Reconstitution of a Partnership Firm – Retirement/Death of a Partner

Meaning and Concept of Dissolution of Partnership Firm

**Dissolution of partnership** refers to the termination of the relationship between partners, whereas **dissolution of a partnership firm** means the complete winding up of the firm itself. According to **Section 39 of the Partnership Act 1932**, the dissolution of a partnership between all partners of a firm constitutes the dissolution of the firm. This is a critical distinction: dissolution of partnership changes the relationship between partners but the firm may continue; dissolution of firm necessarily brings an end to the entire business operation.

When a firm dissolves:

All business activities cease except winding-up operations

Assets must be sold and liabilities paid

Partners' claims are settled

Books of account are permanently closed

No further business transactions occur

Distinction Between Dissolution of Partnership and Dissolution of Firm

| **Basis** | **Dissolution of Partnership** | **Dissolution of Firm** |

|-----------|-------------------------------|------------------------|

| **Termination of Business** | Business continues; only partner relationship changes | Business is completely closed |

| **Settlement of Assets** | Assets/liabilities revalued; new balance sheet prepared | Assets sold; all liabilities paid in full |

| **Court Intervention** | Typically by mutual agreement; no court needed | Court can order dissolution |

| **Economic Relationship** | Between partners continues in modified form | Relationship ends completely |

| **Book Closure** | Books remain open | Books permanently closed |

**Exam Focus:** Students must clearly explain that changing profit-sharing ratio, admitting a new partner, or one partner retiring = dissolution of partnership (not firm). Complete cessation of business = dissolution of firm.

Modes of Dissolution of Partnership

Dissolution of partnership occurs when:

1. **Change in profit-sharing ratio** among existing partners

2. **Admission of a new partner** to the firm

3. **Retirement of a partner** from the firm

4. **Death of a partner**

5. **Insolvency of a partner**

6. **Completion of the venture** (if formed for specific purpose)

7. **Expiry of the period** if partnership has fixed term

These changes terminate the existing partnership agreement but firm may continue under new partnership deed.

Ways of Dissolution of Firm

1. **Dissolution by Agreement**

A firm is dissolved when:

All partners give **mutual consent** for dissolution, OR

Partners act in **accordance with partnership deed** provisions for dissolution

This requires formal agreement; typically the most amicable method.

2. **Compulsory Dissolution**

Automatic dissolution occurs without consent when:

**All partners or all but one partner become insolvent** (legally incompetent to sign contracts)

**Business becomes illegal** (e.g., smuggling operation becomes criminal)

**Unlawful to continue partnership** (e.g., partner becomes alien enemy during wartime; citizen of enemy nation)

3. **Dissolution on Happening of Contingencies**

Firm dissolves automatically (unless partnership deed provides otherwise) upon:

**Expiry of fixed term** if partnership was constituted for specific duration

**Completion of venture** if partnership was formed for one or more specific ventures

**Death of a partner** (major contingency)

**Adjudication of partner as insolvent** (bankruptcy)

4. **Dissolution by Notice**

In case of **partnership at will** (no fixed term):

Any one partner may give **written notice** to other partners expressing intention to dissolve

Firm dissolves immediately upon notice

No consent of other partners required

Governed by **Section 43 of Partnership Act 1932**

5. **Dissolution by Court Order**

Court may order dissolution at suit of a partner on grounds of:

**Partner becomes insane** (legally incapable)

**Partner becomes permanently incapable** of performing duties

**Misconduct by a partner** likely to harm firm's business

**Persistent breach of partnership agreement**

**Partner transferred entire interest** to third party without consent

**Business runs at continuous loss** (economically unviable)

**Just and equitable grounds** (discretionary; if court finds dissolution is fair and reasonable)

**Section 44** of Partnership Act 1932 provides these grounds; court has discretion to grant relief.

Settlement of Accounts on Dissolution

Hierarchy of Claims - **Section 48 of Partnership Act 1932**

When firm dissolves, assets and contributions are applied in strict order:

**Treatment of Losses:**

1. **First from profits** – offset against firm's profit balance

2. **Next from capital** – debit partners' capital accounts

3. **Finally by partners** – as additional contribution in profit-sharing ratio

**Application of Assets and Firm's Funds:**

Realised assets + partner contributions applied in this order:

1. **Debts to third parties** (secured creditors, unsecured creditors, bills payable, bank loans, overdrafts). *Secured loans have precedence over unsecured.*

2. **Partner loans** (advances made by partners to firm, treated as liabilities not capital). *Paid proportionately if insufficient funds.*

3. **Capital accounts** (repayment of capital to each partner). *Paid proportionately if deficient.*

4. **Profit surplus** (remaining balance after all liabilities paid). *Divided in profit-sharing ratio.*

**Example:** Firm dissolves with assets of Rs. 1,00,000. Third-party creditors owed Rs. 60,000, Partner A's loan Rs. 10,000, Partner A's capital Rs. 15,000, Partner B's capital Rs. 15,000. Surplus after paying third-party creditors = Rs. 40,000. This is used to repay Partner A's loan fully (Rs. 10,000), then repay both capitals proportionately.

