Liquidation is the process of converting a business’s assets into cash, settling its claims in legal order of priority, and winding its operations down. It is the point at which the going concern assumption stops applying, and once liquidation is imminent the accounting itself changes rather than merely being disclosed.
Two separate systems govern it in the United States. Accounting standards decide when the books switch to a liquidation basis and what they then report. Bankruptcy law decides who gets paid out of the proceeds and in what sequence. A business can be in the first without ever entering the second.
The Accounting Trigger
The switch is not a judgment call about how things look. An entity prepares its financial statements using the liquidation basis of accounting when liquidation is imminent (FASB, Accounting Standards Update 2013-07).
Imminent is defined two ways, an owner-approved plan or one imposed by other forces such as involuntary bankruptcy, with remoteness a condition of both (FASB, Accounting Standards Update 2013-07, paragraph 205-30-25-2); both routes are worked through in going concern. What that entry does not carry is the carve-out.
There is a carve-out for entities that were always going to end. Where a plan for liquidation was specified in the entity’s governing documents from inception, as with a limited-life fund, the liquidation basis applies only if the approved plan differs from the one specified at inception (FASB, Accounting Standards Update 2013-07). The standard adds a presumption with teeth: an entity presumes its plan does not follow the original one if it is forced to dispose of assets for consideration not commensurate with their fair value (FASB, Accounting Standards Update 2013-07, paragraph 205-30-25-3). A fire sale is evidence that this is not the orderly wind-down the documents contemplated. Other departures from the original plan, an earlier commencement date for instance, count only to the extent they bear on whether the consideration is commensurate with fair value (FASB, Accounting Standards Update 2013-07, paragraph 205-30-25-3).
The earlier and softer signal, substantial doubt about the entity’s ability to continue, is a different test with different consequences, and it is in going concern.
What Changes on the Books
The measurement objective changes, and how assets are remeasured is set out in going concern. The part that is specific to a wind-down is what comes onto the statements that was never there before: an entity recognizes other items it previously had not recognized, trademarks for example, that it expects either to sell in liquidation or to use to settle liabilities, and those items may be recognized in the aggregate (FASB, Accounting Standards Update 2013-07, paragraph 205-30-25-4).
That is a different objective from anything in ordinary reporting. Historical cost stops being relevant because nothing will be used over a remaining life, and the question becomes what each asset will actually fetch.
For a preparer the practical difficulty is that a client rarely announces the switch. The approval that makes liquidation imminent is usually a board resolution or a members’ vote, and it belongs in the file with the date on it, because the date decides which period is the last one prepared on a going concern basis.
Who Gets Paid, and in What Order
Where liquidation runs through a Chapter 7 bankruptcy, the order is statutory rather than negotiated. Property of the estate is distributed first in payment of claims of the kind specified in, and in the order specified in, the priority section, then to allowed unsecured claims that were timely filed, then to allowed unsecured claims filed late, then to allowed claims for any fine, penalty or forfeiture or for punitive damages, then to interest at the legal rate from the date of the filing of the petition on any claim paid under those paragraphs, and sixth to the debtor (11 U.S.C. 726(a)).
The owners come last, and the statute says so in terms: paragraph (a)(6) reaches the debtor only if something survives the five paragraphs above it. Nothing in the section guarantees a residue.
Secured creditors sit outside this queue to the extent of their collateral. Before the final distribution under section 726, the trustee disposes of any property in which an entity other than the estate has an interest, such as a lien (11 U.S.C. 725), so the waterfall runs over what is left after that. The general reading of a company’s ability to cover claims before any of this arises is in solvency.
Three Words That Are Not Synonyms
Insolvency is a financial condition, and the two statutory tests that wear the word are set out in what it means to be insolvent. A business can be insolvent for a period and trade out of it without ever liquidating.
Liquidation is the process of turning assets into cash and settling claims. It can be voluntary, decided by the owners, or involuntary, imposed through a court process.
Dissolution is the legal ending of the entity under state law, the filing that removes it from existence. It follows liquidation rather than replacing it, and a company that has liquidated its assets but not dissolved still exists and still carries whatever annual filing and fee obligations its state of formation imposes. What a dissolved corporation must pay before anything reaches its holders is in stockholder.
Common Questions
No. Bankruptcy is a court process, and one of its chapters produces a liquidation while another is designed to reorganize a business and keep it operating. Liquidation is the substance, converting assets to cash and paying claims, and it happens outside bankruptcy too whenever owners decide to wind a solvent business down and distribute what is left. The statutory payment order described above applies where the liquidation runs through the court; a solvent voluntary wind-down follows the entity’s own documents and state law instead.
Employment ends as operations end. Unpaid wages, salaries and commissions earned within 180 days before the filing of the petition or the cessation of the business, whichever occurs first, are a priority claim up to a per-employee cap (11 U.S.C. 507(a)(4)), and the distribution pays that class ahead of general unsecured claims (11 U.S.C. 726(a)). Wages earned outside that window, and anything above the cap, fall back into the general unsecured class. Executory contracts and leases are dealt with in the process rather than simply lapsing, and the treatment depends on the terms and on whether the process is a court one. Those are legal questions on which a client needs counsel, not an accounting answer.
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