class 12 notes

Class 12 Accountancy Notes Chapter 5 (Dissolution of Partnership Firm) – Accountancy-I Book

Philoid

Philoid

— 8 min read

Accountancy-I
Alright class, let's dive into Chapter 5: Dissolution of Partnership Firm. This is a crucial chapter, not just for your board exams but also frequently tested in various government recruitment exams where accountancy knowledge is required. We need to understand the concepts clearly and the accounting treatment meticulously.

Chapter 5: Dissolution of Partnership Firm - Detailed Notes

1. Introduction: Meaning and Distinction

  • Dissolution of Partnership: This refers to a change in the existing relationship between partners. The firm continues its business, but the existing partnership agreement comes to an end, and a new one (often implicitly) comes into being. This happens in cases like:
    • Admission of a new partner
    • Retirement or Death of a partner
    • Change in Profit Sharing Ratio among existing partners.
    • Essentially, it's the termination of the old agreement.
  • Dissolution of Partnership Firm: This means the firm ceases to exist. The business operations are completely stopped, assets are sold off, liabilities are paid off, and the accounts of all partners are finally settled. The economic relationship between all partners comes to an end.
    • Key takeaway: Dissolution of the firm always involves dissolution of the partnership, but dissolution of partnership does not necessarily mean dissolution of the firm.

2. Modes of Dissolution of a Firm (Section 39-44 of the Indian Partnership Act, 1932)

A firm may be dissolved in the following ways:

  • (a) Dissolution by Agreement (Sec 40):
    • With the consent of all partners.
    • In accordance with a contract already existing between the partners (e.g., partnership formed for a specific venture or period).
  • (b) Compulsory Dissolution (Sec 41):
    • When all partners, or all but one partner, become insolvent.
    • When the business of the firm becomes unlawful.
    • When some event makes it unlawful for the partners to carry on the business in partnership (e.g., a partner becoming an alien enemy due to war).
  • (c) On the Happening of Certain Contingencies (Sec 42): Subject to contract between partners:
    • Expiry of the term for which the firm was constituted.
    • Completion of the venture(s) for which the firm was formed.
    • Death of a partner.
    • Adjudication of a partner as an insolvent.
  • (d) Dissolution by Notice (Sec 43):
    • Applicable in case of 'Partnership at Will'.
    • Any partner can give notice in writing to all other partners of their intention to dissolve the firm. The firm is dissolved from the date mentioned in the notice, or if no date is mentioned, from the date of communication of the notice.
  • (e) Dissolution by the Court (Sec 44): The court may dissolve a firm on the suit of a partner on grounds like:
    • A partner becoming of unsound mind.
    • Permanent incapacity of a partner to perform duties.
    • Misconduct by a partner affecting the business.
    • Persistent breach of the partnership agreement by a partner.
    • Transfer of the whole interest in the firm by a partner to a third party.
    • When the business cannot be carried on except at a loss.
    • On any other ground rendering it just and equitable to dissolve the firm.

3. Settlement of Accounts (Section 48)

This section dictates the order in which accounts must be settled upon dissolution.

  • (a) Treatment of Losses: Losses, including deficiencies of capital, shall be paid:

    • First, out of profits.
    • Next, out of capital.
    • Lastly, if necessary, by the partners individually in their profit-sharing ratio.

  • (b) Application of Assets: The assets of the firm, including any sums contributed by partners to make up deficiencies of capital, shall be applied in the following order:

    • 1st: Paying the debts of the firm to third parties (External Liabilities like Creditors, Bills Payable, Bank Overdraft, Outstanding Expenses, Loans from outsiders).
    • 2nd: Paying to each partner rateably what is due to him/her from the firm for advances (Loans given by partners to the firm), as distinguished from capital.
    • 3rd: Paying to each partner rateably what is due to him/her on account of capital.
    • 4th: The residue, if any, shall be divided among the partners in their profit-sharing ratio.

  • Firm's Debts and Private Debts (Section 49):

    • Firm's assets are applied first to pay firm's debts. Any surplus can be used to pay partners' private debts to the extent of their share in the surplus.
    • Partner's private assets are applied first to pay their private debts. Any surplus can be used to pay firm's debts if the firm's liabilities exceed firm's assets.

