CHAPTER 16

ANSWERS TO QUESTIONS 1. Realization gains or losses are allocated to partners in their profit and loss ratio because the changes in asset values are the result of risk assumed by the partnership. Also, because it may be difficult to separate gains and losses that result from liquidation from the under- or over-statement in book values that result from accounting policies followed in prior years. 2. The final cash distribution is based on capital balances, not on profit and loss ratios, since the capital balance represents the partners' "residual claims" to the assets remaining after settlement of partnership obligations. 3. Because the UPA order of payment ranks partnership obligations to a partner ahead of asset distributions to a partner for capital investments, a debit balance in a partner's capital account will create problems when that partner has an outstanding loan balance. Other partners will have a claim against this partner for the amount of his/her debit balance which is considered to be an asset of the partnership by the UPA. If the partner with a debit balance settles his/her obligation with the partnership, there is no problem. However, if he/she can't settle, the other partners must absorb the deficit as a loss, even though the partner with the debit balance had received cash for his/her outstanding loan balance. To avoid this inequity, the courts have recognized the right of the partnership to offset the loan balance against the debit capital balance. 4. Maintaining separate accounts for outstanding loan and capital accounts recognizes the legal distinction between the two. This would be important if the liquidation is carried on over an extended period, since the UPA provides that a partner is entitled to accrued interest on the loan balance. 5. When the equity interest of one partner is inadequate to absorb realization losses several alternative outcomes are possible. If the partner is personally solvent, he may pay the partnership for the amount he is liable. If he/she is personally insolvent then the other partners must absorb his/her debit balance in their respective profit and loss ratio. If the other partners are unsure of what the partner with the debit balance will do, but still wish to distribute cash, they can assume the worst (absorbing their share of the debit balance) to determine what amount of cash can be safely distributed. 6. Cash should not be distributed to any partner until all liquidation losses are recognized in the accounts or are provided for in determining a safe cash payment. 7. The classification of assets into personal and partnership categories in recognition of the rights of both partnership creditors and creditors of the individual partners is referred to as "marshalling of assets." 8. To the extent that personal creditors do not recover from personal assets they can seek recovery from those partnerships assets still available after partnership obligations have been met. This recovery, however, is limited to the extent that the partner involved has a credit interest in partnership assets.

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9. Because in an installment liquidation the amount of cash to be received from the unsold assets and the resulting gain or loss is unknown, the partners should view each cash distribution as if it were the final distribution. 10. The three assumptions upon which a safe cash distribution is determined are (1) any loan balances to partners are offset against their capital accounts, (2) the remaining noncash assets will not generate any more cash, and (3) any partner with a deficit capital balance will not settle his/her obligation to the partnership. In other words, assume the worst. The safe cash balance is computed as the difference between the current capital balances and the balance required to maintain the above assumptions. 11. Unexpected costs are added to the book value of noncash assets. When the potential loss on the noncash assets is allocated in the determination of a safe payment, these costs are also included. 12. The objective of the procedure is to bring the balance of the partners' capital accounts into the agreed profit and loss ratio as soon as possible so that no one partner is placed in a better position than any other partner. 13. The "loss absorption potential" is determined by dividing the partners' net capital balances by their respective profit ratio. This determines the maximum amount of loss each partner can absorb. 14. The Uniform Partnership Act provides that the liabilities of the partnership shall rank in order of payment as follows: (1) (2) (3) (4) Those owing to creditors other than partners, Those owing to partners other than for capital and profits, Those owing to partners in respect of capital, Those owing to partners in respect of profits.

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ANSWERS TO EXERCISES 15,000

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Exercise 16-2 Part A Account balances Sale of assets Payment to creditors Cash distribution Cash $70,000 270,000 340,000 (98,000) 242,000 (242,000) $ -0Noncash Assets $260,000 (260,000) 0 _______ 0 _______ $ -0-

Liabilities $(98,000) _______ (98,000) 98,000 _______ $ -0270,000

John $(90,000) (3,000) (93,000) _______ (93,000) 93,000 $ -0-

Capital Balanc Jake $(78,000) (4,000) (82,000) _______ (82,000) 82,000 $ -0-

Part B 1. Cash Other Assets John, Capital Jake, Capital Joe, Capital 2. Liabilities Cash 3. John, Capital Jake, Capital Joe, Capital Cash

260,000 3,000 4,000 3,000 98,000 98,000 93,000 82,000 67,000 242,000

Exercise 16-3 Capital balances Estimated loss on sale of assets ($45,000) Allocate debit balance Estimated cash payment

