CBSE Class 12 Accountancy Part 1 Chapter 5: Dissolution of Partnership Firm

Understanding Dissolution of Partnership Firm

The term 'dissolution' might sound daunting, but in accountancy, it simply refers to the cessation of the partnership business. It's crucial to distinguish between 'Dissolution of Partnership' and 'Dissolution of Partnership Firm.'

• Dissolution of Partnership: This implies a change in the existing relationship among partners but the firm continues its business. For example, admission of a new partner, retirement or death of an existing partner, or change in profit-sharing ratio. In such cases, the old partnership ends, and a new one begins, but the business itself often continues. This leads to the preparation of a Revaluation Account.
• Dissolution of Partnership Firm: This means the complete breakdown of the business relationship between all partners and the closure of the firm's operations. The firm ceases to carry on its business, and its assets are disposed of to pay off its liabilities. This is the focus of this chapter, and it involves the preparation of a Realisation Account.

Modes of Dissolution: A partnership firm can be dissolved in several ways, as per the Indian Partnership Act, 1932:

1. Dissolution by Agreement (Section 40): A firm may be dissolved with the consent of all partners or in accordance with a contract between the partners.
2. Compulsory Dissolution (Section 41): This occurs when all partners (or all but one) become insolvent, rendering them incompetent to contract, or when the business becomes unlawful.
3. Dissolution by Notice (Section 43): In the case of a partnership at will, a firm may be dissolved by any partner giving notice in writing to all other partners of his intention to dissolve the firm.
4. Dissolution on the Happening of Certain Contingencies (Section 42): This includes dissolution on the expiry of the period for which the firm was constituted, or on the completion of the venture, or on the death or insolvency of a partner.
5. Dissolution by Court (Section 44): A court may order the dissolution of a firm on various grounds, such as a partner becoming of unsound mind, permanent incapacity of a partner, misconduct by a partner affecting the business, persistent breach of agreement by a partner, continuous losses, or for any other just and equitable ground.

Accounting Procedure for Dissolution

1. Preparation of Realisation Account — The Realisation Account is a nominal account prepared to close the books of the firm, record the sale of assets, payment of liabilities, and ascertain the profit or loss arising from the dissolution process. All assets (except cash, bank, and fictitious assets) and all external liabilities are transferred to this account. Steps: 1. Transfer Assets: Debit Realisation Account and credit individual Asset Accounts (at their book values). Exclude Cash/Bank balance, Partner's Current/Capital Accounts, and Fictitious Assets (e.g., P&L Debit Balance, Advertisement Suspense). 2. Transfer Liabilities: Credit Realisation Account and debit individual External Liability Accounts (at their book values). This includes Sundry Creditors, Bills Payable, Bank Overdraft, Loans from third parties, etc. Exclude Partner's Loan (which is paid separately before capital) and Partner's Capital/Current Accounts. 3. Realisation of Assets: For cash sales: Debit Cash/Bank Account and Credit Realisation Account. For assets taken over by a partner: Debit Partner's Capital Account and Credit Realisation Account. 4. Payment of Liabilities: For cash payment: Debit Realisation Account and Credit Cash/Bank Account. For liabilities taken over by a partner: Debit Realisation Account and Credit Partner's Capital Account. 5. Realisation Expenses: Debit Realisation Account and Credit Cash/Bank Account. 6. Calculate Profit/Loss: Balance the Realisation Account. A Credit balance indicates profit, which is debited to Realisation A/c and credited to Partner's Capital A/cs in their profit-sharing ratio. A Debit balance indicates loss, which is credited to Realisation A/c and debited to Partner's Capital A/cs in their profit-sharing ratio.
2. Preparation of Partner's Capital Accounts — After the Realisation Account, Partner's Capital Accounts are prepared to ascertain the final amount due to or from each partner. Steps: 1. Opening Balances: Credit with their opening capital balances (if credit) or Debit (if debit). 2. Reserves & Accumulated Profits/Losses: Credit with their share of General Reserve, Reserve Fund, P&L Credit Balance. Debit with their share of accumulated losses (P&L Debit Balance, Advertisement Suspense). 3. Assets/Liabilities Taken Over: Debit for assets taken over, Credit for liabilities taken over (from Realisation Account). 4. Profit/Loss on Realisation: Credit for profit on realisation, Debit for loss on realisation (from Realisation Account). 5. Partner's Loan: If a partner has given a loan to the firm, it is paid separately before the capital accounts are settled. If the firm has given a loan to a partner, it is adjusted through their capital account. 6. Final Settlement: After all adjustments, if a partner's capital account shows a credit balance, the firm pays them by debiting Capital A/c and crediting Cash/Bank A/c. If it shows a debit balance, the partner brings in cash by debiting Cash/Bank A/c and crediting Capital A/c.
3. Preparation of Cash/Bank Account — The Cash/Bank Account is the final account prepared to verify the accuracy of all transactions. It should always balance at the end of the dissolution process, showing a zero balance. Steps: 1. Opening Balance: Debit with the opening balance of Cash in Hand and Cash at Bank. 2. Cash Inflows: Debit for cash received from sale of assets, and cash brought in by partners (to cover debit balances). 3. Cash Outflows: Credit for cash paid for liabilities, realisation expenses, partner's loans, and final payments to partners. The Cash/Bank Account must balance, implying that all cash received has been paid out, leaving no balance.

