Dissolution of a Partnership Firm | ISC Class 12 Accounts Notes

This note covers the meaning of dissolution of a partnership firm and how it differs from dissolution of partnership, the settlement of accounts under Section 48 of the Indian Partnership Act, 1932, the rules on private debts and firm's debts under Section 49, the preparation of the Memorandum Balance Sheet, the Realisation Account, the Partners' Loan Account, the Partners' Capital Account and the Cash/Bank Account, and the specific rules on reserves and funds, fixed capitals, bank overdraft versus bank loan, silent assumptions about assets and liabilities, loans to and from partners, and realisation expenses.

What is dissolution of a partnership firm, and how does it differ from dissolution of partnership?

The dissolution of partnership changes the existing relationship between partners, but the firm may continue its business as before.

It occurs on a change in the profit-sharing ratio, the admission of a new partner, the retirement or death of a partner, the insolvency of a partner, the completion of a venture for which the firm was formed, or the expiry of a fixed period of partnership.

In all these cases the business is not terminated; assets and liabilities are merely revalued and a new balance sheet is drawn up.

The dissolution of a firm, by contrast, is the dissolution of partnership between all the partners of a firm.

This brings an end to the existence of the firm, and no business is transacted after dissolution except activities related to closing the firm, as its affairs are wound up by selling the firm's assets, paying its liabilities and discharging the claims of the partners.

Dissolution of a firm necessarily brings in dissolution of partnership, but dissolution of partnership does not necessarily involve dissolution of the firm.

Definition: Dissolution of a firm. The dissolution of partnership between all the partners of a firm, which brings an end to its existence and requires the firm's assets to be sold and its liabilities discharged.

In what ways can a firm be dissolved?

A partnership firm may be dissolved without the intervention of the court or by the order of a court. Under the Indian Partnership Act, 1932, the ways are:

1. Dissolution by agreement, with the consent of all partners or in accordance with a contract between them.
2. Compulsory dissolution, when all partners or all but one become insolvent, when the business becomes illegal, or when an event occurs that makes it unlawful to carry on the business, such as a partner becoming an alien enemy on a declaration of war.
3. Dissolution on the happening of certain contingencies, subject to contract: on expiry of a fixed term, on completion of a venture, on the death of a partner, or on a partner being adjudicated insolvent.
4. Dissolution by notice, where in a partnership at will any partner gives written notice of intention to dissolve.
5. Dissolution by court, at the suit of a partner, on grounds such as a partner becoming insane or permanently incapable, misconduct affecting the business, persistent breach of the agreement, transfer of a partner's whole interest to a third party, the business being workable only at a loss, or any ground the court regards as just and equitable.

How are accounts settled on dissolution under Section 48?

Subject to agreement among the partners, Section 48 of the Indian Partnership Act, 1932 governs the settlement of accounts.

On the treatment of losses, including deficiencies of capital, these are paid first out of profits, next out of the capital of partners, and lastly, if necessary, by the partners individually in their profit-sharing ratio.

Definition: Section 48 settlement. The statutory order in which losses are met and assets of a dissolved firm are applied, unless the partners have agreed otherwise.

On the application of assets, the assets of the firm, including any sum contributed by partners to make up deficiencies of capital, are applied in this order:

1. In paying the debts of the firm to third parties, secured loans taking precedence over unsecured loans.
2. In paying each partner proportionately what is due for advances as distinguished from capital, that is, a partner's loan.
3. In paying each partner proportionately what is due on account of capital.
4. The residue, if any, is divided among the partners in their profit-sharing ratio.

If the balance remaining after paying outside liabilities is not adequate to pay off partners' loans and advances in full, they are paid proportionately.

What are the rules on private debts and the firm's debts under Section 49?

Where both the firm's debts and a partner's private debts co-exist, Section 49 of the Act applies two rules.

First, the property of the firm is applied first in payment of the firm's debts, and the surplus, if any, is divided among the partners as per their claims, which can then be used to pay their private liabilities.

Second, the private property of a partner is applied first in payment of his private debts, and the surplus, if any, may be used to pay the firm's debts if the firm's liabilities exceed its assets.

The private property of a partner does not include the personal properties of his wife and children. If the firm's assets are not adequate to pay off the firm's liabilities, partners must contribute out of their net private assets.

