1 Chapter - v DISSOLUTION OF PARTNERSHIP FIRM Insolvency of partnership if any partner becomes and his account shows a debit balance, then the solvent partners have to share such loss. But the problem arises as to the ratio of sharing such loss due to the insolvency of partner by the solvent partners. The solvent partners may share such deficiency in the following ways: In their profit sharing ratio (like any other business losses) In the ratio of their last agreed capitals (as decided by Garner Vs Murray) Garner Vs Murray decision (1904) As per Garner Vs Murray decision, in the absence of any agreement to the contrary, the loss due to the insolvency of a partner should be borne by the solvent partner’s in the ratio of their capitals. The capital for the purpose means the agreed capital or capital standing just prior to the time of dissolution. The agreed capital or capital standing just prior to the time of dissolution should be interpreted as under: Case a. In case of fluctuating capitals b. In case of fixed capitals Meaning of last agreed capitals Agreed capitals means the capital after adjustments for past accumulated reserves, profit & losses , drawings, interest on capitals, interest on drawings, remuneration to a partner etc. To the date of dissolution but before making adjustment for profit & loss on realisation Agreed capital means the fixed capital without any adjustment (given in the balance sheet) Practical guidelines in case of insolvency of a partner according to the decision in Garner Vs Murray. a. Realisation account should be prepared in the usual manner and its profit or loss should be transferred to the capital accounts of all partners in the profit sharing ratio. b. Solvent partners should bring in cash equal to their respective shares of the loss (if any) on realisation. c. The ratio of the last agreed capitals of the solvent partners should be calculated. d. If any amount is received from the private estate of an insolvent partner, it should be credited to his capital account. 2 e. The unrecovered debit balance after making all adjustments (including the share of any profit or loss on realisation be transferred to the capital accounts of the solvent partners ), in the ratio of their Last Agreed Capitals (step c). When all partners are insolvent The realisation account is prepared in usual manner, but the external liabilities such as creditors, bills payable etc, will not be transferred to this account as they cannot be paid in full. Any available cash balance is utilised for the payment of liabilities and unpaid portion is transferred to the ‘deficiency account.’ Any deficiency in the capital accounts also be transferred to the deficiency account, to get it closed. Gradual realisation of assets and piecemeal distribution In the actual practice the sale of assets and realisation of liabilities immediately after dissolution is unrealistic. In process of assets are sold one after another to get maximum amount. But creditors & partners could not wait until last realisation. Interim payments are made to them whenever assets realised. But one problem arise is the profit or loss on realisation can be determined only after the completing the realisation process. And no partners have to be overpaid or underpaid. i.e., if a partner is paid more than his balance due and he becomes insolvent then excess amount cannot be recovered from him. Therefore, a method called piecemeal is followed to make payments to the partners in a proper manner. I.e., no partner is paid more than actual amount due to him and unpaid amount will be in their profit sharing ratio. Distribute the amount available on realisation on the basis of priority a. b. c. d. e. Priority for distribution Realisation expenses Preferential creditors Creditors/liabilities to third parties Partner’s loans Partner’s capital Methods of piecemeal distribution i. ii. Proportionate capital method Maximum loss or notional loss method Proportionate capital method Calculate the balances of partners capital accounts( after making adjustments for reserves , accumulated profit , profit and loss balance etc ) distribute it to partners in profit sharing ratio. After distribution of realisation amount to third party next comes the partners capital 3 If the partners capital are their profit sharing ratio, then the realisation amount is to be paid in that ratio If the partners capital is not in the ratio ,then following steps are considered Take smallest capital as base capital and calculate the proportionate capital by multiplying the base capital and profit sharing ratio. For eg: suppose A, B, C is partners with profit sharing ratio 2:2:1 and their capital balances is as follows: A – 16,000 B – 12,000 C-5,000 Here smallest amt of capital is C’s capital i.e. 5000 take this as base capital and multiply the remaining partners ratio with this base.(2:2:1) A -5000 X 2 = 10,000 B – 5000 X 2 = 10,000 C- 5000 X 1 = 5000 Proportionate capitals = 10,000 : 10,000: 5,000 Calculate the surplus amount by deducting proportionate capital from actual capital A – 16000 – 10000 = 6000 B – 12000 – 10000 = 2000 C – 5000 – 5000 = 0 If one partner has the surplus capital, make payment to him first. If there are 2 or more partners and their surplus is: In profit sharing ratio – distribute the cash in their profit sharing ratio till such surplus is paid off Not in profit sharing ratio – make it in profit sharing ratio first for that divide the surplus capital by profit sharing ratio and treat smallest as revised base capital and then divide the amount. In the above given example A’s surplus 6000 is more than B’s -2000 so first make them in ratio. Hence they are equal partners make their capitals equal i.e. first pay 4000 to A so balance of A & B will become equal. Once the partners balance due reaches at the proportionate capital then distribute the amount in their profit sharing ratio and the balance remaining at the end of all realisation is realisation loss. Maximum loss or notional loss method Steps 1. Calculate the partners capital ratio just before the date of dissolution 2. Calculate the balances of partners capital accounts( after making adjustments for reserves , accumulated profit , profit and loss balance etc ) distribute it to partners in profit sharing ratio. 3. After distribution of realisation amount to third party next comes the partners capital 4. Calculate the maximum loss in the assumption that it is a last realisation and remaining assets will realise nothing. Maximum loss=Total of balances of partners capital account less cash available for realisation 5. Then distribute the maximum loss (step 5) among the partners in profit sharing ratio. 6. If capital account shows 4 No negative balances (Dr balances)- distribute the cash available to the partners in their profit sharing ratio If any capital account shows a negative balance (dr balance) then that particular partner is treated as insolvent and remaining partners(having cr balance) have to share the loss in their capital ratio (step 1).(application of Garner Vs Murray ruling).repeat this till negative balances is abolished.