Month: January 2021

Management Notes

Profits Prior to Incorporation and Accounting Treatment

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Profit of a business for the period prior to the date company into existence is referred to as Pre-Incorporation profit. Hence prior period item are those item which is done before incorporation of the company. Profit prior to incorporation is the profit earned or loss suffered during the period before incorporation. It is a capital profit and not legally available for distribution as dividend because a company cannot earn a profit before it comes into existence.

Profit earned after incorporation is revenue profit, which is available for dividend. Profit of prior period and post period however divided separately because the prior period profit and loss hence always credited and charged from capital reserve A/c. Post period profit and loss thus credited and charged from Profit & Loss A/c.

When a running business is taken over from a date prior to its incorporation/commencement, the profit earned up to the date of incorporation/commencement (incorporation, in case of private company; and commencement, in case of public company) is known as ‘Pre-incorporation profit’.

The same is to be treated as capital profit since these are profits which have been earned before the company came into existence. In short, the profit earned after the date of purchase of business is called ‘Post-incorporation or Post-acquisition profit’ and the profit earned before the date of purchase of business is termed as ‘Pre-incorporation profit’.

Method of Computation of Profits/Loss Prior to Incorporation:

In order to ascertain the profit prior to incorporation a Profit and Loss Account is to be prepared at the date of incorporation. But in practice, the same set of books of accounts is maintained throughout the accounting year.

A Profit and Loss Account is prepared at the end of the year and thereafter the profits (or losses) between the two periods are allocated:

(i) From the date of purchase to the date of incorporation or pre-incorporation period;

(ii) From the date of incorporation to the closing of the accounting year or post-incorporation period.

Method of Accounting of Profit/Loss Prior to Incorporation:

Steps may be suggested for ascertaining profit or loss prior to incorporation:

Step I:

A Trading Account should be prepared at first for the whole period, i.e., between the date of purchase and the date of final accounts, in order to calculate the amount of gross profit.

Step II:

Calculate the following two ratios:

(i) Sales Ratio:

Amount of sales should be calculated for the pre-incorporation and post-incorporation periods.

(ii) Time Ratio:

It is calculated after considering the time period, i.e., one is required to calculate the period falling between the date of purchase and the date of incorporation and the period between the date of incorporation and the date of presenting final accounts.

Step III:

A statement should be prepared for calculating the amount of net profit before and after incorporation separately on the following principle:

(i) Gross Profit should be allocated for the two periods on the basis of sales ratio which will present the gross profit for the two separate periods, viz. pre-incorporation and post- incorporation.

(ii) Fixed Expenses or expenses incurred on the basis of time, viz., Rent, Salary, Depreciation, Interest, etc. should be allocated for the two periods on the basis of time ratio.

(iii) Variable Expenses or expenses connected with sales should be allocated for the two periods on the basis of sales ratio.

(iv) Certain expenses, viz., partners’ salary, directors’ salary, preliminary expenses, interest on debentures, etc. are not apportioned since they relate to a particular period. For example, partners’ salary is to be charged against pre-acquisition profit whereas directors’ remuneration, debenture interest, etc. are to be charged against post-acquisition profit.

List of Expenses: Allocated on the basis of Sales/Turnover:

(a) Gross Profit

(b) Selling Expenses

(c) Advertisement

(d) Carriage Outwards

(e) Godown Rent

(f) Discount Allowed

(g) Salesmen’s Salaries

(h) Commission to Salesmen

(i) Promotion Expenses for Sales

(j) Distributions Expenses (Variable Portions)

(k) Free Samples given

(l) Expenses incurred for After-Sale Service, etc.

(m) Delivery Van Expenses.

List of Expenses: Allocated on the basis of Time:

(a) Office and Administration Expenses

(b) Salaries to Office Staff

(c) Rent, Rates and Taxes

(d) Depreciation on Fixed Assets

(e) Printing and Stationery

(f) Insurance

(g) Audit Fees

(h) Miscellaneous Expenses

(i) Distribution Expenses (Fixed Portion)

(j) Travelling Expenses (General)

(k) Interest of Debenture

(l) General Expenses

(m) Expenses Fixed in Nature.

Application/Accounting Treatment of Profit/Loss Prior to Incorporation:

(a) Pre-incorporation Profit:

Since “Profit prior to Incorporation” is a Capital Profit the same should be written off against:

(i) Preliminary Expenses Account

(ii) Formation Expenses Account

(iii) Liquidation Expenses Account

(iv) Write down the value of Fixed Assets, if any

(v) Goodwill Account

(vi) Balance, if any, transferred to Capital Reserve.

(b) Pre-incorporation Loss:

Since “Pre-incorporation Loss” is a Capital Loss the same is adjusted against

(i) Any Capital Profit

(ii) Debited to Goodwill Account

(iii) Writing-off Fictitious Assets

(iv) Capital Reserve.

Basis of allocation of items between ‘pre’ and ‘post’ incorporation period

Time basis

Some type of expense and income which thus divided between pre- and post-period item on basis of time ratio.

For example: Depreciation, salary & wages, Rent and trade expenses etc.

Turnover basis

Some type of expense and income thus divided between pre- and post-period item on the basis of turnover.

Debtors & Creditors Suspense Accounts

  • A company taking over a running business may also agree to collect its debts as an agent for the vendor and may further undertake to pay the creditors on behalf of the vendors in such a case, the debtors and creditors of a vendors will include in the accounts for the company by debit or credit separate total accounts in the general ledger to distinguish them from the debtors and creditors of the business and contra entries will make in corresponding suspense account. Also details of debtors and creditors balance will thus kept in separate ledger.
  • The vendor hence treated as a creditors for the cash received by the purchasing company in respect of the debts due to the vendor, just as if he has himself collected cash from his debtors and remitted the proceeds to the purchasing company.
  • The vendor thus considers a debtor in respect of cash paid to his creditors by the purchasing company. The balance of cash collected, less paid, will represent the amount due to or by the vendor, arising from debtors and creditors balances which have taken over, subject to any collection expenses.
  • Balance in suspense account will be equal to the amount of debtor and creditors taken over remaining unadjusted at anytime.
Management Notes

Net Assets Method of Valuation of Share

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Net Asset Method, also known as the Asset Backing Method or Intrinsic Value Method, is a method of valuation of shares based on the net worth of a company. Under this method, the value of shares is determined by considering the fair value of total assets and deducting all external liabilities. The balance represents the net assets available to shareholders. The value per share is calculated by dividing net assets by the number of shares. This method focuses on the company’s financial strength rather than its earning capacity.

The basic concept of the Net Asset Method is that the value of a share depends on the assets backing it. It assumes that shareholders are entitled to the residual interest in the company’s assets after settling all liabilities. Therefore, a company with strong assets and fewer liabilities will have a higher share value. This method is particularly useful when the company is liquidating, asset-rich, or not earning normal profits.

Applicability of Net Asset Method

The Net Asset Method is commonly used in the following situations:

  • Valuation of shares of unquoted companies
  • Valuation during liquidation or winding up
  • Companies with low or fluctuating profits
  • Investment holding or real-estate companies
  • Determination of value for merger, takeover, or buy-back

It is less suitable for highly profitable companies where earnings matter more than assets.

