Dissolution of Partnership Firms
Unit – 5: Dissolution of Firm, Insolvency and Piecemeal Distribution
Dissolution of Partnership and Firm:
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Table of Contents |
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1. Meaning of Dissolution of Partnership and Partnership Firm 2. Difference between Dissolution of Partnership and Dissolution of Partnership Firm 3. Various modes of dissolution of firm 4. Realisation Account – Meaning, Preparation and Objectives 5. Difference between Revaluation Account and Realisation Account 6. Settlement of accounts in case of dissolution of firms 7. Insolvency of a partner – Rules of Garner vs Murray 8. Piecemeal Distribution – Meaning and methods of Piecemeal distribution 9. Conversion of Partnership into company or acquisition of firm by a company 10. Journal Entries in case of dissolution of Partnership Firms |
Dissolution
of a partnership means the termination of connections with the
firm by some of the partners of the firm, and remaining partners of the firm
continuing the business of the firm under the same firm’s name under an
agreement. Hence, admission, retirement and a death of a partner are considered
dissolution of partnership. The dissolution of partnership may take place in
any of the following ways:
a) Change in
existing profit sharing ratio among partners;
b) Admission
of a new partner;
c) Retirement
of a partner;
d) Death of a
partner;
e) Expiry of
the period of partnership, if partnership is for a specific period of time;
Dissolution
of a firm means discontinuation of the firm’s business and termination of
relationship between the partners. When all the partners stop carrying on the
partnership business, it is dissolution of the firm. According to Sec. 39 of
Indian Partnership Act 1932, “Dissolution of firm means dissolution of
partnership between all the partners in the firm."
In other words, if some partners dissociate
from the firm and remaining partners continue the business of the firm, it is
dissolution of partnership not the dissolution of the firm. Therefore when a
firm is dissolved, assets of the firm are disposed off, liabilities are paid
off and the accounts of all the partners are also settled.
Difference between dissolution of partnership
and dissolution of firm
|
Basis of
distinction |
Dissolution
of partnership |
Dissolution
of firm |
|
Relationship |
Relationship amongst all the partners does
not come to an end. |
Relationship amongst all the partners comes
to an end. |
|
Continuation of business |
Business of the firm may continue. |
Business of the firm does not continue. |
|
Inter relationship |
Dissolution of partnership may or may not
result in dissolution of the firm. |
Dissolution of the firm necessarily results
in dissolution of partnership. |
|
Books of accounts |
Books of accounts are not closed. |
Books of accounts are closed. |
|
Nature |
Dissolution of partnership is voluntary. |
Dissolution of partnership may sometimes
compulsory or sometimes voluntary. |
|
Account |
Revaluation account is prepared. |
Realisation account is prepared. |
Various modes of Dissolution of Firm
The dissolution of partnership between all the
partners of a firm is called the "dissolution of the firm". A firm
may be dissolved with the consent of all the partners or in accordance with a
contract between the partners. The Indian Partnership Act, 1932 provides that a
partnership firm may be dissolved in any of the following modes:
1.
Dissolution without Court’s order:
(i) Dissolution
by agreement (Sec. 40)
(ii) Compulsory
dissolution (Sec. 41)
(iii) Dissolution
on the happening of certain contingencies (Sec. 42)
(iv) Dissolution
by notice of partnership at will (Sec. 43)
2. Dissolution by the court’s order
(i)
Dissolution by agreement (Sec. 40): A firm may be dissolved with the consent
of all the partners. A partnership is set up by an agreement; similarly, it can
be dissolved by an agreement. If there is any contract between the partners
about the mode of dissolution of the firm, it may be dissolved accordingly.
(ii)
Compulsory Dissolution (Sec.41): A firm is dissolved compulsorily:
(a) If all the partners or a partner has been
adjudicated as insolvent, then the firm is dissolved as on the date of his
insolvency.
(b) If any event of the business of the firm
becomes unlawful, then the firm is dissolved.