4. Accounting Procedure on Dissolution

When a firm is dissolved, the books of account are closed. The following accounts are generally prepared:

  • (a) Realisation Account:

    • Purpose: To close the books of account related to assets and liabilities, and to ascertain the net profit or loss on the sale of assets and payment of liabilities.
    • Preparation:
      • Debit Side:
        • All assets (except Cash, Bank, Fictitious Assets like Debit balance of P&L A/c, Deferred Revenue Exp) are transferred at their book values. (Includes Goodwill if appearing in books).
        • Payment made for any liability (whether recorded or unrecorded).
        • Payment of realisation expenses.
        • Any liability taken over by a partner.
      • Credit Side:
        • All external liabilities (Creditors, B/P, Bank Overdraft, Outstanding Exp., Partner's relative's loan) are transferred at their book values. (Do not transfer Partner's Loan A/c, Partner's Capital/Current A/cs, Accumulated Profits/Reserves).
        • Provisions against assets (e.g., Provision for Doubtful Debts, Provision for Depreciation if assets are shown gross) are transferred.
        • Amount realised from the sale of assets (whether recorded or unrecorded).
        • Any asset taken over by a partner.
    • Balancing:
      • If Credit Side > Debit Side = Profit on Realisation (transferred to Partners' Capital A/cs in PSR).
      • If Debit Side > Credit Side = Loss on Realisation (transferred to Partners' Capital A/cs in PSR).
    • Important Points:
      • Assets and liabilities must be transferred at book value, regardless of any agreement about realisation value.
      • Cash/Bank balance is NOT transferred to Realisation A/c.
      • Provisions related to assets (like Prov. for Doubtful Debts) are transferred to the credit side.
      • External liabilities ONLY are transferred. Partner's Loans/Capitals are settled separately.
      • Accumulated profits/losses/reserves are transferred directly to Partners' Capital Accounts.
      • Realisation expenses paid by the firm are debited. If paid by a partner on behalf of the firm, first debit Realisation A/c, then credit Partner's Capital A/c. If a partner agrees to bear expenses for a remuneration, debit Realisation A/c with remuneration, and the actual expense is not recorded in the firm's books (it's the partner's personal expense).
      • If a creditor accepts an asset in full/part settlement, no entry is made for that part in the Realisation A/c (unless there's a difference paid/received in cash).

  • (b) Partners' Loan Accounts:

    • If a partner has given a loan to the firm, it is paid off after external liabilities but before repayment of capital.
    • Entry: Partner's Loan A/c Dr. To Cash/Bank A/c.
    • This account is NOT transferred to Realisation A/c.

  • (c) Partners' Capital Accounts:

    • Purpose: To determine the final amount due to or due from each partner.
    • Preparation:
      • Credit Side: Opening capital balances, share of accumulated profits/reserves (General Reserve, P&L Credit Bal.), share of realisation profit, any liability paid or asset's realisation cost borne by the partner, remuneration for realisation work, interest on capital (if provided).
      • Debit Side: Opening debit balances (if any), share of accumulated losses (P&L Debit Bal., Deferred Rev Exp), drawings, interest on drawings, share of realisation loss, any asset taken over by the partner, cash withdrawn.
    • Balancing:
      • If Credit Balance: Final amount payable to the partner. Entry: Partner's Capital A/c Dr. To Cash/Bank A/c.
      • If Debit Balance: Deficiency to be brought in by the partner. Entry: Cash/Bank A/c Dr. To Partner's Capital A/c.
    • Insolvency: If a partner becomes insolvent and cannot bring in the required cash (debit balance), the deficiency is borne by the solvent partners according to the rule in Garner vs. Murray (in Capital ratio standing before dissolution, after adjusting accumulated profits/losses/reserves, unless the partnership deed specifies otherwise) or as per agreement. (Note: For many exams, simply knowing the principle might suffice, detailed calculations might not be needed unless specified).

  • (d) Cash/Bank Account:

    • Purpose: To record all cash/bank receipts and payments during the dissolution process. It serves as a final check.
    • Preparation:
      • Debit Side: Opening balance, proceeds from sale of assets, cash brought in by partners (for deficiency).
      • Credit Side: Payment of liabilities, payment of realisation expenses, payment of partners' loans, final payments made to partners on closing their capital accounts.
    • Balancing: This account must automatically balance if all entries have been made correctly. Total Debits = Total Credits.

