Solution manual advanced accounting 9e by hoyle ch15

The liquidation process usually involves the disposal of noncash assets, payment of liabilities and liquidation expenses, and distribution of any remaining cash to the partners based on

CHAPTER 15 PARTNERSHIPS: TERMINATION AND LIQUIDATION

A The accountant provides timely financial information

B The accountant works to ensure an equitable settlement of all claims

III The schedule of liquidation

A The liquidation process usually involves the disposal of noncash assets, payment of liabilities and liquidation expenses, and distribution of any remaining cash to the partners based on their final capital balances

B A schedule of liquidation should be produced periodically by the accountant to disclose losses and gains that have been incurred, remaining assets and liabilities, and current capital balances

IV Deficit capital balances

A By the end of the liquidation process, one or more partners may have a negative (or deficit) capital balance often as a result of losses incurred in disposing of assets

B Legally, any deficit should be eliminated by having that partner contribute enough additional assets to offset the negative balance

C If this contribution is not immediately received, the remaining partners may request a preliminary distribution of any partnership cash that is available

1 This payment is based on safe capital balances, the amounts that will remain in the

V Marshaling of assets

A To provide an equitable system for distributing assets during liquidation, the Uniform Partnership Act states that claims against an insolvent partner shall be ranked as follows:

1 Claims by separate creditors

2 Claims by partnership creditors

3 Claims by partners

B This priority listing is referred to as the marshaling of assets doctrine

C The Uniform Partnership Act also provides that an individual partner's own creditors may seek recovery of losses directly from the partnership

1 Payment of all partnership debts must be assured before any distribution to an individual partners' creditors

2 Payment of personal debts cannot exceed the capital balance of the specific partner

Vl Preliminary distribution of assets to the partners

A The liquidation process can extend over a lengthy period of time as business activities wind down and property is sold

B More cash may be generated than the amount needed to extinguish all potential liabilities and liquidation expenses

C If possible, the distribution of excess cash amounts should be made as quickly as possible to enable the partners to make use of their funds

1 The accountant may choose to produce a proposed schedule of liquidation at such times to determine the equitable distribution of cash amounts that become available

2 The proposed schedule of liquidation is developed based upon simulating the accounting recognition that would be required by a possible series of transactions: assets are sold, expenses are paid, etc

a These events are simulated with the anticipation of maximum losses in each case

b Noncash assets are assumed to have no resale value; maximum possible liquidation expenses are included; all partners are considered personally insolvent; etc

3 Ending potential capital balances that remain on a proposed schedule of liquidation are safe capital balances, the amounts that could be immediately paid to each partner without jeopardizing future payments Safe capital balances indicate that the partner will still have a sufficient interest in the partnership to absorb all potential losses even after a preliminary distribution

C Information for the predistribution plan is generated by assuming the occurrence of a series of losses, each just large enough to eliminate one partner's claim to any partnership property

D Once a series of losses has been simulated that would eliminate the capital balances of all partners, the actual plan is developed by measuring the effects that occur if the losses

do not materialize

E By working backwards through this series of possible losses, a predistribution plan can

be produced that will direct all payments made within the liquidation

2 Produce journal entries to record the transactions incurred in the liquidation of a partnership

3 Prepare a schedule of liquidation

4 Determine the appropriate distribution of any cash that remains at the end of a liquidation when one or more of the partners has a deficit capital balance

5 Explain the meaning of the term "safe capital balance."

6 Discuss “marshaling of assets” and explain how this doctrine is applied in distributing the assets of an insolvent partnership

7 Prepare a proposed schedule of liquidation to determine an equitable preliminary distribution

of available partnership assets

8 Develop a predistribution plan and explain the advantages of such a plan over a proposed schedule of liquidation

Answer to Discussion Question

What Happens if a Partner Becomes Insolvent?

