The Realisation Method, and Why MU Allows Only It
Chapter Eighteen
Syllabus topic 1, "Provisions related to Conversion/ Sale by use of Realisation method only"
Pages 54 to 56 of 168
In one line
Close the old firm through a single realisation account rather than by revaluing its assets and continuing the same books.
What the realisation method is
One account collects the whole closing of the firm.
| Debit | Credit |
|---|---|
| Every asset transferred, at book value | Every liability transferred, at book value |
| Cash paid on liabilities not taken over | The purchase consideration due from the company |
| Realisation expenses borne by the firm | Proceeds of any asset sold |
| Profit on realisation, to the partners | Loss on realisation, to the partners |
And the balancing figure is the profit or loss, shared in the old ratio.
That is exactly the account of Module I. The only difference is the name of the debtor on the credit side: a company instead of a new firm.
The alternative MU excludes
The other treatment is the revaluation method, sometimes called the "no realisation account" approach, in which the firm's existing books are continued by the company: the assets are revalued in situ, a revaluation account absorbs the differences, the partners' capital accounts are converted into share capital, and no separate account closes the firm.
Why it exists at all. Where the partners form the company themselves and nothing really changes hands, continuing the books is arguably a truer description of what happened, and it saves opening a new ledger.
Why MU excludes it. Two reasons, and either is enough for an answer.
It obscures the sale. Conversion is in law a sale of the business by one person, the firm, to another, the company. A realisation account records that sale explicitly, with a seller closing its books and a buyer opening its own. A revaluation account records an adjustment inside one continuing entity, which is not what happened.
It cannot be marked consistently. The realisation method produces one account with a known form and a single balancing figure, so a marker can follow it. The revaluation approach varies with how the writer chooses to handle each item.
The consequence for an answer
Three things follow from the restriction and each is worth stating.
Always open a realisation account, even where the partners form the company themselves and the question makes the conversion look like a formality.
Always close the firm's books. The company opens fresh books; the firm's ledger ends.
Never revalue assets inside the firm's own accounts. The agreed values belong to the company's opening entry. The realisation account takes book values, and the difference between the two is what the realisation profit measures.
Why the profit arises at all
A point students find genuinely puzzling.
The firm's books say the assets are worth their book values. The company has agreed to pay a consideration based on higher agreed values plus, usually, something for goodwill. The difference is a gain the firm makes on selling its business, and it belongs to the partners who owned it.
The Realisation Method, and Why MU Allows Only It
It is not the company's gain. The company simply paid what it agreed. And it is not goodwill, which arises in the company's books as the excess of what it paid over what it received.
Both numbers can exist at once and mean different things, which is the single most useful thing to understand about this module.
The order of work
| Step | What is done | Whose books |
|---|---|---|
| 1 | Compute the purchase consideration | Working note |
| 2 | Open the realisation account and transfer assets and liabilities at book value | The firm |
| 3 | Record the consideration due from the company | The firm |
| 4 | Discharge liabilities not taken over, and deal with assets not taken over | The firm |
| 5 | Transfer the profit or loss on realisation in the old ratio | The firm |
| 6 | Record the receipt of shares, debentures and cash, and distribute them | The firm |
| 7 | Pass the opening entry and draw the Schedule III balance sheet | The company |
Steps four and six are where conversion questions are actually lost, and they have chapters of their own.
What it does NOT mean
"Realisation method only" is not a restriction on the computation of the consideration. Both the net assets and net payment methods remain available for that.
It does not mean the firm is dissolved and wound up. The business continues; it is the firm's books that end.
It does not make the revaluation approach wrong in principle. It makes it wrong for this paper.
Quick revision
- MU's printed words: "by use of Realisation method only".
- The method closes the firm through one account, debiting assets and crediting liabilities at book value and crediting the consideration, with the balance being the profit or loss in the old ratio.
- The excluded alternative is the revaluation method, which continues the firm's books; it obscures that a sale took place and cannot be marked consistently.
- Consequences: always open a realisation account, always close the firm's books, and never revalue inside them.
- Realisation profit and goodwill are different numbers in different books, and both can exist at once.
Test yourself
1. What does MU's syllabus say about the method? That the provisions relating to conversion or sale are to be dealt with by use of the realisation method only.
2. What is the excluded alternative, and why is it excluded? The revaluation approach, which continues the firm's own books and adjusts values in situ; it is excluded because it obscures the fact that a sale took place between two separate persons, and because it cannot be marked to a consistent form.
The Realisation Method, and Why MU Allows Only It
3. At what values do assets enter the realisation account? At their book values; the agreed values belong to the company's opening entry, and the difference between the two is what the realisation profit measures.
4. Distinguish the realisation profit from goodwill. The realisation profit arises in the firm's books as the excess of the consideration over the book value of the net assets given up, and belongs to the partners in the old ratio; goodwill arises in the company's books as the excess of the consideration over the agreed value of the net assets received.
5. Where are conversion questions usually lost? On the assets and liabilities not taken over, and on the distribution of the shares, debentures and cash among the partners.
Answer in one sentence
Explain the realisation method and why the syllabus allows only it. Under the realisation method the firm is closed through a single account which is debited with every asset transferred at its book value, with cash paid on any liability the company does not take over and with realisation expenses the firm bears, and credited with the liabilities transferred at book value, with the purchase consideration due from the company and with the proceeds of anything sold, the balancing figure being the profit or loss on realisation which goes to the partners in their old ratio; MU's syllabus prescribes it alone, excluding the revaluation approach that would continue the firm's own books, because conversion is in law a sale of the business by the firm to the company and a realisation account records that sale explicitly with a seller closing its books and a buyer opening its own, whereas a revaluation records an adjustment inside a single continuing entity, which is not what happened, and cannot be marked to a consistent form.
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.