Definition: Net private assets. A partner's private assets minus his private liabilities, the amount available to meet a firm's debts when the firm's own assets fall short.

Net private assets = Private assets − Private liabilities

What is a Memorandum Balance Sheet, and how is it prepared?

Before the formal accounts are drawn up, accountants often prepare a Memorandum Balance Sheet: a working statement, not forming part of the firm's books, used to find a missing or balancing figure (such as an unstated capital or asset) so that the formal Realisation Account, Capital Accounts and Cash/Bank Account can be completed with consistent totals.

The method is simple. List the capitals and liabilities on one side and the assets on the other, at the book figures given in the question, with any provision deducted from its asset. Where one figure is missing, such as the cash and bank balance or a partner's capital, it is the balancing figure that makes the two sides equal.

Worked example: finding the cash balance. Supriya and Monika's balance sheet shows capitals of Rs.32,500 and Rs.11,500, Sundry Creditors Rs.48,000 and General Reserve Rs.13,500. Its assets are Stock Rs.7,500, Sundry Debtors Rs.21,500 less a provision of Rs.500, and Fixed Assets Rs.36,500. The cash and bank balance has been left out.

Answer: Capitals and liabilities total Rs.1,05,500 (Rs.32,500 + Rs.11,500 + Rs.48,000 + Rs.13,500). The assets other than cash total Rs.65,000 (Stock Rs.7,500 + Debtors Rs.21,000 net + Fixed Assets Rs.36,500). So the Memorandum Balance Sheet shows Cash and Bank of Rs.40,500 as the balancing figure (Rs.1,05,500 less Rs.65,000), and the Bank Account on dissolution opens with that amount.

How is the Realisation Account prepared?

When a firm is dissolved, its books of account are closed, and the profit or loss arising on realisation of its assets and discharge of its liabilities is computed through a Realisation Account.

All assets other than cash, bank balance and fictitious assets, and all external liabilities, are transferred to this account at book value. It also records the sale of assets, the payment of liabilities and realisation expenses.

The balance, termed profit or loss on realisation, is transferred to the partners' capital accounts in their profit-sharing ratio.

Realisation profit = Credit total − Debit total

How are reserves and funds, general reserve and accumulated losses treated?

Sundry debtors are transferred to the Realisation Account at their gross value, and the provision for doubtful debts is transferred to the credit side of the Realisation Account along with liabilities, because it is a fund related to that specific asset.

The same applies to an Investment Fluctuation Fund related to investments: when the related asset or liability is taken to the Realisation Account, any corresponding fund or reserve tied to it is also transferred to the Realisation Account, not to the partners' capital accounts.

A general reserve or accumulated profit that is not tied to a specific asset or liability is instead transferred directly to the partners' capital accounts in their profit-sharing ratio, as is any accumulated loss (such as a debit balance of Profit and Loss Account), which is debited to the capital accounts in the same ratio.

How are fixed capitals, current accounts, bank overdraft and bank loan treated?

Where accounts are kept on a fixed capital basis, each partner has a Capital Account and a separate Current Account. On dissolution, the current account balances are transferred to the capital account; no further adjustments are passed through the current account once this transfer is made.

A bank overdraft is taken directly to the Bank/Cash Account and is not transferred to the Realisation Account, because it is settled through the bank balance itself.

A bank loan, however, must be transferred to the Realisation Account, since it is an external liability to be discharged from the firm's realised assets.

What is assumed when the question is silent?

Several default assumptions apply unless the question states otherwise:

1. If the question is silent about the payment of a liability, it has to be paid out in full.
2. If the question is silent about the realised value of tangible assets and investments, they are considered realised at book value.
3. If the question is silent about the realised value of intangible assets, accrued income and prepaid expenses, they are considered to have realised nil (zero) value.

How are partners' loans treated on dissolution?

A loan taken by the firm from a partner is settled through the Cash or Bank Account, and this is so even if that partner's capital account itself shows a debit balance; the two accounts are not merged.

A Partners' Loan Account is therefore kept separate from the Capital Account and is paid off after outside liabilities but before the balance of capital accounts, as required by the order of application of assets under Section 48.

A loan given by the firm to a partner, on the other hand, is transferred (debited) to that partner's Capital Account, since it represents an amount owed by the partner to the firm.

Definition: Partner's loan. An advance made by a partner to the firm, as distinguished from capital, which is repaid after outside creditors but before the balance due on capital accounts.