This case demonstrates one of the nightmares of a partnership: the apparent insolvency of a partner is threatening the future of a successful business The problem is especially acute to Wilkinson and Walker since this partnership was created solely for convenience; the partners share the facilities but do not actually work together Therefore, the presence of Rogers is not essential to the other partners except that he pays a portion of the business's expenses However, the claim that has been filed could lead to the actual liquidation of the entire business Obviously, the partners should take no immediate action until they have spoken with Rogers The entire issue may prove to be a mistake Conversely, numerous other claims against Rogers may also be outstanding with the initial claim simply being the first to be filed Because of the various possibilities, Wilkinson and Walker should consult with a lawyer to learn of the partnership laws that apply in their state They should also begin considering possible alternatives to salvage their business if Rogers is indeed insolvent

One course of action is for Wilkinson and Walker to buy out the partnership interest of Rogers

In that way, Rogers would receive his money and the remaining partnership could be left intact However, they would have to prove—for legal reasons—that a fair price was being paid They would also be forced to come up with a significant amount of cash in a short period of time Finally, Wilkinson and Walker would have a building that was apparently larger than their needs Unless they could utilize the space in some manner, they might have no way of recouping their additional investment

As a second possibility, a new dentist could be brought in to acquire Rogers’ interest in the partnership Again, the money is conveyed to Rogers but now the original partners are not forced to make the payment The building would continue to be fully utilized so that the partners' expenses would not escalate In this case, though, a new partner may have to be identified in a short period of time Furthermore, since the partners are sharing space, Wilkinson and Walker will probably want to ensure that the new partner is someone with whom they can work comfortably Because of time considerations, they may not have the opportunity of getting the new partner they would like

Finally, the partnership can be liquidated Wilkinson and Walker could then take their share of the proceeds and buy a new building for the continuation of their practices Unfortunately, in liquidation, assets do not always bring fair market value Thus, the partners may be forced to absorb significant losses as a result of Rogers' insolvency In addition, the moving of any business can disrupt service and have a possible adverse impact on profitability

Although Wilkinson and Walker have several possible actions that can be taken, none of these

is without problems Therefore, partners should always include agreements within their Articles

of Partnership to specify actions that will be taken in such cases The insolvency of a partner is not a particularly unusual event Hence, the partners (or their lawyers and accountants) should have the forethought to arrange the resolution of the business if insolvency of a partner does occur

Answers to Questions

1 A dissolution refers to the cessation of a partnership In many cases, this process is simply a preliminary step in the transfer of business property to a newly formed partnership Therefore, a dissolution does not necessarily affect the operations of the business In a liquidation, however, actual business activities must cease Partnership property is sold with the remaining cash distributed to creditors and to any partners with positive capital balances Dissolution refers to changes in the composition of a partnership whereas liquidation is the selling of a partnership's assets

2 Many reasons can exist that would lead to the termination and liquidation of a partnership The business might simply have failed to generate sufficient profits or the partners may elect

to enter other lines of work Liquidation can also be required by the death, retirement, or withdrawal of one of the partners In such cases, liquidation is often necessary to settle the partner's interest in the business The bankruptcy of an individual partner can also force the termination of the business as can the bankruptcy of the partnership itself

3 During the liquidation process, monitoring the balance of the partners' capital accounts becomes of paramount importance That amount will eventually indicate either the cash to

be received by the partners as final distributions or the additional contributions that they are required to pay Consequently, all liquidation gains and losses are recorded directly as changes to these capital balances Such recording enhances the informational value of the accounts As an additional factor, the computation of a net income figure is of diminished importance since normal operations have ceased

4 Final distributions made to the various partners are based solely on their ending capital account balances unless the partners have agreed otherwise If any partner has a deficit balance, an additional contribution should be made to offset the negative amount In some situations, a question may arise as to whether compensation for a deficit will ever be forthcoming from the responsible party The remaining partners may choose to allocate the available cash immediately based on the assumption that the deficit balance eventually will prove to be a total loss