Types of Net Asset Method

The Net Asset Method can be classified into two types:

(a) Going Concern Basis

Assets are valued at their fair or replacement value, assuming the business will continue operations.

(b) Liquidation Basis

Assets are valued at their realizable value, considering forced sale or liquidation expenses.

The choice depends on the purpose of valuation.

Steps Involved in Net Asset Method

The valuation under this method involves the following steps:

Step 1. Ascertain the fair value of all assets, including fixed assets, investments, current assets, and intangible assets (excluding goodwill if internally generated).

Step 2. Deduct external liabilities, such as creditors, debentures, loans, and provisions.

Step 3. Determine net assets available to shareholders.

Step 4. Allocate net assets between preference shareholders and equity shareholders.

Step 5. Divide the net assets available to equity shareholders by the number of equity shares to obtain the value per share.

Treatment of Assets and Liabilities

  • Fixed Assets are taken at fair or market value.
  • Current Assets are taken at realizable value.
  • Fictitious Assets like preliminary expenses are excluded.
  • Goodwill is included only if purchased.
  • Contingent Liabilities are usually ignored unless likely to occur.
  • Preference Share Capital is treated as a liability while valuing equity shares.

Formula for Valuation

Value per Equity Share = Net Assets available to Equity Shareholders / Number of Equity Shares

Where,

Net Assets = Total Assets – External Liabilities

Advantages of Net Asset Method

  • Simple and easy to understand
  • Useful for asset-based companies
  • Suitable during liquidation
  • Reflects financial stability
  • Less affected by profit fluctuations

Limitations of Net Asset Method

  • Ignores earning capacity
  • Valuation of assets may be subjective
  • Not suitable for service-based companies
  • Does not consider future prospects
  • May undervalue profitable companies
Management Notes

Issue of Shares at Par, Premium and Discount

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Companies raise capital by issuing shares, and the method of issuance determines how these shares are distributed among investors. The three main types of share issues are Initial Public Offering (IPO), Follow-on Public Offering (FPO), and Private Placement.

  1. Initial Public Offering (IPO): An IPO is when a private company offers its shares to the public for the first time, transitioning into a publicly traded company. This method helps businesses raise funds for expansion, debt repayment, or operational growth. IPOs can be priced either through a fixed-price method, where a pre-determined price is set, or a book-building process, where investors bid for shares within a price range. Once issued, shares are listed on stock exchanges for trading. Regulatory authorities such as SEBI (in India) oversee IPOs to ensure transparency.

  2. Follow-on Public Offering (FPO): After an IPO, companies may issue additional shares through an FPO to raise more capital. This can be dilutive, where new shares are created, reducing the ownership percentage of existing shareholders, or non-dilutive, where existing shareholders sell their shares to new investors. Companies use FPOs to fund expansion, acquisitions, or improve financial stability.

  3. Private Placement: Instead of offering shares to the general public, companies may issue them to specific investors such as venture capitalists, institutional investors, or high-net-worth individuals. This method is quicker and avoids regulatory complexities, making it a preferred option for raising capital efficiently.

Issue of Shares at Par

When shares are issued at par, they are sold at their nominal value (also called face value). The nominal value is the price printed on the share certificate, typically set at ₹10, ₹100, or another standard amount. This means investors pay exactly the face value of the share without any additional premium or discount.

For example, if a company issues 1,000 shares with a face value of ₹10 each, the total capital raised will be ₹10,000.

Features of Shares Issued at Par:

  1. Fair Valuation: The share price is neither inflated nor reduced, reflecting its actual worth as per the company’s books.

  2. Common for New Companies: Startups and newly established firms often issue shares at par because they do not have a market reputation to justify a premium.

  3. No Capital Gains for the Company: Since shares are issued at their face value, the company does not earn any extra capital beyond the nominal value.

  4. Lower Investor Risk: Investors do not overpay, reducing risks associated with stock market volatility.

  5. Transparency in Pricing: The fixed price prevents speculation and manipulation.

Shares issued at par are considered a straightforward and risk-free way to raise capital, especially for companies that are just entering the market.

Issue of Shares at Premium

When shares are issued at a premium, they are sold at a price higher than their nominal value. This happens when a company has strong financial performance, a good reputation, or high demand for its shares. The extra amount over the face value is called the securities premium and is credited to the company’s Securities Premium Account.

For example, if a company issues shares with a face value of ₹10 at ₹50 per share, the ₹40 excess is the premium.

Reasons for Issuing Shares at a Premium:

  1. Strong Market Reputation: Companies with good earnings history can charge a premium due to high investor confidence.

  2. Demand Exceeds Supply: If many investors want the shares, companies set higher prices.

  3. Profitability and Growth Prospects: Companies with consistent profits and expansion plans attract investors willing to pay a premium.

  4. Reserves for Future Needs: The premium amount can be used for writing off expenses, issuing bonus shares, or funding business expansion.

  5. Enhances Market Perception: A higher issue price reflects strong company fundamentals, boosting investor trust.

Issuing shares at a premium benefits both the company (by raising more capital) and investors (who gain ownership in a promising business). However, it also carries risks, as the stock price may fluctuate post-issue, affecting investor returns.

Issue of Shares at Discount

When shares are issued at a discount, they are sold at a price lower than their nominal value. Companies generally avoid this method, as issuing shares below face value indicates financial instability. However, in special cases, businesses may offer discounted shares to attract investors.

For example, if a company issues shares with a face value of ₹10 at ₹8 per share, the ₹2 difference is the discount.

Reasons for Issuing Shares at a Discount:

  1. Financial Difficulties: Companies struggling to raise funds may offer discounts to attract investors.

  2. Encouraging Subscription: If there is low demand, a discount helps ensure the shares are fully subscribed.

  3. Compensating Initial Investors: Sometimes, early investors or employees are given discounted shares as incentives.

  4. Clearing Unsold Shares: Companies that fail to sell shares in an IPO or FPO may offer discounts to encourage purchases.

  5. Special Approvals Required: In many countries, issuing shares at a discount requires regulatory approval to prevent misuse.

Management Notes

Pro-rata basis Allotment of Share

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Pro-rata Allotment of Shares refers to the proportional distribution of shares among applicants when the number of shares applied for exceeds the shares available for issuance, typically in cases of oversubscription. Under this system, each applicant receives shares in proportion to the amount they applied for. For example, if an investor applies for 1,000 shares in an issue that is oversubscribed by 200%, they may receive only 500 shares (i.e., half of their application). Pro-rata allotment ensures a fair and equitable distribution of shares to all applicants.

Reasons of Pro-rata basis Allotment of Shares:

  1. Fair Distribution:

Pro-rata allotment ensures a fair and equitable distribution of shares among applicants. When demand exceeds supply, this method allows each applicant to receive shares in proportion to their applications, minimizing feelings of unfairness among investors.

  1. Equity Among Investors:

By allotting shares on a pro-rata basis, companies uphold the principle of equity. Each applicant receives an opportunity to invest in proportion to their interest, regardless of the size of their application, thus maintaining investor confidence in the fairness of the process.

  1. Mitigation of Oversubscription issues:

In cases where a public offering is oversubscribed, pro-rata allotment provides a structured way to address the excess demand. This method simplifies the allocation process and helps manage investor expectations, as they know they will receive a portion of their requested shares.

