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) Those owing to creditors other than partners,(2) Those owing to partners other than for capital and profits,(3) Those owing to partners in respect of capital,(4) Those owing to partners in respect of profits.

Business Ethics SolutionBusiness ethics solutions are merely suggestions of points to address.  The objective is to raise the students' awareness of the topics, and to invite discussion.  In most cases, there is clear room for disagreement or conflicting viewpoints.

1) Partnership laws grant each partner the right to information about the firm’s business. This allows each partner to monitor the firm’s activities. Given the circumstances of the case, it would be your duty to inspect any questionable transaction. Furthermore, you should ask the partner to explain the reason for increasing the cost by $10,000. This would give you the opportunity to raise the concern regarding the presence of the previously undetected rock. If the additional charge is not based on fact, the cost should be removed.

2) In the present scenario, it appears that the partner might be experiencing personal financial pressures. However, the firm’s reputation and future implications of the action must be considered for the benefit of the partnership. Your loyalty to your partner does not alter these responsibilities. You may wish to find other, more constructive ways to offer assistance to your partner in meeting his personal obligations, and surviving what may be a difficult time in his life. However, ignoring the situation is dishonest to the client and is likely to result in more serious long-term consequences.

Reference: http://www.lrc.ky.gov/KRS/362-01/403.PDF

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ANSWERS TO EXERCISES

Exercise 16-1

Part A (30%) (50%) (20%)       Cook           Parks         Argo      

Capital balances $(30,000) $(10,000) $(15,000)Loan balances _______ (10,000) ______Net interest (30,000) (20,000) (15,000)Potential loss - $50,000 15,000 25,000 10,000

(15,000) 5,000 (5,000)Potential loss - $5,000 3,000 (5,000) 2,000 Cash distribution $(12,000) $ - 0 - $(3,000)

Liabilities 25,000Cash 25,000

Cook, Capital 12,000Argo, Capital 3,000

Cash 15,000

Part B Cash 15,000Cook, Capital ($35,000 0.30) 10,500Parks, Capital ($35,000 050) 17,500Argo, Capital ($35,000 0.20) 7,000

Other Assets 50,000

Parks, Loan 10,000Parks, Capital 10,000

Parks, Capital ($10,000 - $17,500 + $10,000) 2,500Cook, Capital 7,500Argo, Capital 5,000

Cash 15,000

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Exercise 16-3 (1/3) (1/3) (1/3)    Doug       Dave         Dan      

Capital balances $(55,000) $(50,000) $8,000Estimated loss on sale of assets ($45,000) 15,000 15,000 15,000

(40,000) (35,000) 23,000Allocate debit balance 11,500 11,500 (23,000)Estimated cash payment $(28,500) $(23,500) $ - 0 -

16 - 4

Exercise 16-4 (1/5) (2/5) (2/5) Amos Boone Childs    

Capital balances $(49,000) $(18,000) $(10,000)Drawing account 10,000 15,000 20,000Loans (8,000) (25,000)Operating loss 4,200 8,400 8,400Liquidation loss 2,400 4,800 4,800

(32,400) 2,200 (1,800)Allocate debit balance 733 (2,200 ) 1,467Cash distribution $(31,667) $0 $(333 )

The first $40,000 is paid to satisfy the claims of creditors.

Exercise 16-5 Capital BalancesNoncash Brink Davis Olsen

      Cash           Assets     Liabilities       40%               40 %       20 % Account balances $10,000 $130,000 $(18,000) $(45,000) $(27,000) $(50,000)Sale of inventory, collect accounts receivable - allocate loss 38,000 (43,000 ) _______   2,000   2,000 1,000

48,000 87,000 (18,000) (43,000) (25,000) (49,000)Payment to creditors   (18,000 )                             18,000 _______  _______ _______

30,000 87,000 0 (43,000) (25,000) (49,000)Payment to partners (Schedule 1) (30,000) _______ _______     1,667                             28,333

$ 0 $87,000 $ 0 $(41,333 ) $(25,000) $(20,667)

Schedule 1      Brink             Davis         Olsen    

Capital balances $(43,000) $(25,000) $(49,000)Allocation of potential loss 34,800 34,800 17,400

(8,200) 9,800 (31,600)Allocation of deficit 6,533 (9,800) 3,267Safe Payment $(1,667) $ - 0 - $(28,333)

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Exercise 16-7 Exercise 16-8

1. c 1. c; X = ¼ ($690,000 + X); X = $230,0002. c 2. b3. a 3. d4. d 4. c5. d 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 Capital Balance Cash Liabilities           Q                 R               S                 T        

Balances $ 0 $(2,000) $(500) $(7,500) $6,000 $4,000Investment by Q 2,000 _______ (2,000 ) ______ ______ ______

