Dissolution of Partnership Firm

Dissolution Of Partnership

A partnership is created by an agreement between partners. Dissolution of Partnership refers to the change in the existing relationship between partners without necessarily ending the business of the firm. When there is a change in the composition of the firm due to the admission of a new partner, retirement of an existing partner, or death of a partner, the old partnership is dissolved, and a new partnership is formed among the remaining or new partners. This is known as Reconstitution of the Partnership Firm. In such cases, the firm's business usually continues.

Modes of Dissolution of Partnership (which lead to reconstitution, not closure of business):

Admission of a new partner.
Retirement of a partner.
Death of a partner.
Change in the profit sharing ratio among existing partners.
Completion of the venture (if partnership was for a specific venture).
Expiry of the fixed term (if partnership was for a fixed period).

In all these situations, the partnership agreement changes, but the business may continue under a new agreement among the continuing partners. Accounting on dissolution of partnership involves adjustments like revaluation of assets, distribution of reserves, goodwill treatment, etc., as discussed in previous chapters.

Dissolution Of A Firm

Dissolution of a Firm means the termination of the partnership business itself. The relationship among all partners comes to an end, and the firm ceases to exist. The assets of the firm are realised (sold), liabilities are paid off, and the remaining balance (if any) is distributed among the partners.

Dissolution of a firm can take place in various ways as per the Indian Partnership Act, 1932:

Dissolution by Agreement: The firm can be dissolved if all partners agree to dissolve it, or in accordance with a contract between the partners.
Compulsory Dissolution: A firm is compulsorily dissolved if all or all but one partner become insolvent, or if the business becomes illegal.
Dissolution on the Happening of Certain Contingencies: A firm may be dissolved if constituted for a fixed term, on the expiry of that term; if constituted to carry out one or more adventures, on the completion of that adventure; by the death of a partner; or by the adjudication of a partner as an insolvent.
Dissolution by Notice: If the partnership is at will, any partner can dissolve the firm by giving a notice in writing to all other partners of their intention to dissolve the firm.
Dissolution by Court: A court may order the dissolution of a firm on certain grounds, such as a partner becoming of unsound mind, permanent incapacity of a partner, misconduct by a partner affecting the business, persistent breach of agreement by a partner, transfer of the whole of a partner's interest to a third party, the business cannot be carried on except at a loss, or on any other just and equitable ground.

Accounting on dissolution of a firm involves closing down the business and settling the accounts.

Distinction Between Dissolution Of Partnership And Dissolution Of Firm

Basis of Difference	Dissolution of Partnership	Dissolution of Firm
Continuity of Business	Business continues (under a new agreement).	Business comes to an end.
Relationship between Partners	Changes (old agreement terminates, new one starts).	Terminates completely.
Scope	Narrower concept (part of reconstitution).	Wider concept (complete closure).
Economic Impact	Firm may grow or restructure.	Firm ceases to exist economically.
Accounting	Focuses on adjustments of assets, liabilities, and partners' capital.	Focuses on realisation of assets, payment of liabilities, and final settlement with partners.
Court Intervention	Usually not required (unless dispute).	May be ordered by the court.

Accounting on Dissolution of a Firm:

The main accounting steps on dissolution of a firm are:

Closing down the existing Ledger accounts (except Cash/Bank and Partners' Capital/Current Accounts) by transferring them to a Realisation Account.
Preparing the Realisation Account to record the realisation of assets and payment of external liabilities, and to ascertain the profit or loss on realisation.
Transferring the profit or loss on realisation to Partners' Capital Accounts in their profit sharing ratio.
Paying off external liabilities.
Settling the amount due to each partner (paying the final balances in their Capital/Current Accounts).

This process aims to convert all assets into cash, pay off all debts, and distribute the remaining cash among the partners.

Settlement Of Accounts

Section 48 of the Indian Partnership Act, 1932, lays down rules for the settlement of accounts on the dissolution of a firm. These rules determine the order in which assets should be applied and liabilities paid off.

Application of Assets:

The assets of the firm, including any sums contributed by partners to make up deficiencies of capital, are applied in the following order:

In paying the debts of the firm to third parties: External liabilities are paid first.
In paying to each partner rateably what is due to him from the firm for advances as distinguished from capital (Partner's Loan): Loans given by partners to the firm are paid after external liabilities but before capital.
In paying to each partner rateably what is due to him on account of capital: Partners' capital is repaid after external liabilities and partner's loans.
The residue, if any, is divided among the partners in the ratio in which they were entitled to share profits: Any amount remaining after paying off all liabilities and capital is distributed as profit on realisation.