(iii)
Dissolution on the Happening of Certain Contingencies (Sec. 42): Subject
to contract between the partners, a firm is dissolved on the happening of
certain contingencies:
a) On expiry
of the term for which the firm was constituted.
b) If firm is
constituted for a particular venture and that venture is completed.
c) On the
death of a partner; and
d) By the
adjudication of a partner as an insolvent.
(iv)
Dissolution by Notice of Partnership at Will (Sec. 43): Where the
partnership is at will, the firm may be dissolved by any partner giving notice
in writing to all the other partners of his intention to dissolve the firm. The
firm is dissolved as from the date mentioned in the notice as the date of
dissolution or, if no date is so mentioned, as from the date of the
communication of the notice.
(v)
Dissolution by Court (Sec. 44): A court may order a partnership firm
to be dissolved in the following cases:
a) When a
partner becomes of unsound mind.
b) When a
partner becomes permanently incapable of performing his/her duties as a
partner.
c) When
partner deliberately and consistently commits breach of partnership agreement.
d) When a
partner’s conduct is likely to adversely affect the business of the firm.
e) When a
partner transfers his/her interest in the firm to a third party;
f) When the
business of the firm cannot be carried on except at a loss in future also.
g) When the
court considers it just and equitable to dissolve the firm. The following are
the cases for the just and equitable grounds:
1. Deadlock in the management.
2. Where the partners are in talking
terms between them.
3. Loss of substratum.
4. Gambling by a partner on a stock
exchange.
Realisation Account
Realisation account is prepared at the time of
dissolution of firm. Realisation Account is a nominal account. It is prepared
to find out profit or loss on realisation of assets and payment of liabilities
when a firm is dissolved. Any profit or loss on realisation is transferred to
the capital accounts of all the partners in their profit sharing ratio.
Realisation
Accounts is prepared in the following manner:
a) All the
realisable assets given in the books of the firm are entered at their book
values on the debit side of the Realisation Account
b) All the
external liabilities are entered at their book values on the credit side of the
Realisation Account
c) On the
realisation of assets, the actual amount of cash received is entered on the
credit side of the account. - Cash/bank account is debited
d) On the
payment of liabilities, the actual amount of cash paid is entered on the debit
side of the account. Cash/bank account is credited
e) Realisation
expense if any, is also debited to the Realisation Account and bank account is
credited
f) After
making the above entries in the Realisation Account, the account is balanced.
The profit or loss on realisation is transferred to the capital accounts of all
the partners in their profit sharing ratio.
The main
objectives of preparing realisation account are:
1) To close all the books of account at the
times of dissolution of the firm.
2) To record all the transactions relating to
the sale of assets and payment of liabilities.
3) To determine profit or loss due to the
realisation of assets and liabilities.
Difference between Revaluation Account and Realisation Account:
|
Basis |
Revaluation
Account |
Realisation
Account |
|
Meaning |
Revaluation account is prepared in order to
work out the profit or loss on revaluation of assets and liabilities. |
Realisation account is prepared to work out
the profit or loss on realisation of assets and payment to liabilities. |
|
Preparation |
Revaluation account is prepared at the time
of admission, retirement or death of a partner. |
Realisation account is prepared at the time
of dissolution of a partnership firm. |
|
Closing of accounts |
After preparing the revaluation account the
firm’s business gets going with the same set of books. |
After preparation of Realisation account,
all the accounts of the firm are closed. |
|
Remaining balance |
Balance of this account is transferred to
the capital account of old partners. |
Balance of this account is transferred to
the capital account of all partners. |
|
Accounting entries |
Entries are based on the difference between
the book value and the revalued amount of assets and liabilities. |
Entries are based on the book value of
assets and liabilities. |
Settlement of Accounts
As soon as a firm
is dissolved, the normal business of the firm is discontinued and accounts of
all the partners are settled. Usually the partnership deed contains the clause
for settlement of partners account. But in the absence of any agreement between
the partners, the provisions of Sec. 48 of the Indian Partnership Act are
followed. The accounts of the partners are settled as follow:
1) When the firm
has suffered huge losses, the undistributed profits, if any, are first of all
to be applied to the payment of such losses. If the profits are insufficient,
the capital must be applied for payment of the losses and lastly, if necessary,
contributed by the partners individually in the proportion in which they share
profits.