  1. Transparency:

Pro-rata allotment promotes transparency in the share allocation process. The method is straightforward, and investors can easily understand how many shares they will receive based on their application size, enhancing trust in the company’s operations.

  1. Encourages Participation:

Knowing that shares will be allotted fairly encourages more investors to participate in future offerings. This can lead to a more extensive shareholder base, which can be beneficial for companies in terms of stability and market presence.

  1. Simplified Accounting:

From an accounting perspective, pro-rata allotment simplifies the share issuance process. Companies can easily calculate the number of shares to be allotted to each applicant based on the total number of shares applied for, streamlining record-keeping and reporting.

  1. Reduced Administrative Burden:

By adopting a pro-rata approach, companies can reduce the administrative burden associated with managing oversubscriptions. Instead of handling individual requests and conducting lotteries or other complex allocation methods, a pro-rata system simplifies the process.

  1. Legal Compliance:

Pro-rata allotment can help companies comply with regulatory requirements. Many jurisdictions have guidelines regarding fair allotment processes, and adhering to a pro-rata system can help ensure compliance with these rules, minimizing legal risks.

Accounting of Pro-rata basis Allotment of Shares:

Accounting for pro-rata allotment of shares involves recording the applications, allotment, and any refund due to oversubscription.

Example Scenario:

  • A company issued 10,000 shares at ₹10 each.
  • Applications were received for 15,000 shares, resulting in oversubscription.
  • The company refunds 5,000 shares and allots the remaining 10,000 shares on a pro-rata basis.

Accounting Entries for Pro-rata Allotment:

Transaction Journal Entry

Amount (₹)
1. On receipt of application Money: Bank A/c Dr. 1,50,000
– To Share Application A/c 1,50,000
(Being application money received for 15,000 shares @ ₹10 per share) – –
2. On transfer of application money to share Capital: Share Application A/c Dr. 1,00,000
To Share Capital A/c 1,00,000
(Being application money for 10,000 shares transferred to share capital) – –
3. On refund of excess application Money: Share Application A/c Dr. 50,000
– To Bank A/c 50,000
(Being refund made to applicants for 5,000 shares on pro-rata basis) – –
4. On allotment of Shares: Share Allotment A/c Dr. 50,000
– To Share Capital A/c 50,000
(Being allotment of 10,000 shares at ₹10 each) – –

Management Notes

Re-issue of Shares

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Requirements of Companies Act

The following are the requirements of the Companies Act regarding the reissue of forfeited shares:

  1. The forfeited shares are generally issued at a price lesser than their face value. But the discount so allowed to the new buyers should not exceed the amount already paid by the defaulting member.
  2. A resolution sanctioning the reissue must be passed in the Board Meeting.
  3. The forfeited shares are to be transferred in the name of the buyer and his name should be entered in the Register of Members.
  4. A public notice in newspapers should be given stating that such and such shares have been forfeited due to the non-payment of calls.

Re-issue of Forfeited Shares

Forfeited shares are available with the company for sale. After the forfeiture of shares, the company is under an obligation to dispose off the forfeited shares.

The company requires to pass a resolution in its Board Meeting for the re-issue of forfeited shares. Re-issue of forfeited shares is a mere sale of shares for the company. A company does not make allotment of these shares.

The company auctions the forfeited shares and disposes them off. A company can re-issue these shares at any price but the total amount received on these shares should not be less than the amount in arrears on these shares. Here, total amount refers to the amount received from the original allottee and the second purchaser.

Notes:

  • We show the Forfeited shares A/c under the heading ‘Share Capital’.
  • When a company re-issues only a part of the forfeited shares, then it will transfer only the profit relating to this part to the capital reserve.
  • When a company re-issues shares at a price more than their face value, it needs to transfer the excess amount to the Securities Premium A/c.

(a) Reissue of forfeited Share Originally Issued at Par:

When the forfeited shares are reissued at a discount, the amount of discount should not exceed the amount credited to Share Forfeited Account. If the discount allowed on reissue of shares is less than the forfeited amount, there will be some balance left in the Forfeited Account, which should be transferred to capital reserve, because it is a profit of capital nature.

Accounting entries:

On reissue of shares at discount:

Bank A/c … Dr. (With reissue price)

Share Forfeited A/c …Dr. (With the discount allowed on reissue)

To Share Capital A/c (With the amount called up)

Transfer to Capital Reserve:

The balance remaining in share forfeited account is in the nature of capital gain and would be closed by transfer to the capital reserve account.

The necessary journal entry will be:

Share forfeited a/c Dr. (with credit balance left in share forfeited account after reissue)

To Capital reserve a/c

(Being share forfeited account transferred)

(b) Reissue of forfeited shares originally issued at discount:

If the shares which were originally issued at a discount are forfeited and reissued, then on reissue the new allottee would get the advantage of discount, besides getting some additional discount from share forfeited account.

The requisite entry in this case will be:

Bank a/c Dr. (with amount received on reissue)

Discount on issue of shares a/c Dr. (with normal discount)

Share forfeited a/c Dr. (with extra discount on reissue)

To Share capital a/c Dr. (with total amount)

(Being forfeited shares reissued, originally issued at discount)

Journal Entries for Re-issue of Forfeited Shares:

Date Particulars   Amount (Dr.) Amount (Cr.)
1. On re-issue of shares Bank A/c (Actual amount received) Dr.  XXX
Forfeited Shares A/c (loss on re-issue) Dr.  XXX
     To Share Capital A/c Cr.  XXX
(Being ….. forfeited shares re-issued @ ₹…each as per the Board’s Resolution no… dated….)
2. On transfer of profit on re-issue Forfeited Shares A/c Dr.  XXX
     To Capital Reserve A/c Cr.  XXX
(Being profit on re-issue of the shares transferred to capital reserve)  

Auditor’s Duty regarding reissue of forfeited shares

  1. The auditor should ascertain whether the Articles authorize the Board of Directors to reissue the forfeited shares.
  2. He should examine the resolution passed by the Board of Directors at their meeting under which the forfeited shares have been re-allotted.
  3. He should vouch the entries made for re-allotment in the Cash Book.
  4. He should see that the balance remaining in the forfeited shares account has been transferred to the Capital Reserve Account.
  5. In case the shares were reissued at a price above par value, he should see that the excess has been transferred to the Share Premium Account.
  6. He should vouch the copy of the return of allotment filed with the Registrar of Joint Stock Companies.
Management Notes

Accounting of Bonus Shares

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Section 81 of the Companies Act requires that a public limited company, whenever it proposes to increase its subscribed capital after the expiry of two years from the date of its incorporation or after the expiry of one year from the date of allotment of shares in that company, made for the first time after its formation, whichever is earlier, shall be required to offer those shares to the existing equity shareholders in the proportion of paid-up capital as nearly as possible. Such shares are known as rights shares.

From an accounting perspective, a bonus issue is a simple reclassification of reserves which causes an increase in the share capital of the company on the one hand and an equal decrease in other reserves. The total equity of the company therefore remains the same although its composition is changed.

The price at which these shares are offered to the existing shareholders is normally below the market price of the shares. The existing shareholders thus have a specific advantage in the sense that market price of the shares offered is more than its issue price. This specific advantage has a money value called as value of the right.

