Partnership and LLP Accounts — Dissolution of Partnership Firms and LLP

Figure 1: On dissolution, all assets are sold out and all liabilities are discharged.

Learning Outcomes

• Go through the circumstances in which a partnership is dissolved.
• Understand that on the dissolution of a partnership all assets are sold out and all liabilities are discharged. Learn the accounting technique relating to the disposal of assets and payment of liabilities.
• Learn how to settle the partner's claims in case of surplus and how to raise money from partners in case of a deficit.
• Deal with piecemeal distribution to partners of the amount realized from assets net of liabilities.
• Winding up of a Limited Liability Partnership (LLP).

6.1 Introduction

• Apart from the readjustment of rights of partners in the share of profit by way of change in the profit-sharing ratio and admission of a new partner or for retirement/death of a partner, another important aspect of partnership accounts is how to close books of accounts in case of dissolution.
• In this Unit, we will discuss the circumstances leading to the dissolution of a partnership firm and accounting treatment necessary to close its books of accounts.
• Also, we will discuss the special problems relating to the insolvency of partners and the settlement of the partnership's liabilities.

KNOWLEDGE NUGGET

• Dissolution: Business comes to an end
• Realization Account: Used to close books on dissolution
• Garner vs. Murray Rule: Insolvency loss borne by solvent partners in capital ratio

6.2 Circumstances Leading to Dissolution of Partnership

• A partnership is dissolved or comes to an end when:
  • 1. By mutual agreement of all partners
  • 2. When the term for which it was formed expires
  • 3. When the business becomes illegal
  • 4. On death of a partner
  • 5. On insolvency of a partner
  • 6. On retirement of a partner (if only two partners)
  • 7. By notice of dissolution (in partnership at will)
  • 8. By order of the Court

DISTINCTION — DISSOLUTION OF PARTNERSHIP vs DISSOLUTION OF PARTNERSHIP FIRM

Dissolution of Partnership	Dissolution of Partnership Firm
Discontinuance of the relation between partners	Entire firm ceases to exist
Business continues, partnership is reconstituted	Business ceases to end
No court intervention	Court has inherent power to intervene
Assets and liabilities are revalued	Assets are sold and realized; liabilities are paid off
Revaluation account is prepared	Realization account is prepared
Books of accounts are not closed	Books of accounts are closed

6.4 Closing of Partnership Books on Dissolution

• To close books of accounts of Partnership Firm, we need to transfer all the assets and liabilities to Realization Account.

SPECIMEN OF REALIZATION ACCOUNT

Debit Side	Amount (₹)	Credit Side	Amount (₹)
To Sundry Assets	XXX	By Sundry Liabilities	XXX
To Bank (expenses for realization)	XXX	By Provision on Assets	XXX
To Bank (amount paid for liabilities)	XXX	By Bank (amount realized from assets)	XXX
To Partners' Capital A/cs (expenses paid by partners)	XXX	By Partners' Capital A/cs (assets taken over by partners)	XXX
To Partners' Capital A/cs (Profit)	XXX	By Partners' Capital A/cs (Loss)	XXX

STEPS TO CLOSE BOOKS ON DISSOLUTION

• I. Transfer all assets (except cash/bank) to Realization Account.
• II. Transfer liabilities to credit side of Realization Account.
• III. Record actual amount realized by sale of assets.
• IV. Record dissolution expenses.
• V. Record payment to creditors.
• VI. Transfer profit/loss on realization to Partners' Capital Accounts.
• VII. Pay off partners' loans.
• VIII. Transfer reserves/accumulated profits to Capital Accounts.
• IX. Settle partners' Capital Accounts.

Illustration 1

X, Y, and Z are partners of the firm XYZ and Co., sharing Profits and Losses in the ratio of 4:3:2. Partners decided to dissolve the firm.

SOLUTION

Realization Account

Particulars	Amount (₹)	Particulars	Amount (₹)
To Fixed assets	5,00,000	By Creditors	3,20,000
To Stock in trade	3,00,000	By Cash (assets realized)	9,60,000
To Debtors	5,00,000	By Y (Stock taken over)	2,50,000
To Cash — Expenses	6,000	By Loss transferred:
To Cash — Creditors	3,04,000	X	35,555
		Y	26,667
		Z	17,778
Total	16,10,000	Total	16,10,000

Partners' Capital Accounts

Particulars	X (₹)	Y (₹)	Z (₹)	Particulars	X (₹)	Y (₹)	Z (₹)
To Realization A/c	35,555	26,667	17,778	By Balance b/d	4,00,000	3,00,000	2,00,000
To Realization A/c (Stock)	—	2,50,000	—	By General reserve	40,000	30,000	20,000
To Cash	4,04,445	53,333	2,02,222
Total	4,40,000	3,30,000	2,20,000	Total	4,40,000	3,30,000	2,20,000

6.5 Consequences of Insolvency of a Partner

• If a partner is insolvent, the deficiency may be borne by the solvent partners in their profit-sharing ratio or according to the principle settled in the well-known case of Garner vs. Murray.
• In Garner vs. Murray, the deficiency would be borne by the solvent partners in proportion to their capitals and not in the proportion in which they share profits and losses.

