Q.At the time of dissolution of a firm, which of the following liability will be paid first?
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Dissolution of a Partnership Firm – The Accounting Treatment
Let’s start with something you already know. Imagine you and a friend run a small tiffin service together. You both put in money, buy utensils, rent a space, and share the profits. One day, you decide to stop. You sell the utensils, pay the rent you owe, and split whatever cash is left. That’s dissolution — the end of the partnership.
Now, in Accountancy, dissolution means the firm ceases to exist. All assets are sold, all liabilities are paid off, and the remaining money (or loss) is divided among the partners. The accounting treatment is simply the set of rules we follow to record this winding-up process in the books.
Why does dissolution need a separate treatment?
During the life of a firm, we use a Profit and Loss Appropriation Account to share profits, and a Capital Account to track each partner’s stake. But when the firm dissolves, we stop using those accounts. Instead, we open a Realisation Account — the star of dissolution accounting.
The Realisation Account is like a temporary “sale and settlement” account. It collects:
- All assets (except cash/bank) at their book value.
- All liabilities (except partner’s loan or capital) at their book value.
- The actual sale proceeds of assets.
- The actual payment made to settle liabilities.
- Any expenses of dissolution.
At the end, the balance of the Realisation Account — profit or loss on realisation — is transferred to the partners’ capital accounts in their profit-sharing ratio.
The accounting treatment step-by-step
Step 1: Transfer assets (except cash/bank) to the debit of Realisation Account
Journal entry:
Realisation A/c Dr. [Book value of all assets except cash/bank]
To Sundry Assets A/c [Individually or collectively]
Why? Because we are removing the assets from the books. The Realisation Account now “holds” them.
Step 2: Transfer liabilities (except partner’s loan or capital) to the credit of Realisation Account
Journal entry:
Sundry Liabilities A/c Dr. [Book value of all liabilities]
To Realisation A/c [Total liabilities]
Why? Liabilities are obligations. By transferring them to the credit side, we show that the Realisation Account will now handle their payment.
Step 3: Record sale of assets
When assets are sold:
Bank A/c Dr. [Actual sale amount]
To Realisation A/c [Sale proceeds]
If an asset is taken over by a partner (instead of sold outside):
Partner’s Capital A/c Dr. [Agreed value]
To Realisation A/c [Agreed value]
Step 4: Record payment of liabilities
When liabilities are paid:
Realisation A/c Dr. [Amount paid]
To Bank A/c [Amount paid]
If a liability is taken over by a partner:
Realisation A/c Dr. [Amount of liability]
To Partner’s Capital A/c [Amount of liability]
Step 5: Record dissolution expenses
If paid by the firm:
Realisation A/c Dr. [Expense amount]
To Bank A/c [Expense amount]
If paid by a partner personally (and not reimbursed), no entry is needed — it’s treated as the partner’s contribution.
Step 6: Close the Realisation Account
After all assets are sold and liabilities paid, the Realisation Account will have a balance.
- If the credit side is larger → Profit on Realisation → transfer to partners’ capital accounts in profit-sharing ratio.
- If the debit side is larger → Loss on Realisation → transfer to partners’ capital accounts in profit-sharing ratio.
Journal entry for profit:
Realisation A/c Dr. [Profit amount]
To Partner’s Capital A/c [Each partner’s share]
For loss:
Partner’s Capital A/c Dr. [Each partner’s share]
To Realisation A/c [Loss amount]
Step 7: Close partners’ capital accounts
After all adjustments, the capital accounts show the final amount due to each partner. This is paid in cash:
Partner’s Capital A/c Dr. [Final balance]
To Bank A/c [Amount paid]
If a partner’s capital account shows a debit balance (they owe the firm), they bring in cash:
Bank A/c Dr. [Amount brought in]
To Partner’s Capital A/c [Amount brought in]
The format of the Realisation Account
Here’s how it looks in the NCERT textbook style:
| Dr. | Realisation Account | Cr. |
|---------|--------------------------|---------| …
On dissolution the sale proceeds of assets are applied in a legally fixed order of priority, and outside (third-party) liabilities always rank ahead of anything owed to the partners themselves. …
Outside liabilities are settled before any partner claim, so Sundry Creditors — option (d) — are paid first.
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Showing the 12 most recent of 43 on this concept.
- CBSE 2026Set MARCH1 markMCQQ.To which account credit balance of general reserve is transferred at the time of the dissolution of a firm?(a) Realisation A/c(b) Cash A/c(c) Profit and loss A/c(d) Partners' capital A/c
›Reveal solutionSolution
The credit balance of general reserve is transferred to the partners' capital accounts on dissolution, so the answer is (d).
General reserve represents profits set aside in the past that were never distributed. It is not a liability to an outsider and is not connected with the sale of any asset, so it is not passed through the Realisation Ac …
- CBSE 2026Set MARCH1 markQ.Describe the methods of dissolution of a partnership firm.
›Reveal solutionSolution
A firm may be dissolved either without the court's intervention or through a court order.
- Dissolution without the intervention of the court:
- By mutual agreement of all partners.
- Compulsory dissolution (for example when all but one partner become insolvent, or the business becomes unlawful).
- On the happening of certain contingencies (expiry of the term, completion of the venture, death or insolvency of a partner), subject to the agreement.
- By notice, where the partnership is at will, any partner may dissolve it by giving notice to the others. …
- CBSE 2026Set MARCH1 markQ.How would you deal with the provident fund balance shown in the balance sheet at the time of dissolution?
›Reveal solutionSolution
Provident fund is an external liability; transfer it to the credit of the Realisation A/c and pay it in cash.
The provident fund represents amounts belonging to the employees that the firm must pay out. It is therefore a genuine liability to outsiders, not a partners' reserve.
On dissolution:
- Transfer entry: Provident Fund A/c Dr, To Realisation A/c (credit side of Realisation A/c).
- Payment entry: Realisation A/c Dr, To Cash/Bank A/c when the amount is actually paid. …
- CBSE 2026Set MARCH1 markQ.On dissolution of a firm, Partner's Loan Account is transferred to __________ Account.
›Reveal solutionSolution
On dissolution, the Partner's Loan Account is transferred to the Bank (Cash) Account when it is paid off.
A loan given by a partner to the firm is kept separate from the Realisation Account. In the order of payment on dissolution, outside liabilities are paid first, then the partner's loan, and finally the partners' capitals. The partner's loan is discharged by the entry: Partner's Loan A/c Dr, To Bank A/c - so its balance is transferred to (settled through) the B …
- CBSE 2026Set ANNUAL1 markMCQQ.On dissolution of the firm, General Reserve is transferred to(a) Realization A/c(b) Partners' Capital A/cs in their profit-sharing ratio(c) Partners' Capital A/cs in capital ratio(d) Cash A/c
›Reveal solutionSolution
General Reserve is an accumulated profit, so on dissolution it goes straight to the Partners' Capital Accounts in the profit-sharing ratio — never through the Realisation Account.
When a firm is dissolved, the Realisation Account is opened only to record the sale/realisation of external assets and the payment/settlement of external liabilities, and to work out the resulting profit or loss on realisation. Items such as General Reserve, Reserve Fund, and credit balance of Profit & Loss Account are not assets or liabilities to be "realised" — they represent profits already earned by the firm in earlier years but kept back (undistributed) for contingencies. Since this money genuinely belongs to the partners, it is transferred directly to the Partners' Capital Accounts in their existing profit-sharing ratio (not the capital ratio, and not via the Realisation Account).
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- CBSE 2026Set ANNUAL1 markMCQQ.On dissolution of the firm, the liability paid by the partner is to be credited to ............................... .(a) Bank Account(b) Realisation Account(c) Partner's Capital Account(d) Realisation Expenses Account
›Reveal solutionSolution
A liability paid by a partner personally (not out of the firm's bank) on dissolution is credited to that Partner's Capital Account.
On dissolution of a firm, all assets are realised and all liabilities are paid off through the Realisation Account. Normally, when the FIRM pays a liability out of its own bank/cash, the entry is:
Realisation A/c Dr.
To Bank A/c
But sometimes a partner personally pays a firm liability (e.g., a partner settles a creditor out of his own pocket because the firm's cash was tight, or he undertakes to discharge a specific liability as part of the settlement). In that case, the firm has not paid anything out of its own funds — instead, it now owes that amount to the partner who paid on its behalf. The correct entry is:
Realisation A/c Dr. …
- CBSE 2026Set ANNUAL1 markQ.Which account is to be debited to write off Preliminary expenses appearing in the Balance Sheet at the time of dissolution of Partnership firm ?
›Reveal solutionSolution
Preliminary expenses (and other fictitious assets like a debit balance of P&L A/c) are written off directly to the Partners' Capital Accounts, NOT through the Realisation Account.
When a partnership firm is dissolved, every REAL asset (machinery, stock, debtors, premises, etc.) is transferred to the Realisation Account so that its realisation (sale) can be accounted for. However, some items appearing on the asset side of the Balance Sheet are not real, saleable assets at all — they are fictitious assets, representing expenses/losses not yet written off. Common examples: Preliminary Expenses, Discount on Issue of Debentures, debit balance of Profit & Loss Account, Deferred Advertisement Expenditure.
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- CBSE 2025Set 67/4/11 markMCQQ.White, Shaun and Todd were partners in a firm sharing profits and losses equally. Shaun's wife had advanced a loan of ₹ 1,00,000 to the firm. The firm was dissolved. Shaun's wife's loan had already been transferred to Realisation account. The account credited to discharge Shaun's wife's loan will be : (A) Shaun's capital account (B) Bank account (C) Realisation account (D) Shaun's loan account
›Reveal solutionSolution
Bank Account is credited to discharge Shaun's wife's loan. A loan from a partner's wife is an outside (third-party) liability, so it is correctly transferred to the Realisation Account; when it is actually paid off, cash goes out and Bank is credited. The answer is (B) Bank account.
Concept: whose loan gets transferred to Realisation Account?
On dissolution, all external (third-party) liabilities are transferred to the credit side of the Realisation Account, and all assets (except cash/bank and fictitious assets) to its debit side. A crucial distinction decides where a "loan" goes:
- A partner's own loan to the firm (e.g. Shaun's Loan) is not routed through Realisation Account. It is settled through a separate Partner's Loan Account after outside liabilities are paid.
- A loan from a partner's wife or other relative is treated as an outside liability, because the wife is not a partner. It is transferred to the Realisation Account, exactly like creditors or bills payable.
So in this question, transferring Shaun's wife's loan to the Realisation Account is the correct treatment, not an error.
Discharging the loan
Once the loan sits on the credit side of the Realisation Account, paying it off is simply a payment of a liability during dissolution. The entry is:
Particulars L.F. Debit (₹) Credit (₹) Realisation A/c ....Dr. 1,00,000 To Bank A/c 1,00,000 (Being Shaun's wife's loan paid on dissolution) The account credited is Bank A/c, because cash flows out of the firm to settle the external liability. …
- CBSE 2025Set 67/6/11 markMCQQ.In the event of dissolution of a partnership firm, the order of payment of losses including deficiencies of capital shall be : (A)(i) First out of profits,(ii) Next by the partners individually in their profit sharing ratio,(iii) Lastly, if necessary, out of capital of partners. (B)(i) First out of capital of partners,(ii) Next out of profits,(iii) Lastly, if necessary, by the partners individually in their profit sharing ratio. (C)(i) First by the partners individually in their profit sharing ratio,(ii) Next out of profits,(iii) Lastly, if necessary, out of capital of partners. (D)(i) First out of profits,(ii) Next out of capital of partners,(iii) Lastly, if necessary, by the partners individually in their profit sharing ratio.
