600 (3,200) (23,600)
9,600 24,800 (9,600) (24,800)
The other assets with a book value of P136,000 were sold for P100,000 resulting in a loss on realization of P 36,000 that can be fully absorbed by the capital balances of all the partners. The entries to record the liquidation process are: (a) Realization of assets and distribution of loss on realization, 2:2:1 Cash Henson, Capital (36,000,000 x 2/5) Domingo, Capital (36,000 x 2/5) Diaz, Capital (36,000 x 1/5)
100,000 14,400 14,400 7,200
Other Assets
136,000
(b) Payment of liabilities Liabilities
44,800 Cash
(c ) Payment to partners Domingo, Loan Diaz, Loan Henson, Capital Domingo, Capital Diaz, Capital Cash
44,800
2,000 3,200 23,600 9,600 24,800 63,200
Case 3 - The other assets were sold for P74,000. (Loss on realization, capital deficiency, right of offset)
Cash Profit & Loss ratio Balances before liquidation Sales of assets and distribution of loss Balances Payment of liabilities Balances Offset of loan against the debit balance in the capital of Domingo Balances Payment to partners
Henson, Domingo and Diaz Statement of Liquidation December 1 - 31, 2015 (all in Pesos P) Loan Liabilities Domingo Diaz
Other Assets
8,000
136,000
74,000 82,000
(136,000) 0
44,800
2,000
3,200
0
(44,800) 0
2,000
3,200
0 0
(800) 1,200 (2,000)
(44,800) 37,200
37,200 (37,200)
0 0
44,800
2,000
3,200
Capital Henson Domingo Diaz 2(40%) 2(40%) 1(20%) 38,000
24,000
32,000
(24,800) (24,800) (12,400) 13,200 (800) 19,600
13,200
3,200 13,200 (3,200) (13,200)
(800)
19,600
(800) 19,600 800 (19,600)
The other assets with a book value of P136,000 were sold for P74,000 resulting in a loss on realization of P 62,000. The distribution of the loss on realization resulted in a debit balance in the capital of Domingo. The right of offset can be exercised in as much as Domingo has a loan to the partnership. The entries to record the liquidation process are: (a) Realization of assets and distribution of loss on realization, 2:2:1
Cash Henson, Capital (62,000,000 x 2/5) Domingo, Capital (62,000 x 2/5) Diaz, Capital (62,000 x 1/5) Other Assets
74,000 24,800 24,800 12,400 136,000
(b) Payment of liabilities Liabilities
44,800 Cash
44,800
(c ) Offset of Loan against deficiency Domingo, Loan Domingo, Capital (d) Payment to partners Domingo, Loan Diaz, Loan Henson, Capital Diaz, Capital Cash
800 800
1,200 3,200 13,200 19,600 37,200