2) When a partnership firm is dissolved, its
assets are disposed of and the proceeds there from including contribution by
the partners are utilised in the following manner:
(a) First, in
paying off the debts of the firm due to third parties;
(b) Then in paying
to each partner ratably any advances or loans given by him in addition to or
apart from his capital contribution;
(c) If any
surplus is available after discharging the above liabilities, the capital contributed
by the partners may be returned, if possible, in full or otherwise ratably;
(d) The
surplus, if any, shall be divided among the partners in their profit-sharing
ratios.
3) If the amount realised by sale of assets is
not sufficient to discharge the claims of the creditors in full, the deficiency
can be recovered proportionately from the personal properties of the partners.
If any partner becomes insolvent, the remaining solvent partners will bear the
loss in their capital ratio.
Insolvency of a Partner – (Rules of Garner vs. Murray)
If a partner’s capital account shows a debit
balance on the dissolution of the firm, he is required to bring cash in the
firm to settle his account. But if such partner is unable to satisfy his debt
to the firm due to his insolvency, then his deficiency is to be borne by the
solvent partners in accordance with the decision in Garner vs. Murray.
According to the rules of Garner vs. Murray, in the absence of any agreement to
the contrary, the deficiency of the insolvent partner’s capital account must be
borne by other solvent partners in proportion to their capital which stood
before the dissolution of the firm. The effect of this ruling is to make a
distinction between an ordinary loss caused due to business operation and loss
on account of insolvency of a partner.
Some
important judgments in Garner vs.
Murray case by Lord Justice Joyce was stated below:
a)
Loss on realisation
considered being ordinary loss and therefore to be shared by all the partners
according to their profit sharing ratio.
b)
Solvent partners to
bring cash equal to their share of loss on realisation
c)
Loss on account of
deficiency of insolvent partner considered being capital loss; therefore to be shared by solvent partners according
to their last agreed capital.
Accounting treatment when the firm is
dissolved due to insolvency of partners:
1)
When there are more than two partners and one becomes insolvent, the
solvent partners are liable to bear the loss of insolvent partner. The loss is
borne by the solvent partners in the following partners:
a)
When Garner Versus Murray rule is not
applicable, the solvent partners are supposed to bear the loss according to the
profit sharing ratio.
b)
When the Garner versus Murray rule is
applicable, the solvent partners are liable to bear the loss of insolvent partners according to the ratio of last
agreed capital.
Last Agreed Capital means
1. In case of Fixed Capitals: Fixed Capital (as
given in the Balance Sheet) without any adjustment
2. In case of Fluctuating Capitals: Capital after
making adjustments for past accumulated reserves, profits or losses, drawings, Interest on capital,
Interest on Drawing, remuneration to a partner etc. to the date of dissolution
but before making adjustment for profit or loss on realisation.
2) In the case of dissolution of a firm where
all the partners are insolvent, the following procedure should be followed:
a) The Realisation Account is prepared without
transferring external liabilities to it.
b) Cash Account should be prepared after the
Realisation Account.
c) Cash in hand together with the amount realized
on sale of asset and the amount received from the estate of insolvent partners
shall be applied in the following order:
i)
For meeting the
realization expenses
ii) For meeting the external liabilities like bank
loan, creditors, outstanding expenses, etc.
iii) For meeting partners loan account.
iv) For paying partners’ capital account balances.
Note:
In case of deficiency of cash, balances of above accounts
shall be transferred to the Deficiency Account. (Deficiency Account: When all the partners become insolvent, external
liabilities will not be met in full and balance due from partners also cannot
be recovered from partners in full. Hence, the balance due to external
creditors and balance due from partners are transferred to a separate account
called Deficiency Account.)