Payment of Liabilities:

Losses, including deficiencies of capital, are paid first out of profits, next out of capital, and lastly, if necessary, by the partners individually in their profit sharing ratio.

Private Debts And Firm’s Debts

Section 49 of the Indian Partnership Act, 1932, deals with the situation where there are both debts of the firm and private debts of a partner.

Firm's property shall be applied first in payment of firm's debts, and then the surplus (if any) shall be divided among the partners as per their rights, which can then be used by partners to pay their private debts.
Any partner's private property shall be applied first in payment of his private debts, and the surplus (if any) may be used to pay firm's debts if the firm's property is insufficient.

This establishes the priority of claims on firm property and private property.

Inability Of A Partner To Contribute Towards Deficiency

If, on dissolution, a partner's Capital Account shows a debit balance (meaning they owe money to the firm) and that partner is insolvent (unable to pay), the deficiency becomes a capital loss. According to the rule in Garner vs. Murray (a historical English case often applied unless the partnership deed specifies otherwise), this capital loss (insolvent partner's debit balance) is borne by the solvent partners in their capital ratio existing just before the dissolution. This rule applies if the partnership deed does not have a clause to the contrary.

The Garner vs. Murray rule is often a point of discussion in partnership dissolution accounting.

Example 1. Garner vs. Murray Rule.

A, B, and C are partners sharing profits 3:2:1. Their Capital Balances (assuming fixed capital method, before revaluation/realisation profit/loss distribution) are A: ₹60,000, B: ₹40,000, C: ₹20,000. Firm is dissolved. Realisation loss is ₹12,000. C is insolvent and his Capital Account shows a final debit balance of ₹5,000 after adjusting his share of loss, drawings, etc.

Answer:

C's debit balance of ₹5,000 is a capital loss. According to Garner vs. Murray rule, this loss will be borne by the solvent partners (A and B) in their capital ratio just before dissolution adjustments for realisation profit/loss. In this simplified example, let's assume the capital ratio before dissolution process was A:B = 60,000 : 40,000 = 3:2.

A will bear: ₹5,000 $\times \frac{3}{5} = ₹3,000$.
B will bear: ₹5,000 $\times \frac{2}{5} = ₹2,000$.

A's Capital A/c will be debited by ₹3,000, and B's Capital A/c will be debited by ₹2,000. C's Capital A/c will be credited by the total deficiency of ₹5,000, making his balance zero. The cash received from C (which is zero, as he's insolvent) is accounted for.

The rules for settlement ensure an orderly winding up of the firm's affairs.

Accounting Treatment

Accounting on the dissolution of a firm involves a specific set of steps and journal entries to close the books and settle the accounts. The main objective is to realise assets, pay liabilities, and distribute the remaining cash.

Preparation of Realisation Account:

A Realisation Account is prepared to close all asset accounts (except Cash/Bank) and transfer external liabilities. It is used to record the sale of assets, payment of liabilities, and calculate the profit or loss on the realisation process. It is a Nominal Account.

Debit Side of Realisation Account:

Transfer of all assets (at their book value, excluding cash/bank, fictitious assets, and partner's current account debit balance).
Expenses on realisation.
Payment of unrecorded liabilities.
Profit on realisation (balance transferred to Partners' Capital A/cs).

Credit Side of Realisation Account:

Transfer of external liabilities (at their book value).
Sale proceeds of assets realised.
Assets taken over by partners (at agreed value).
Payment of unrecorded assets.
Loss on realisation (balance transferred to Partners' Capital A/cs).

Journal Entries

1. For Transferring Assets (except Cash/Bank) to Realisation Account:

Date	Particulars	Debit (₹)	Credit (₹)
(Date of Dissolution)	Realisation A/c Dr.	[Total Book Value of Assets transferred]
	To Individual Asset A/c (e.g., Machinery A/c, Furniture A/c, Debtors A/c, Stock A/c)		[Book Value]
	...
	(Being assets transferred to Realisation A/c)

(Note: Provision for Depreciation, Provision for Doubtful Debts related to transferred assets are transferred to the Credit side of Realisation A/c).