(1/3) Doug $(55,000) 15,000 (40,000) 11,500 $(28,500)

(1/3) Dave $(50,000) 15,000 (35,000) 11,500 $(23,500)

(1/3) Dan $8,000 15,000 23,000 (23,000) $ -0-

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Exercise 16-4 Capital balances Drawing account Loans Operating loss Liquidation loss Allocate debit balance Cash distribution

(1/5) Amos $(49,000) 10,000 4,200 2,400 (32,400) 733 $(31,667)

(2/5) Boone $(18,000) 15,000 (8,000) 8,400 4,800 2,200 (2,200) $0

(2/5) Childs $(10,000) 20,000 (25,000) 8,400 4,800 (1,800) 1,467 $(333)

The first $40,000 is paid to satisfy the claims of creditors. Exercise 16-5 Cash $10,000 38,000 48,000 (18,000) 30,000 (30,000) $ 0 Noncash Assets $130,000 (43,000) 87,000 87,000 _______ $87,000 Liabilities $(18,000) _______ (18,000) 18,000 0 _______ $ 0

Ca Brink 40% $(45,000) 2,000 (43,000) _______ (43,000) 1,667 $(41,333)

Account balances Sale of inventory, collect accounts receivable - allocate loss Payment to creditors Payment to partners (Schedule 1)

Schedule 1 Capital balances Allocation of potential loss Allocation of deficit Safe Payment Brink $(43,000) 34,800 (8,200) 6,533 $(1,667) Davis $(25,000) 34,800 9,800 (9,800) $ -0Olsen $(49,000) 17,400 (31,600) 3,267 $(28,333)

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Exercise 16-6 Part A Balances Sale of other assets and allocation of loss Allocate Zack's debit balance Investment by Tom Payment to creditors Payment to Pete 45,000 14,286 59,286 (42,000) 17,286 (17,286) $0 0 0 0 (42,000) (42,000) 42,000 0 Cash $15,000 30,000 45,000 Noncash Assets $110,000 (110,000) 0

Liabilities $(42,000) 0 (42,000)

Capital Balan Pete Tom 40% 30% $(55,000) $(14,000 32,000 24,000 (23,000) 10,000 5,714 4,286 (17,286) 14,286 (14,286 (17,286) 0 (17,286) 17,286 $0

$0 $0 Pete receives $17,286. Tom makes an additional investment of $14,286. Zack receives zero and cannot make an investment in the partnership because he is personally insolvent.

$0

Part B Pete Tom Zack

Personal Assets $55,000 30,000 30,000

Personal Liabilities $80,000 10,000 50,000

Excess (Deficiency) $(25,000) 20,000 (20,000)

Distribution from Partnership $17,286 -----

Exercise 16-7 1. 2. 3. 4. 5.

Exercise 16-8 1. c; X = ($690,000 + X); X = $230,000 2. b 3. d 4. c 5. d

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Exercise 16-9 Part A The partnership creditors will receive payment before any distributions are made to the partners. The creditors can seek recovery from Q and S's personal assets after their personal creditors have been paid from their personal assets.

Part B The personal creditors have first claim to the personal assets. If they have not fully recovered the amount owed, they have a right to partnership assets after partnership creditors to the extent the partner has a credit interest in the partnership.

Part C Cash Balances Investment by Q Payment of Liabilities Allocation of T's deficit Investment by S Payment to partners $ 0 2,000 2,000 (2,000) 0 ______ 0 7,000 (7,000) ______ $ 0 $ 0 $ Liabilities $(2,000) _______ (2,000) 2,000 0 ______ 0 Q $(500) (2,000) (2,500) ______ (2,500) 2,000 (500) 500 0

Capital Balanc R $(7,500) $6 ______ ___ (7,500) 6, ______ ___ (7,500) 6, 1,000 1, (6,500) 7, (7, 6,500 ___ $ 0 $

Part D & E R T Personal Assets $8,000 6,000 Partnership Distribution $6,500 --Total $14,500 6,000

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Exercise 16-10 Part A Net capital interest Profit-loss ratio Loss absorption potential Order of cash distribution

Matt $54,000 0.45 $120,000 1

Allen $30,000 0.30 100,000 2

Dave $18,000 0.25 $72,000 3 Loss Absorption Potential Matt Allen Dave 0.45 0.30 0.25 $120,000 $100,000 $72,000 20,000 100,000 28,000 $72,000 ______ 100,000 28,000 $72,000 ______ 72,000 ______ $72,000