Piecemeal Distribution
In case of dissolution of firm, it is practically not possible to
realise all the assets at a time. In fact, on the dissolution of a partnership,
assets are sometimes realized gradually over a period of time. In such a case it
may be agreed that different parties are to be paid in order of preference as
and when assets are realized without unnecessarily waiting for the final
realization of all the assets. The order of the payment will be as follows:
a. Realisation
expenses
b. For provision
for expenses that are to be made
c. Preferential
creditors (say, Income Tax or any payment made to the Government)
d. Secured
creditors – upto the amount realized from the disposal of assets by which they
are secured and for the balance, if any, to be paid to unsecured creditors
e. Unsecured
creditors – in proportion to the amount of debts, if more than one creditor
f.
Partners’ loan – if there is more than one
partner – in that case, in proportion to the amount of loan
g. And
Finally, Partners’ capital.
The following two methods are followed to determine the order of
repayment of capital of the partners:
(a) Surplus Capital Method/ Proportionate Capital Method/ Highest Relative Capital Method:
1. Adjusted capital: the balance lying in the capital accounts of
the partners are adjusted with the undistributed profit or loss, drawings and
reserves.
2. Base capital: the adjusted capital is divided by the unit of
profit share and the minimum amount is called the base capital. For example if
profit sharing ratio is 5:3:2 the respective capitals will be divided by 5, 3
and 2 respectively.
3. Proportionate capital: the amount is ascertained by multiplying
the base capital with unit of profit share. For example if base capital is
20,000 it is multiplied by 5,3 and 2 respectively.
4. Surplus capital: it is ascertained by the difference of
adjusted capital and the proportionate capital. The process continues until we
get an absolute surplus.
(b) Maximum Possible Loss Method:
An alternative method of piecemeal distribution amongst partner is to calculate the maximum possible
loss on every realisation after the outside liabilities and the partner’s loan has been paid. The amount available for
distribution amongst partners is
compared with the total amount of capital payable to the partners and the maximum loss is ascertained on the
assumption that in future assets will not realize any amount. The maximum possible loss so ascertained is deducted from
the capital balances of the partners
in their profit and loss sharing ratio and the balance left in the capital account after deducting the maximum
possible loss will be the amount payable to the partner.
If a partner’s share of maximum possible loss is more than the
amount standing to the credit of his
capital account, he should be treated as insolvent and his deficiency should be debited to the capital accounts of the
solvent partners in the proportion of their capitals which stood on the dissolution date as stated under the Garner
V/s. Murray Rule. The amount
standing to the credit of the partners after debiting their share of maximum
loss and their share of insolvent
partners deficiency will be equal to the cash available for the distribution amongst the partners. This process of maximum possible loss
is repeated on each realisation till all the assets are disposed.
Conversion of Partnership into company or acquisition of firm by a company
For various reasons, an existing partnership may sell its entire
business to an existing Joint Stock Company which is called absorption of a
partnership firm by a company or for the purpose of expansion; it can also convert itself into a Joint
Stock Company which results into floatation of a new company to take over the
business of the partnership. In either of the above cases, the existing
partnership firm is dissolved and all the books of account are closed. The
procedure of liquidation of the partnership business is same as in case of
dissolution of firms but the assets of the firm are not disposed off and
liabilities are not repaid instead they are transferred to the new company for
a lump sum amount which is called purchase consideration.
Purchase
Consideration refers to the consideration payable by the purchasing company to
the vendor company for taking over the assets and liabilities of Vendor
Company.