Date	Particulars	Debit (₹)	Credit (₹)
(Date of Dissolution)	Provision for Depreciation A/c Dr.	[Balance]
	Provision for Doubtful Debts A/c Dr.	[Balance]
	...
	To Realisation A/c		[Total]
	(Being provisions transferred to Realisation A/c)

2. For Transferring External Liabilities to Realisation Account:

Date	Particulars	Debit (₹)	Credit (₹)
(Date of Dissolution)	Individual Liability A/c (e.g., Creditors A/c, Bills Payable A/c, Bank Loan A/c) Dr.	[Book Value]
	...
	To Realisation A/c		[Total Book Value of Liabilities transferred]
	(Being external liabilities transferred to Realisation A/c)

3. For Realisation of Assets (Sale of Assets):

Date	Particulars	Debit (₹)	Credit (₹)
(Date of Realisation)	Cash/Bank A/c Dr.	[Amount Received]
	To Realisation A/c		[Amount Received]
	(Being assets realised for cash)

4. For Assets Taken Over by a Partner:

Date	Particulars	Debit (₹)	Credit (₹)
(Date of Dissolution)	Partner's Capital/Current A/c Dr.	[Agreed Value]
	To Realisation A/c		[Agreed Value]
	(Being asset taken over by partner)

5. For Payment of External Liabilities:

Date	Particulars	Debit (₹)	Credit (₹)
(Date of Payment)	Realisation A/c Dr.	[Amount Paid]
	To Cash/Bank A/c		[Amount Paid]
	(Being external liabilities paid)

6. For Payment of Realisation Expenses:

Date	Particulars	Debit (₹)	Credit (₹)
(Date of Payment)	Realisation A/c Dr.	[Amount]
	To Cash/Bank A/c		[Amount]
	(Being realisation expenses paid)

(Note: If realisation expenses are borne by a partner and paid by the firm, or vice-versa, additional entries are needed to adjust partners' accounts).

7. For Transferring Profit or Loss on Realisation:

The balance of the Realisation Account (Total Credits - Total Debits) is the profit or loss on realisation.

If Profit on Realisation: Realisation A/c has a Credit balance. Transferred to Partners' Capital/Current Accounts in their profit sharing ratio.

Date	Particulars	Debit (₹)	Credit (₹)
(Date of Dissolution)	Realisation A/c Dr.	[Profit Amount]
	To Partner 1's Capital/Current A/c		[Share]
	To Partner 2's Capital/Current A/c		[Share]
	...
	(Being profit on realisation transferred to partners' accounts)

If Loss on Realisation: Realisation A/c has a Debit balance. Transferred to Partners' Capital/Current Accounts in their profit sharing ratio (debited).

Date	Particulars	Debit (₹)	Credit (₹)
(Date of Dissolution)	Partner 1's Capital/Current A/c Dr.	[Share]
	Partner 2's Capital/Current A/c Dr.	[Share]
	...
	To Realisation A/c		[Loss Amount]
	(Being loss on realisation transferred to partners' accounts)

8. For Payment of Partner's Loan:

Loans given by partners are paid after external liabilities are settled.

Date	Particulars	Debit (₹)	Credit (₹)
(Date of Payment)	Partner's Loan A/c Dr.	[Amount]
	To Cash/Bank A/c		[Amount]
	(Being partner's loan paid)

9. For Final Settlement with Partners:

After all other accounts are closed and assets realised/liabilities paid through Realisation A/c, the Partners' Capital Accounts are balanced. The balances represent the final amount due to or from each partner.

If Partner's Capital Account has a Credit balance: Amount is due to the partner. Paid out in cash.

Date	Particulars	Debit (₹)	Credit (₹)
(Date of Final Settlement)	Partner's Capital/Current A/c Dr.	[Final Credit Balance]
	To Cash/Bank A/c		[Final Credit Balance]
	(Being final payment to partner on dissolution)

If Partner's Capital Account has a Debit balance: Amount is due from the partner. The partner brings in cash to settle.

Date	Particulars	Debit (₹)	Credit (₹)
(Date of Final Settlement)	Cash/Bank A/c Dr.	[Final Debit Balance]
	To Partner's Capital/Current A/c		[Final Debit Balance]
	(Being cash brought in by partner to settle deficiency)

(Note: If a partner with a debit balance is insolvent, the Garner vs. Murray rule or deed provisions apply, and their deficiency is borne by solvent partners - see Section I3).

After all these entries, the Cash/Bank Account should automatically balance, showing that all cash has been received from asset realisation and partners (for deficiencies) and paid out to liabilities and partners (for final settlement). All Ledger accounts should have a zero balance, indicating the firm's books are closed.

Accounting for dissolution of a firm is a systematic process of winding up the business and settling claims according to the provisions of the Indian Partnership Act, 1932.