Profit-loss ratio Loss absorption potential Net capital interest Distribution to Matt to reduce loss potential to Allen's Balance after distribution Distribution to Matt and Allen to reduce loss potential to Dave's Remainder of assets distributed Cash Distribution Plan Order of Cash Distribution 1. First $18,000 2. Next $9,000 3. Next $21,000 4. Remainder Matt 45 100% 60% 45%

Mat 0.45

$54,0 9,0 45,0 12,6 $32,4 0.45

Liabilities 100%

Allen 30

Dave 25

40% 30%

25%

Part B First $9,000 available to partner Next $21,000 Total Matt, Loan Matt, Capital Allen, Capital Cash

Matt $9,000 12,600 21,600

Allen $8,400 $8,400 10,000 11,600 8,400

Dave _______ $ -0-

30,000

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ANSWERS TO PROBLEMS Problem 16-1 Part A - 1 DISCOUNT PARTNERSHIP Schedule of Partnership Liquidation January 14, 2008

Explanation Balances before realization Sales of noncash assets Balances Payment of liabilities Balances Allocation of Hardin's debit balance Balances Distribution of cash to partners Balances

Cash $25,000 60,000 85,000

Other Assets Liabilities $120,000 $(40,000) (120,000) 0 ______ (40,000)

Capi Dawson $(31,000) 18,000 (13,000)

(40,000) __________ 45,000 0 ______ __________ 45,000 0 (45,000) __________ $ 0 $ 0

40,000 ________ _ 0 (13,000) ______ 0 ______ $ 0 3,857 (9,143) 9,143 $ 0

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Problem 16-1 (continued) Part A - 2 DISCOUNT PARTNERSHIP Schedule of Partnership Liquidation January 14, 2008

Explanation Balances before realization Sales of noncash assets Balances Payment of liabilities Balances Cash investment by Hardin Balances Distribution of cash to partners Balances

Cash Other Assets $25,000 $120,000 60,000 85,000 (40,000) 45,000 9,000 54,000 (54,000) $0 (120,000) 0

Ca Liabilities Dawson $(40,000) $(31,000) 18,000 (13,000)

(40,000) 40,000 0

(13,000)

(13,000) 13,000 $0

$0

$0

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Problem 16-1 (continued) Part A 3 Explanation Balances before realization Sales of noncash assets Balances Payment of liabilities Balances Cash investment by Hardin Balances Allocation of Hardin's deficit Balances Distribution of cash to partners Balances Part B Cash Dawson, Capital Feeney, Capital Hardin, Capital Other Assets Liabilities Cash Cash Hardin, Capital Dawson, Capital Feeney, Capital Cash Problem 16-3

DISCOUNT PARTNERSHIP Schedule of Partnership Liquidation January 14, 2008

Ca Cash Other Assets Liabilities Dawson $25,000 $120,000 $(40,000) $(31,000) 50,000 75,000 (40,000) 35,000 8,000 43,000 43,000 (43,000) $0 60,000 18,000 24,000 18,000 120,000 40,000 40,000 9,000 9,000 13,000 41,000 54,000 Cash $10,000 80,000 90,000 26,000 116,000 (110,000) 6,000 (5,000) 1,000 --16 - 11 Other Assets $218,000 (90,000) 128,000 (30,000) 98,000 --98,000 --98,000 3,000 Liabilities $(110,000) --(110,000) --(110,000) 110,000 0 --0 --Hann 0.50 $(50,000) 5,000 (45,000) 2,000 (43,000) --(43,000) --(43,000) (1,500) (120,000) 0 0 0 0 $0 (40,000) 40,000 0 0 0 $0 21,000 (10,000) (10,000) (10,000) 1,714 (8,286) 8,286 $0

Capita

Beginning Balances 3/15 asset sale 3/16 A/R sale 3/16 pay creditors 3/18 cash distribution (Schedule 1) 3/19 adjustment to fair value

3/19 withdrawal by Murphey 3/21 sale allocate loss 3/25 assign lease 3/25 cash distribution (Schedule 2) 4/1 adjustment to fair value 4/1 withdrawal by Hamm 4/5 sale and allocate loss 4/6 investment by Hamm 4/6 final distribution

1,000 --1,000 30,000 31,000 12,000 43,000 (43,000) 0 --0 --0 4,000 4,000 2,000 6,000 (6,000) $0

101,000 (13,000) 88,000 (50,000) 38,000 --38,000 --38,000 (2,000) 36,000 (8,000) 28,000 (28,000) 0 --0 --$0

