Chapter 4 — Dissolution of Partnership Firm

Chapter 4 covers the dissolution of a partnership firm, including its distinction from dissolution of partnership, the five modes of dissolution under the Partnership Act 1932, rules for settlement of accounts under Section 48, and the preparation of a Realisation Account with detailed journal entries.

Dissolution of partnership changes the existing relationship between some or all partners but the firm may continue its business. Dissolution of a firm, as defined in Section 39 of the Partnership Act 1932, ends all business operations — assets are sold, liabilities are paid, economic relationships between partners come to an end, and the books of account are closed.

A firm may be dissolved by agreement (with the consent of all partners or as per contract), compulsorily (when all or all but one partner become insolvent, or the business becomes illegal), on the happening of certain contingencies (such as death of a partner, expiry of a fixed term, or completion of the venture), by notice in the case of partnership at will, or by an order of court.

A court may order dissolution when a partner becomes insane or permanently incapable of performing his duties, when a partner is guilty of misconduct likely to adversely affect the business, when a partner persistently commits breach of the partnership agreement, when a partner has transferred his whole interest to a third party, when the business cannot be carried on except at a loss, or when the court regards dissolution to be just and equitable.

Under Section 48 of the Partnership Act 1932, losses are paid first out of profits, next out of capital, and lastly by partners in their profit sharing ratio. Assets are applied to pay third-party debts first (secured loans take precedence over unsecured), then partners' loans and advances proportionately, then partners' capital balances, and any residue is divided among partners in their profit sharing ratio.

A Realisation Account is prepared at the time of dissolution to record the sale of assets, settlement of liabilities, and realisation expenses, and to ascertain the net profit or loss on realisation. All assets except cash, bank balances, and fictitious assets are transferred to its debit at book value; all external liabilities including provisions are transferred to its credit. The resulting balance (profit or loss) is transferred to partners' capital accounts in their profit sharing ratio.

Cash and bank balances and fictitious assets are not transferred to the Realisation Account. Partner's loan account is also not transferred to Realisation Account — it is paid from cash or bank after third-party debts are settled.

Accumulated profits and general reserve are not transferred to the Realisation Account. They are transferred directly to partners' capital accounts in their profit sharing ratio.

When an unrecorded asset is realised, the amount received is debited to the Bank Account and credited to the Realisation Account. When an unrecorded liability is paid, it is debited to the Realisation Account and credited to the Bank Account. If a partner takes over an unrecorded asset, the partner's capital account is credited.

When the firm pays realisation expenses, Realisation Account is debited and Bank Account is credited. When a partner pays the expenses on behalf of the firm, Realisation Account is debited and the partner's capital account is credited. When a partner has agreed to bear the expenses and the firm pays them, the partner's capital account is debited and Bank Account is credited. If the partner pays the expenses himself after agreeing to bear them, no entry is required in the firm's books.

If a partner cannot contribute towards the debit balance in his capital account, he is said to be insolvent and the amount not recoverable is treated as a capital loss for the firm. In the absence of any contrary agreement, the Garner vs. Murray principle applies: the remaining solvent partners bear such loss in the ratio of their capitals as on the date of dissolution.

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