5 A schedule of liquidation provides financial data about the liquidation process as it has progressed to date Information to be presented includes the balances of all remaining assets, the liability total, and the capital account of each partner In addition, the allocation of all gains and losses incurred in the liquidation process as well as the payment of expenses should be evident

7 A safe capital balance is the amount of a partner's capital account that exceeds all possible needs of a partnership as it goes through liquidation A partner should, therefore, be able to receive this balance immediately without endangering the future amount to be received by any other party connected with the liquidation Safe capital balances are computed by projecting a series of assumptions whereby the partnership undergoes maximum losses during the remainder of the liquidation process All noncash assets are assumed to have no resale value, liquidation expenses are set at the largest possible estimation, and all partners are viewed as personally insolvent Any capital balance that would remain after this series of anticipated events can be distributed to the partners immediately without incurring any risk

8 The marshaling of assets doctrine is a provision within the Uniform Partnership Act that indicates the priority of claims when a partner becomes personally insolvent By providing a ranking of these claims, an orderly and fair distribution of available property can be made The marshaling of assets provision states:

Where a partner has become bankrupt or his estate is insolvent, the claims against his separate property shall rank in the following order:

(I) Those owing to separate creditors,

(II) Those owing to partnership creditors,

(III) Those owing to partners by way of contributions

9 A partner's personal creditors do have a limited claim against partnership assets Recovery

is possible but only if payment of all partnership debts is assured and the insolvent partner has a positive capital balance

10 For distribution purposes, the Uniform Partnership Act states that loans from partners rank ahead of the partners’ capital balances Thus, the handling of loans in a liquidation would seem to be obvious: When money becomes available for the partners, all loans from partners should be repaid before any amount is given to a partner because of a safe capital balance

A problem arises, though, in the above solution if a partner (especially if the partner is currently insolvent) has made a loan to a partnership but has a potentially negative capital balance The final capital balance may require a contribution to the partnership that the partner may be unable or unwilling to make If the Uniform Partnership Act is followed precisely, a partner could collect money on a loan while still having an obligation to the partnership because of a negative capital balance

To avoid this problem, in practice a partner’s loan balance is usually merged with that partner’s capital balance to minimize the chance of a negative capital balance occurring This particular partner may get less money from the liquidation because of this treatment but the other partners are better protected

11 A proposed schedule of liquidation is used by the accountant to determine the allocation of any cash balances generated during the early stages of liquidation Often, sufficient cash will

be collected to pay all liabilities as well as potential liquidation expenses Additional cash should then be distributed to the partners to allow them immediate use of their funds A proposed schedule of liquidation can be produced to determine the allocation of this available cash The statement is based on anticipating a series of assumed losses from the current day forward: all remaining noncash assets are scrapped, maximum liquidation expenses are incurred, and each partner is personally insolvent The ending balances that would result from these simulated transactions represent safe capital balances This amount

of cash can be distributed presently and the partners will still retain enough capital to absorb all future losses

12 A predistribution plan is produced based on an assumed series of losses Each loss is calculated to eliminate in turn the capital balance of one of the partners In this manner, the accountant can determine the vulnerability to losses exhibited by each capital account When the last balance is eliminated, the accountant will have established a series of losses that exactly offsets each balance The predistribution plan is then developed by measuring the effects that are created if the losses do not occur In effect, the accountant works backwards through the assumed losses to create a pattern of available cash, the predistribution plan

on a 4:3:3 basis (8,800) (6,600) (6,600) Adjusted balances $ 9,200 $18,400 $19,400 Anticipated liquidation expenses ($12,000)

split on a 4:3:3 basis (4,800) (3,600) (3,600) Anticipated maximum loss on inventory

($31,000) split on a 4:3:3 basis (12,400) (9,300) (9,300) Potential balances $(8,000) $ 5,500 $ 6,500 Potential loss from Art deficit (split 3:3) 8,000 (4,000) (4,000) Current cash distribution $ -0- $ 1,500 $ 2,500