The value of the right can be calculated as follows:

  1. Ascertain the total market value of the shares which a shareholder is required to possess in order to get additional shares from of the fresh issue.
  2. Add to the above market price, the amount to be paid to the company for additional shares of the fresh issue.
  3. Find average price. This can be calculated by dividing the total prices calculated under step 2 by the total number of shares.
  4. Deduct average price from market price. This difference is called value of the right.

The accounting entries in each of these cases would be as follows:

(A) For converting partly paid shares into fully paid shares

(i) Equity share final call a/c Dr.

  To equity capital a/c

(Being call money due on … shares)

(ii) P&L a/c Dr.

Securities Premium a/c

Reserve a/c Dr.

  To bonus to shareholders a/c

(Being bonus declared)

(iii) Bonus to shareholders a/c Dr.

  To equity share final call a/c

(Conversion of partly paid equity shares into fully paid equity shares)

(B) For fully paid bonus shares

(i) P&L a/c

Securities Premium a/c

Reserve a/c Dr.

  To bonus to shareholders a/c

(ii) Bonus to shareholders a/c Dr.

  To equity share capital a/c

(Being bonus utilised to issue fully paid up bonus shares)

Following journal entries are required to account for a bonus issue:

Debit Undistributed Profit Reserves / Share Premium Reserve / or Other reserves Number of bonus shares × nominal value of 1 share
Credit Share Capital Account Number of bonus shares × nominal value of 1 share

Advantages

  • Cash-starved companies can issue bonus shares instead of cash dividends to provide temporary relief to shareholders.
  • Issuing bonus shares improves the perception of company’s size by increasing the issued share capital of the company.
  • When distributable reserves (e.g. un-appropriated profits) are used to account for a bonus issue, it decreases the risk to creditors as it reduces the amount of reserves available for distribution to the shareholders of the company.

Disadvantages

  • It is not a meaningful alternative to cash dividends for shareholders as selling the bonus shares to meet liquidity requirements would lower their percentage stake in the company.
  • Bonus issue does not generate cash for the company.
  • As bonus shares increase the issued share capital of the company without any cash consideration to the company, it could cause a decline in the dividends per share in the future which may not be interpreted rationally by all market participants.

Case 1

When new fully paid up bonus shares are issued

a) for providing amount of bonus

Capital reserve account debit xxxx

share premium account debit xxxx

Capital redemption reserve account debit xxxx

Other general reserve account debit xxxx

Profit and loss account debit xxxx

Bonus to shareholder account credit xxxx

b) for issue of bonus

Bonus to equity shareholder account debit

Equity share capital account credit

Management Notes

Dissolution of Partnership, Concepts, Meaning, Modes, Causes and Effects

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Dissolution of partnership refers to the termination of the relationship between all the partners of a firm. Under the Indian Partnership Act, 1932, dissolution of a firm means the dissolution of partnership between all the partners of the firm. It brings the partnership relationship to an end and generally requires the firm’s affairs to be wound up. Dissolution involves realization of assets, payment of liabilities, settlement of accounts, and distribution of any remaining amount among partners according to their rights. It is different from the retirement or death of an individual partner, where the existing partnership may continue with the remaining partners.

Meaning of Dissolution of Partnership

Dissolution of partnership occurs when there is a reconstitution of the firm without ending its overall business operations. It is a change in the structure of the partnership due to:

  • Admission of a new partner

  • Retirement or death of an existing partner

  • Insolvency of a partner

  • Change in profit-sharing ratio

The firm continues to exist, but the partnership agreement among the partners changes.

Legal Definition (Section 4):

According to Section 4 of the Indian Partnership Act, a partnership is “the relation between persons who have agreed to share profits of a business carried on by all or any of them acting for all.”

When this relationship is altered—without completely closing the business—the partnership is said to be dissolved, though the firm may still exist in a reconstituted form.

Modes of Dissolution of Partnership Firm

A partnership firm can be dissolved either voluntarily or compulsorily, depending on circumstances. The Indian Partnership Act, 1932 provides legal provisions for dissolution. Understanding the modes helps partners terminate their business smoothly, distribute assets fairly, and protect legal rights. The modes can broadly be classified as follows:

1. Dissolution by Agreement

A partnership firm can be dissolved by mutual consent of all partners. If the partnership agreement specifies a method or procedure, it must be followed. Dissolution by agreement is the most common and amicable method, ensuring all partners cooperate in winding up the business. It can occur at any time during the partnership, irrespective of its duration. Partners may agree to dissolve due to business difficulties, personal reasons, or retirement. Legal formalities include notifying creditors, settling liabilities, and distributing remaining assets according to the partnership deed or mutual consent.

2. Dissolution on the Expiration of Term

If the partnership was formed for a fixed term, it automatically dissolves when the term expires, unless partners decide to continue. For instance, a firm formed for five years will dissolve after five years unless renewed. Expiration-based dissolution is natural and does not require a new agreement. Partners must still settle accounts, pay debts, and distribute remaining assets. This mode is simple but requires prior planning. Any delay or negligence in winding up can lead to disputes among partners and with creditors. The legal framework ensures orderly closure.

3. Dissolution on Completion of Objective

Partnership firms formed for a specific purpose or project automatically dissolve after achieving that objective. For example, a firm set up to construct a building will dissolve once the construction is completed. If the objective is partly achieved or impossible, partners may decide whether to continue or dissolve. Completion-of-objective dissolution avoids unnecessary continuation of the partnership. All assets must be liquidated, liabilities cleared, and profits or losses shared according to the deed or agreed ratios. This mode ensures the firm exists only as long as the business purpose remains relevant.

4. Dissolution by Notice of Partnership at Will

A partnership at will is one without a fixed term or objective. Any partner may dissolve such a firm by giving notice to all other partners. The notice serves as an official declaration of intent to dissolve the firm. Partners must then wind up business, pay debts, and distribute assets. This mode allows flexibility but requires reasonable notice to avoid disputes. Partners’ cooperation is essential for smooth liquidation. Legal steps such as informing creditors, settling accounts, and closing contracts must follow the notice.

5. Dissolution by Insolvency of a Partner

If a partner becomes insolvent, the firm may be dissolved either wholly or partially. Insolvency affects the firm’s ability to continue business reliably. Creditors’ claims must be settled using the insolvent partner’s share. If multiple partners exist, the firm may continue unless the partnership deed specifies otherwise. Dissolution due to insolvency ensures that financial liabilities are met and prevents remaining partners from being exposed to undue risk. Legal provisions protect both creditors and remaining partners, facilitating orderly closure of the insolvent partner’s share.

6. Dissolution by Death of a Partner

The death of a partner generally results in the dissolution of the firm, unless the deed provides otherwise. In case of a firm with multiple partners, remaining partners may continue if agreed. The deceased partner’s share in assets, profits, and losses must be settled with heirs or legal representatives. Notification to creditors and proper winding-up procedures are essential. This mode ensures smooth transition or closure, protects heirs’ rights, and maintains compliance with statutory requirements. Legal clarity reduces disputes among surviving partners and successors.