How are realisation expenses treated in different situations?

Realisation expenses may arise in several patterns, each with its own entry:

1. Paid by the firm: the Realisation Account is debited and Cash/Bank is credited.
2. Paid by a partner on behalf of the firm: the Realisation Account is debited and that partner's Capital Account is credited.
3. Borne by a partner who has agreed to meet the expenses himself: no entry is required if he pays them personally; if the firm pays on his behalf, his Capital Account is debited and Cash/Bank is credited.
4. To be borne by a partner who does not pay them himself: if the firm pays the expenses on his behalf, the partner's Capital Account is debited and Cash/Bank is credited for the amount paid, whether or not a separate remuneration has also been agreed.
5. A partner reimbursed by the firm for expenses he paid, with an asset of the firm instead of cash: the asset is treated as taken over by that partner at the agreed value.

If the question gives no information about who is paying realisation expenses, it is implied that they are paid by the partner who has agreed to bear them.

What are the advantages of preparing a Realisation Account before closing the books?

Preparing a single Realisation Account brings together the sale of every asset and the discharge of every liability in one place, so that the net profit or loss on winding up the firm is ascertained as a single balancing figure rather than scattered across many ledger accounts.

This profit or loss is then shared among partners strictly in their profit-sharing ratio, so the method keeps the final settlement consistent with the partnership agreement.

Items taken over by a partner, assumed by a partner, or settled at a discount are all recorded through the same account, which keeps the Cash/Bank Account and the Capital Accounts clean and makes the closing of the firm's books, including every asset, liability, reserve and fund, traceable through a single, standard format.

What are the limitations of settlement under Sections 48 and 49?

The rules of Section 48 apply only "subject to agreement among the partners": where the partnership deed provides a different order of settlement, that agreement overrides the statutory order, so the rule is a default rather than a compulsory one.

The default assumptions used when a question is silent, such as treating tangible assets as realised at book value, are conventions for working problems and not a guarantee of what a firm will actually realise in practice.

The accounting treatment following from the Garner vs Murray rule for an insolvent partner, and situations such as admission-cum-retirement, amalgamation of firms, conversion or sale to a company, piecemeal distribution and insolvency of a partner, are not part of this topic, so the rules above do not by themselves cover every real-world dissolution.

Worked examples on settlement of accounts

Worked example 1. Supriya and Monika share profits 3:2. On dissolution their balance sheet showed capitals of Rs.32,500 (Supriya) and Rs.11,500 (Monika), Sundry Creditors Rs.48,000 and General Reserve Rs.13,500 on the liabilities side, and Cash and Bank of Rs.40,500 among the assets.

Debtors (book value Rs.21,500, less provision Rs.500) realised at a discount of 5%, Stock (book value Rs.7,500) realised Rs.7,000, Fixed Assets (book value Rs.36,500) realised Rs.42,000, realisation expenses were Rs.1,500, and creditors were paid in full.

Answer: Assets transferred to Realisation Account total Rs.65,500 (Stock Rs.7,500 + Debtors Rs.21,500 + Fixed Assets Rs.36,500); Creditors Rs.48,000 and Provision for doubtful debts Rs.500 are credited to Realisation Account, total Rs.48,500.

Debtors realise Rs.20,425 (95% of Rs.21,500), Stock Rs.7,000, Fixed Assets Rs.42,000, a total realisation of Rs.69,425. Creditors and expenses paid total Rs.49,500 (Rs.48,000 + Rs.1,500).

The Realisation Account shows a profit of Rs.2,925, shared Rs.1,755 to Supriya and Rs.1,170 to Monika in the 3:2 ratio. The General Reserve of Rs.13,500 is transferred directly to capital accounts, Rs.8,100 to Supriya and Rs.5,400 to Monika.

Supriya's capital account closes at Rs.42,355 (Rs.32,500 + Rs.8,100 + Rs.1,755) and Monika's at Rs.18,070 (Rs.11,500 + Rs.5,400 + Rs.1,170), and these amounts are paid from the bank.

The Bank Account then closes at nil: receipts of Rs.1,09,925 (opening balance Rs.40,500 + realisations Rs.69,425) equal payments of Rs.1,09,925 (creditors Rs.48,000, expenses Rs.1,500, Supriya Rs.42,355 and Monika Rs.18,070).