CONSEQUENCES OF INSOLVENCY

• 1. The partner adjudicated as insolvent ceases to be a partner on the date of the order of adjudication.
• 2. The firm is dissolved on the date of the order of adjudication unless there is a contract to the contrary.
• 3. The estate of the insolvent partner is not liable for any act of the firm after the date of the order of adjudication.
• 4. The firm cannot be held liable for any acts of the insolvent partner after the date of the order of adjudication.

6.6 Loss Arising from Insolvency of a Partner

• According to Garner vs. Murray, solvent partners have to bear the loss due to insolvency of a partner.
• Normal loss on realization is borne by all partners (including insolvent partner) in the profit-sharing ratio.
• Loss due to insolvency has to be borne by the solvent partners in the capital ratio.
• If a partner has a debit balance in his Capital Account and is not insolvent, he cannot be called upon to bear the loss on account of the insolvency of other partner.

CAPITAL RATIO ON INSOLVENCY

• Fixed Capitals: Insolvency loss distributed in the ratio of fixed capitals
• Fluctuating Capitals: Capital ratio determined after adjusting all reserves and accumulated profits to the date of dissolution, but before adjusting profit or loss on Realization Account
• Garner vs. Murray Rule: Solvent partners bear deficiency in capital ratio

Illustration 2

P, Q, and R were partners sharing profits and losses in the ratio of 3:2:1. On 1st July, 2022 the partnership was dissolved. R was forced into bankruptcy and was only able to bring 1/3 of the amount due.

SOLUTION — Partners' Capital Accounts

Particulars	P (₹)	Q (₹)	R (₹)	Particulars	P (₹)	Q (₹)	R (₹)
To Current A/c	5,500	—	2,400	By Balance b/d	20,000	20,000	10,000
To Realization A/c (Loss)	25,500	17,000	8,500	By Current A/c	—	5,000	—
To Realization A/c (Car)	—	500	—	By Bank	—	—	300
To R's Capital A/c	300	300	—	By Bank	25,500	17,000	—
To Bank	14,200	24,200	—	By P & Q (Deficiency)	—	—	600
Total	45,500	42,000	10,900	Total	45,500	42,000	10,900

Note: Solvent partners P and Q have to bear the loss due to insolvency of R in their fixed capital ratio (Garner vs. Murray rule).

6.7 Piecemeal Payments

• Generally, the assets sold upon dissolution of partnership are realized only in small instalments over a period of time.
• In order to ensure that the distribution of cash among the partners is in proportion to their interest in the partnership concern, either of the two methods may be followed:
  • (1) Maximum Loss Method
  • (2) Highest Relative Capital Method

6.7.1 Maximum Loss Method

• Each installment realized is considered to be the final payment.
• Outstanding assets and claims are considered worthless.
• Partners' accounts are adjusted on that basis each time when a distribution is made.

MAXIMUM LOSS METHOD — STEPS

• Step 1: Determine the maximum possible loss assuming all remaining assets are worthless
• Step 2: Deduct this loss from partners' capitals in profit-sharing ratio
• Step 3: Distribute the available cash to partners based on the resulting balances
• Step 4: If any partner's capital becomes negative, transfer that deficiency to other partners in capital ratio (Garner vs. Murray)

6.7.2 Highest Relative Capital Method

• Also called Proportionate Capital Method.
• The partner who has the higher relative capital (capital in proportion to profit-sharing ratio) is paid off first.

HIGHEST RELATIVE CAPITAL METHOD — STEPS

• Step 1: Divide capitals by profit-sharing ratio to get relative capital
• Step 2: Identify the partner with smallest relative capital as base
• Step 3: Calculate hypothetical capital of other partners
• Step 4: Excess capital is paid off in order of highest relative capital
• Step 5: Repeat process between partners having excess capital

6.8 Winding Up of a Limited Liability Partnership (LLP)

• The winding up of a LLP may be either voluntary or by the Tribunal.
• Winding up of a LLP may be initiated by Tribunal if:
  • The LLP wishes to wind up
  • The LLP has less than 2 partners for more than 6 months
  • The LLP is unable to pay its debts
  • The LLP has not acted in the interest of the sovereignty and integrity of India
  • The LLP has failed to submit statements for more than five consecutive financial years
  • The Tribunal thinks it is Just and Equitable that the LLP should be wound up

Illustration 9

P and Q were partners sharing profits equally in LLP. The firm was dissolved. You are required to prepare Realization Account, Partners' capital accounts and Bank Account.