›Reveal solutionSolution
The correct order of payment of losses (including capital deficiencies) on dissolution is: first out of profits, next out of capital, and lastly by partners individually in their profit-sharing ratio — Option (D).
Concept: Order of Application of Losses on Dissolution
When a partnership firm dissolves, assets are realised and liabilities are settled. The difference between what is realised and what is owed often results in a loss (or gain). The Indian Partnership Act, 1932, and accounting principles establish a clear hierarchy for absorbing these losses.
The fundamental principle is that losses are business obligations first, to be met from business resources before calling upon partners' personal wealth. This mirrors the logic of appropriation: profits belong to the firm before distribution, so losses must be borne by the firm's accumulated resources before partners contribute individually.
The Three-Stage Hierarchy
Stage 1: Out of Profits
Any accumulated profits (reserves, undistributed profits, profit and loss account credit balance) are applied first. These are the firm's retained earnings and represent the primary cushion against losses.
Stage 2: Out of Capital
If profits are insufficient, the loss is charged against the partners' capital accounts in their profit-sharing ratio. Capital represents the partners' investment in the firm — it is the second line of defence. Each partner's capital is reduced proportionately.
Stage 3: By Partners Individually (Personal Contribution)
If even after exhausting capital accounts a partner's capital account shows a debit balance (a deficiency), that partner must bring in cash from personal resources to make good the deficiency. This is the last resort. The partner with the deficiency has a personal liability to contribute, because losses are shared in the profit-sharing ratio and his share of losses exceeded his capital.
Watch outA common confusion: students sometimes think capital is applied before profits, or that partners contribute individually before touching capital. Remember, the firm's own resources (profits, then capital) are exhausted first; only a residual deficiency triggers personal contribution.
Why This Order?
The logic is rooted in the nature of partnership:
- Profits are collective earnings held by the firm. They exist precisely to absorb fluctuations, including losses.
- Capital is the partners' stake in the firm. It is meant to fund operations and bear risk, so it is the natural second absorber.
- Personal contribution is invoked only when a partner's share of the loss creates a deficit beyond what his capital can cover. This respects limited liability to the extent of capital, but enforces the profit-sharing agreement when capital is insufficient.
This sequence ensures that the firm's internal resources are fully utilised before any partner is asked to dip into personal funds, and it treats all partners equitably according to their profit-sharing ratio.
Application to the Question …
- CBSE 2025Set MARCH1 markMCQQ.Which is the last payment made from the realisation of assets, at the time of the dissolution of a firm :(a) Dissolution expense(b) Partner's capital(c) Liabilities towards third parties(d) Partner's loan
›Reveal solutionSolution
Order of payment on dissolution: (1) realisation expenses & outside liabilities, (2) partners' loans, (3) partners' capital — capital is paid last. Correct option: (b).
As per the rule of application of assets in dissolution (GSEB Class-12 Commerce Accountancy):
- Expenses of realisation and liabilities of the firm to third parties.
- Loans/advances given by partners to the firm. …
- CBSE 2025Set MARCH1 markQ.What is voluntary dissolution?
›Reveal solutionSolution
Voluntary dissolution = dissolution of a firm brought about by the mutual consent/agreement of all partners (or as per the partnership deed), not by compulsion of law or a court order.
In GSEB Class-12 Commerce Accountancy (Dissolution of a Firm):
- Voluntary dissolution takes place when all partners agree to dissolve the firm, or in accordance with a term/contingency provided in the partnership deed (e.g., expiry of the agreed period, completion of the venture). …
- CBSE 2025Set MARCH1 markMCQQ.In the event of dissolution of a firm, the amount realised from the sale of assets is first applied to :(a) Pay partners' capital(b) Pay off loans from partners(c) Settle external liabilities(d) Distribute among partners in their profit sharing ratio
›Reveal solutionSolution
Realised amounts are applied first to settle external liabilities. Correct option: (c).
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