Worked Examples of Dissolution Accounting

• Example 1: Simple Dissolution
  Anita and Babita were partners sharing profits and losses in the ratio of 3:2. Their Balance Sheet as on March 31, 2023, was:

  Balance Sheet as on March 31, 2023
  | Liabilities | Amount (₹) | Assets | Amount (₹) |
  |:----------------------|:-----------|:----------------------|:-----------|
  | Creditors | 30,000 | Sundry Assets | 80,000 |
  | Anita's Capital | 50,000 | Cash at Bank | 20,000 |
  | Babita's Capital | 20,000 | | |
  | Total | 100,000| Total | 100,000|

  The firm was dissolved on this date. Sundry Assets realised ₹75,000. Creditors were paid in full. Realisation expenses amounted to ₹2,000.

  Prepare the Realisation Account, Partners' Capital Accounts, and Cash at Bank Account.

  A: Step 1: Realisation Account
  | Particulars | Amount (₹) | Particulars | Amount (₹) |
  |:----------------------------|:-----------|:-----------------------------|:-----------|
  | To Sundry Assets A/c | 80,000 | By Creditors A/c | 30,000 |
  | To Bank A/c (Creditors paid) | 30,000 | By Bank A/c (Assets realised) | 75,000 |
  | To Bank A/c (Expenses) | 2,000 | By Loss on Realisation | |
  | | | Anita's Capital A/c (3/5) | 10,200 |
  | | | Babita's Capital A/c (2/5) | 6,800 |
  | | | Total Loss | 17,000 |
  | Total | 112,000| Total | 112,000|

  (Calculation of Loss: Total Debit = 80,000 + 30,000 + 2,000 = 112,000. Total Credit = 30,000 + 75,000 = 105,000. Loss = 112,000 - 105,000 = 7,000. Wait, there's a mistake in the example calculation. Let's recalculate: 80,000 (assets) + 30,000 (creditors paid) + 2,000 (expenses) = 112,000. Realisation credit: 30,000 (liab transfer) + 75,000 (asset sales) = 105,000. Loss = 112,000 - 105,000 = 7,000. This loss should be distributed. Example text has 17,000. Let's correct the example to match a realistic outcome.)

  Corrected Realisation Account (assuming 80,000 assets, 75,000 realised, 30,000 creditors, 2,000 expenses)
  | Particulars | Amount (₹) | Particulars | Amount (₹) |
  |:----------------------------|:-----------|:-----------------------------|:-----------|
  | To Sundry Assets A/c | 80,000 | By Creditors A/c | 30,000 |
  | To Bank A/c (Creditors paid) | 30,000 | By Bank A/c (Assets realised) | 75,000 |
  | To Bank A/c (Expenses) | 2,000 | By Loss on Realisation (7,000)| |
  | | | Anita's Capital A/c (3/5) | 4,200 |
  | | | Babita's Capital A/c (2/5) | 2,800 |
  | Total | 112,000| Total | 112,000|