7. Dissolution by Court Order

The court can dissolve a partnership firm under Section 44 of the Indian Partnership Act if certain conditions exist:

  • Insanity of a partner

  • Permanent incapacity or misconduct

  • Breach of agreement

  • Continuous disputes affecting business

  • Persistent loss or impracticability of business continuation

A partner or creditor can approach the court for dissolution. Court-ordered dissolution ensures fairness and legal protection. The court supervises the settlement of liabilities, distribution of assets, and resolution of disputes, making this mode crucial when voluntary dissolution is not possible.

8. Dissolution on Illegality of Business

A partnership firm carrying on an illegal business is automatically dissolved. If the business violates laws, such as operating without licenses, engaging in prohibited trades, or contravening statutory regulations, the firm cannot continue legally. The assets are liquidated, and liabilities settled as per law. Partners may face legal consequences. This mode ensures adherence to statutory regulations and prevents misuse of partnership structure for illegal purposes. Dissolution protects creditors and the public from illegal activities while maintaining legal integrity.

Causes of Dissolution of Partnership

Indian Partnership Act, 1932 provides different circumstances in which a partnership firm may be dissolved. Dissolution may occur by agreement, compulsorily, on the happening of certain contingencies, by notice in a partnership at will, or through an order of the court. The major causes are discussed below.

  • Dissolution by Agreement

A partnership firm may be dissolved by mutual agreement among all the partners. Since partnership is based on contract, the partners have the freedom to agree to terminate the firm, subject to applicable law. The partnership deed may contain specific provisions regarding voluntary dissolution and the procedure for winding up the business. The agreement may determine the effective date of dissolution, settlement of liabilities, realization of assets, and distribution of the remaining surplus. Mutual agreement is generally one of the simplest methods of dissolution because it reflects the collective decision of all partners. Proper documentation helps avoid disputes during the winding-up process.

  • Expiry of Fixed Term

Where a partnership is established for a fixed period, the firm may be dissolved upon expiry of that period, subject to the terms of the partnership agreement and applicable law. Partners may agree to continue the business after the original period, in which case the legal consequences depend on the circumstances. A fixed-term partnership provides certainty regarding the intended duration of the business relationship. Before the term expires, partners should review the firm’s financial position, pending contracts, liabilities, and future plans. If continuation is not agreed upon, the firm must undertake appropriate winding-up procedures and settle its assets and liabilities.

  • Completion of a Specific Undertaking

A partnership may be formed for carrying out a particular project, activity, or undertaking. When the specified undertaking is completed, the firm may be dissolved in accordance with the partnership agreement and applicable law. This is particularly relevant where the partners establish a business relationship for a limited commercial purpose rather than continuous operations. The partnership deed should clearly identify the undertaking and specify what happens after its completion. Once the objective is achieved, partners should settle outstanding obligations, realize or distribute assets, and determine their final financial interests. Proper documentation of completion helps establish the basis for winding up the partnership.

  • Death of a Partner

The death of a partner can result in dissolution of the firm where the partnership agreement does not provide otherwise and the statutory conditions for dissolution are satisfied. Since partnership is based on a personal relationship between partners, the death of one partner can significantly affect the constitution of the firm. However, partners may agree that the firm will continue with the surviving partners or with the legal representative of the deceased partner, subject to applicable law. Where dissolution occurs, the firm’s accounts must be settled and the deceased partner’s financial interest determined. Proper contractual provisions can reduce uncertainty concerning continuity after a partner’s death.

  • Insolvency of a Partner

Adjudication of a partner as insolvent can affect the continuation of the partnership and may lead to dissolution in circumstances specified by the Indian Partnership Act, 1932. Insolvency may significantly affect the partner’s capacity to meet financial obligations and can create uncertainty regarding the firm’s future operations. The partnership agreement may contain provisions dealing with the consequences of insolvency. Where dissolution occurs, the firm’s assets and liabilities must be appropriately settled. Partners should maintain accurate financial records and address outstanding obligations. The insolvency of a partner therefore represents an important legal and financial event that can affect the stability and continuation of the partnership.

  • Compulsory Dissolution Due to Unlawful Business

A partnership firm may be compulsorily dissolved when an event occurs that makes the carrying on of the firm’s business unlawful. A business cannot legally continue when its activities become prohibited by law. The prohibition may arise from changes in legislation or other circumstances recognized by applicable law. Once continuation becomes unlawful, the partners cannot simply continue operations through mutual agreement. The firm’s affairs must be wound up in accordance with the legal framework. Assets and liabilities should be identified and settled appropriately. This cause of dissolution demonstrates the importance of ensuring that partnership activities remain lawful throughout the existence of the firm.

  • Insolvency of All or All but One Partner

A firm may be compulsorily dissolved when all the partners or all but one partner are adjudicated insolvent, subject to the provisions of the Act. Partnership requires a relationship between multiple persons, and widespread insolvency can make continuation of the firm impractical or legally unsustainable. In such circumstances, dissolution occurs according to law rather than merely through a voluntary decision. The firm’s assets must then be realized and its liabilities settled according to applicable rules. Proper financial records are particularly important in such circumstances because creditors and partners need to determine the firm’s financial position and the amounts available for settlement.

  • Dissolution by Notice in Partnership at Will

A partnership at will may be dissolved when any partner gives written notice to the other partners expressing an intention to dissolve the firm. The notice must comply with the requirements of the Indian Partnership Act, 1932. This provides flexibility because a partnership at will has no predetermined duration or specific termination arrangement. Once effective notice is given, the firm proceeds toward dissolution and settlement of its affairs. Partners should clearly establish the effective date and communicate the decision to relevant stakeholders. Proper winding-up procedures should then be followed to settle debts, realize assets, and distribute any remaining surplus.

  • Persistent Breach of Partnership Agreement

The court may order dissolution where a partner persistently commits breaches of the partnership agreement, making it impracticable for the other partners to continue the business together. A serious or repeated breach can undermine mutual trust and interfere with effective management. The breach may concern financial obligations, management responsibilities, authority, confidentiality, or other important contractual terms. Where continued cooperation becomes impractical, dissolution may provide a legal solution. The court considers the relevant circumstances before granting dissolution. Clearly drafted partnership agreements are therefore important because they identify partner obligations and provide a basis for addressing serious violations that threaten the continuation of the firm.

  • Misconduct by a Partner

A court may order dissolution where a partner is guilty of conduct that is likely to adversely affect the carrying on of the business. Misconduct can undermine the trust and confidence necessary for partnership. The nature and seriousness of the conduct are considered in determining whether continuation of the firm is reasonably possible. Since partners act as agents of the firm, serious misconduct may also expose the partnership to financial and legal risks. Where the relationship becomes unworkable, dissolution may be appropriate. Proper internal controls, contractual obligations, and dispute-resolution mechanisms can help partners address misconduct before it causes irreversible damage to the business relationship.

Effects of Dissolution of Partnership

The dissolution of a partnership brings the relationship among all partners to an end and initiates the process of winding up the firm’s affairs. Under the Indian Partnership Act, 1932, dissolution has several legal, financial, and operational consequences. The major effects are discussed below.