Accounting
Standard – 14 defines the term purchase consideration as the “aggregate of the
shares and other securities issued and the payment made in the form of ach or
other assets by the transferee company to the shareholders of the transferor
company”. Although, purchase consideration refers to total payment made by
purchasing company to the shareholders of Vendor Company, its calculation could
be in different methods, as explained below:
a. Lump sum
method
b. Net Assets
method
c. Net Payment
Method
a. Lump sum Method: Under this
method purchase consideration will be paid in lump sum as per the valuation of
purchasing companies valuation. E.g., if it is stated that A Ltd. takes over
the business of B Ltd. for Rs.15, 00,000 here the sum of the Rs.15, 00,000 is
the Purchase Consideration.
b. Net Assets Method: Under this
method P.C. shall be computed as follows:
|
Particulars |
Rs. |
|
Agreed value of assets taken over Less: Agreed value of Liabilities taken over |
XXX XXX |
|
Purchase Consideration |
XXX |
Note: i. The term
“agreed value” means the amount at which the transferor company has agreed to sell
and the transferee company has agreed to take over a particular assets or a
liability Otherwise book value will be the agreed value.
ii. Fictitious
assets (i.e., preliminary expenses, underwriting commission, discount on issue
of shares, discount on issue of debentures and debit balance in P & L A/c)
are not taken over.
c. Net Payment Method: Under this
method P.C. should be calculated by aggregating total payments made by the
purchasing company. E.g.: A Ltd. had taken over B Ltd. and for that it agreed
to pay Rs.5, 00,000 in cash 4, 00,000 Equity Shares of Rs.10 each fully paid at
an agreed value of Rs.15 per share then the P.C. will be ascertained as
follows:
|
Particulars |
Rs. |
|
Cash 4,00,000 E. Shares of Rs.10 each fully paid, at
Rs.15 per share |
5,00,000 60,00,000 |
|
Purchase Consideration |
65,00,000 |
Journal Entries in case of Dissolution
of Partnership Firms
Accounting for
dissolution begins with the closing of assets and liabilities accounts by
transferring them to Realisation Account.
i) For transfer of assets
Realisation
Account Dr.
To Asset Account
ii) For Transfer of liabilities
Liability
Account Dr.
To Realisation Account
(Accumulated profits such as General Reserves,
Profit and Loss Account Credit Balance etc. are transferred to capital Accounts
in the profit sharing ratio.)
iii) For transfer of accumulated profits
Accumulated
Profit Account (General Reserve; P&L etc.) Dr.
To Partner’s Capital Account
Note: Provision
for doubtful debts; Investment fluctuation fund, Joint life Policy Fund etc.
are credited to realization account and ignored thereafter. These are internal
provisions having no claim against the firm and therefore these amounts will
merge into realization profit or loss and finally get transferred to Capital
Accounts of partners.
iv) For transfer of accumulated losses in
partner’s capital account
Partner’s
capital account Dr.
To Accumulated losses/Suspense Account
v) For assets including unrecorded assets
realized
Cash/Bank
account Dr
To Realisation Account
Note: We do not
have separate asset account anymore. Realisation account is the common account
representing all assets and liabilities transferred into it. Please check the
next entry also.
vi) For Liabilities including unrecorded
liabilities are paid off
Realisation
Account Dr.
To Cash/Bank Account
vii) For assets including unrecorded assets
taken over by a partner
Partner’s
Capital Account Dr.
To Realisation Account
viii) For Liability taken up by the partner
Realisation
Account Dr.
To Partner’s Capital Account
ix) For payment of realisation expenses
Realisation
Account Dr.
To Cash/Bank Account
x) Asset taken over by creditors: No entry; only settlement of balance amount is
shown in
the books.
xi) For repayment
of partner’s loan:
Partner’s
loan Account Dr
To
Cash/Bank Account
xii) For distribution of Profit or Loss on
Realisation
If Profit
Realisation
Account Dr.
To Partner’s Capital Account
If loss
Partner’s
Capital Account Dr
To
Realisation Account
xiii) For final payment to partners:
Partner’s
Capital Account Dr.
To Cash/Bank Account
xiv) For realisation of cash from partner’s in
case of dissolution
Cash/Bank
Account Dr.
To
Partner’s Capital Account
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