Key Journal Entries Summary:

  1. For Transfer of Assets: Realisation A/c Dr. To Sundry Assets A/c (Individually, at book value)
  2. For Transfer of Liabilities: Sundry Liabilities A/c Dr. (Individually, at book value) To Realisation A/c
  3. For Transfer of Provisions: Provisions A/c Dr. To Realisation A/c
  4. For Sale of Assets: Cash/Bank A/c Dr. To Realisation A/c
  5. For Asset taken by Partner: Partner's Capital A/c Dr. To Realisation A/c
  6. For Payment of Liabilities: Realisation A/c Dr. To Cash/Bank A/c
  7. For Liability taken by Partner: Realisation A/c Dr. To Partner's Capital A/c
  8. For Payment of Realisation Expenses: Realisation A/c Dr. To Cash/Bank A/c
  9. For Expenses paid by Partner: Realisation A/c Dr. To Partner's Capital A/c
  10. For Closing Realisation A/c (Profit): Realisation A/c Dr. To Partners' Capital A/cs (In PSR)
  11. For Closing Realisation A/c (Loss): Partners' Capital A/cs Dr. (In PSR) To Realisation A/c
  12. For Transfer of Reserves/Accumulated Profits: Reserves/P&L A/c Dr. To Partners' Capital A/cs (In PSR)
  13. For Transfer of Accumulated Losses: Partners' Capital A/cs Dr. (In PSR) To P&L A/c / Deferred Exp A/c
  14. For Payment of Partner's Loan: Partner's Loan A/c Dr. To Cash/Bank A/c
  15. For Final Settlement (Payment to Partner): Partner's Capital A/c Dr. To Cash/Bank A/c
  16. For Final Settlement (Cash brought by Partner): Cash/Bank A/c Dr. To Partner's Capital A/c

Remember to thoroughly understand the difference between dissolution of partnership and dissolution of the firm, the order of settlement of accounts (Sec 48), and the purpose and preparation of the Realisation Account. This forms the backbone of this chapter.

Multiple Choice Questions (MCQs)

Here are 10 MCQs to test your understanding:

  1. On dissolution of a firm, which item is transferred to the Credit side of the Realisation Account?
    (a) Cash Balance
    (b) Partner's Capital Account Balance
    (c) Provision for Doubtful Debts
    (d) Partner's Loan Account

  2. According to Section 48(b) of the Indian Partnership Act, 1932, after paying firm's debts to third parties, the next payment should be made towards:
    (a) Partners' Capital Accounts
    (b) Partners' Loans/Advances to the firm
    (c) Distribution of remaining profit
    (d) Partners' private debts

  3. Dissolution of Partnership is different from Dissolution of Firm because:
    (a) Dissolution of Partnership leads to closure of business.
    (b) Dissolution of Firm does not terminate the business.
    (c) Dissolution of Partnership terminates the existing agreement but the firm may continue.
    (d) Dissolution of Firm involves only a change in profit sharing ratio.

  4. Unrecorded liability, when paid on dissolution of a firm, is debited to:
    (a) Partners' Capital Accounts
    (b) Liabilities Account
    (c) Profit & Loss Account
    (d) Realisation Account

  5. If a partner takes over an asset of the firm upon dissolution, the partner's capital account is:
    (a) Credited
    (b) Debited
    (c) Not affected
    (d) Debited only if the asset is taken below book value

  6. Realisation expenses incurred and paid by the firm on dissolution are debited to:
    (a) Cash Account
    (b) Concerned Partner's Capital Account
    (c) Realisation Account
    (d) Profit & Loss Adjustment Account

  7. Which of the following is NOT transferred to the Realisation Account?
    (a) Goodwill appearing in the books
    (b) Debtors
    (c) General Reserve
    (d) Creditors

  8. In case of dissolution, the final closing account prepared to verify arithmetic accuracy is:
    (a) Realisation Account
    (b) Partners' Capital Accounts
    (c) Cash/Bank Account
    (d) Profit & Loss Account

  9. Loss on realisation is distributed among partners:
    (a) Equally
    (b) In their capital ratio
    (c) In their profit-sharing ratio
    (d) As per the Garner vs Murray rule

  10. A partner 'X' agrees to pay off a firm's creditor amounting to Rs. 10,000. The correct journal entry would be:
    (a) Creditors A/c Dr. 10,000 To X's Capital A/c 10,000
    (b) Realisation A/c Dr. 10,000 To X's Capital A/c 10,000
    (c) Realisation A/c Dr. 10,000 To Creditors A/c 10,000
    (d) X's Capital A/c Dr. 10,000 To Realisation A/c 10,000

Answer Key for MCQs:

  1. (c)
  2. (b)
  3. (c)
  4. (d)
  5. (b)
  6. (c)
  7. (c)
  8. (c)
  9. (c)
  10. (b)

Study these notes carefully. Focus on the process and the 'why' behind each step. Practice preparing the accounts – Realisation, Capital, and Cash/Bank. Good luck with your preparation!

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