Practice Questions: Conversion of a Firm
Chapter Twenty-Seven
Syllabus topic Module II entire
Pages 80 to 83 of 168
How to use this chapter
Cover the answers and write. Where you differ, the step is almost always one of four: an item not taken over that was included anyway, agreed values put into the realisation account, the reserve routed through realisation, or the discharge distributed in the wrong ratio.
Before starting Question 1, do one thing: compare the net assets with the consideration and note which is larger. It decides whether you are looking for goodwill or a capital reserve, and it takes ten seconds.
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Question 1 (15 marks)
G and H are partners in GH & Co sharing profits 2:1. Their balance sheet as at 31 March 2027 is:
| Liabilities | Rs | Assets | Rs |
|---|---|---|---|
| Creditors | 70,000 | Building | 2,40,000 |
| Bank overdraft | 30,000 | Machinery | 1,00,000 |
| General reserve | 60,000 | Stock | 80,000 |
| Capital: G | 2,40,000 | Debtors | 70,000 |
| Capital: H | 1,20,000 | Cash | 30,000 |
| Total | 5,20,000 | Total | 5,20,000 |
On 1 April 2027 GH Ltd is formed to take over the business. It takes all the assets except the cash, and takes over the creditors. The bank overdraft is not taken over and is discharged in full by the firm out of its cash. The assets are taken at building Rs 3,00,000, machinery Rs 92,000, stock Rs 76,000 and debtors Rs 70,000 subject to a provision of Rs 4,000. The purchase consideration is discharged by the issue of 40,000 equity shares of Rs 10 each fully paid and 500 twelve per cent debentures of Rs 100 each. H is to take all the debentures, the balance of each partner's account being settled in shares.
Prepare the realisation account and partners' capital accounts in the books of the firm, and the balance sheet of GH Ltd.
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Question 2 (8 + 7 marks)
(a) Explain the realisation method and say why the syllabus prescribes it alone for conversion. (8)
(b) A firm's realisation account shows a profit of Rs 60,000 and the company's books show goodwill of Rs 18,000 on the same transaction. Explain how both can be correct, and reconcile them given that the assets were taken over at Rs 42,000 above their book values. (7)
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Question 3 (15 marks)
(a) Write short notes on any two: (10)
- Treatment of assets and liabilities not taken over
- Discharge of the purchase consideration
- The four things that change when a firm becomes a company
(b) Answer in one sentence each: (5)
- At what value is share capital credited where shares are issued at a premium?
- Under which Schedule III heading does goodwill appear?
- In which ratio are the reserves of the firm distributed?
- What arises where the net assets taken over exceed the purchase consideration?
- Why do the partners' capitals sometimes exceed the purchase consideration?
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Practice Questions: Conversion of a Firm
Answers
Answer 1
Step one: the consideration and the difference.
| Rs | |
|---|---|
| 40,000 equity shares of Rs 10 each | 4,00,000 |
| 500 debentures of Rs 100 each | 50,000 |
| Purchase consideration | 4,50,000 |
| Assets taken over, at agreed values | Rs |
|---|---|
| Building | 3,00,000 |
| Machinery | 92,000 |
| Stock | 76,000 |
| Debtors, Rs 70,000 less provision Rs 4,000 | 66,000 |
| Total | 5,34,000 |
| Rs | |
|---|---|
| Assets taken over | 5,34,000 |
| Less: creditors taken over | 70,000 |
| Net assets | 4,64,000 |
| Rs | |
|---|---|
| Net assets taken over | 4,64,000 |
| Less: purchase consideration | 4,50,000 |
| Capital reserve | 14,000 |
The net assets exceed the consideration, so the company acquired more than it gave and a capital reserve of Rs 14,000 arises. There is no goodwill in this question, and a candidate who has written one has run the subtraction the wrong way.
Step two: the realisation account.
| Dr | Rs | Cr | Rs |
|---|---|---|---|
| To Building | 2,40,000 | By Creditors | 70,000 |
| To Machinery | 1,00,000 | By Bank overdraft | 30,000 |
| To Stock | 80,000 | By GH Ltd | 4,50,000 |
| To Debtors | 70,000 | ||
| To Cash, bank overdraft discharged | 30,000 | ||
| To Profit to G's capital | 20,000 | ||
| To Profit to H's capital | 10,000 | ||
| Total | 5,50,000 | Total | 5,50,000 |
Check: the consideration of Rs 4,50,000 less the net book value that passed, being Rs 4,90,000 of assets less Rs 70,000 of creditors, that is Rs 4,20,000, gives Rs 30,000, shared 2:1 as Rs 20,000 and Rs 10,000.
The overdraft appears twice, credited as a liability transferred and debited as cash paid, and it nets to nil because it was settled in full at book value.
Step three: the partners' capital accounts.
| Particulars | G, Rs | H, Rs |
|---|---|---|
| By balance brought down | 2,40,000 | 1,20,000 |
| By General reserve, 2:1 | 40,000 | 20,000 |
| By Realisation, profit 2:1 | 20,000 | 10,000 |
| Total credited | 3,00,000 | 1,50,000 |
| Particulars | G, Rs | H, Rs |
|---|---|---|
| To 12% Debentures in GH Ltd | nil | 50,000 |
| To Equity shares in GH Ltd | 3,00,000 | 1,00,000 |
| Total debited | 3,00,000 | 1,50,000 |
The proof. The capitals total Rs 4,50,000, exactly the consideration, because nothing was retained: the firm's cash of Rs 30,000 went entirely on the bank overdraft of Rs 30,000, leaving nothing for the partners. And the shares distributed, Rs 3,00,000 and Rs 1,00,000, come to Rs 4,00,000, exactly the shares received.
Step four: the balance sheet.
Balance Sheet of GH Ltd as at 1 April 2027
| Particulars | Rs |
|---|---|
| I. EQUITY AND LIABILITIES | |
| (1) Shareholders' funds: share capital, 40,000 equity shares of Rs 10 each fully paid | 4,00,000 |
| (1) Shareholders' funds: reserves and surplus, capital reserve | 14,000 |
| (3) Non-current liabilities: long-term borrowings, 500 twelve per cent debentures | 50,000 |
| (4) Current liabilities: trade payables | 70,000 |
| TOTAL | 5,34,000 |
| Particulars | Rs |
|---|---|
| II. ASSETS | |
| (1) Non-current assets: property, plant and equipment | 3,92,000 |
| (2) Current assets: inventories | 76,000 |
| (2) Current assets: trade receivables | 66,000 |
| TOTAL | 5,34,000 |
No goodwill and no cash. The capital reserve sits under reserves and surplus, not as a deduction from anything.
Practice Questions: Conversion of a Firm
Answer 2
(a) Set out the account: assets transferred at book value on the debit side together with cash paid on liabilities not taken over and any realisation expenses borne by the firm; liabilities transferred at book value, the purchase consideration and the proceeds of anything sold on the credit side; and the balancing figure the profit or loss on realisation, shared in the old ratio. The partners' capitals, the reserves and the company's goodwill never enter it.
Then why MU prescribes it alone. Conversion is in law a sale of the business by one person, the firm, to another, the company, and a realisation account records that sale explicitly, with a seller closing its books and a buyer opening its own. The excluded alternative, continuing the firm's books through a revaluation account, records an adjustment inside a single continuing entity, which is not what happened, and it varies with how each writer chooses to handle an item, so it cannot be marked to a consistent form.
(b) Both are correct because they are different measurements in different books.
| Arises in | Measured as | Belongs to | |
|---|---|---|---|
| Realisation profit, Rs 60,000 | The firm's books | Consideration less the book value of net assets given up | The partners, in the old ratio |
| Goodwill, Rs 18,000 | The company's books | Consideration less the agreed value of net assets received | The company, as an intangible asset |
The reconciliation. The same consideration is compared with two different figures for the same net assets, and those figures differ by the revaluation of Rs 42,000.
| Rs | |
|---|---|
| Goodwill in the company's books | 18,000 |
| Add: excess of agreed values over book values | 42,000 |
| Profit on realisation in the firm's books | 60,000 |
So the gap between the two numbers is always the revaluation surplus, and where they do not reconcile, an agreed value has been misread.
Answer 3
(a) Short notes
1. Assets and liabilities not taken over. They stay with the firm and must be cleared before its books close. A liability not taken over is credited to realisation when transferred out of the books and debited when discharged in cash, the two cancelling where it is paid at book value but any saving increasing the profit; where a partner assumes it personally, realisation is debited and his capital credited. An asset not taken over is sold, with the proceeds credited to realisation; taken over by a partner, whose capital is debited at the agreed figure; or used to meet the firm's remaining obligations, as cash usually is. The check is that the partners' capitals equal the consideration plus what was retained and distributed, less what a partner took over.
Practice Questions: Conversion of a Firm
2. Discharge of the consideration. Two entries, not one. The firm first receives the shares, debentures and cash, debiting each and crediting the company, which closes the company's account that had been debited with the consideration. It then distributes them, debiting each partner's capital with his closing balance and crediting what he takes. The ratio is whatever the question specifies and otherwise the ratio of final capital balances, items expressly allotted being deducted first and the balance settled in shares. Three checks: the company's account closes, the shares distributed equal the shares received, and every capital account closes to nil.
3. The four things that change. Liability becomes limited to the amount unpaid on shares instead of extending to a partner's private estate; the business acquires perpetual succession instead of ending on a partner's death or retirement; ownership takes the form of transferable shares rather than capital accounts; and the accounts are drawn in the Schedule III form that section 129 of the Companies Act 2013 requires, rather than the horizontal partnership form.
(b) Answers in one sentence
1. At the face value of the shares, the excess of the issue price being credited to securities premium.
2. Under non-current assets, as an intangible asset.
3. In the old profit-sharing ratio, because the old firm earned them.
4. A capital reserve, the company having acquired more than it gave.
5. Because something was retained by the firm and distributed to them, so their claim is the consideration plus that retained value.
Marking yourself
| If your answer | Then |
|---|---|
| Shows goodwill in Question 1 | The net assets exceed the consideration; it is a capital reserve |
| Shows cash on GH Ltd's balance sheet | The company did not take the cash, and the firm spent it all on the overdraft |
| Omitted the overdraft from realisation | It is credited when transferred and debited when paid; both entries are made |
| Put the agreed values in the realisation account | Book values there; the difference is what the profit measures |
| Made the capitals differ from Rs 4,50,000 | Nothing was retained here, so they equal the consideration exactly |
The rest of this subject
These notes are cut from the University's printed syllabus. Open the syllabus itself, or the past papers, for the same subject.