2,000 (2,000) (2,500) (7,500) 6,000 4,000Payment of Liabilities (2,000 ) 2,000 ______ ______ ______ ______

0 0 (2,500) (7,500) 6,000 4,000Allocation of T's deficit ______ ______ 2,000 1,000 1,000 (4,000)

0 0 (500) (6,500) 7,000 0Investment by S 7,000 (7,000)Payment to partners (7,000 ) ______ 500 6,500 ______ ______

$ 0 $ 0 $ 0 $ 0 $ 0 $ 0

Part D & EPersonal Assets Partnership Distribution Total

R $8,000 $6,500 $14,500T 6,000 - - - 6,000

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Exercise 16-10 Matt Allen Dave

Part A Net capital interest $54,000 $30,000 $18,000Profit-loss ratio 0.45 0.30 0.25Loss absorption potential $120,000 100,000 $72,000Order of cash distribution 1 2 3

    Loss Absorption Potential                         Assets Distribution                   Matt             Allen             Dave             Matt             Allen           Dave      

Profit-loss ratio 0.45 0.30 0.25 0.45 0.30 0.25Loss absorption potential $120,000 $100,000 $72,000Net capital interest $54,000 $30,000 $18,000Distribution to Matt to reduce loss potential to Allen's 20,000 ______ ______ 9,000 ______ ______Balance after distribution 100,000 100,000 72,000 45,000 30,000 18,000Distribution to Matt and Allen to reduce loss potential to Dave's 28,000 28,000 ______ 12,600 8,400 ______

$72,000 $72,000 $72,000 $32,400 $21,600 $18,000Remainder of assets distributed 0.45 0.30 0.25

Cash Distribution Plan Matt Allen DaveOrder of Cash Distribution Liabilities 45 30 25 1. First $18,000 100%2. Next $9,000 100%3. Next $21,000 60% 40%4. Remainder 45% 30% 25%

Part B Matt Allen DaveFirst $9,000 available to partner $9,000Next $21,000 12,600 $8,400 _______

Total 21,600 $8,400 $ - 0 -

Matt, Loan 10,000Matt, Capital 11,600Allen, Capital 8,400

Cash 30,000

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ANSWERS TO PROBLEMS

Problem 16-1

Part A - 1 DISCOUNT PARTNERSHIPSchedule of Partnership Liquidation

January 14, 2008

Capital BalancesExplanation Cash Other Assets Liabilities Dawson Feeney HardinBalances before realization $25,000 $120,000 $(40,000) $(31,000) $(65,000) $(9,000)

Sales of noncash assets 60,000 (120,000 ) ______ 18,000 24,000 18,000 Balances 85,000 0 (40,000) (13,000) (41,000) 9,000

Payment of liabilities (40,000 __________ 40,000 ________ ________ ________Balances 45,000 0 0 (13,000) (41,000) 9,000

Allocation of Hardin's debit balance ________________ ______ 3,857 5,143 (9,000)Balances 45,000 0 0 (9,143) (35,857) 0

Distribution of cash to partners (45,000 __________ ______ 9,143 35,857 ________Balances $ 0 $ 0 $ 0 $ 0 $ 0 $ 0

16 - 9

Problem 16-1 (continued)DISCOUNT PARTNERSHIP

Part A - 2 Schedule of Partnership LiquidationJanuary 14, 2008

Capital BalancesExplanation Cash Other Assets Liabilities Dawson Feeney HardinBalances before realization $25,000 $120,000 $(40,000) $(31,000) $(65,000) $(9,000

Sales of noncash assets       60,000 (120,000 )                                         18,000     24,000     18,000 Balances 85,000 0 (40,000) (13,000) (41,000) 9,000

Payment of liabilities   (40,000                                       40,000                                                                                               Balances 45,000 0 0 (13,000) (41,000) 9,000

Cash investment by Hardin           9,000                                                                                                                                           (9,000 Balances 54,000 0 0 (13,000) (41,000) 0

Distribution of cash to partners   (54,000                                                                               13,000           41,000                               Balances $0 $0 $0 $0 $0 $0

16 - 10

Problem 16-1 (continued) DISCOUNT PARTNERSHIPSchedule of Partnership Liquidation

Part A – 3 January 14, 2008

Capital BalancesExplanation Cash Other Assets Liabilities Dawson Feeney HardinBalances before realization $25,000 $120,000 $(40,000) $(31,000) $(65,000) $(9,000

Sales of noncash assets     50,000 (120,000 )                                         21,000     28,000     21,000 Balances 75,000 0 (40,000) (10,000) (37,000) 12,000

Payment of liabilities   (40,000                                           40,000                                                                                       Balances 35,000 0 0 (10,000) (37,000) 12,000