Worked example 2. Sita, Rita and Meeta share profits 2:2:1. On dissolution, Plant and Machinery (book value Rs.4,500) realised Rs.4,250, Stock (Rs.2,500) realised Rs.3,500, Debtors (Rs.2,000) realised Rs.1,850, Furniture (Rs.1,000) realised Rs.750.

There was an unrecorded asset of Rs.250, taken over by Rita at Rs.200. Creditors of Rs.2,000 were paid 2% less.

Actual realisation expenses paid by the firm were Rs.450, and Sita, who agreed to bear all realisation expenses, was paid Rs.60 for the service.

Answer: Assets transferred total Rs.10,000 (Stock Rs.2,500 + Furniture Rs.1,000 + Debtors Rs.2,000 + Plant and Machinery Rs.4,500). Rita's capital is debited Rs.200 for the unrecorded asset taken over; Creditors of Rs.2,000 are credited to Realisation Account.

Cash realised from assets totals Rs.10,350 (Rs.4,250 + Rs.1,850 + Rs.3,500 + Rs.750). Creditors are paid Rs.1,960 (2% less than Rs.2,000), realisation expenses of Rs.450 are paid by the firm, and Sita's capital is credited Rs.60 for her remuneration.

The Realisation Account shows a profit of Rs.530, shared Rs.212 to Sita, Rs.212 to Rita and Rs.106 to Meeta in the 2:2:1 ratio.

Worked example 3. Rose and Lily shared profits 2:3. Creditors of Rs.40,000 and Lily's loan of Rs.32,000 appeared in the balance sheet. On dissolution, assets (except bills receivable) realised Rs.4,84,000 and creditors agreed to accept Rs.38,000 in final settlement.

Answer: Under the order of application of assets in Section 48, the amount realised is applied first to the firm's outside debts: creditors are paid Rs.38,000.

The remaining cash is then applied to Lily's loan, since a partner's loan ranks after outside liabilities but before capital: Rs.32,000 is paid to Lily's Loan Account.

Only after both these payments is the residue applied to the partners' capital accounts, and any further surplus divided in the 2:3 profit-sharing ratio.

How are the Realisation, Partners' Capital, Partner's Loan and Bank Accounts prepared together?

A complete dissolution question asks for all four accounts at once. They are prepared in this order: the Realisation Account first, because its profit or loss goes to the capital accounts; then the Partners' Capital Accounts; a Partner's Loan Account for any loan from a partner; and the Cash/Bank Account last. When the work is right, every one of them closes with nothing left over.

Worked example 4. Surjit and Rahi share profits and losses 3:2. Their balance sheet on 31 March 2017 shows: Creditors Rs.38,000; Mrs. Surjit's loan Rs.10,000; Reserve Rs.15,000; Rahi's loan Rs.5,000; Capitals: Surjit Rs.10,000 and Rahi Rs.8,000 (total Rs.86,000). Assets: Bank Rs.11,500; Stock Rs.6,000; Debtors Rs.19,000; Furniture Rs.4,000; Plant Rs.28,000; Investments Rs.10,000; Profit and Loss Account (debit balance) Rs.7,500 (total Rs.86,000).

The firm is dissolved on that date. Surjit takes over the investments at Rs.8,000 and agrees to pay Mrs. Surjit's loan himself. Stock realises Rs.5,000, Debtors Rs.18,500, Furniture Rs.4,500 and Plant Rs.25,000. Realisation expenses are Rs.1,600, and the creditors accept Rs.37,000 in full settlement. Prepare the Realisation Account, the Partners' Capital Accounts, Rahi's Loan Account and the Bank Account.

Answer: Loss on realisation Rs.6,600 (Surjit Rs.3,960, Rahi Rs.2,640); Bank Account total Rs.64,500; final payments Rs.12,540 to Surjit and Rs.8,360 to Rahi. The four accounts are set out below.

Realisation Account

Mrs. Surjit's loan is an outside liability, so it is credited to the Realisation Account like the creditors. Because Surjit pays it himself, the Realisation Account is debited and his capital credited with Rs.10,000. The loss of Rs.6,600 is shared 3:2: Rs.3,960 to Surjit and Rs.2,640 to Rahi.

Partners' Capital Accounts

The reserve is a profit kept back, so it is credited to the partners; the debit balance of the Profit and Loss Account is an accumulated loss, so it is debited to them, both in the profit-sharing ratio.

Rahi's Loan Account

The partner's loan is not transferred to the Realisation Account. It is paid through the bank after the outside creditors and before the capital balances, as Section 48 requires.

Bank Account

Every account now closes at nil: the loss on realisation is Rs.6,600, the Bank Account totals Rs.64,500, and the partners receive Rs.12,540 (Surjit) and Rs.8,360 (Rahi), the figures the textbook gives for this problem.

Going beyond the syllabus

What is the Garner vs Murray rule?

When a partner is unable to contribute towards the deficiency showing on his capital account (a debit balance), he is said to be insolvent, and the sum not recoverable is treated as a capital loss for the firm.

In the absence of an agreement to the contrary, such a capital loss is borne by the remaining solvent partners in the ratio of their capitals as on the date of dissolution, a principle known as the Garner vs Murray rule.

Definition: Garner vs Murray rule. The principle that an insolvent partner's unrecoverable capital deficiency is a capital loss borne by the solvent partners in the ratio of their capitals as on the date of dissolution.

Capital loss ratio = Solvent partners' capitals on dissolution date

Although the accounting treatment for an insolvent partner is kept out of this topic, the underlying Garner vs Murray principle is worth remembering conceptually: it treats an unrecoverable capital deficiency as a loss for the remaining solvent partners rather than as a loss of the firm as a whole, allocating it in proportion to their capitals rather than their profit-sharing ratio.

This distinction between a capital-ratio loss and a profit-ratio loss is one reason examiners sometimes test the difference between "capitals as on the date of dissolution" and "the agreed profit-sharing ratio" in a single question, even where full insolvency accounting is not required.

Glossary

• Dissolution of partnership: a change in the relationship between partners, such as on admission, retirement or death, after which the firm's business continues
• Dissolution of a firm: the breaking of the relationship between all partners, ending the firm's existence and requiring its affairs to be wound up
• Section 48: the provision of the Indian Partnership Act, 1932 setting out the order for treating losses and applying assets on dissolution, subject to agreement among partners
• Section 49: the provision governing the order of payment where both the firm's debts and a partner's private debts exist
• Realisation Account: the account prepared to record the sale of assets, discharge of liabilities and realisation expenses, and to ascertain the resulting profit or loss
• Partner's loan: an advance made by a partner to the firm, distinguished from his capital, repaid after outside creditors but before capital balances
• Net private assets: a partner's private assets minus his private liabilities, available to meet the firm's debts if the firm's own assets fall short
• Garner vs Murray rule: the principle that an insolvent partner's unrecoverable deficiency is borne by solvent partners in the ratio of their capitals on the date of dissolution
• Memorandum Balance Sheet: a working statement, outside the firm's books, used to find a missing or balancing figure before the formal accounts are drawn up
• Fixed capital: a method of maintaining partners' capitals unchanged except for additional capital or withdrawal, with day-to-day adjustments passed through a current account
• Current account: a partner's account recording interest, salary, drawings and share of profit when capitals are kept fixed; transferred to capital account on dissolution
• Bank overdraft: a short-term credit facility from a bank, settled directly through the Bank/Cash Account on dissolution rather than through the Realisation Account
• Fictitious assets: expenses or losses not yet written off, such as a debit balance of Profit and Loss Account, excluded from transfer to the Realisation Account
• Investment Fluctuation Fund: a reserve created against a possible fall in the value of investments, transferred to the Realisation Account along with the related investments
• Partnership at will: a partnership with no fixed term, which may be dissolved by any partner giving written notice of his intention

