Problem 23 - Accounting

Question

Hilliard, Downey, and Petrov are partners sharing income 3:2:1. After the firm's loss from liquidation is distributed, the capital account balances were: Hilliard, \$24,000 Dr.; Downey, \(\$ 90,000 \mathrm{Cr}\).; and Petrov, \(\$ 64,000 \mathrm{Cr}\). If Hilliard is personally bankrupt and unable to pay any of the \(\$ 24,000\), what will be the amount of cash received by Downey and Petrov upon liquidation?

Step-by-Step Solution

Answer

Downey receives $74,000 and Petrov receives $56,000 upon liquidation.

Step 1: Understand the Problem

We need to determine the cash each partner receives upon liquidation. The key information includes that Hilliard has a deficit (loss) of $24,000 and is unable to pay it. Downey and Petrov have credit balances, meaning they are owed money: Downey has $90,000, and Petrov has $64,000.

Step 2: Determine Total Available Cash

To find out how much cash is available to be distributed, we combine Downey's and Petrov's credit balances: \[ \text{Total cash available} = 90,000 + 64,000 = 154,000 \] Since Hilliard cannot pay his $24,000 deficit, this affects the distribution rather than the total cash available.

Step 3: Distribute Hilliard's Deficit

Since Hilliard cannot pay his deficit, Downey and Petrov have to absorb the $24,000 loss in their income-sharing ratio (3:2:1). Thus, Downey (2 parts) and Petrov (1 part) will share Hilliard's $24,000 deficit, absorbing $16,000 and $8,000 respectively.

Step 4: Adjust Downey's and Petrov's Balances

After absorbing the loss, Downey and Petrov's new balances are:\[\text{Downey's new balance} = 90,000 - 16,000 = 74,000\]\[\text{Petrov's new balance} = 64,000 - 8,000 = 56,000\]

Step 5: Final Cash Distribution

Downey and Petrov will receive their adjusted balances as the final cash distribution: - Downey receives $74,000 - Petrov receives $56,000.

Key Concepts

Capital Account Balances

In a partnership, each partner has a capital account that reflects their share in the business. This account shows the partner's net worth within the firm. When the business undergoes liquidation, these balances play a crucial role in determining the final distribution of funds.
It's important to understand the basics: a credit balance in a capital account indicates that the business owes money to the partner. Conversely, a debit balance reveals that the partner owes money to the firm.
In our scenario with Hilliard, Downey, and Petrov, we see the following:

• Hilliard has a debit balance of $24,000, meaning he owes this to the firm.
• Downey has a credit balance of $90,000, showing the firm owes him this amount.
• Petrov also has a credit balance, standing at $64,000.

Understanding these balances is critical in accurately distributing remaining assets once the firm's operations cease and liabilities have been settled.

Distribution of Loss

During the liquidation of a partnership, any deficit or loss needs to be absorbed by the remaining partners. This is often one of the most technical parts of liquidating a partnership since everyone not only wants a fair share but also wants to abide by legal requirements.
The partnership agreement usually specifies how profits and losses are shared among partners. In this case, the partners share in the ratio of 3:2:1. When a partner like Hilliard is unable to cover their share of a loss, the remaining partners—Downey and Petrov—must absorb that loss.

• The total deficit that needs absorption is $24,000 due to Hilliard's financial inability.
• Given the agreed ratio, Downey, who represents 2 parts of the loss, absorbs $16,000 of the deficit.
• Petrov, with 1 part, absorbs $8,000 of the loss.

This adjustment ensures that all partners equally bear the financial outcome, even in circumstances where one partner cannot contribute monetarily.

Income-Sharing Ratio

The income-sharing ratio is a pre-determined agreement that dictates how profits and losses are divided among partners in a business. This agreement reflects each personal investment and aspect of labor in the partnership.
In the Hilliard, Downey, and Petrov partnership, their income-sharing ratio is 3:2:1. This means for every 6 parts of profit or loss, Hilliard receives or is responsible for 3, Downey for 2, and Petrov for 1. This structure not only applies to income distribution but also becomes the guiding principle during loss calculations.
This ratio is vital in the case of liquidation as it simplifies the process of distributing remaining assets or absorbing losses when the partnership is dissolved. Aligning these responsibilities ensures that the financial relationships among partners remain clear and organized even when facing financial challenges or closures.

Personal Bankruptcy in Partnerships

Partnerships can face complications when a partner becomes personally bankrupt, as seen with Hilliard. In such a case, any deficit in the bankrupt partner’s capital account cannot be funded by their private assets. This situation directly affects how the liquidation proceeds are shared.
When a partner like Hilliard is unable to contribute financially to cover their deficit, the remaining partners must shoulder the burden of additional losses.
This increases the financial responsibility on solvent partners like Downey and Petrov, requiring them to reassess the distribution of remaining funds following the pre-established income-sharing ratio.

• Solvent partners absorb the losses of the bankrupt partner.
• They distribute the firm's resources following the adjusted capital accounts.

Overall, understanding the implications of personal bankruptcy within a partnership helps partners plan and prepare for such outcomes. Keeping open lines of communication and having clear agreements can ease the burden should such events occur.