Private Debts and Firm's Debts - **Section 49 of Partnership Act 1932**

When both firm debts and partner's private debts exist:

**Firm's property applied first** to firm's debts; surplus available to partners

**Partner's private property applied first** to private debts; surplus available for firm's debts

**Private property excludes** wife's and children's property

If firm assets insufficient, solvent partners must contribute from net private assets

Insolvent Partner and Garner vs. Murray Rule

When a partner cannot contribute toward his capital deficiency (debit balance):

Partner is **insolvent**

Loss is **non-recoverable from that partner**

Such loss treated as **capital loss**

**Garner vs. Murray Principle:** In absence of agreement, solvent partners bear insolvent partner's deficiency **in ratio of their capitals as on date of dissolution** (not profit-sharing ratio).

**Example:** A, B, C partners with capitals Rs. 50,000, Rs. 40,000, Rs. 30,000 (total Rs. 120,000); profit ratio 3:2:1. On dissolution, after realisation and paying creditors, C shows capital deficit of Rs. 6,000 and is insolvent. A and B bear loss in capital ratio = 50,000:40,000 = 5:4. A bears Rs. 3,333; B bears Rs. 2,667.

Realisation Account - Concept and Format

**Realisation Account** is a **temporary nominal account** opened at dissolution to:

Record all assets (except cash/bank) being sold

Record all external liabilities being paid

Calculate **net profit or loss on realisation**

Transfer this profit/loss to partners' capital accounts in profit-sharing ratio

Entries on Debit Side of Realisation Account

All non-cash/bank **assets** transferred at **book value**:

Stock/inventory

Sundry debtors (at **gross value**, not after provision)

Fixed assets (at **gross value**, not after depreciation)

Investments

Goodwill

Bills receivable

Loans to other parties

Unrecorded assets discovered (credited to bank if sold)

All **external liabilities** transferred to credit side:

Sundry creditors

Bills payable

Bank loans/overdrafts

Provision for doubtful debts (credited to realisation)

Provision for depreciation (credited to realisation)

Outstanding expenses

Entries on Credit Side of Realisation Account

**Bank/Cash from asset sales**

**Partner takes asset over** at agreed value

**Liability assumed by partner** (partner agrees to pay creditor directly)

**Unrecorded liabilities** paid through bank

**Realisation expenses** paid through bank

**Partner's capital account** (if partner pays realisation expenses or takes unrecorded liability)

**Profit on realisation** transferred to partners' capital accounts in profit-sharing ratio

**Loss on realisation** (if net debit balance)

Key Rules for Realisation Account

1. **Provision for doubtful debts** transferred to **credit** of realisation (treated as liability)

2. **Depreciation provision** transferred to **credit** of realisation

3. **Debtors transferred at gross value** (before deducting provision)

4. **Fixed assets transferred at gross value** (before deducting depreciation)

5. **Unrecorded assets realised** credited to realisation (credited = treated as income)

6. **Unrecorded liabilities paid** debited to realisation (debited = treated as expense)

7. **General reserve and other accumulated profits** transferred **directly to partners' capital accounts** (NOT through realisation account) in profit-sharing ratio

8. **Fictitious assets** (preliminary expenses, goodwill carried at Rs. 0) transferred **directly to partners' capital accounts**

9. **Realisation profit** transferred to capital accounts in **profit-sharing ratio**

10. **Realisation loss** transferred to capital accounts in **profit-sharing ratio**

Journal Entries for Dissolution

1. Transfer of Assets to Realisation Account

**Dr. Realisation A/c**

**Cr. Asset A/c** (individually)

Assets transferred at book value. Debtors transferred at gross amount; provision transferred separately to credit.

2. Transfer of External Liabilities

**Dr. Liability A/c** (individually)

**Cr. Realisation A/c**

All external debts and provisions transferred to credit of realisation.

3. Sale of Assets

**Dr. Bank A/c**

**Cr. Realisation A/c** (with realisation proceeds)

For assets sold at gain/loss, the entire proceeds credited to realisation account which will show profit/loss.

4. Partner Takes Over Asset

**Dr. Partner's Capital A/c**

**Cr. Realisation A/c** (with agreed value)

Partner accepts asset in settlement; reduces his liability to firm.

5. Payment of Liabilities

**Dr. Realisation A/c**

**Cr. Bank A/c** (with amount paid)

Creditors and external liabilities paid through bank; debited to realisation.

6. Partner Assumes Liability

**Dr. Realisation A/c**

**Cr. Partner's Capital A/c** (with amount assumed)

Partner agrees to pay creditor directly; reduces firm's liability and his capital balance.

7. Realisation Expenses Paid by Firm

**Dr. Realisation A/c**

**Cr. Bank A/c** (with expenses amount)

Costs of dissolution (auctioneers' fees, legal fees, selling costs) debited to realisation.

8. Realisation Expenses Paid by Partner

**Dr. Realisation A/c**

**Cr. Partner's Capital A/c** (with expenses amount)

If partner advances money for expenses, credited to partner's capital account.

9. Realisation Profit (Credit Balance) Transferred

**Dr. Realisation A/c**

**Cr. Partners' Capital A/c** (individually, in profit-sharing ratio)

Net profit on realisation distributed proportionately.

10. Realisation Loss (Debit Balance) Transferred

**Dr. Partners' Capital A/c** (individually, in profit-sharing ratio)

**Cr. Realisation A/c**

Net loss on realisation borne proportionately.

11. Transfer of General Reserve

**Dr. General Reserve A/c**

**Cr. Partners' Capital A/c** (individually, in profit-sharing ratio)

Accumulated reserves divided in profit-sharing ratio; credited to capital accounts.

12. Transfer of Other Accumulated Profits/Funds

**Dr. Investment Fluctuation Fund/Workmen Comp Fund A/c**

**Cr. Partners' Capital A/c** (in ratio)

All reserves and accumulated profits transferred to capital accounts in profit-sharing ratio.

13. Settlement with Partners

**Dr. Partners' Capital A/c** (individual balances)

**Cr. Bank A/c** (total due to partners)

Final settlement: partners receive their capital balances plus share of profit minus share of loss.

14. Unrecorded Assets Sold

**Dr. Bank A/c**

**Cr. Realisation A/c** (with proceeds)

Assets not in books (goodwill, land appreciation) sold; proceeds credited to realisation as income.

15. Unrecorded Liabilities Paid

**Dr. Realisation A/c**

**Cr. Bank A/c** (with amount paid)

Liabilities not recorded (warranty claims, legal settlement) paid; debited as expense in realisation.

Format of Realisation Account with Worked Illustration

**Dr. Realisation Account Cr.**

| **Debit (Expenses)** | **Amount (Rs.)** | **Credit (Income)** | **Amount (Rs.)** |

|---|---|---|---|

| Stock | 7,500 | Sundry Creditors | 48,000 |

| Sundry Debtors | 21,500 | Provision for Doubtful Debts | 500 |

| Fixed Assets | 36,500 | Bank (from asset sales) | 69,425 |

| | | Partner A (takes asset) | — |

| | | Profit transferred to Capital A/c (3:2) | 2,925 |

| | | **Total** | **1,17,925** |

| **Total** | **1,17,925** | | |

**Calculation of Profit on Realisation:**

Assets realised: Debtors Rs. 20,425 (after 5% discount on Rs. 21,500), Stock Rs. 7,000, Fixed Assets Rs. 42,000 = **Rs. 69,425**

Liabilities paid: Creditors Rs. 48,000 + Realisation expenses Rs. 1,500 = **Rs. 49,500**

Profit = Rs. 69,425 – (Rs. 7,500 + Rs. 21,500 + Rs. 36,500 + Rs. 500 + Rs. 1,500) + (Rs. 48,000 + Rs. 500) = **Rs. 2,925**

**Transfer to Capital Accounts (3:2 ratio):**

A: Rs. 2,925 × 3/5 = Rs. 1,755

B: Rs. 2,925 × 2/5 = Rs. 1,170

Partners' Capital Accounts on Dissolution

After all journal entries, partners' capital accounts show final balances:

**Dr. A's Capital Account Cr.**

| **Debit** | **Amount (Rs.)** | **Credit** | **Amount (Rs.)** |

|---|---|---|---|

| Bank (Final payment) | 42,355 | Opening Balance | 32,500 |

| | | Realisation Profit | 1,755 |

| | | General Reserve | 8,100 |

| **Total** | **42,355** | **Total** | **42,355** |

These final credit balances represent total due to partners, paid through bank transfer or cheque.