0 --0 --0 --0 --0 --0 --0 --0 --0 --$0

(44,500) --(44,500) 10,000 (34,500) (6,000) (40,500) 21,500 (19,000) 1,000 (18,000) 8,000 (10,000) 12,000 2,000 (2,000) 0 --$0

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Problem 16-3 (continued) Schedules to Compute Safe Payments Schedule 1 Capital balances Allocation of potential loss ($99,000) Allocation of deficit balance Safe cash payment Schedule 2 Capital balance Allocation of potential loss ($38,000) Safe cash distribution Problem 16-4 Hann $(40,500) 19,000 $(21,500) Murphey $(19,100) 11,400 $(7,700) Ryan $(21,400) 7,600 $(13,800) Hann 0.50 $(43,000) 49,500 6,500 (6,500) $0 Murphey 0.30 $(37,800) 29,700 (8,100) 3,900 $(4,200) Ryan 0.20 $(23,200) 19,800 (3,400) 2,600 $(800)

MARY, PAULA, AND RAY Schedule of Partnership Liquidation Cash $10,000 20,000 30,000 30,000 20,000 50,000 (50,000) $0 Other Assets $100,000 (100,000) 0 0 0 $0 Liabilities $(40,000) (40,000) (40,000) (40,000) 40,000 $0 Mary 0.40 $(50,000) 32,000 (18,000) 8,000 (10,000) (10,000) 10,000 $0

Part A Balances before realization Sale of assets Allocate Ray's debit balance Investment by Paula Distribution of cash

Mary will receive $10,000. Paula must invest $20,000. Ray is personally insolvent and cannot make an investment in the partnership to eliminate the deficit balance. Problem 16-4 (continued) Part B Payments to Personal Creditors Personal $50,000 10,000 30,000 Partnership Distribution $10,000 0 0 Total $60,000 10,000 30,000

Mary Paula Ray

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Problem 16-6 Part A

MALONE, PATTON, AND SPENCER Statement of Changes in Partners' Capital For the Year Ended December 31, 2008 Malone $ 0 140,000 21,000 161,000 30,000 $131,000 Patton 0 160,000 24,000 184,000 0 $184,000 $ Spencer $ 0 100,000 15,000 115,000 0 $115,000 Total $ 0 400,000 60,000 460,000 30,000 $430,000

Capital balances, 1/1/2008 Add: Investments Net income allocation* Totals Less: Withdrawals Capital balances, 12/31/2008 * Malone Patton Spencer Total

$60,000 ($140,000/$400,000) $60,000 ($160,000/$400,000) $60,000 ($100,000/$400,000)

$21,000 24,000 15,000 $60,000 30,000 30,000 60,000 21,000 24,000 15,000

Part B Malone, Capital Malone, Drawing Income Summary Malone, Capital Patton, Capital Spencer, Capital Problem 16-6 (continued) Part C On next page Part D Cash Malone, Capital Patton, Capital Spencer, Capital Accounts Receivable Inventory Furniture and Fixtures Accounts Payable Cash Patton, Capital Mortgage Payable Land Building Malone, Capital Patton, Capital 16 - 14

243,000 36,400 41,600 26,000 129,000 188,000 30,000 74,000 74,000 120,000 145,000 85,000 180,000 94,600 22,400

Spencer, Capital Cash

89,000 206,000

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Problem 16-6 (continued) Part C MALONE, PATTON, AND SPENCER Schedule of Partnership Liquidation January 2, 2009 Capital Balances Malone Patton Spencer Other Assets Liabilities 35%_ 40%_ 25%_ $612,000 $(219,000) $(131,000) $(184,000) $(115,000) (347,000) 265,000 __________ 265,000 (265,000) 0 __________ $0 ________ (219,000) 74,000 (145,000) 145,000 0 ________ $0 36,400 (94,600) ________ (94,600) ________ (94,600) 94,600 $0 41,600 (142,400) ________ (142,400) 120,000 (22,400) 22,400 $0 26,000 (89,000) ________ (89,000) ________ (89,000) 89,000 $0

Explanation Balances before realization Sales of noncash assets Balances Payment of accounts payable Balances Distribution of land, bldg., and assumption of mortgage Balances Distribution to partners Balances Cash $37,000 243,000 280,000 (74,000) 206,000 ________ 206,000 (206,000) $0

