Dissolution of firm means closure of business. As a result all the liabilities of the firm are paid off by disposing off all the assets of the firm and if there is cash balance, it is used to pay off the capital of the partners. It is mentioned in the ‘Indian Partnership Act, 1932, section 42 to 44’ that under which circum-stances a partnership firm can be dissolved.
Dissolution by Agreement : When all the partners of the business decide unanimously to dissolve the partnership, the firm is dissolved. This method is known as dissolution of partnership firm by mutual consent.
Compulsory Dissolution : Under the following circumstances, a partnership firm is compulsorily dissolved :
(i) When the number of partners in the ordinary business exceeds twenty and in case of banking business, the number exceeds the limit of ten partners, the partnership firm is dissolved.
(ii) When the government of the country declares the business of the firm illegal.
(iii) When the native of an inimical country becomes a partner the partnership firm is compulsorily dissolved.
Dissolution on the Happening of Certain Contingencies :
(i) On the expiry of the period for which the partnership was formed.
(ii) On the insolvency of a partner.
(iii) On the death of a partner.
(iv) On the fulfillment of the affect for which the firm was formed.
It may be noted here that the firm is dissolved when the relations of all the partners are severed with one another, but partnership is also dissolved when a partner severes relations with other partners.
If all the partners agree that business will continue inspite of the above circumstances, the partnership is not dissolved.
Dissolution of Partnership by Court : The court on receiving the application for the dissolution by the partner, can order for dissolution under the following circumstances :
(i) When the partners except the one applying for dissolution become permanently disable to run the business.
(ii) When a partner becomes insane.
(iii) When a partner, except the one who applied for dissolution, transfers his share to someone else.
(iv) When a partner, except the one who applied for dissolution, wilfully acts against the partnership agreement.
(v) When a partner, except the one who applied for dissolution, is found guilty of misconduct.
(vi) When the business of the firm cannot be run without loss.
(vii) When the court thinks it necessary to dissolve the partnership business due to some other reasons.
Settlement of accounts on dissolution
First of all, the amount of loss, including the deficiency of the capital will be paid out of profits, then out of capital, and then if necessary, will be raised from the partners in their profit sharing ratio.
The procedure of payment out of the firm’s assets will be as under :
(i) First of all outside creditors will be paid.
(ii) Out of the remaining amount, the loans of the partners be paid.
(iii) Then the capital of the partners be paid.
(iv) If something remains, it will be divided among the partners in their profit sharing ratio.
Accounting treatment on dissolution
When the partnership is dissolved, the following accounts are closed :
(a) Realisation Account
(b) Capital Accounts of Partners
(c) Loan Accounts of Partners
(d) Cash or Bank Account
Realisation Account
This account is opened to close the account of the firm. The aim of this account is to dispose all the assets and payments of liabilites and to find out profits or losses on account of it. The method of opening and closing of this account is as follows :
On Closing the Assets Account : All the assets of the firm (except cash and bank balances) are transferred to the debit side of the Realisation account at their book value. Its entry is as follows :
Realisation A/c Dr.
To Various Assets A/c (By Name)
(For various assets transferred to realisation account at book value)
On Closing all the Liabilities Accounts : All the external liabilities (except capital account of partners undivided profits and reserves) are transferred to realisation account at book value. Their entry will be as follows :
Sundry Creditors A/c Dr
Bills Payable A/c Dr
Loan from Partners A/c Dr
To Realisation A/c
(For transfer of all liabilities to realisation account)
On Disposal of Assets : The amount realised from the disposal of assets in the market is debited to the cash account and credited to the realisation account. There is no need to make separate entries for the disposal of every asset. The following entry is made at the disposal of assets:
Cash A/c Dr
To Realisation A/c
(For each account debited on disposal of various assets in the market)
On taking assets by a partner : Capital A/c of Partner Dr
(by name)
To Realisation A/c
(For assets taken over the partner)
For Realisation Expenses : The amount for realisation expenses is debited to the realisation account and credited to the cash account. This entry is made in the following manner.
Realization A/c Dr
To Cash A/c
(For expenses incurred on disposal of various assets)
On Payment of Liabilities : Cash account is credited and realisation account is debited by the amount paid to creditors and various liabilities. This amount may be different from the amount given in the books of accounts. The following entry will be made for it.
Realisation A/c Dr
To Cash A/c
(For the various liabilities disposed off)
On Owning Liabilities by a partner:
Realisation A/c Dr
To Capital A/cs of Partners
(By Name)
(Being a liability taken over by a partner)
On Closing Realisation Account : In the end, Realisation account shows either profit or loss. If the total credit side is bigger than the debit side, there will be profit. On the contrary, if total of credit side is less than debit side, it is a case of loss. This profit or loss is divided among the partners in their profit sharing ratio. In case of profit, partners’ capital accounts are credited and realisation account is debited. Its journal entry is as follows :
Realisation A/c Dr
To Partners Capital Accounts
(For profit on realisation transferred to capital accounts of partners)
Capital Accounts of partners
The balances of current accounts of partners are transferred to their capital accounts. If any partner takes assets of the firm at the time of dissolution, its amount will be debited to his capital account. On the contrary, if any partner has owned a liability, his capital account will be credited by the amount of liability. The following personal entries are made at the time of dissolution in addition to the entries already mentioned.
