Dissolution of Partnership – SS2 Financial Accounting Lesson Note (Third Term)

Dissolution of partnership is a change in the relationship between partners, such as a change in the profit-sharing ratio, or the admission, retirement or death of a partner, after which the firm continues its business. Dissolution of a firm closes the business, and the relationship between the partners ends.

Behavioural objectives

By the end of the lesson, students should be able to:

• State the ways in which a partnership can be dissolved.
• Explain the five types of dissolution of a firm.
• State the order in which losses are met and assets are applied when a firm is dissolved without an agreement.
• Distinguish between dissolution of partnership and dissolution of a firm.

What is dissolution of partnership?

After the dissolution of a partnership, the existing relationship between the partners changes. However, the firm continues its activities. A partnership is dissolved in any of the following ways:

1. Change in the existing profit-sharing ratio.
2. Admission of a new partner.
3. Retirement of an existing partner.
4. Death of an existing partner.
5. Insolvency of a partner, as he becomes incompetent to contract and can no longer be a partner in the firm.
6. Completion of a specific venture, where the partnership was formed for that particular venture only.
7. Expiry of the period for which the partnership was formed.

The dissolution of a firm may take place with or without the intervention of the court. The dissolution of a partnership does not necessarily result in the dissolution of the firm. However, the dissolution of a firm always results in the dissolution of the partnership.

How is a partnership firm dissolved?

1. Dissolution by agreement

A firm may be dissolved if all the partners agree to the dissolution. It may also be dissolved under a contract between the partners that provides for dissolution.

2. Compulsory dissolution

A firm is dissolved compulsorily in the following cases:

1. Insolvency of all the partners, or of all but one partner, as this makes them incompetent to enter into a contract.
2. The business of the firm becomes illegal for some reason.
3. Some event makes it unlawful for the firm to carry on its business. For example, a firm has a partner from another country and India declares war against that country. He becomes an enemy, so the business becomes unlawful.

3. Dissolution when certain contingencies happen

The dissolution of the firm takes place, subject to a contract among the partners, if:

1. The firm is formed for a fixed term, on the expiry of that term.
2. The firm is formed to carry out specific ventures, on the completion of those ventures.
3. A partner dies.
4. A partner becomes insolvent.

4. Dissolution by notice

When the partnership is at will, the firm may be dissolved if any one of the partners gives written notice to the other partners stating his intention to dissolve the firm.

5. Dissolution by court

When a partner files a suit, the court may order the dissolution of the firm on any of the following grounds:

1. A partner becomes insane.
2. A partner becomes permanently incapable of performing his duties.
3. A partner is guilty of misconduct that adversely affects the firm’s business.
4. A partner continuously commits a breach of the partnership agreement.
5. A partner transfers the whole of his interest in the firm to a third party.
6. The business cannot be carried on except at a loss.
7. The court regards the dissolution of the firm as just and equitable on any ground.

How are accounts settled when a firm is dissolved?

Where the partners have no agreement on the dissolution of the firm, the following provisions apply:

1. The firm pays losses, including any deficiency of capital, firstly out of profits, secondly out of the partners’ capital and lastly by the partners individually in their profit-sharing ratio.
2. The firm applies its assets, including any contribution made to cover a deficiency, firstly to pay third-party debts, secondly to pay any loan or advance made by a partner and lastly to pay back the partners’ capital. Any surplus left after these payments is shared by the partners in the profit-sharing ratio.

What is the difference between dissolution of partnership and dissolution of a firm?

Evaluation

1. List four ways in which a partnership may be dissolved.
2. State three cases in which a firm is dissolved compulsorily.
3. When may a firm be dissolved by notice?
4. State the order in which a firm’s assets are applied when it is dissolved without an agreement.
5. State two differences between dissolution of partnership and dissolution of a firm.

Assignment

1. List five grounds on which the court may order the dissolution of a firm.
2. Explain how losses are met when partners have no agreement on dissolution.