Cash investment by Hardin         8,000                                                                                                                                         (8,000 Balances 43,000 0 0 (10,000) (37,000) 4,000

Allocation of Hardin's deficit                                                                                                             1,714             2,286       (4,000 Balances 43,000 0 0 (8,286) (34,714) 0

Distribution of cash to partners   (43,000                                                                                   8,286           34,714                             Balances $0 $0 $0 $0 $0 $0

Part B Cash 60,000Dawson, Capital 18,000Feeney, Capital 24,000Hardin, Capital 18,000

Other Assets 120,000

Liabilities 40,000Cash 40,000

Cash 9,000Hardin, Capital 9,000

Dawson, Capital 13,000Feeney, Capital 41,000

16 - 11

Cash 54,000Problem 16-2 Capital & Loan   Balances  

Other    Nelson   Parker   Rice Cash Assets Liabilities 0.40 0.30

Balances $5,000 $60,000  $(20,000) $(20,000) $(12,000) $(13,000)Sale of asset and  allocation of gain   16,000 (12,000 )           ---             (1,600 )   (1,200 )   (1,200 )

 21,000  48,000   (20,000)  (21,600)  (13,200)  (14,200)Payment to creditors (20,000 )       ---                   20,000           ---                     ---                     ---          

  1,000  48,000 0  (21,600)  (13,200)  (14,200)Payment to partners (Schedule 1) (1,000 )         ---                   ---                   1,000           ---                                        

0  48,000 0  (20,600)  (13,200)  (14,200)Sale of assets and allocation of gain 1 2,000 (10,000)           ---           (800 ) (600 ) (600 )

 12,000  38,000   0  (21,400)  (13,800)  (14,800)Payment to partners (Schedule 2) (12,000 )       ---                       ---                 6,200       2,400       3,400

0  38,000 0  (15,200)  (11,400)  (11,400)Sale of assets and allocation of loss 10,000 (20,000 )         ---                   4,000       3,000       3,000

10,000  18,000 0  (11,200)  (8,400) (8,400)Payment to partners (10,000 )       ---                     ---                 4,000       3,000       3,000

0  18,000 0  (7,200)  (5,400) (5,400)Sale of asset and allocation of loss     2,000 (18,000 )            ---                6,400       4,800      4,800

  2,000 0 0  (800)  (600) (600)Payment to partners    (2,000 )         ---                       ---                       800           600                 600

$0 $0 $0 $0 $0 $0

Schedules to Compute Safe Payments

Schedule 1    Nelson         Parker             Rice      

Capital Balance $(21,600) $(13,200) $(14,200)Allocation of potential loss ($48,000)        19,200     14,400     14,400

(2,400) 1,200 200Allocation of deficit balance           1,400   (1,200 )     (200 )Safe payment $(1,000) $0 $0

Schedule 2 Nelson Parker Rice

Capital Balance $(21,400) $(13,800) $(14,800)Allocation of potential loss ($38,000) 15,200 11,400 11,400

16 - 12

Safe payment $(6,200) $(2,400) $(3,400)

Problem 16-4 MARY, PAULA, AND RAYSchedule of Partnership Liquidation

 Other    Mary    Paula    Ray Cash     Assets   Liabilities 0 .40 0 .30 0 .30

Part A Balances before realization $10,000 $100,000 $(40,000) $(50,000) $(10,000) $(10,000)Sale of assets     20,000 (100,000 )                            32,000         24,000         24,000

  30,000     0  (40,000)  (18,000)   14,000   14,000Allocate Ray's debit balance                                                                                         8,000           6,000      (14,000 )

  30,000     0 (40,000)  (10,000)   20,000     0Investment by Paula       20,000                                                                                  (20,000 )                            

  50,000     0  (40,000)  (10,000)     0   0Distribution of cash   (50,000)                                   40,000          10,000                                                          

$0 $0 $0 $0 $0 $0

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

PartnershipPersonal Distribution     Total        

Mary $50,000 $10,000 $60,000Paula 10,000 0 10,000Ray 30,000 0 30,000

Problem 16-5 Baker   Strong     Weak        

Part A Capital and loan balances $55,000 $45,000 $24,000Profit and loss ratio .40 .40 .20

16 - 13

Loss absorption potential $137,500 $112,500 $120,000Order of cash distribution 1 3 2

            Loss Absorption Potential                               Cash Distribution         Baker               Strong                 Weak     Baker     Strong     Weak    

Profit and loss rates .40 .40 .20 .40 .40 .20Loss absorption potential $137,500 $112,500 $120,000Net capital interest $55,000 $45,000 $24,000Reduce loss absorption potential of Baker          17,500                                                                 7,000                                                    

120,000 112,500 120,000 48,000 45,000 24,000Reduce loss absorption potential of -Baker 7,500 3,000 -Weak                                                                         7,500                                                             1,500

