Dissolution of Partnership Firms: Concepts, Types, and Accounting Treatment

Source: Pixabay

Introduction to Dissolution and Winding Up

Defining Dissolution vs. Winding Up

Dissolution of a partnership refers to the change in the relationship among partners caused by one or more ceasing to be associated in carrying on the business. It marks the end of the partnership agreement as it existed but does not immediately end the legal entity. Winding up is the subsequent process: settling debts, realizing assets, and distributing what remains among partners. The partnership continues only for this purpose until all affairs are closed.

During winding up, partners conclude unfinished business, pay creditors, and distribute surplus. It's critical to recognize that dissolution is a legal event; winding up is a practical process. The partnership ceases to exist after winding up is complete, and only then is it dissolved in the eyes of the law.

Aspect	Dissolution	Winding Up
Definition	Legal termination of partnership agreement	Settling debts, realizing assets, distributing surplus
Process Stage	Initial legal event	Follows dissolution
Business Existence	Partnership exists for winding up	Ceases after winding up
Authority	Partners/court	Partners/liquidator/court

Types of Dissolution of Partnership Firms

a. Dissolution by Agreement

Partners may decide unanimously or as per their agreement to dissolve the firm. The partnership deed often outlines the process for voluntary dissolution. Such consensus is the most straightforward method, requiring mutual understanding and cooperation.

b. Compulsory Dissolution

Compulsory dissolution occurs due to legal events: all partners become insolvent, the business becomes illegal, or the firm’s term expires. In these cases, dissolution is mandatory and beyond the partners' discretion.

c. Dissolution by Notice

In a partnership at will, any partner may dissolve the firm by giving written notice to all other partners. The partnership dissolves from the date specified in the notice, or if unspecified, from the date of communication.

d. Dissolution by Court

A partner may apply to the court for dissolution on grounds such as incapacity, misconduct, persistent breach of agreement, or when the firm's business cannot be carried on except at a loss. The court, after considering the evidence, may order dissolution.

e. Dissolution by Insolvency or Death

If a partner is adjudicated insolvent, or upon death, dissolution may occur unless the partnership agreement provides otherwise. In some cases, the remaining partners may continue the business, forming a new partnership.

Accounting Treatments During Dissolution

a. Realisation Account

The Realisation Account is central to partnership dissolution. It tracks the sale of assets and payment of liabilities. Here’s how it works:

• Transfer of Assets: All assets (except cash/bank and fictitious assets) are transferred to the debit side of the Realisation Account at book value.
• Transfer of Liabilities: All external liabilities are credited to the Realisation Account at book value.
• Realization of Assets: Proceeds from selling assets are credited to the Realisation Account.
• Payment of Liabilities: Payments to creditors and other liabilities are debited to the Realisation Account.
• Profit or Loss on Realisation: The balance (profit or loss) is transferred to partners’ capital accounts in their profit-sharing ratio.

b. Partners’ Capital Accounts

Each partner’s capital account is adjusted for:

• Share of profit/loss on realization.
• Any remaining reserves or undistributed profits/losses.
• Drawings and interest thereon.
• Final settlement amounts to be paid or received.

c. Cash/Bank Account

The Cash or Bank Account records all receipts from asset realization and all payments made—to creditors, expenses, and partners. The final balance represents the amount paid to (or brought in by) partners to settle their accounts.

Garner v. Murray Rule

Deficiency Due to Insolvent Partner

When a partner is insolvent and cannot pay their capital deficiency, the Garner v. Murray Rule applies:

The deficiency is borne by the solvent partners in proportion to their capital (at dissolution, not their profit-sharing ratio). 

This rule ensures fairness, reflecting the partners’ relative investments in the firm.

Why not use the profit-sharing ratio? Because capital—rather than profits—represents each partner’s financial stake. This distinction is vital for accurate accounting and equitable treatment.

Step-by-Step Solved Example: Dissolution Accounting

Case Study

Suppose partners A, B, and C share profits in the ratio 2:2:1. Their capitals are ₹50,000, ₹30,000, and ₹20,000 respectively. The firm is dissolved. After realizing assets and paying liabilities, the following outcomes occur:

• Assets realized: ₹90,000
• Liabilities paid: ₹40,000
• Realization expenses: ₹10,000
• Partner C is insolvent; no recovery from him.

Step 1: Prepare Realisation Account

Debit	Credit
To Assets (transferred at book value)	By Liabilities (transferred at book value)
To Expenses	By Assets realized
To Cash (paid to creditors, expenses)

Step 2: Partners’ Capital Accounts

Particulars	A	B	C
Opening Capital	₹50,000	₹30,000	₹20,000
Share of Realisation Profit/Loss	To be calculated	To be calculated	To be calculated
Final Settlement	Balance to be paid/received	Balance to be paid/received	Deficiency unpaid

Step 3: Cash/Bank Account

Receipts	Payments
Assets realized: ₹90,000	Liabilities: ₹40,000
	Expenses: ₹10,000
	Settlement to A & B

Step 4: Applying Garner v. Murray

Assume C’s deficiency after settlement is ₹10,000. This amount is shared by A and B in their capital ratio (A:B = 50,000:30,000 = 5:3). So, A bears ₹6,250 and B bears ₹3,750.

Final Settlement

• Calculate each partner’s final balance after adjusting for realization losses and deficiency sharing.
• Make final payments from cash available.

This systematic approach ensures accuracy and transparency—essential for effective exam preparation and for future practice as a commerce professional.

UGC NET Commerce: Partnership Dissolution explained—definitions, types, accounting, and Garner v. Murray rule, with solved example.

---