On Transferring undivided Profits & Reserves to Partners’ Capital Accounts :
Profit & Loss A/c Dr
Reserve Fund A/c Dr
To Partner’s Capital Acs.
(For transfer of profit and reserves to capital accounts of partners)
On meeting the shortage of
Capital :
Cash/Bank A/c
To Partners’ capital A/cs
(For cash taken from partners to make up deficiency of capital)
On Paying Back excess to
partners :
Partners’ Capital A/c Dr
To Cash/Bank A/c
(Being excess capital refunded to partners)
Partners’ Loan Account : When a partner gives loan to a firm, his account is credited. After making payment to others when payments’ made to refund the loan of the partners, the following journal entry is passed.
Partners’ Capital A/c Dr
To Cash A/c
(For payment is made of partners’ loan)
Cash or Bank Account : If both the cash and bank accounts are given in the sum, it will be in the fitness of things to open only one account. Opening balance and receipts are written on its debit side and amounts of payment are written on the credit side. To close cash or bank account, the following entry will be made and all the accounts will be closed.
Capital Accounts of Partners (By names)
To Cash/Bank A/c
(For full and final payment made to all the partners)
The difference
Purpose : Realisation account is prepared to finalise the net gain or loss in the disposal of assets and liablities at the time of dissolution of a partnership firm. Revaluation of assets and liabilities is done to find out the make value of assets.
Time : Realisation account is prepared at the time of dissolution of a firm, whereas revaluation account is prepared at the time of retirement or admission of a partner.
Effect : Realisation account is prepared when the firm is going to dissolve. After its preparation, all the accounts in the ledger are closed, whereas the firm continues after the retirement or admission of a partner.
Goodwill : The partnership does not face any problem on account of goodwill at the time of dissolution. If the amount of the goodwill is shown in the balance sheet, it is also transferred to realisation account like other assets.
In case the amount of goodwill is not shown in the balance sheet, there is no question of raising it. If any amount is received against goodwill, cash account is debited and realisation account is credited. If a partner purchases goodwill, capital account of the respective partner is debited and realisation account is credited.
On Transfer of Goodwill to the Realisation Account :
Realisaton A/c Dr
To Goodwill A/c
(For goodwill account transferred to realisation account)
On Receiving Cash Against Goodwill :
Cash A/c Dr
To Realisation A/c
(For Cash realized for goodwill)
On Purchase of Goodwill by a Partner :
Partner’s Capital A/c Dr
To Realisation A/c
(For goodwill purchased by the partner)
Unrecorded assets & liabilities
Sometimes, at the time of dissolution, there might be some assets which are not shown in the books of accounts. These are the assets which have been already written off. But they actually (materially) exist and can bring some value. Likewise, there might be liabilities which are not recorded but have to be cleared at the time of dissolution. For example, payment in respect of certain court cases. In such cases, the following points have to be kept in mind:
(i) Such assets and liabilities are not recorded in the books and transferred to realisation account.
(ii) When cash is realised for some asset which is not recorded in the books the entry will be:
On receiving Cash for Unrecorded Assets :
Cash A/c Dr
To Realisation A/c
(For cash realized due to unrecorded assets)
When a Partner Takes over unrecorded Assets :
Partners’ Capital A/c (By Name) Dr
To Realisation A/c
(For unrecorded assets are taken over by a partner)
On Payment for unrecorded Liabilities :
Realisation A/c Dr
To Bank/Cash A/c
(For payment of unrecorded liabilities)
Insolvency
When all the Partners Except one are Insolvent : When a person is unable to pay off his liabilities, he becomes insolvent. In case of partnership, if there is debit balance of his capital account and he is unable to pay off that amount, the amount thus unpaid by an insolvent partner is loss to partnership firm. If there is only one solvent partner in the firm, and the remaining ones are insolvent, their whole loss will be paid by the solvent partner.
The solvent partner may have to dispose off all his private property in order to make payment of the liabilities of the partnership firm.
Under such circumstances realisa-tion account will be prepared in the manner described in the previous pages an the profit or loss of this account will be debited to the capital account of all the partners. If an insolvent partner can bring in some money to make up the deficiency of his capital account, that amount is credited to his capital account. In the end, balance of capital account of insolvent partners are closed by transferring them to capital account of solvent partner (debiting). After making payment of the liabilities of the firm, if there is any cash balance, it is transferred to the capital account of the solvent partner and his account is closed.
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