Dissolution of Partnership FirmClass 12 Accountancy Part 1 Notes

Dissolution of Partnership Firm

When a partnership firm is dissolved, it means the business is coming to a complete end. This is different from the reconstitution of a firm that happens during the admission, retirement, or death of a partner. In those cases, the old partnership agreement ends, but the firm itself can continue to do business.

According to Section 39 of the Partnership Act 1932, the dissolution of partnership between all the partners of a firm is called the dissolution of the firm. This means the relationship between all partners is broken, and the firm ceases to exist. Once a firm is dissolved, it stops all business transactions, except for the activities needed to close everything down. This "winding up" process involves:

• Selling all the firm's assets.
• Paying off all its liabilities (debts).
• Settling the final claims of the partners.

Dissolution of Partnership

A dissolution of partnership simply means there is a change in the existing relationship between the partners. The business of the firm, however, can continue as before. This happens in several situations:

• Change in the existing profit-sharing ratio among partners.
• Admission of a new partner.
• Retirement of a partner.
• Death of a partner.
• Insolvency of a partner.
• Completion of the specific venture for which the partnership was formed.
• Expiry of the time period for which the partnership was formed.

Dissolution of a Firm

The dissolution of a firm means the complete breakdown of the relationship between all partners, leading to the closure of the business. It's important to remember that the dissolution of a firm necessarily includes the dissolution of the partnership, but the reverse is not always true.

A firm can be dissolved in two main ways: without a court order or with a court order.

Modes of Dissolution without Court Intervention

1. Dissolution by Agreement: The simplest way to dissolve a firm is by mutual consent. This happens when:

   • All partners agree to dissolve the firm.
   • The dissolution is done according to a contract that was already made between the partners.

2. Compulsory Dissolution: In certain situations, a firm must be dissolved by law. This is not optional.

   • When all partners, or all partners but one, become insolvent (unable to pay their debts).
   • When the business of the firm becomes illegal.
   • When an event makes it unlawful for the partners to continue the business. For example, if a partner is a citizen of a country that is now at war with India, they become an alien enemy, and the partnership must be dissolved.

3. On the Happening of Certain Contingencies: Unless the partnership agreement says otherwise, the firm is dissolved if:

   • It was formed for a fixed term, and that term expires.
   • It was formed for a specific venture, and that venture is completed.
   • A partner dies.
   • A partner is declared insolvent by a court.

4. Dissolution by Notice: If the partnership is a partnership at will (meaning it has no fixed duration), any partner can dissolve the firm by giving a written notice to all other partners of their intention to do so.

Dissolution by Court

A partner can file a lawsuit to have the firm dissolved by a court on the following grounds:

• Insanity: When a partner becomes of unsound mind.
• Permanent Incapacity: When a partner becomes permanently unable to perform their duties.
• Misconduct: When a partner is guilty of conduct that negatively affects the business.
• Breach of Agreement: When a partner repeatedly and deliberately breaks the partnership agreement.
• Transfer of Interest: When a partner has transferred their entire interest in the firm to an outside third party.
• Business at a Loss: When the business cannot be carried on except at a loss.
• Just and Equitable: When the court finds any other reason that makes it fair and just to dissolve the firm.

Distinction between Dissolution of Partnership and Dissolution of Firm

Settlement of Accounts

When a firm is dissolved, its accounts must be settled. The Partnership Act 1932 provides specific rules for this process under Section 48, assuming there is no other agreement between the partners.

Treatment of Losses

Losses, including any shortfall in partners' capital, must be paid in the following order:

1. First, out of the firm's accumulated profits.
2. Next, out of the partners' capital.
3. Lastly, if necessary, by the partners individually in their profit-sharing ratio.

Application of Assets

The money raised from selling the firm's assets, along with any contributions from partners to cover deficiencies, must be used in a specific order of priority:

1. Paying Third-Party Debts: First, pay off all outside liabilities like creditors, bank loans, bank overdrafts, etc. (Secured loans are paid before unsecured loans).
2. Paying Partners' Loans: Next, repay any loans or advances made by partners to the firm. If the money is not enough to pay everyone in full, they are paid proportionately.
3. Paying Partners' Capital: After paying loans, return the capital contributed by each partner.
4. Distributing the Residue: If any money is left over (surplus), it is divided among the partners in their profit-sharing ratio.

Private Debts and Firm's Debts

Section 49 of the Act clarifies how to handle the personal debts of partners versus the debts of the firm.

• Firm's Property: The firm's assets must first be used to pay the firm's debts. Any surplus can then be distributed to partners, who can use it to pay their private debts.
• Partner's Private Property: A partner's personal assets must first be used to pay their own private debts. Any surplus can then be used to pay the firm's debts if the firm's assets are insufficient.

Inability of a Partner to Contribute Towards Deficiency

If a partner's capital account has a debit balance (a deficiency) at the end of the dissolution process and they are unable to pay it, that partner is considered insolvent. This unrecoverable amount is a capital loss for the firm.

According to the principle laid down in the famous case of Garner vs. Murray, this capital loss must be borne by the remaining solvent partners. They must share this loss in the ratio of their capitals as they stood on the date of dissolution, not their profit-sharing ratio.

Accounting Treatment

When a firm is dissolved, the books of account must be closed. To do this, a special account called the Realisation Account is prepared.

Realisation Account

The Realisation Account is a temporary account created for the sole purpose of closing the books of a dissolved firm. Its main function is to determine the net profit or loss from the sale of assets and the settlement of liabilities.

Here’s how it works:

1. Transfer of Assets: All assets of the firm (except for cash, bank balances, and fictitious assets like a debit balance in the Profit & Loss A/c) are transferred to the debit side of the Realisation Account at their book values.
2. Transfer of Liabilities: All external liabilities (debts owed to outsiders like creditors and bank loans) are transferred to the credit side of the Realisation Account.
3. Recording Realisation: When assets are sold for cash, the amount received is recorded on the credit side. When liabilities are paid off, the amount paid is recorded on the debit side.
4. Calculating Profit or Loss: After all transactions are recorded, the account is balanced.
   • If the credit side is greater than the debit side, there is a profit on realisation.
   • If the debit side is greater than the credit side, there is a loss on realisation.

This final profit or loss is then transferred to the partners' capital accounts in their profit-sharing ratio.

Journal Entries for Dissolution

Here are the standard journal entries passed during the dissolution process:

1. For transfer of assets to Realisation A/c:

   • Realisation A/c Dr.
   • To Assets (Individually) A/c (This closes all individual asset accounts.)

2. For transfer of liabilities to Realisation A/c:

   • Liabilities (Individually) A/c Dr.
   • To Realisation A/c (This closes all external liability accounts.)

3. For sale of assets:

   • Bank A/c Dr.
   • To Realisation A/c (Records the cash received from selling assets.)

4. For an asset taken over by a partner:

   • Partner's Capital A/c Dr.
   • To Realisation A/c (Instead of cash, the partner's capital is reduced.)

5. For payment of liabilities:

   • Realisation A/c Dr.
   • To Bank A/c (Records cash paid to settle liabilities.)

6. For a liability discharged by a partner:

   • Realisation A/c Dr.
   • To Partner's Capital A/c (The firm now owes this money to the partner, so their capital increases.)

7. For settlement with a creditor by transferring an asset:

   • Full Settlement: If a creditor accepts an asset in full settlement of their dues, no journal entry is needed.
   • Part Settlement: If an asset is given as part payment, an entry is only made for the remaining cash paid.
   • Asset Value > Liability: If a creditor takes an asset worth more than their claim and pays the difference in cash, the cash received is recorded: Bank A/c Dr. to Realisation A/c.

8. For payment of realisation expenses:

   • Paid by the firm:
     • Realisation A/c Dr.
     • To Bank A/c
   • Paid by a partner on behalf of the firm:
     • Realisation A/c Dr.
     • To Partner's Capital A/c
   • Borne by a partner, but paid by the firm:
     • Partner's Capital A/c Dr.
     • To Bank A/c
   • Borne and paid by the partner: No entry is required in the firm's books.

9. For remuneration paid to a partner for dissolution work:

   • Realisation A/c Dr.
   • To Partner's Capital A/c

10. For realisation of an unrecorded asset:

    • Bank A/c Dr.
    • To Realisation A/c (Since it was unrecorded, it's treated as a pure gain on realisation.)

11. For settlement of an unrecorded liability:

    • Realisation A/c Dr.
    • To Bank A/c (Treated as an expense of realisation.)

12. For transfer of profit or loss on realisation:

    • For Profit: Realisation A/c Dr. to Partners' Capital A/cs (in profit-sharing ratio).
    • For Loss: Partners' Capital A/cs Dr. to Realisation A/c (in profit-sharing ratio).

13. For transfer of accumulated profits (e.g., General Reserve):

    • General Reserve A/c Dr.
    • To Partners' Capital A/cs (in profit-sharing ratio).

14. For payment of loan due to a partner:

    • Partner's Loan A/c Dr.
    • To Bank A/c

15. For final settlement of partners' accounts:

    • If a partner has a credit balance (firm owes them money):
      • Partner's Capital A/c Dr.
      • To Bank A/c
    • If a partner has a debit balance (they owe money to the firm):
      • Bank A/c Dr.
      • To Partner's Capital A/c