  • End of Partnership Relationship

The primary effect of dissolution is the termination of the partnership relationship among all partners. The partners cease to carry on the business as a continuing partnership firm, except to the extent necessary for winding up its affairs. Their mutual authority to conduct new business on behalf of the firm generally comes to an end. However, partners may continue to have responsibilities connected with completing existing transactions and settling outstanding obligations. Dissolution therefore marks the transition from normal business operations to the winding-up stage. The rights and liabilities of partners are thereafter determined according to the partnership agreement, the Indian Partnership Act, 1932, and other applicable laws.

  • Winding Up of Business

Dissolution generally results in the winding up of the firm’s business. Winding up involves collecting receivables, realizing assets, paying liabilities, completing necessary obligations, and determining the final financial position of the firm. The partners or authorized persons may take necessary steps to protect and realize partnership property. New business activities are generally avoided except where necessary for completing unfinished transactions or winding up the firm’s affairs. Proper accounting records should be maintained throughout the process. An organized winding-up procedure ensures that the firm’s assets are appropriately used to discharge obligations before the remaining surplus is distributed among the partners.

  • Settlement of Firm’s Debts

After dissolution, the firm’s outstanding debts and liabilities must be identified and settled. Partnership assets are generally applied toward the payment of external creditors and other legally recognized obligations before any surplus is distributed to partners. Partners may remain liable for obligations incurred during the existence of the firm, subject to applicable law. The settlement process requires accurate identification of creditors, amounts payable, contractual obligations, and other liabilities. Proper communication with creditors and maintenance of financial records are important. Settlement of debts protects stakeholders and provides the financial foundation for completing the dissolution process in an orderly manner.

  • Realization of Partnership Assets

Dissolution requires the firm’s assets to be realized or otherwise dealt with according to the partnership agreement and applicable law. Assets may include cash, inventory, equipment, receivables, investments, intellectual property, and other business property. The assets are generally applied toward satisfying the firm’s liabilities. Proper valuation and realization are important because the amount ultimately available for partners depends upon the value obtained from the firm’s assets. The partners should maintain complete records of assets and transactions during winding up. Proper realization prevents unauthorized disposal or misuse of partnership property and ensures that the firm’s resources are appropriately applied toward settlement of its obligations.

  • Settlement of Accounts Among Partners

Dissolution requires settlement of the financial accounts among partners. The firm’s assets and liabilities must be determined, and each partner’s capital account, advances, profits, and losses must be calculated. The Indian Partnership Act provides rules concerning the application of partnership property and settlement of accounts, subject to the partnership agreement. Accurate accounting is essential for determining the amount payable to or recoverable from each partner. Any remaining surplus is distributed according to the partners’ rights. Proper settlement reduces the possibility of disputes and provides financial closure to the partnership relationship.

  • Distribution of Surplus

After the firm’s external liabilities and other recognized obligations have been satisfied, any remaining surplus may be distributed among the partners according to their respective rights. The distribution is generally based on the partnership agreement and statutory provisions. Partners should ensure that all liabilities, taxes, employee dues, contractual obligations, and other relevant payments have been addressed before distributing the surplus. Proper documentation should support the calculation and distribution. The final surplus represents the remaining value of the partnership after its obligations have been discharged. Distribution of surplus provides partners with their final financial entitlement and completes an important stage of the dissolution process.

  • Continuing Authority for Winding Up

Although dissolution terminates the continuing partnership relationship, partners may retain authority necessary to wind up the firm’s affairs. This can include collecting outstanding amounts, selling or realizing partnership assets, settling liabilities, completing unfinished transactions, and taking other actions necessary for an orderly conclusion. The authority should not generally be treated as permission to start new business unrelated to winding up. Partners must act responsibly and in accordance with applicable law. The continuation of limited authority during winding up ensures that the firm’s affairs can be properly completed even though the ordinary business relationship among partners has ended.

  • Liability of Partners Continues for Certain Acts

Dissolution does not automatically remove all liabilities of partners. Partners may remain responsible for obligations arising from transactions conducted before dissolution. In certain circumstances, liability may also continue for acts undertaken after dissolution if appropriate public notice has not been given. Therefore, partners should take appropriate steps to communicate the dissolution to customers, suppliers, creditors, banks, and other relevant parties. They should also update business registrations and records where required. Proper notice and documentation help prevent third parties from mistakenly believing that the former partners continue to have authority to conduct business on behalf of the dissolved firm.

  • Public Notice of Dissolution

Public notice of dissolution is an important legal consequence and procedural requirement in appropriate circumstances. The Indian Partnership Act contains provisions concerning the effect of public notice on the liability of partners after dissolution. Public notice informs third parties that the partnership has ceased and that partners may no longer have authority to act on behalf of the firm except for winding-up purposes. Appropriate notices should be given according to statutory requirements. Failure to provide required notice may expose partners to continuing liability for certain acts. Therefore, public notice contributes to legal clarity and protects both partners and third parties from confusion.

  • Effect on Partnership Property

After dissolution, partnership property continues to be used primarily for settling the firm’s obligations and distributing the remaining amount among partners. Individual partners cannot ordinarily appropriate partnership assets for personal use before the firm’s liabilities are settled. Partnership property may need to be sold, transferred, or otherwise realized during winding up. The value and treatment of property should be properly recorded. Special attention may be necessary for intellectual property, licenses, contractual rights, and other non-physical assets. Proper treatment of partnership property protects the interests of creditors and partners and ensures that the firm’s assets are distributed according to law.

  • Effect on Contracts and Business Relations

Dissolution affects the firm’s existing contracts and commercial relationships. Pending transactions may need to be completed, terminated, or settled depending upon their terms and applicable law. Customers, suppliers, lenders, employees, and other stakeholders should be informed where necessary. The partners must identify contractual rights and obligations and determine how they will be dealt with during winding up. Some agreements may contain provisions specifically addressing termination or dissolution. Proper contract management helps prevent claims for breach and ensures that the firm’s obligations are appropriately discharged. The dissolution process should therefore include a systematic review of all significant contracts.

  • Effect on Employees and Regulatory Obligations

Dissolution may affect employees and workers associated with the partnership. The firm must address wages, benefits, notice requirements, statutory dues, and other employment obligations according to applicable labour laws and contractual terms. Regulatory obligations may also continue during the winding-up period. Tax filings, statutory payments, licenses, registrations, and other compliance requirements should be properly addressed. The partners should ensure that necessary closure or cancellation procedures are completed with relevant authorities. Ignoring these obligations can result in penalties or continuing liabilities. Therefore, dissolution requires attention not only to partnership law but also to employment, taxation, and other applicable regulatory requirements.

Management Notes

Insolvency of a Partner

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An insolvent is a person unable to pay or settle his just debts. When a person or a partnership firm or Hindu undivided family is not able to meet its liabilities and is in financial difficulties, the Court intervenes, at the instance of the creditors or the debtor himself, and brings about a settlement whereby the debtor surrenders his entire property and obtains freedom from having to pay his debts. A joint stock company may also be insolvent but the necessary action in this respect is taken under the Companies Act the company has to be wound up and its assets realized and distributed in accordance with that Act.

  • Where a partner in a firm is adjudicated an insolvent, he ceases to be a partner on the date on which the order of adjudication is made, whether or not the firm is hereby dissolved.
  • Where under a contract between the partners the firm is not dissolved by the adjudication of a partner as an insolvent, the estate of a partner so adjudicated is not liable for any act of the firm and the firm is not liable for any act of the insolvent, done after the date on which the order of adjudication is made.

Individuals and Partnerships:

There is one chief difference between insolvency of individuals and partnership firms. In case of individuals, no distinction is made between private assets and business assets and similarly for liabilities.

In case of partnership, a distinction between firm’s liabilities and assets and private liabilities and assets of partners is made. Private assets must first be utilized for paying private liabilities. If there is a surplus, it is utilized to pay firm’s liabilities.

Firm’s assets must first be utilized to pay firm’s liabilities and, if there is a surplus, a partner can utilize his share of the surplus to pay his private liabilities. It should be noted that a minor partner is not liable to contribute to the assets of the firm out of his private estate. In his case, therefore, the firm’s creditors will not be able to look to his private estate for satisfaction of their claims. In other words, the private estate and private liabilities of a minor partner will be kept totally separate from those of the firm.

Accounts:

Statement of Affairs:

When a person or a firm is adjudicated as insolvent, he or the firm has to prepare a statement showing the financial position. The true financial position can be shown by preparing a sort of balance sheet. The only point to remember is that the “balance sheet” must show the assets at realizable value and not at book value. The purpose is to show how much money will be available for distribution among creditors and, therefore, for this purpose assets should be put down at the figure they are expected to fetch. All liabilities should be recorded. This can be done by setting down assets at their realizable value and the amount payable to creditors.

Preferential Creditors:

Out of the unsecured creditors, some have to be paid, under the law, before others. Such creditors are known as preferential.

By law, the following are the Preferential Creditors:

(a) All debts due to Government or local authority.

(b) The salary of any clerk in respect of services rendered to the insolvent during four months before the date of the presentation of the petition, not exceeding Rs 300 for each such clerk. (In case of the Provincial Insolvency Act, the maximum amount per clerk is Rs 20).

(c) The wages of any servant or labourer in respect of services rendered to the insolvent during four months before the date of the presentation for the petition not exceeding Rs 100 for each such labourer or servant (Rs 20 in case of Provincial Insolvency Act).

(d) Rent due to the landlord not exceeding one month’s rent. (Rent is not preferential under the Provincial Insolvency Act.)

Deferred Creditors:

In England some creditors are treated as deferred and cannot be paid till others are paid off.

Such creditors are:

(a) Loan from wife to husband or from husband to wife;

(b) Creditors whose rate of interest varies with profit; and

(c) Creditors for goodwill who take a share of profit.

Deficiency Account:

In addition to various statements (A, B, C, D, E, F and G) and the Statement of Affairs, the debtor must also prepare an account showing how the capital introduced by the proprietor came to be lost along with amounts belonging to creditors. In other words, the deficiency appearing in the statement of affairs must be explained. The method to prepare it is simple. On the left hand side is put the capital plus all that increases capital, viz., profit or interest on capital or salary to proprietor.

On the right hand side, losses and withdrawals (all that decreases capital) are put. In case of a sole trader, any surplus of household assets over household liabilities should be put on the left hand side. If household liabilities exceed household assets, the difference should be put on the right hand side. The difference between the right hand side and the left hand side is deficiency. It must agree with the figure appearing in the statement of affairs. The account must cover the period specified by the Official Receiver.

University of Mumbai BMS Notes

Capital Accounts (Fixed and Fluctuating)

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A Capital Account is a general ledger account which shows some of the special transactions like proprietor’s investment in his own business, the aggregate amount of earning, expenses of companies, etc. There are many more transactions which affect the Capital. Like: Interest on Capital, Interest on Drawings, Salaries to the Partners, Commission for the Partners, etc. These values are put in Profit and Loss Appropriation Account and at the same time credited or debited to their respective Capital Accounts.

In the case of Partnership Capital Account of all partnership maintained mandatory. In sole proprietorship, capital account of the sole proprietor is maintained and net profit or loss is transferred to his/her capital account. But in the case of a partnership firm, capital is contributed by all partners and capital account of every partner is maintained separately. Capital account partnership may be:

(1) Fixed Capital Account

In case of fixed capital account, balance of capital in the beginning of the year, fresh capital introduced during the current year is recorded credit site and permanent withdrawal of excess capital and closing balance of capital are recorded on debit site of the capital account. There is always a credit balance in the capital account of a partner, which is shown on equities site of balance sheet. Following is format of fixed capital account.

Under the fixed nature of capital, the capital of each partner remains constant from the start of partnership till at the end of it. No adjustments like interest on capital, partner’s salary/commission, Drawings and profit or loss earned during the operation is made.

To have record of all such adjustments each partner’s current account is opened, which is debited with Drawings, share of loss sustained during a period and credit is given for partner’s salary/commission, interest on capital and share of profit earned.

After all the adjustments have been made in the current A/c., it is balanced, if it shows debit balance it will be shown in the balance sheet on asset side and if it shows credit balance it will be shown on the liability side.

At the time of dissolution of the partnership, each partner’s current account balance is transferred to capital A/c. The credit balance of current account will be credited to capital account and debit balance of the current account will be debited to respective partners’ capital account.

Format of Fixed Capital Account

Partners’ Capital Account

Description

 Amount

Description

 Amount
Bank Account $$$$$ Balance b/d $$$$$
(Permanent withdrawl of excess capital) (Capital contributed till last year)
Balance c/d $$$$$ Bank Account $$$$$
(Balance of capital at the end of year) (Fresh Capital introduced by partner)
Total $$$$$ $$$$$$

To record, drawing made by a partner and his share in allocation of profit etc. an account known as Partner’s Current Account is opened. The format of Partner’s Current Account is as follows:

Partners’ Current Account

Description

 Amount

Description

 Amount
Bank b/d $$$$$ Balance b/d $$$$$
(In case of Debit opening balance) (In case of Credit opening balance)
Drawing Account Salary Account $$$$$
Interest on Drawing Account Interest on Capital Account $$$$$
Profit and Loss Appropriate Account Profit and Loss Appropriate Account $$$$$
(For Share of Loss) (For share of profit)
Balance c/d $$$$$ Balance c/d $$$$$
(In case of Credit closing balance) (In case of Debit closing balance)
Total $$$$$ $$$$$$

The closing balance of a partner’s current account is shown on equities side, in case of credit balance; and in case of debit balance, it is shown on assets side.

It may be noted that in case of fixed capital, the balance of capital account remains unchanged except when either fresh capital is introduced or the excess capital is permanently withdrawn. Moreover, the word ‘fixed’ is not prefixed to capital account of a partner because maintenance of partner’s current account implies that capitals are fixed.

(2) Fluctuating Capital Account

Under this method as is apparent from the name, capital of each partner goes on changing from time to time. Each partner will have his separate capital account, which will be credited by his initial investment and any additional capital introduced during the year will also be credited to his capital account.

All the adjustments, which result decrease in capital will be debited to partner’s capital, such as drawing made by each partner, interest on drawings and share of loss. On the other hand, adjustments resulting increase in capital will be credited to partner’s capital, like interest on capital, partners salary if any, partner’s share of profit etc.

Balance of each partner’s capital account will be shown in the balance sheet. Debit balance of partner’s capital account is shown on the asset side and credit balance is shown on the liability side.