SOLUTION — Realization Account

Particulars	Amount (₹)	Particulars	Amount (₹)
To Debtors	25,000	By Creditors	20,000
To Stock	35,000	By Bank overdraft	5,000
To Furniture	40,000	By Bank (assets realized)	1,48,870
To Machinery	60,000	By P's Capital (Stock taken over)	15,750
To Bank (liabilities)	27,000
To Profit transferred:
P's Capital	1,310
Q's Capital	1,310
Total	1,89,620	Total	1,89,620

Summary

• Reasons for which a partnership could be dissolved:
  • Expiry of term for which it was formed
  • Death of a partner
  • Insolvency of a partner
• Reasons when a firm stands dissolved:
  • When partners mutually decide to dissolve
  • Partners except one become insolvent
  • Business becomes illegal
  • If partnership is at will, any partner can give notice for dissolution
  • Court orders
• The winding up of a LLP may be either voluntary or by the Tribunal.
• On dissolution, assets are realized and all liabilities are paid off.
• If any liability remains unpaid, it is to be realized from partners in their profit-sharing ratio.
• Piecemeal distribution involves either of two methods:
  • Maximum loss method
  • Highest relative capital method
• Garner vs. Murray Rule: Insolvency loss borne by solvent partners in capital ratio.

Test Your Knowledge

True and False

• 1. Books of accounts are closed in dissolution of partnership. False
• 2. On the dissolution of a partnership, firstly, the assets of the firm are realized. Then the amount realized is applied first towards repayment of liabilities to outsiders. True
• 3. In event of the dissolution of the firm, the business ceases to end. In event of dissolution of the partnership, the partnership is reconstituted and the business discontinues. False
• 4. Expenses of dissolution on realization of assets are credited to the Realization Account. False
• 5. Revaluation Account is prepared at the time of dissolution of partnership but Realization Account is prepared at the time of dissolution of partnership firm. True

Multiple Choice Questions

1. Partnership could be dissolved because of	(a) Death of a partner. (b) Insolvency of a partner. (c) Either (a) or (b).
2. On the dissolution of partnership, profit or loss on realization of assets and liabilities should be divided among partners	(a) In the ratio of their capitals. (b) In the same ratio in which they share profits. (c) Equally.
3. An unrecorded asset realized at the time of dissolution is credited to	(a) Realization account. (b) Revaluation account. (c) Capital accounts.
4. A liability taken over by a partner at the time of dissolution is credited to	(a) Profit and loss account. (b) Partners' capital accounts. (c) Realization account.
5. Realization account is a	(a) Nominal account. (b) Real account. (c) Personal account.
6. Which of the following method/methods is adopted to ensure that distribution of cash among partners is in proportion to their interest in partnership?	(a) Maximum loss method. (b) Highest relative capital method. (c) Either (a) or (b).

High-Yield Interactive Quiz — Dissolution of Partnership Firms and LLP

Q1. On dissolution of a partnership firm, the account used to close the books is:

Correct Answer: B. On dissolution of a partnership firm, a Realization Account is prepared to close the books of accounts.

Q2. According to Garner vs. Murray rule, the loss due to insolvency of a partner is borne by:

Correct Answer: B. According to Garner vs. Murray, the loss due to insolvency of a partner has to be borne by the solvent partners in the capital ratio.

Q3. On dissolution, an unrecorded asset realized is credited to:

Correct Answer: B. An unrecorded asset realized at the time of dissolution is credited to the Realization Account.

Q4. In Maximum Loss Method, each installment is considered as:

Correct Answer: B. In Maximum Loss Method, each installment realized is considered to be the final payment, and outstanding assets and claims are considered worthless.

Q5. The Highest Relative Capital Method is also called:

Correct Answer: B. The Highest Relative Capital Method is also called the Proportionate Capital Method.

Q6. Realization Account is a:

Correct Answer: C. Realization Account is a nominal account as it records the profit or loss on realization of assets and payment of liabilities.

Q7. If an asset is taken over by a partner on dissolution, the entry is:

Correct Answer: B. If a partner takes over an asset, his Capital Account should be debited and Realization Account credited with the value agreed upon.

Q8. The winding up of a LLP can be initiated by Tribunal if:

Correct Answer: D. The Tribunal can initiate winding up if the LLP wishes to wind up, has less than 2 partners for more than 6 months, is unable to pay its debts, or for other specified reasons.

Q9. The normal loss on realization is borne by:

Correct Answer: B. Normal loss on realization is borne by all partners (including insolvent partner) in the profit-sharing ratio.

Q10. In dissolution of partnership firm, the order of payment is:

Correct Answer: B. On dissolution, outsiders' liabilities (creditors) are paid first before making payments to partners.

Q11. When a liability is taken over by a partner, the entry is:

Correct Answer: A. If any liability is taken over by a partner, his Capital Account should be credited and Realization Account debited with the amount agreed upon.

Q12. Under the Highest Relative Capital Method, the partner with the highest relative capital:

Correct Answer: B. Under the Highest Relative Capital Method, the partner who has the higher relative capital is first paid off.