Key Takeaways
- Understand the legal and accounting framework for insolvency in partnership firms.
- Learn practical steps for preparing Statement of Affairs and Deficiency Account.
- Master the adjustment of private and firm assets and liabilities as per statutory rules, with a clear numerical example.
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Meaning of Insolvency in Partnership Firms
Insolvency in partnership means the firm is unable to pay its debts as they fall due. The firm, or sometimes individual partners, may face legal proceedings if creditors are not paid. When a competent court declares a partnership or partner insolvent, the law mandates liquidation of assets to satisfy outstanding liabilities.
Legal Treatment under Indian Insolvency Law
a. Statutory Framework
The Indian Partnership Act, 1932 and the Insolvency and Bankruptcy Code, 2016 (IBC) govern insolvency for partnership firms. Section 34 of the Partnership Act states that a partner ceases to be a partner on being adjudged insolvent. Unless there is an agreement to the contrary, the firm is usually dissolved upon insolvency of any partner (Section 42(d))[1].
b. Practical Consequences
- The insolvent partner's private estate is used to pay their personal debts first. Any surplus is applied to firm debts.
- The firm's assets are used to pay firm debts. Any surplus, if any, is distributed among partners or their legal representatives.
- Creditors of the firm are paid from firm assets; private creditors of partners are paid from the partner's individual estate.
Accounting for Insolvency: Statements and Adjustments
a. Statement of Affairs
This statement presents the financial position of the insolvent firm—very similar to a balance sheet, but with assets valued at their realizable amounts. It helps determine how much is available for distribution to creditors.
| Statement of Affairs of XYZ & Co. as on 31 March 2025 | |
|---|---|
| Liabilities | Assets (Realisable Value) |
| Secured Creditors | Cash at Bank |
| Unsecured Creditors | Debtors (after provision) |
| Partners' Loan | Stock (at net realisable value) |
| Partners' Capital | Plant & Machinery (realisable) |
| Other Assets | |
b. Deficiency Account
The deficiency account explains the shortfall—how much the firm's assets fall short of meeting its liabilities. It traces the loss from the last balance sheet to the deficiency now revealed, listing causes such as trading losses, drawings, bad debts, depreciation, or loss on realization.
| Deficiency Account | |
|---|---|
| To | By |
| Loss on Realization of Assets | Balance as per last Balance Sheet (Capital) |
| Trading Losses | Profits (if any) since last Balance Sheet |
| Bad Debts | Additional Capital Introduced |
| Drawings by Partners | |
| Deficiency (Balancing Figure) | |
Adjustment of Private Estate and Private Liabilities of Partners
a. Marshalling of Assets: The Golden Rule
The famous rule, derived from English law and adopted in India, is:
- Firm’s property is used for the payment of firm’s debts first; any surplus goes to the partners.
- Partner’s private property is used for their private debts first; any surplus can be used to pay off the firm’s debts.
What does this mean in practice? If a partner’s private estate isn’t enough to pay their personal creditors, the firm’s creditors can’t touch the private estate. But if there’s a surplus after paying private debts, it’s contributed toward firm debts. This principle prevents unfair prejudice to either group of creditors.
Practical Example: Insolvency & Deficiency Account
Let’s consider a partnership firm, ABC & Co., with the following balance sheet as of the date of insolvency:
| Balance Sheet of ABC & Co. | |
|---|---|
| Liabilities | Assets |
| Creditors 60,000 | Cash 5,000 |
| Partners’ Capital: A: 30,000 B: 20,000 | Debtors 20,000 |
| Stock 15,000 | |
| Plant 40,000 | |
On realization:
- Debtors recover Rs. 10,000
- Stock realises Rs. 8,000
- Plant sells for Rs. 15,000
- Cash in hand Rs. 5,000
Total realisable assets = 10,000 + 8,000 + 15,000 + 5,000 = Rs. 38,000
Creditors to be paid = Rs. 60,000
Deficiency = 60,000 - 38,000 = Rs. 22,000
Deficiency Account (Summary)
| Deficiency Account | |
|---|---|
| To | By |
| Loss on Realization (Assets sold below book value) | Partners’ Capitals (A+B) |
| Bad Debts (if any) | |
| Drawings (if any) | |
| Deficiency (Balancing Figure) | |
If partners’ private estates have surplus after paying their personal debts, that surplus is added to the firm’s assets for payment to firm creditors. If not, the deficiency remains with the firm’s creditors.
Insolvency Adjustments
| Adjustment Area | Treatment |
|---|---|
| Firm’s Property | Used for payment of firm’s debts first; surplus to partners |
| Partner’s Private Property | Used for private debts first; surplus may be used for firm’s debts |
| Statement of Affairs | Shows estimated realizable assets and liabilities to reveal deficiency |
| Deficiency Account | Explains causes and amount of capital deficiency to creditors |
| Insolvent Partner’s Estate | Private creditors have priority; any surplus goes to firm’s creditors |
| Creditors’ Rights | Firm creditors claim firm assets; private creditors claim private assets |
| Firm Dissolution | Usually follows insolvency unless agreement says otherwise |
Master these principles, and you’ll approach any exam question on partnership insolvency with confidence. Always read questions carefully for the sequence of asset realization, creditor payments, and the impact of private estates. The examiner wants to see if you understand both the accounting technique and the legal logic behind each adjustment.