9 D Since the partnership currently has total capital of $400,000, the $30,000

that is available would indicate maximum potential losses of $370,000

Potential loss from C's deficit (split 2:3) (2,000) (3,000) 5,000

10 C A predistribution plan should be created

Maximum Losses That Can Be Absorbed

The assumption is made that a $130,000 loss occurs

Kevin Michael Brendan Jonathan

Reported balances $59,000 $39,000 $34,000 $34,000 Assumed loss ($130,000) split on

a 4:3:1:2 basis (52,000) (39,000) (13,000) (26,000) Adjusted balances $ 7,000 $ -0- $21,000 $ 8,000

Maximum Losses That Can Now Be Absorbed

Kevin Brendan Jonathan

Reported balances $7,000 $21,000 $8,000 Assumed loss ($12,250) split on a

4:1:2 basis (7,000) (1,750) (3,500)

Maximum Losses That Can Now Be Absorbed

11 C To work this problem, a predistribution schedule is necessary That

schedule, which is computed below, is as follows:

 First $3,000 goes to Menton

 Next $15,000 goes to Menton (2/3) and Hoehn (1/3)

 Next $42,000 goes to Carney (4/7), Menton (2/7), and Hoehn (1/7)

 All remaining cash goes to Carney (4/10), Pierce (3/10), Menton (2/10), and Hoehn (1/10)

Carney Pierce Menton Hoehn

Assumed loss of $90,000 (see

Assumed loss of $42,000 (see

Schedule 2) (allocated on

Assumed loss of $15,000 (see

Schedule 3

Maximum Loss Capital Balance/ That Can Partner Loss Allocation Be Absorbed

12 C The $16,000 available cash can be distributed but should be done under the

assumption that all deficit balances will be total losses After offsetting Jones' loan, the two deficits total $4,000 Fuller and Rogers, the two partners with positive capital balances, share profits in a 30:20 relationship (the equivalent of a 60%:40% ratio) Fuller would absorb $2,400 of the potential loss with Rogers being allocated $1,600 The remaining capital balances ($10,600 and $5,400) are safe capital balances and those amounts can be immediately distributed

13 (8 Minutes) (Payment of safe capital balances)

$6,800 to Cleveland and $1,200 to Pierce

Since the partnership currently has total capital of $350,000, the $8,000 that is available would indicate maximum potential losses of $342,000

Nixon Cleveland Pierce

Reported balances $170,000 $110,000 $70,000 Anticipated loss ($342,000) split

on a 5:3:2 basis (171,000) (102,600) (68,400) Potential balances $ (1,000) $ 7,400 $ 1,600 Potential loss from Nixon's deficit (split 3:2) 1,000 (600) (400) Current cash distribution $ -0- $6,800 $ 1,200

14 (20 Minutes) (Final settlement of a partnership being liquidated)

Part a Brown gets $21,000, Fish gets $12,000, and Stone gets $2,000

Brown Fish Stone

Reported balances $25,000 $15,000 $5,000 Loss on sale of land ($10,000) split

on a 4:3:3 basis (4,000) (3,000) (3,000) Cash distribution $21,000 $12,000 $2,000 Part b Brown gets $16,429 and Fish gets $8,571

Brown Fish Stone

Reported balances $25,000 $15,000 $5,000 Loss on sale of land ($20,000) split on

a 4:3:3 basis (8,000) (6,000) (6,000) Adjusted balances $17,000 $ 9,000 $(1,000) Potential loss from Stone's deficit (split 4:3) (571) (429) 1,000 Cash distribution $16,429 $ 8,571 $ -0- Part c Brown gets $10,714 and Fish gets $4,286

Reported balances $25,000 $15,000 $5,000 Loss on sale of land ($30,000) split on

a 4:3:3 basis (12,000) (9,000) (9,000) Adjusted balances $13,000 $ 6,000 $(4,000) Potential loss from Stone's deficit (split 4:3) (2,286) (1,714) 4,000 Cash distribution $10,714 $ 4,286 $ -0-

