Class 12-commerce NCERT Solutions Accountancy Chapter 4 - Dissolution of Partnership Firm

According to Section 48 of the Partnership Act, 1932, following are the rules of the settlement of accounts on dissolution:

1. Application of Assets: Proceeds received from the sale (realisation) of the assets shall be applied in the following order:
1. First, all external liabilities and expenses are to be paid.
2. Second, all loans and advances lent by partners to the firm should be paid.
3. Lastly, the capital of each partner should be paid off.

If any surplus remains after the payment of (a), (b) and (c), then it should be distributed among the partners in their profit-sharing ratio.

2. Treatment of Loss: In case of any loss and deficiency, the treatment for the same should be made in the following order:
1. First, it should be adjusted against the firm's profits.
2. Then, it should be adjusted against total capital of the firm.
3. If any loss and deficiencies still exist, then it should be borne by all the partners individually in their profit-sharing ratio.

The process of discontinuation of a partnership business is known as dissolution of partnership. According to Section 39 of the Partnership Act, dissolution of partnership between all partners of a firm is called dissolution of a partnership firm. Dissolution involves winding up of business, disposal of assets, paying off liabilities and distribution of any surplus or loss by partners of the firm. According to the Partnership Act 1932, a partnership firm may be dissolved on any of the following grounds:

1. Dissolution by Agreement (Sec. 40)
2. Compulsory Dissolution (Sec. 41)
3. Dissolution due to Certain Contingencies (Sec. 42)
4. Dissolution by Notice of Partnership at Will (Sec. 43)
5. Dissolution by Court (Sec. 44)

Although the process of dissolution remains the same, the ways and modes in all five are different.

1. Dissolution by Agreement:

A firm may be dissolved with

a. Consent of all partners

b. Contract between partners

2. Compulsory Dissolution:

A firm may be dissolved by

a. Adjudication of all partners or of all partners but one as involved

b. Happening of an event or change in government policies which make the business unlawful

3. Dissolution due to Certain Contingencies:

Subject to the contract between partners, a firm is dissolved

a. If formed for a specific period, then on the expiry of the period

b. If formed for a specific purpose, then on completion of the purpose

c. On the death of partner/partners

d. On insolvency of a partner/partners

4. Dissolution by Notice:

If a partnership is at will, then the partnership firm is dissolved if any partner gives a written notice to all the other partners expressing his/her intention to dissolve the firm.

5. Dissolution by Court:

The court may order dissolution of a partnership firm when

a. A partner becomes insane or a lunatic.

b. A partner becomes permanently incapable of performing duties.

c. A partner is guilty of misconduct and affects business activities.

d. A partner repeatedly breaks the terms of agreement.

e. A partner transfers his interest to a third party without the consent of other partners.

f. A business persistently incurs losses.

Besides these circumstances, a partnership firm may be dissolved if the court at any stage finds dissolution of the firm to be justified and inevitable.

Dissolution of a firm is carried out in three steps:

1. Preparation of a balance sheet of the firm to be dissolved
2. Realisation of assets and liabilities
3. Distribution of cash to creditors and partners

Also, for the settlement of accounts, Section 48 of the Partnership Act 1932 would be applicable.

1. Application of Assets: Amount received by the realisation (sale) of assets shall be used in the following order:  
1. Debts of the firm towards third parties, or first, external liabilities and expenses are to be paid.
2. Then all loans and advances forwarded by partners should be paid.
3. Then the capital of each partner should be paid off. Any surplus remaining after the payment of (a), (b) and (c) should be distributed among partners in their profit-sharing ratio.
2. Treatment of Loss: Loss and any deficiency of capital should be paid in the following order: 
1. First, these should be adjusted against the firm's profits.
2. Then against the total capital of the firm.
3. If there is still any loss and deficiency, then it should be borne by all partners individually in their profit-sharing ratio.

Dissolution of a partnership firm leads to discontinuation of business activities wherein all the books of accounts are to be closed. All the assets of business are sold off and all liabilities are paid off. To record the sale of assets and discharge of liabilities, a nominal account named realisation account is opened. The main purpose of this account is to ascertain the profit or loss due to the realisation of assets and liabilities. Realisation profit  (i.e. credit side exceeding debit side) or realisation loss (i.e. debit side falling short of credit side) would be transferred to the partner's capital account in the profit-sharing ratio.

Important objectives of preparing a realisation account:

1. Closure of all the books of accounts
2. To record transactions relating to the sale of assets and discharge of liabilities
3. To determine profit or loss due to the realisation of assets and liabilities

Accounting treatment of items related to a realisation account

Dissolution of a firm calls for closure of all accounts and realisation of assets and making payment to meet  liabilities. At the time of dissolution of a firm, the amount received from the sale of the firm's assets is used to pay off creditors. If the amount received from the sale falls short, then the partner's private assets are used for settling the dues of the firm's creditors. Even if some portion of the amount due to creditors is left unpaid, then there arises deficiency of creditors. This deficiency can be treated in the following two ways:

1. Transferring deficiency to the Deficiency Account
2. Transferring deficiency to the Partner's Capital Account

In case the amount of deficiency is to be transferred to the Deficiency Account, then a separate account is prepared for the firm's creditors. A Cash Account is prepared to ascertain the firm's cash balance accruing from the sale of the firm's assets and partner's private assets. After ascertaining the cash availability with the firm, creditors and external liabilities are paid proportionately. The remaining unpaid creditors or the deficiency is transferred to the Deficiency Account.

In the second case, creditors are paid by the cash available with the firm, including the partner's individual contribution. The deficiency or unpaid creditor's amount is transferred to the Partner's Capital Account. Thus, the deficiency of creditors is borne by all partners in their profit-sharing ratio. If any partner becomes insolvent and is unable to bear the deficiency, then this will be regarded as a capital loss to the firm. If the partnership deed is silent about such capital loss in the facet of insolvency of a partner, then according to the Garner vs. Murray case, such capital loss needs to be borne by the solvent partners in their capital ratio.

Accounting treatment for

1. Unrecorded Assets: Unrecorded assets are omitted from the books or are assets whose value has been written off in the books of accounts but are still in working condition. The accounting treatment for unrecorded asset is 

2. Unrecorded Liabilities: Unrecorded liabilities are not recorded in the books of accounts. The accounting treatment for unrecorded liability is 

1. If a partner's loan appears on the assets side of the balance sheet, then it means that a partner has taken a loan from the firm and is liable to repay the amount to the firm. In such a situation, the loan amount is transferred to his/her capital account. Thus, the accounting entry will be

2. If a partner's loan appears on the liabilities side of the balance sheet, then it means that the partner has lent a loan to the firm and the firm is liable to pay back the amount to the partner. In such a situation, the partner's loan is paid off after paying all the external liabilities of the firm. The partner's loan will be paid in cash and the following accounting entry will be passed:

According to section 48 of Partnership Act, 1932 at the time of dissolution, loans and advances from the partners must be paid off before the settlement of their capital accounts. Hence, Yastin's argument is correct that her loan of Rs.2,00,000 must be paid off before the payment of partners' capital.