Common errors and misconceptions

• Misconception: dissolution of partnership and dissolution of a firm mean the same thing. Correct: dissolution of partnership leaves the business running under a new agreement, while dissolution of a firm ends the business and closes the books.
• Misconception: a bank loan, like a bank overdraft, is settled directly through the Bank Account. Correct: a bank loan must be transferred to the Realisation Account, while only a bank overdraft is taken directly to the Bank/Cash Account.
• Misconception: if a question does not mention the realised value of goodwill or a prepaid expense, it is assumed to realise at book value. Correct: intangible assets, accrued income and prepaid expenses are assumed to realise at nil unless stated otherwise; only tangible assets and investments default to book value.
• Misconception: a partner's loan to the firm is adjusted against his debit capital balance. Correct: a loan taken from a partner is settled through Cash or Bank even if his capital account shows a debit balance; the two are never merged.
• Misconception: all reserves, including the general reserve, are transferred to the Realisation Account. Correct: only funds related to a specific asset or liability, such as a provision for doubtful debts or an Investment Fluctuation Fund, go to the Realisation Account; a general reserve goes directly to the capital accounts.
• Misconception: partners' capitals are always paid off before a partner's loan on dissolution. Correct: under Section 48, outside liabilities are paid first, then partners' loans, and only then the balance on capital accounts.
• Misconception: realisation expenses are always debited to the Realisation Account. Correct: the entry depends on who pays and who has agreed to bear the expenses, and may instead debit or credit a partner's Capital Account.

Exam-style questions with model answers

Q1. State, with a reason, whether dissolution of a firm necessarily involves dissolution of partnership. [1 mark]

1. Yes, dissolution of a firm necessarily brings in dissolution of partnership, because once the relationship between all the partners ends, the firm itself ceases to exist and no partnership relationship remains to continue.

Q2. A firm's balance sheet on dissolution shows Bank overdraft Rs.5,000 and Bank loan Rs.1,20,000. State how each is treated in the firm's books on dissolution. [2 marks]

1. The Bank overdraft of Rs.5,000 is taken directly to the Bank/Cash Account and is not transferred to the Realisation Account, since it represents a shortfall already in the bank balance.
2. The Bank loan of Rs.1,20,000, being an external liability, must be transferred to the credit side of the Realisation Account and discharged out of the firm's realised assets.

Q3. Vibha, Shobha and Anubha are partners. On dissolution, Anubha was to look after the dissolution process for a remuneration of Rs.12,000 and agreed to bear the dissolution expenses herself. Actual expenses of Rs.9,500 were paid by the firm. Pass the journal entries for the remuneration and the expenses. [3 marks]

1. Realisation Account is debited with Rs.12,000 and Anubha's Capital Account is credited with Rs.12,000, for the remuneration allowed to Anubha for the dissolution work.
2. Since Anubha agreed to bear the expenses herself but the firm actually paid Rs.9,500 on her behalf, Anubha's Capital Account is debited with Rs.9,500 and Cash/Bank Account is credited with Rs.9,500.
3. No entry is made crediting the Realisation Account for this payment, because the expenses belong to Anubha personally and not to the firm; only her capital account absorbs the amount paid on her behalf.

Q4. Explain the order in which the assets of a dissolved firm are applied under Section 48 of the Indian Partnership Act, 1932. [4 marks]

1. First, the assets (including any contribution made by partners to cover a capital deficiency) are applied to pay the debts of the firm to third parties, such as creditors and bills payable, with secured loans being paid before unsecured loans.
2. Second, each partner is paid proportionately what is due to him for advances distinguished from capital, that is, his partner's loan.
3. Third, each partner is paid proportionately what is due to him on account of capital.
4. Finally, any residue left after all the above payments is divided among the partners in their profit-sharing ratio, since it represents the profit on realisation.

Q5. Distinguish between dissolution of partnership and dissolution of a firm on the basis of (a) termination of business and (b) closure of books. [2 marks]

1. On termination of business, dissolution of partnership does not terminate the business, while dissolution of a firm closes the business of the firm altogether.
2. On closure of books, dissolution of partnership does not require the books to be closed because the business continues, whereas on dissolution of a firm the books of account are closed.

Q6. A firm's balance sheet shows Lily's loan of Rs.32,000 and Creditors of Rs.40,000, settled at Rs.38,000. Assets (except bills receivable) realised Rs.4,84,000. Explain the order in which these amounts are paid and why a partner's loan is paid before the partners' capital accounts. [4 marks]

1. Out of the Rs.4,84,000 realised, the firm's outside liability, the Creditors, is paid first and settled at the agreed Rs.38,000, because Section 48 requires debts to third parties to be paid before any amount due to a partner.
2. After the creditors are paid, Lily's loan of Rs.32,000 is paid next, because a partner's loan is an advance distinguished from capital and ranks after outside liabilities but before the partners' capital balances.
3. Only the residue remaining after both these payments is then applied to settle the balance due on the partners' capital accounts.
4. A partner's loan is paid before capital because it is a debt owed by the firm to the partner in a capacity other than as an owner, so it is treated more like an outside liability than like an ownership stake.

Q7. Explain, with reasons, how a Realisation Account treats (a) a general reserve appearing in the balance sheet and (b) a provision for doubtful debts appearing against debtors. [5 marks]

1. A general reserve that is not tied to any specific asset or liability is not transferred to the Realisation Account at all; instead, it is transferred directly to the partners' capital accounts in their profit-sharing ratio.
2. This is because a general reserve represents an undistributed share of past profits belonging to the partners as owners, and has no connection to the realisation of any particular asset, so it does not affect the profit or loss on realisation.
3. A provision for doubtful debts, on the other hand, is directly related to the sundry debtors shown on the assets side, since it represents the estimated shortfall in collecting those debtors.
4. Sundry debtors are transferred to the Realisation Account at their full, gross book value on the debit side, and the related provision for doubtful debts is transferred to the credit side of the same account, alongside liabilities.
5. Keeping the provision in the Realisation Account, rather than moving it to capital accounts, ensures that the actual shortfall or surplus on collecting debtors is correctly reflected in the overall profit or loss on realisation.

Q8. Sita, Rita and Meeta shared profits 2:2:1. An unrecorded asset of Rs.250 was taken over by Rita at Rs.200, and realisation expenses of Rs.450 were paid by the firm, though Sita had agreed to bear all expenses and was paid Rs.60 for the service. Pass the journal entries for these two items. [3 marks]

1. For the unrecorded asset taken over by Rita, Rita's Capital Account is debited with Rs.200 and the Realisation Account is credited with Rs.200, the agreed taking-over value.
2. For the realisation expenses actually paid by the firm, Rs.450 is debited to Sita's Capital Account, since she had agreed to bear them, and Cash/Bank Account is credited with Rs.450.
3. For the remuneration allowed to Sita for carrying out the dissolution work, the Realisation Account is debited with Rs.60 and Sita's Capital Account is credited with Rs.60.

Key takeaways

• Dissolution of partnership leaves the business running under a changed agreement, while dissolution of a firm ends its existence under Section 39 of the Indian Partnership Act, 1932.
• Section 48 requires losses to be met first from profits, then from partners' capital, and lastly from partners individually in their profit-sharing ratio.
• Assets are applied in a fixed order: outside debts first, then partners' loans, then partners' capital, and finally the residue in profit-sharing ratio.
• Section 49 settles the firm's debts from the firm's property first, and private debts from private property first, before any surplus crosses over.
• The Realisation Account gathers every asset (except cash, bank and fictitious assets) and every external liability to find the profit or loss on dissolution.
• A fund or reserve tied to a specific asset or liability goes to the Realisation Account, but a general reserve goes straight to the partners' capital accounts.
• A bank overdraft is settled through the Bank/Cash Account, but a bank loan must pass through the Realisation Account.
• When a question is silent, liabilities are assumed paid in full, tangible assets and investments are assumed realised at book value, and intangible assets, accrued income and prepaid expenses are assumed to realise at nil.
• A loan from a partner is paid through Cash/Bank even against his debit capital balance, while a loan given to a partner is debited to his capital account.

Test yourself

What section of the Indian Partnership Act, 1932 defines the dissolution of a firm?

Section 39, which states that the dissolution of partnership between all the partners of a firm is called the dissolution of the firm.

Name two grounds on which a court may order the dissolution of a firm.

Any two of: a partner becoming insane, a partner becoming permanently incapable, a partner's misconduct harming the business, persistent breach of the partnership agreement, transfer of a partner's whole interest, or the business being workable only at a loss.

Which is paid first on dissolution, outside creditors or a partner's loan?

Outside creditors are paid first; a partner's loan is paid only after the firm's debts to third parties have been settled.

How is a bank overdraft treated differently from a bank loan on dissolution?

A bank overdraft is taken directly to the Bank/Cash Account, but a bank loan is transferred to the Realisation Account as an external liability.

If a question does not say how intangible assets realised, what value is assumed?

They are assumed to have realised nil (zero) value, unlike tangible assets and investments, which default to book value.

Where does a loan given by the firm to a partner get transferred on dissolution?

It is transferred (debited) to that partner's Capital Account, since it represents an amount the partner owes the firm.