15 (10 Minutes) (Distribution made of contribution made by partner with deficit balance)

The entire $20,000 goes to Atkinson

Atkinson Kaporale Dennsmore Rasputin

Capital contribution -0- -0- -0- 20,000

Potential loss from Dennsmore

and Rasputin ($60,000) split

16 (8 Minutes) (Determine safe capital balances)

Ball gets $143, Eaton gets $1,429, and Lake gets $3,428

Reported balances $25,000 $28,000 $20,000 $22,000 Maximum losses on land and building

($85,000) split on a 3:3:2:2 basis (25,500) (25,500) (17,000) (17,000) Estimated liquidation expenses

($5,000) split 3:3:2:2 (1,500) (1,500) (1,000) (1,000) Potential balances $(2,000) $ 1,000 $ 2,000 $ 4,000 Potential loss from Ace ($2,000) split

on a 3:2:2 basis 2,000 (857) (571) (572) Cash distributions $ 0 $ 143 $ 1,429 $ 3,428

17 (15 Minutes) (Prepare a proposed schedule of liquidation)

HARDWICK, SAUNDERS, AND FERRIS Proposed Schedule of Liquidation

18 (7 Minutes) (Amount of cash needed to assure payments to all partners)

Watson is the partner most vulnerable to a loss A loss of only $50,000 would completely eliminate Watson's capital balance:

Miller $50,000/60% = $ 83,333 loss to eliminate capital

Tyson $50,000/20% = $250,000 loss to eliminate capital

Watson $10,000/20% = $ 50,000 loss to eliminate capital

Thus, if the loss on disposal is less than $50,000, all partners will retain positive capital balances and receive some cash in liquidation Because of this, since "other assets" are $140,000, they must be sold for any amount over

$90,000 for all partners to get cash

19 (5 Minutes) (Determine safe capital balances)

Maximum potential losses are $128,000, $8,000 in liquidation expenses and a complete $120,000 loss on the noncash assets Such a loss would reduce the capital balances to: Babb $8,800, Whitaker ($5,600), and Edwards ($1,200) Babb must retain sufficient capital ($6,800) to be able to absorb the possible losses of Whitaker and Edwards The remaining $2,000 is a safe capital balance for Babb

20 (10 Minutes) (Determine amount to be contributed by partner with a deficit balance)

White and Blue are both insolvent and have negative capital balances (after offsetting the loan from White) totaling $15,000 Absorption by the other partners of these losses would be as follows (on a 30:10:20 basis):

Partner Share of Loss New Capital Balance

21 (50 Minutes) (Compute effects of a liquidation under a variety of

circumstances)

a Dobbs receives the entire $10,000

Maximum potential losses of $250,000 on noncash assets would be allocated

b Adams receives the entire $10,000

Maximum potential losses of $250,000 on noncash assets would be allocated

21 c (continued)

Maximum potential loss of $130,000 on the land would be allocated as follows:

Partner Share of Loss New Capital Balance

These amounts represent safe capital balances for distribution purposes

d The land and building must be sold for over $115,000 to ensure that Carvil will receive some cash

Assumed loss of $100,000 (see

Assumed loss of $35,000 (see

Schedule 2) (allocated on a

Assumed loss of $90,000 (see

Schedule 3) (allocated on a

Step Three balances $ 35,000 $ -0- $ -0- $ -0-

21 d (continued)

PREDISTRIBUTION PLAN

The first $35,000 available goes to Adams Next $90,000 is split between Adams and Dobbs on a 1:2 basis Next $35,000 is split between Adams, Carvil, and Dobbs on a 1:4:2 basis All remaining cash is split between Adams, Baker, Carvil, and Dobbs on the original profit and loss ratio

Total cash of $125,000 ($35,000 + $90,000) has to be available before Carvil will receive any cash Since the partnership already has $10,000 cash in excess of its liabilities, the land and building must be sold for over $115,000 to ensure Carvil of receiving some amount