  Step 2: Partners' Capital Accounts
  | Particulars | Anita (₹) | Babita (₹) | Particulars | Anita (₹) | Babita (₹) |
  |:--------------------|:----------|:-----------|:--------------------|:----------|:-----------|
  | To Realisation A/c (Loss) | 4,200 | 2,800 | By Balance b/d | 50,000 | 20,000 |
  | To Bank A/c (Final Pay) | 45,800 | 17,200 | | | |
  | Total | 50,000| 20,000 | Total | 50,000| 20,000 |

  Step 3: Cash at Bank Account
  | Particulars | Amount (₹) | Particulars | Amount (₹) |
  |:----------------------------|:-----------|:----------------------------|:-----------|
  | To Balance b/d | 20,000 | By Realisation A/c (Creditors) | 30,000 |
  | To Realisation A/c (Assets) | 75,000 | By Realisation A/c (Expenses) | 2,000 |
  | | | By Anita's Capital A/c | 45,800 |
  | | | By Babita's Capital A/c | 17,200 |
  | Total | 95,000 | Total | 95,000 |

  Final Answer: All accounts balance, indicating correct dissolution.

Exam Tips for Dissolution of Partnership Firm

To ace questions on dissolution, remember these critical points:

1. Distinguish Realisation vs. Revaluation: The Realisation Account is for dissolution of firm, while the Revaluation Account is for reconstitution of partnership. They serve different purposes and have different entries. Realisation aims to close accounts and determine liquidation profit/loss; Revaluation aims to adjust asset/liability values to current market values for a continuing business.
2. Order of Payments (Section 48): The Indian Partnership Act, 1932, prescribes a specific order for the application of assets:

• Firstly, in paying the debts of the firm to third parties.
• Secondly, in paying to each partner rateably what is due to him on account of advances as distinguished from capital (i.e., Partner's Loan).
• Thirdly, in paying to each partner rateably what is due to him on account of capital.
• Finally, if any residue remains, it shall be divided among the partners in their profit-sharing ratio.

1. Unrecorded Assets/Liabilities: If an unrecorded asset is realised, credit Realisation Account. If an unrecorded liability is paid, debit Realisation Account. No prior transfer to Realisation Account is needed for unrecorded items.
2. Partner's Loan: A loan given by a partner to the firm is an external liability in priority to capital and is paid after external creditors but before partners' capital. It is not transferred to Realisation Account. If the firm has given a loan to a partner, it is adjusted through their capital account.
3. Provision for Doubtful Debts/Depreciation Fund: These are usually credited to the Realisation Account along with other liabilities if they represent a reduction in asset value that needs to be 'realised.' General reserves, P&L credit balance are transferred to capital accounts, not realisation.

Practice Questions with Solutions

• Q: A, B and C were partners sharing profits in the ratio 2:2:1. Their Balance Sheet showed Plant & Machinery at ₹1,50,000, Stock at ₹50,000, and Creditors at ₹70,000. They decided to dissolve the firm. Plant & Machinery realised ₹1,20,000, and Stock was taken over by B at ₹40,000. Creditors were paid ₹68,000 in full settlement. Realisation expenses amounted to ₹3,000.

  Pass necessary Journal entries for the dissolution of the firm.
  A: Step 1: Transfer of Assets to Realisation Account
  Journal Entry:
  Realisation A/c Dr. 2,00,000
  To Plant & Machinery A/c 1,50,000
  To Stock A/c 50,000
  (Being assets transferred to Realisation Account at book value)

  Step 2: Transfer of External Liabilities to Realisation Account
  Journal Entry:
  Creditors A/c Dr. 70,000
  To Realisation A/c 70,000
  (Being creditors transferred to Realisation Account)

  Step 3: Realisation of Plant & Machinery
  Journal Entry:
  Bank A/c Dr. 1,20,000
  To Realisation A/c 1,20,000
  (Being Plant & Machinery realised)

  Step 4: Stock taken over by B
  Journal Entry:
  B's Capital A/c Dr. 40,000
  To Realisation A/c 40,000
  (Being Stock taken over by B)

  Step 5: Payment of Creditors
  Journal Entry:
  Realisation A/c Dr. 68,000
  To Bank A/c 68,000
  (Being creditors paid)

  Step 6: Payment of Realisation Expenses
  Journal Entry:
  Realisation A/c Dr. 3,000
  To Bank A/c 3,000
  (Being realisation expenses paid)

  Final answer: All necessary journal entries have been passed for the dissolution process.

• Q: X, Y and Z were partners sharing profits and losses equally. Their Balance Sheet showed a General Reserve of ₹30,000 and Profit & Loss A/c (Cr. balance) of ₹20,000. They decided to dissolve the firm. How will these items be treated during dissolution?
  A: Step 1: Identify nature of items
  General Reserve and Profit & Loss A/c (Cr. balance) are accumulated profits, which belong to the partners.

  Step 2: Distribute to partners' capital accounts
  These accumulated profits are distributed among partners in their profit-sharing ratio (equally, in this case) by crediting their capital accounts.

  Step 3: Pass Journal Entries
  Journal Entry:
  General Reserve A/c Dr. 30,000
  To X's Capital A/c 10,000
  To Y's Capital A/c 10,000
  To Z's Capital A/c 10,000
  (Being General Reserve distributed to partners)

  Journal Entry:
  Profit & Loss A/c Dr. 20,000
  To X's Capital A/c 6,667
  To Y's Capital A/c 6,667
  To Z's Capital A/c 6,666
  (Being P&L credit balance distributed to partners)

  Final answer: General Reserve and P&L (Cr. balance) are credited to partners' capital accounts in their profit-sharing ratio.

• Q: L, M, and N are partners. On dissolution, the firm's assets (other than cash) are ₹2,50,000 and external liabilities are ₹1,00,000. Realisation expenses are ₹5,000. An unrecorded asset of ₹10,000 is sold for ₹12,000. An unrecorded liability of ₹3,000 is paid off. Calculate the profit or loss on realisation if recorded assets realised 90% of their book value.
  A: Step 1: Calculate Realisation of Recorded Assets
  Recorded assets realised = 90% of ₹2,50,000 = ₹2,25,000.

  Step 2: Account for Unrecorded Asset
  Unrecorded asset realised = ₹12,000.

  Step 3: Total Cash Received from Assets
  Total cash received = ₹2,25,000 (recorded) + ₹12,000 (unrecorded) = ₹2,37,000.

  Step 4: Account for External Liabilities and Unrecorded Liability
  Total liabilities paid = ₹1,00,000 (recorded) + ₹3,000 (unrecorded) = ₹1,03,000.

  Step 5: Account for Realisation Expenses
  Realisation expenses = ₹5,000.

  Step 6: Calculate Profit/Loss on Realisation
  Items debited to Realisation A/c: Assets transferred (2,50,000) + Liabilities paid (1,03,000) + Realisation expenses (5,000) = ₹3,58,000.
  Items credited to Realisation A/c: Liabilities transferred (1,00,000) + Assets realised (2,37,000) = ₹3,37,000.
  Loss on Realisation = Total Debits - Total Credits = ₹3,58,000 - ₹3,37,000 = ₹21,000.

  Final answer: The loss on realisation is ₹21,000.

• Q: Explain why a Partner's Loan to the firm is not transferred to the Realisation Account during dissolution.
  A: Step 1: Understand the purpose of Realisation Account
  The Realisation Account is prepared to close asset and external liability accounts and to determine the profit or loss from disposing of assets and settling external liabilities.

  Step 2: Classify Partner's Loan
  A Partner's Loan to the firm is considered an advance from a partner, not a third-party external liability in the same category as creditors or bank loans. According to Section 48 of the Indian Partnership Act, 1932, a partner's loan is paid after external debts but before the partners' capital.

  Step 3: Determine accounting treatment
  Since it's a specific payment to a partner in a pre-defined order, separate from the general realisation of assets and payment of external liabilities, it is settled directly through the Cash/Bank Account or by adjustment against the partner's capital account, rather than being routed through the Realisation Account.

  Final answer: A Partner's Loan to the firm is not transferred to the Realisation Account because it is settled separately, as per the hierarchy of payments defined by the Partnership Act, after external liabilities but before partners' capital, and its purpose is not to ascertain profit/loss on asset disposal or external liability settlement.

Frequently Asked Questions