If current accounts of partners are not maintained, the transactions relating to drawings by partners and their share in allocation of profit including interest on capital, interest on drawings, salary payable to partners, commission payable to partners etc. are recorded in partner’s capital account. In that case, the balance of capital account will fluctuate from year to year and capital accounts in the case are known as Fluctuating Capital Account. None-preparation of current accounts implies capital accounts are fluctuating. The Fluctuating Capital Account Format is given below:

Fluctuating Capital Account Format

Partners’ Current Account

Description

Amount

Description

 Amount
Balance b/d Balance b/d $$$$$
(In case of Debit opening balance) (In case of Credit opening balance)
Bank Account $$$$$ Bank Account $$$$$
(Permanent withdrawal of excess capital) (Fresh capital introduced by pertner)
Drawing Account Salary Account $$$$$
Interest on Drawing Account Interest on Capital Account $$$$$
Profit and Loss Appropriate Account Profit and Loss Appropriate Account $$$$$
(For Share of Loss) (For share of profit)
Balance c/d $$$$$ Balance c/d $$$$$
(In case of Credit closing balance) (In case of Debit closing balance)
Total $$$$$ $$$$$$

Generally, the closing balance of capital account is Credit and it is recorded on equities site of balance sheet. But if a partner’s capital account reveals a debit closing balance, is appears on asset site of balance sheet.

Management Notes

Retirement and Death of a Partner

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A partner may ascertain to either withdraw or retire from the enterprise due to certain reasons such as his bad health, his age, change in enterprise’s nature of a business, etc., In the Partnership at Will, a partner might retire at any time. Retirement leads to a reconstitution of an enterprise where the partners’ contribution ratio and the profit-sharing ratio change. The retiring partner is given his share of capital, revaluation profit or loss and goodwill.

Death or insolvency of a partner is the outcome in the reconstitution of an enterprise when the remaining partners desire to continue the enterprise. In case of bankruptcy or insolvency, all dues are paid to the bankrupt partner and partnership agreement is terminated as per the law a bankrupt is ineffectual to get into an agreement or a contract. In the case of decease, all dues are being paid to the legal successor of the deceased partner.

Treatment of Reserves, Accumulated Profits and Accumulated Losses in the Case of Death of a Partner

Reserves, Existing Goodwill, accumulated profits/losses appearing in the Balance Sheet of the firm at the time of death of a new partner belong to all partners including the retiring or deceased partner. Hence these should be distributed among all the partners in their old profit-sharing ratio.

Following Journal Entries Are Required to Be Passed:
(1) Distribution of Existing Goodwill  All Partners’ Capital A/c  Dr.

         To Goodwill A/c 
(2) Distribution of Reserves  Reserve fund/General Reserve A/c  Dr. 

     To All Partners’ Capital A/c 
(3) Distribution of Accumulated Losses  All Partners’ Capital A/c  Dr.

    To Profit & Loss A/c
(4) Distribution of Accumulated Profits  Profit & Loss A/c  Dr.

   To All Partners’ Capital A/c

The Retirement of an Existing Partner

A partner may decide to retire or withdraw from the firm due to reasons such as his age, his bad health, change in firm’s nature of a business, etc. In case of Partnership at Will, a partner may retire at any time. Retirement amounts to a reconstitution of a firm where the number of partners, their capital contribution ratio and also the profit sharing ratio changes. The retiring partner is paid his share of capital, goodwill and revaluation profit or loss.

For example, A, B, and C are partners in the firm sharing profits in the ratio of 3:2:1. A chooses to retire and B and C decide to share the future profits equally. This is a reconstitution of the firm where the number of partners and their profit-sharing ratio both have changed.

Death or Insolvency of a Partner:

Death or insolvency of a partner also results in the reconstitution of the firm when the remaining partners wish to continue the firm. In case of insolvency, all dues are paid to the insolvent partner and partnership agreement is aborted because as per the law an insolvent is incompetent to enter into a contract or an agreement.

In case of death, all dues are paid to the legal heir of the deceased partner.

The accounting treatment in the occurrence of death of a partner is:

  • Similar to that, when a partner retires and that in case of deceased partner his belonging is transferred to his legal enforcers and settled in a similar way as that of the partner who retires
  • However, there is one primary distinction, the retirement usually takes place during the closure of an accounting period or financial year, the death of a partner may take place any time
  • Therefore, in the case of a partner, his rights shall also incorporate his share of gains or loss, interest on drawings (if any), interest on capital from the last date of the Balance Sheet to the date of his death of these, the main issue associates to the computation of profit for a moderate period
  • Since, it is contemplated burdensome to close the books and outline final a/c, for the period, the dead partner’s share of profit may be computed on the ground of previous year’s gain (or aggregate of past few years) or on the base of sales
(a) Linking Death of a Partner with Retirement of a Partner
(a) Common accounting treatment in case of Retirement of a Partner and Death of a Partner: (Assuming retirement to be on the date of Balance Sheet)

  • Partners Capital Balance
  • Existing goodwill
  • Partner’s share in the present value of Firm’s Goodwill
  • Revaluation Profit or Loss
  • Reserves, Surplus and Fictitious Assets
  • Drawings made by the partner
  • Asset/Liability taken over by a partner
  • Partner’s Loan given on Assets side or Liabilities side
(b) Special accounting treatments required in case of Death of a Partner only:
  • Salary/Commission to a Partner
  • Interest on Capital
  • Interest on Drawings
  • Interest on Loan
  • Share in current year’s Profits
  • Accounting treatments at the time of Death of a Partner is an extension of the Retirement of a Partner. In the above-mentioned list, treatment of category ‘A’ items is exactly the same both for retirement & death. There will be no effect of date of death.
  • But for the treatment of category ‘B’ items date of death plays a very important role.

 
(B) Calculation of Category ‘b’ Items:
i. Salary to the deceased partner:
  • Monthly Salary x Time Period
  • Commission as per the agreement for this period only (if any).

# Time Period = Period from the date of last Balance Sheet to the date of Death

{This period can be in months, weeks or days.}
(B) Calculation of Category ‘b’ Items:
  • Capital Balance as per the last Balance Sheet x Rate of Int./100× Time Period/12
iii. Interest on Drawings
  • We’ll use the rules of Interest on Drawings learned earlier and of course, keep in mind the ‘Time Period’.
iv. Interest on Loan
  • Amount of Loan as per the last Balance Sheet x Rate of Int./100× Time Period/12
v. Share in Current Year’s Profits
  • To compute the deceased partner’s share in estimated profits there are following two approaches/basis:
  • Time Basis: Under this approach his profit share for the current year is computed on the basis of last year’s profit or last few years’ average profits.
  • Formula: Last Year’s Profit × Time Period/12 × Deceased Partner’s Share

Or

Average Profits × Time Period/12 × Deceased Partner’s Share

  • Turnover Basis– In this case, his profit share for the current year is estimated using last year’s sales and last year’s profits.
  • Formula: Step 1. Compute Profits % of last year: Last Year’s Profit/Last Year’s Sales × 100

Step 2. Firm’s estimated profit till the date of death: Current Year’s Sales up to the date of death × Profit %

Step 3. Decease Partner’s share

Firm’s Profit as per Step 2 × Deceased Partner’s ratio

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