$112,500 $112,500 $112,500 $45,000 $45,000 $22,500Remainder 0.40 0.40 0.20

                   Cash Distribution                                 Creditors      Baker     Strong Weak

First $17,000 100%Next 7,000 100% Next 4,500 67% 33%Remainder 40% 40% 20%

Problem 16-5 (continued)                                                  Cash Distribution                                     Total       Creditors      Baker     Strong Weak

To Creditors $17,000 $17,000To Baker 7,000 $7,000To Baker and Weak 4,500 3,000 $1,500Remainder --Profit and Loss Ratio     77,500                                   31,000 $31,000     15,500

$106,000 $17,000 $41,000 $31,000 $17,000

Part BJuly Cash

AccountsReceivable Inventory

Plant andEquipment

Accounts Payable

Baker        0.40

Strong         0.40

Weak        0.20

Account balances $6,000 $22,000 $14,000 $99,000 $(17,000)  $(55,000) $(45,000) $(24,000)Collection of accounts receivable   16,500  (22,000)       2,200    2,200    1,100

16 - 14

Sale of inventory   10,000  (14,000)      1,600    1,600      800Paid liquidation expenses  (1,000)     400      400      200Cash distribution (Schedule 1) (23,500 )                                                                               17,000     6,500                                                 Account balances (end of July) 8,000   0   0  99,000   0 (44,300) (40,800)  (21,900)

August Paid liquidation expenses  (1,500)     600      600      300Gain on equipment    6,000  (2,400)  (2,400)  (1,200)Withdrawal on equipment  (10,000)  10,000Cash distribution (Schedule 2) (4,000 )                                                                                                             3,750           250                           Account balances (end of August)  2,500   0   0   95,000   0 (42,350)  (42,350)  (12,800)

SeptemberSale of equipment   75,000  (95,000)     8,000    8,000    4,000Paid liquidation expense   (1,000 )                                                                                                                     400           400           200 Balances   76,500      0      0      0      0 (33,950)  (33,950)  (8,600)Cash distribution (76,500 )             0       0             0           0   33,950     33,950       8,600

$0 $0 $0 $0 $0 $0 $0 $0

16 - 15

Problem 16-5 (continued)

Schedule 1 0.4 0.4 0.2

Total Creditors      Baker     Strong WeakFirst $17,000 $17,000 $17,000Up to $7,000 6,500 _______ $6,500

$23,500 $17,000 $6,500

Schedule 2

Capital balances $(46,100) $(42,600) $(12,800)Potential loss of $95,000 plusCash retained 97,500 0.4 = 39,000

97,500 0.4 = 39,000 97,500 0.2 = ______ _______     19,500

(7,100) (3,600) 6,700Allocate Weak's potential deficit (6,700)

1/2 3,3501/2 _______ 3,350 _______

$(3,750) $(250 ) $0

16 - 16

Problem 16-7

Part A Valuation Adjustment 2,700Accumulated Depreciation 12,600

Office Equipment 14,200Allowance for Uncollectibles 900Jan, Loan 200

Jan, Loan 6,600Jan, Capital 6,600

Jan, Capital 1,350Sue, Capital 1,350

Valuation Adjustment 2,700

Part B Jan, Capital ($29,400 +  $6,600 - $1,350) 34,650Sue, Capital ($28,000 – $1,350) 26,650

Capital Stock (400 $100) 40,000Additional Paid-in Capital 21,300

Proof Cash $15,000Accounts receivable 32,400Allowance for uncollectibles (2,900)Prepaid insurance 800Office equipment 16,000

Total stockholders' equity $61,300

16 - 17

Problem 16-8

Part A 1. Starnes, Capital 125,000Cash 75,000Partners 1-9, Capital ($50,000 90/95) 47,368Partner 10, Capital ($50,000 5/95) 2,632

Cash 150,000Norwood, Capital ($2,500,000 5%) 125,000Partners 1-9, Capital ($25,000 90/95) 23,684Partner 10, Capital ($25,000 5/95) 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) Increased individual income tax to correspond to his increased earnings.

(b) 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.

(c) 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.

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 25,000Partners 1-9, Capital ($25,000 90%) 22,500Partners 10-11, Capital ($25,000 10%) 2,500

Cash 8,000,000Accounts Receivable 8,000,000

Liabilities - Outside 7,490,000Starns, Loan 10,000

Cash 7,500,000

Partners 1-9, Capital ($3,750 90/95) 3,553Partner 10, Capital ($3,750 5/95) 197

Starns, Capital ($125,000 - $130,000 + $1,250 = $3,750) 3,750

Partners 1-9, Capital ($2,395,000 90/95) 2,268,947Partner 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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