Accounting theory and practice, Volume 2 (of 3)

by Roy B. Kester

Uses to which Realization and Liquidation Statement May be Put

The realization and liquidation statement is frequently used also to analyze the activities of a receiver in equity. Where such is the case, the final section of the statement shows the assets and liabilities returned to the business at the close of the term of the receivership. The statement is sometimes used also to summarize by instalments a trustee’s activities, in which case at the end of the first period (at which time the realization and liquidation have been only partially completed) the final section of the statement will be the inventories of the assets yet to be realized and the liabilities yet to be liquidated which are carried over to the second instalment period. The statement for the second instalment period follows exactly the lines of that presented for the first period.

It should be understood always that the statement has no basis in practice, is purely theoretical, and any discussion of it is largely academic. It is presented here only because it is so frequently met in the formal examinations for the C. P. A. certificate.

Liquidation of a Partnership
by Instalments

Nature of the Problem

In connection with the problem of realization and liquidation, a similar problem is sometimes met upon the voluntary dissolution of a partnership. This, as stated in Volume I, Chapter XLIV, is briefly:

Where the process of liquidation is of long duration, the partners may desire to receive what is due them by instalments rather than wait until the termination of proceedings and receive their respective shares in one amount. If the profit and loss sharing ratios of the partners are the same as their capital ratios, no trouble will be encountered in making the liquidating dividends on capital account as the dividends will be in the profit and loss sharing ratio. Trouble is encountered, however, when the two ratios are different inasmuch as it is not known at the time the various instalments, except the last, are made what the expenses and losses will be in the end. Because of the fact that these expenses and losses are shared in a different ratio from the capital ratios, their capital ratios are constantly changing after the losses and expenses to be borne by the various partners are charged in each case. Liquidating dividends are always made on the basis of capital investment ratios rather than profit and loss ratios. By this is meant simply that after all expenses and losses have been determined and charged to the partners in their profit and loss sharing ratios, their capital accounts show their respective interests in the business, and upon dissolution payment must be made to them in accordance with the showing of their capital accounts. Where, however, payment is made in instalments, neither the capital ratio nor the profit and loss sharing ratio, if these are different, gives the correct basis for making the distribution of the instalment. If payment of the instalments is made on some arbitrary basis or on the ratio of the profit and loss or of their capitals, it may result in an overpayment of some of the partners and an underpayment of others. Accordingly, the only safe method of handling the situation is to pay the first instalments to those partners whose capital ratios are in excess of their profit and loss ratios until their capitals are reduced to the point where the capital ratios of all the partners are the same as their profit and loss ratios. Thereafter further instalment payments are made in the profit and loss ratio, not because it is the profit and loss ratio but because now the capital ratios are the same as the profit and loss ratios so that whatever loss or expense must ultimately be cared for will automatically be distributed to the partners’ accounts in this way.

The solution of the problem is perhaps best handled, at the time of the first instalment, by deducting the amount of the first instalment from the total net capitals of the partners at that time. This leaves the capital remaining after payment of the instalment. A distribution of this net remaining capital is made in the profit and loss ratio. A comparison of the former capital to the credit of each partner with his new capital as derived by means of the distribution just made in profit and loss ratio indicates the share each partner is to receive of the first instalment. If the first instalment is sufficiently large to adjust the partners’ capital ratios to their profit and loss sharing ratios, no trouble will be experienced with future instalments. However, it very frequently happens that the first instalment is not sufficiently large to adjust the capitals to the profit and loss sharing basis. To do this would require the contribution of additional capital by those partners whose capital ratio is less than their profit and loss ratio, and it is doubtful if such a contribution would ever be made. Accordingly, it becomes necessary to distribute the instalments only to those partners whose capital ratios are in excess of their profit and loss ratios.

A new problem is met here, namely, the determination of the respective shares of the deficiency which must be borne by partners sharing the first instalment. How this is to be treated can perhaps be seen best in the illustrative problem on page 654. There it is seen that with the distribution in profit and loss ratio of the capital remaining after the first instalment, a deficiency of $6,000 arises representing the amount of C’s capital deficiency. This $6,000 must be borne by A and B and their shares therein are based on their relative profit and loss sharing ratios. Since A bears 25% of the profits or losses and B 35%, A should bear ⁵/₁₂ of C’s capital deficiency and B ⁷/₁₂—amounting to $2,500 for A and $3,500 for B. This reduces their shares in the first instalment to $3,000 each, as shown in the columns headed “Actual Distribution.” Similarly, the second instalment still results in a capital deficiency for C of $2,700 which must be borne by A and B in the amounts indicated. The third instalment is sufficiently large to give all of them something and at the same time reduce their capital ratios to a profit and loss sharing ratio. Thereafter all instalments are distributed on the profit and loss sharing basis.

After the final instalment is distributed, it will be noted that a net loss results on liquidation of $20,000 which is distributed automatically to the partners in the sums of $5,000 to A, $7,000 to B, and $8,000 to C, which represent their profit and loss sharing ratios. In conclusion it should be said that the problem is theoretical and academic and will perhaps seldom, if ever, be met in practice because of the objections which the partner whose account shows a deficiency would raise to non-participation in all instalments until his capital deficiency had been eliminated. It may be said that where such objections are raised the only course of the liquidating partner or agent is to refuse distribution of any instalment until a sufficiently large sum has accumulated to place the partners’ capitals on a profit and loss sharing basis. Such is the exact situation in strict theory. In practice, however, any agreement which the partners might make as among themselves would have to be carried out by the liquidating partner and would, of course, protect him in case of ultimate overpayment to any of the partners.