As another approach to the problem, Carvil's capital balance is eliminated through the $100,000 Step One loss and the $35,000 Step Two loss Thus, avoiding a complete $135,000 loss ensures that Carvil will receive cash Since the land and buildings have a book value of $250,000, such losses would be avoided by receiving over $115,000

Schedule 1

Maximum Loss Capital Balance/ That Can

Schedule 3

22 (30 Minutes) (Prepare a predistributlon plan)

An assumed series of losses is simulated which eliminates each partner's capital account in turn:

Larson Norris Spencer Harrison

Assumed loss of $75,000 (see

Schedule 1) (allocated on a

Assumed loss of $50,000 (see

Schedule 2) (allocated on a

Assumed loss of $31,250 (see

 Next $35,000 available goes to Spencer

 Next $31,250 is split between Norris and Spencer on a 3:2 basis

 Next $50,000 is split among Norris, Spencer, and Harrison on a 3:2:3 basis

 All remaining cash is split among Larson, Norris, Spencer, and Harrison on the original profit and loss ratio

Schedule 1

Maximum Loss Capital Balance/ That Can

23 (20 Minutes) (Prepare and use a predistribution plan)

Part a

Maximum Losses That Can Be Absorbed

*Able's balance includes capital and the loan to the partnership

The assumption is made that a $100,000 loss occurs

Able Moon Yerkl

 The next $10,000 goes entirely to Able (to pay off loan)

 The next $50,000 is split between Able and Moon based on a 2:3 basis,

Able The remaining $4,000 is divided between Able ($1,600 or 40%) and Moon ($2,400 or 60%)

24 (25 Minutes) (Produce a predistribution plan for a partnership liquidation)

Maximum Losses That Can Be Absorbed

The assumption is made that a $90,000 loss occurs

Assumed loss ($90,000) split

Maximum Losses That Can Now Be Absorbed

The assumption is made that an $8,000 loss occurs

Assumed loss ($8,000) split on a 4:2:2 basis (4,000) (2,000) (2,000)

Maximum Losses That Can Now Be Absorbed

 The next $8,000 is split among Hart (4/8), Bobb (2/8), and Reidl (2/8)

 All remaining cash is split among the partners according to their original profit and loss ratio

25 (30 Minutes) (Determine the ramifications of a variety of liquidation situations) Part A

(a) $48,000 Maximum losses of $100,000 on the noncash assets would increase Milburn's deficit balance by $40,000 (or 40%) Maximum losses would not create any other deficit balances

(b) All $19,000 should go to Thomas As Ross and Thomas view the current situation, maximum potential losses total $108,000: $100,000 on the noncash assets and $8,000 on Milburn's deficit balance In determining safe capital balances, these assumed losses would be allocated on a 4:2 basis

or $72,000 to Ross and $36,000 to Thomas Since such a loss would entirely eliminate Ross' capital account, only Thomas has a safe capital balance at the current time

(c) The minimum cash payment to Thomas would be $35,667 ($19,000 +

$16,667) As shown in (b) above, the available $19,000 is distributed to Thomas, thus reducing that partner's capital balance to $39,000 A loss of

$59,000 on the noncash assets would further reduce this partner's balance

by $11,800 ($59,000 x 20%) to $27,200 That same loss would reduce Ross' capital to $45,400 and Milburn's deficit to ($31,600) The minimum cash amount would be caused by Milburn's failure to contribute this $31,600 so that it has to be absorbed by Ross (4/6 or $21,067) and Thomas (2/6 or

$10,533) The remaining safe capital balance of $16,667 would be paid to Thomas

Part B

(a) Carton will have to contribute $7,429 The $29,000 in deficits will have to be absorbed by Sampson and Carton on a 4:3 basis Thus, Carton will be allocated $12,429 of this amount which creates a deficit of $7,429

(b) Klingon will have to contribute $19,667 [$17,000 + (20/90 x $12,000)] that will

be distributed as follows: