Dissolution of a Firm: Meaning, Types & Settlement of Accounts

A firm’s dissolution marks the end of a partnership business as far as legal, operational, and financial ties are concerned. During the process of dissolution, the assets of the firm are sold, debts are paid off, and any remaining funds or liabilities are divided among the partners according to their shares. This is a very basic concept in accountancy because it deals with certain legal and financial procedures that ensure an orderly end to the partnership. This Article covers all the essential concepts of dissolution of a firm.

What is Dissolution of a Firm?

The dissolution of a firm is the winding up of all business operations and liabilities under the partnership. This is a formal procedure that involves liquidation, clearing of liabilities, and distributing any surplus or deficit that may arise among partners under the agreement drawn up at the start. This process is different from the dissolution of a partnership in that it only reorganizes the partnership instance, through the exit or admission of a partner. It does not end the business itself. In firm dissolution, the partnership ceases to exist legally, and its financial records are permanently closed.

Types of Dissolution of a Firm

Dissolution can take place in many forms depending on the circumstances of a specific business. There are primary types of dissolution and each has its own legal and procedural requirements:

Dissolution by Agreement

• Definition: The partners agree to dissolve the firm amicably. This most of the time occurs when the partners decide that the firm has served its objective or that it is becoming hard to continue the business operation due to unprofitable activities.
• Conditions: The partnership agreement may provide for the dissolution terms or the partners may agree irrespective of any prior arrangements. This type of dissolution is simple and often agreed upon in advance.

Compulsory Dissolution

• Definition: A firm is subject to compulsory dissolution when an outsider causes the firm to close, or when specific circumstances occur that lead to the legal stopping of the partnership.
• Conditions: All partners cannot pay their debts; a partner dies; or their business becomes illegal under existing law. For example, if a new regulation prohibited a firm’s type of business the partnership must compulsorily dissolve.

Dissolution by Notice

• Definition: In partnerships “at will,” meaning partnerships that do not contain a duration, any partner can terminate the firm with written notice to the other partners.
• Conditions: The notice must be in writing and clear, with a declaration of the partner’s intent to end the business. This method is flexible but only available if there is no predetermined date of the end of the partnership.

Dissolution by Court Order

• Definition: The court can further dissolve a partnership if any partner files a petition based on serious disputes or grievances that impede the operation of the firm.
• Conditions: Circumstances that might warrant court enforcement dissolution include. A spouse being rendered mentally incompetent or suffering an illness that cannot be cured, Gross partner malpractice that harms the business, or Repeated arguments among partners that are impeding the smooth operation of the business.
• Purpose: Court-ordered dissolution ensures fairness in distributing all assets and liabilities among partners in cases where the issues involved make it hard for operations to continue.

Settlement of Accounts upon Dissolution

The need for an organized settlement of accounts arises only after a partnership firm decides to dissolve to finally settle its accounts. Proper account settlement would ensure that all liabilities are cleared and the remaining assets are distributed equitably amongst partners.

Preparation of the Realisation Account

1. Function: A realization account is maintained and assets are sold which does not comprise cash or cash in the bank, similarly it includes liability accounts as well.
2. Process: All assets of the firm are credited to the realization account with book values, while the liabilities are debited. On liquidation of all or part of the assets, proceeds are credited, while the payments to creditors will also be recorded. The final amount in this account may well represent a profit or a loss and is therefore allocated to partners’ capital accounts based on their decided-upon profit-sharing ratios.

Clearing Liabilities

1. Record-Keeping: Proper documentation and tracking of each payment are necessary in the presence of external creditors. As this allows the availability of total transparency, it also serves to keep the books under legal compliance.
2. Internal Liabilities: Internal liabilities involve the debts that are payable to the partners like loans or advances. It settles after clearing the external liabilities
3. External Liabilities: It consists of debts payable to outside creditors, bank overdrafts, and other liabilities a firm owes outside parties. For example, in case a firm is dissolved, any bank overdraft transferred to the realization account is credited and cleared.

Distribution of Remaining Assets

1. Surplus Distribution: After liquidating the liabilities, the residue amount is given to partners in proportion as contemplated in the partnership deed or, in its absence, in equal proportions as determined between partners.
2. Deficit Handling: If the realisation goes through short, partners will have to add more funds to clear the outstanding debts. This is usually according to their capital shares or as agreed upon.

Closure of Partners’ Capital Accounts

1. Final Adjustments: Closing the capital accounts by transferring final balances. If there is any shortage, that partner pays the shortfall amount and makes the accounts equal.
2. Settlement of personal accounts: The realisation account is further credited with the remaining balances payable to the creditors as the process of dissolution is ended by clearing all the financial liabilities.

Settlement Item	Debited	Credited
Assets at Book Value	Amount
Realisation Proceeds		Amount
Bank Overdraft Payment	Amount
Surplus (or Deficit)	Final Amount	Distributed to Partners’ Capital Accounts

Accounting Entries in Dissolution of a Firm

1. Realisation account Debits: All the expenses including loss on dissolution are credited to the realisation account. Such expenses include asset book values, outlays on expenses, and other costs of settlement.
2. Partner’s Loan Settlement: Partner loans or advances are paid after the settlement of external liabilities but before that of capital settlements. The same is recorded separately from capital contributions.
3. Capital Deficiency Management: Deficiencies of the capital account of a partner, at the end of all accounts, may be met by other partners if agreed or necessary to balance.

Conclusion

Firm dissolution is a procedure, which is legal and financially close-up on the partnership but very detailed and systematic. Through a systematic method of clearing all liabilities in settling accounts, it respects the interests of everyone during the whole process. Given such a broad understanding of the principles of accountancy, it can be smoother to deal with the dissolving of a firm from the perspectives of partners or stakeholders who do not benefit unfairly but also understand how things go in the business.

Dissolution of a Firm FAQs

What is dissolution of a partnership firm?

Dissolution of a firm involving winding up its business activities, settling liability, and distributing the leftover balance of assets among all partners by its profit-sharing ratio or the principle of equal division if it has not been mentioned.

On dissolution of the firm, realisation account gets what items?

In the process of winding up the firm, the realisation account is debited with the book value of all assets other than cash and bank balance and all expenses and losses.

What happens to a bank overdraft on the liquidation of a firm?

The bank overdraft of the firm, at the time of dissolution, is transferred to the realisation account as a liability. It is paid out of the realisation proceeds or, if necessary, through contributions of partners.

What happens if there is a capital deficiency during dissolution?

In the event of a deficiency in a partner’s capital account, others may make up the deficiency proportionate to their profit-sharing ratio or as stipulated in the partnership agreement to equalize all accounts.

Can a firm go into liquidation without paying off its external liabilities?

No, only after all the liabilities external to the firm have been paid can the balance be made available to partners; if not, then the firm will still legally remain vulnerable and not actually be dissolved.