Accounts Receivable Inventory Furniture/Fixtures Total

Sales Price $ 92,000 141,000 10,000 $243,000

Book Value $129,000 188,000 30,000 $347,000

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Problem 16-7 Part A Valuation Adjustment Accumulated Depreciation Office Equipment Allowance for Uncollectibles Jan, Loan Jan, Loan Jan, Capital Jan, Capital Sue, Capital Valuation Adjustment 2,700 12,600 14,200 900 200 6,600 6,600 1,350 1,350 2,700

Part B Jan, Capital ($29,400 + $6,600 - $1,350) Sue, Capital ($28,000 $1,350) Capital Stock (400 $100) Additional Paid-in Capital Proof Cash Accounts receivable Allowance for uncollectibles Prepaid insurance Office equipment Total stockholders' equity

34,650 26,650 40,000 21,300

$15,000 32,400 (2,900) 800 16,000 $61,300

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Problem 16-8 Part A 1. Starnes, Capital Cash Partners 1-9, Capital ($50,000 90/95) Partner 10, Capital ($50,000 5/95) Cash Norwood, Capital ($2,500,000 5%) Partners 1-9, Capital ($25,000 90/95) Partner 10, Capital ($25,000 5/95) 125,000 75,000 47,368 2,632 150,000 125,000 23,684 1,316

2. Because Alan is now a partner in the partnership, it is more difficult to determine the exact amount of his compensation because he will be taxed on his "share of partnership earnings" reported to him on his Schedule K-1 from BSM. While this share of earnings will most likely bear a relationship to the draws taken by Alan, it will undoubtedly be more or less than $216,000 ($18,000 12). Alan must also consider the following additional expenses which correspond to his increased compensation and status as a partner: (a) (b) Increased individual income tax to correspond to his increased earnings. Self-employment tax. As an employee this was withheld from wages at a rate of 7.65% (2002 rate; with a ceilings of $84.900 for 6.2% of the tax). Now that Alan is a partner, he must pay these taxes himself at a rate of 15.3% with the same ceiling, and with an offsetting deduction for 50% of the self-employment tax. This additional tax must be remitted with Alan's individual income tax return. Alan has invested $150,000 in the partnership. If he borrowed the funds to join, he must make interest and principal payments on the debt. The amount of required annual payments depends of course on the interest rate and term of the loan. If he used his own funds (say from a mutual fund earning 10%) for the investment, he has traded the earning power of the funds for earnings from the partnership. He has given up $15,000 in income from the former investment.

(c)

3. Alan should be concerned about the true value of a 5% interest in the partnership since Mr. Starns was paid $75,000 for his 5% interest while within the same time frame, Alan is expected to pay $150,000 for an equivalent interest. There may be mitigating circumstances (e.g. Mr. Starns contributes little to the firm, Alan lacks sufficient ability to bring in new clients), but Alan has a clear signal of a discrepancy which should prompt him to ask questions before investing in the partnership.

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Problem 16-8 (continued) Part B 1. This matter is sometimes addressed in employment contracts. Some professional firms require employees to agree not to actively recruit clients upon their departure from the firm. Barring such a specific agreement or firm precedent (and profession-related guidelines), Alan and Mary must determine the basis on which they can rely to call a BSM client "their client". This may involve such issues as whether Alan or Mary were involved in bringing the client to BSM originally, or it may involve the extent to which the BSM clients were served by the firm as opposed to exclusively by Alan or Mary. Further, if the client's interests are better served by BSM as a larger firm or by Alan and Mary in a smaller firm, that should enter the decision made by the departing employees. 2. It may be difficult to block actions by Alan and Mary if a written agreement is not in existence. Clearly, the BSM partners can enlighten clients to any benefits of remaining a BSM client.

Part C 1. Current Net income Partners 1-9, Capital ($25,000 90%) Partners 10-11, Capital ($25,000 10%) Cash Accounts Receivable Liabilities - Outside Starns, Loan Cash Partners 1-9, Capital ($3,750 90/95) Partner 10, Capital ($3,750 5/95) Starns, Capital ($125,000 - $130,000 + $1,250 = $3,750)

25,000 22,500 2,500 8,000,000 8,000,000 7,490,000 10,000 7,500,000 3,553 197 3,750

Partners 1-9, Capital ($2,395,000 90/95) 2,268,947 Partner 10, Capital ($2,395,000 5/95) 126,053 Cash 2,395,000 ($2,025,000 - $130,000 + $8,000,000 - $7,500,000 = $2,395,000) 2. Yes. The debit balance in the Starns capital account is considered a partnership asset. Judicial precedent exists to allow offset of the liability by the debit capital account balance. The net payment to the partner with the debit capital account leaves both the partnership and partner's obligations fully paid without "endangering" the capital of other partners.

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