Treatment of Special Items

Fictitious Assets

Preliminary expenses, discount on debentures carried at Rs. 1 or nominal value

**Written off completely** by transfer to partners' capital accounts in profit-sharing ratio

**Never transferred to realisation account**

Goodwill

If goodwill appears in books, transferred to debit of realisation account (like other assets)

If no value in books, discovered goodwill sold during dissolution → proceeds credited to realisation

Profit/loss on goodwill included in realisation profit/loss

Accumulated Profits/Reserves

General Reserve, Profit & Loss Account (credit balance), Workmen Compensation Fund

**Never transferred to realisation account**

**Directly credited to partners' capital accounts** in profit-sharing ratio

Treated as additional capital available for distribution

Bills Receivable

Transferred to debit of realisation at face value

If recovered in full, proceeds credited to realisation = profit

If discounted/dishonoured, loss debited to realisation

Complete Worked Example

**Balance Sheet of Firm A, B, C on March 31, 2020:**

| **Liabilities** | **Rs.** | **Assets** | **Rs.** |

|---|---|---|---|

| A's Capital | 60,000 | Cash | 20,000 |

| B's Capital | 40,000 | Debtors | 50,000 |

| C's Capital | 30,000 | Stock | 30,000 |

| Creditors | 60,000 | Fixed Assets | 80,000 |

| Bank Loan | 20,000 | **Total** | **1,80,000** |

| **Total** | **2,10,000** | | |

Profit-sharing ratio 3:2:1. On dissolution:

Debtors realised at 10% discount = Rs. 45,000

Stock realised at Rs. 35,000

Fixed Assets realised at Rs. 90,000

Creditors paid in full

Bank loan paid in full

Realisation expenses Rs. 5,000

**Realisation Account:**

| **Dr.** | **Rs.** | **Cr.** | **Rs.** |

|---|---|---|---|

| Debtors | 50,000 | Creditors | 60,000 |

| Stock | 30,000 | Bank Loan | 20,000 |

| Fixed Assets | 80,000 | Bank (Realisation proceeds) | 1,70,000 |

| | | Profit to A, B, C (3:2:1) | 10,000 |

| **Total** | **1,60,000** | **Total** | **2,50,000** |

**Profit on Realisation = Rs. 1,70,000 – (Rs. 50,000 + Rs. 30,000 + Rs. 80,000 + Rs. 5,000) + Rs. 80,000 = Rs. 10,000** divided 3:2:1 = A Rs. 5,000, B Rs. 3,334, C Rs. 1,666.

**Capital Accounts After Dissolution:**

| **Particulars** | **A (Rs.)** | **B (Rs.)** | **C (Rs.)** | **Total (Rs.)** |

|---|---|---|---|---|

| Opening Balance | 60,000 | 40,000 | 30,000 | 1,30,000 |

| Realisation Profit | 5,000 | 3,334 | 1,666 | 10,000 |

| **Final Due** | **65,000** | **43,334** | **31,666** | **1,40,000** |

**Journal Entry for Final Settlement:**

**Dr. A's Capital A/c 65,000**

**Dr. B's Capital A/c 43,334**

**Dr. C's Capital A/c 31,666**

**Cr. Bank A/c 1,40,000**

(Final settlement of partners' accounts)

Key Exam Points - Must Remember

1. **Realisation Account is temporary nominal account** – purpose is to compute profit/loss on closure, then closed by transfer to capital accounts

2. **Debtors transferred at gross value** (before deducting provision); provision transferred separately to credit

3. **Fixed assets transferred at gross value** (before deducting depreciation); depreciation transferred separately to credit

4. **General Reserve/accumulated profits NOT transferred through Realisation** – go directly to capital accounts

5. **Fictitious assets NOT transferred through Realisation** – written off directly to capital accounts

6. **Realisation profit/loss distributed in profit-sharing ratio** – not in capital ratio

7. **Unrecorded assets → proceeds credited to Realisation** (treated as gain)

8. **Unrecorded liabilities → amount paid debited to Realisation** (treated as loss)

9. **Settlement priority:** External creditors → Partner loans → Capital → Surplus

10. **Garner vs. Murray:** Insolvent partner's deficiency borne by solvent partners **in capital ratio, not profit ratio**