Purchase Consideration: the Methods of Computing It
Chapter Four
Syllabus topic 4, "Computation of Purchase consideration"
Pages 11 to 14 of 168
In one line
Purchase consideration is the price the new firm pays for what it takes over, and it is computed either by valuing what it received or by adding up what it agreed to pay.
The definition to start from
AS 14 defines it for companies, and the definition translates cleanly:
Consideration for the amalgamation means the aggregate of the shares and other securities issued and the payment made in the form of cash or other assets by the transferee company to the shareholders of the transferor company.
Two features of that definition decide most questions.
It is what is given to the OWNERS. Payments made to anybody else - to the creditors of the old firm, for instance - are not part of the consideration. The creditors are paid because the liability was taken over, not as a price.
It is the aggregate of everything given, in whatever form: capital credited, cash, assets transferred, securities. A question that pays partly in cash and partly in capital wants both added.
Method one: net assets
Take the agreed value of the assets taken over and subtract the agreed value of the liabilities taken over.
| Agreed value of assets taken over | x |
| Less: agreed value of liabilities taken over | x |
| = Purchase consideration | x |
Four rules govern it, and each is a mark.
Use the AGREED values, not the book values. Where the question gives a revised figure for an asset, that is the figure. Where it gives none, the book value stands.
Include only what is TAKEN OVER. An asset the new firm does not want, and a liability it does not assume, are excluded from both sides. They remain with the old partners and are dealt with in their capital accounts.
Goodwill is included if it is being taken over at a value, and excluded if the question is silent.
Do not deduct the partners' capitals or reserves. They are not liabilities of the firm to outsiders; they are the owners' own claim, and deducting them computes something that is not the consideration.
External liabilities, and a liability taken over at a different value
Added by the past-paper check. MU asks "External Liabilities" as a short note, and she sets the takeover of a liability at other than its book value in terms: "Rebate on the liabilities of creditors to be provided at 2 per cent", and "The Company has also agreed to take over Sundry Creditors at Rs 82,000" where the books show Rs 96,000.
External liabilities are the firm's debts to persons OUTSIDE it. Creditors, bills payable, bank overdraft, outstanding expenses, a loan from an outsider. They are what the net assets method deducts.
Purchase Consideration: the Methods of Computing It
| Not an external liability | Why |
|---|---|
| Partners' capital accounts | The owners' own claim on the firm |
| Partners' current accounts | The same claim, in another account |
| General reserve and other free reserves | Undistributed profit, belonging to the partners |
| A partner's loan to the firm | Owed to an insider; settled through his account, not deducted as an outside debt unless the question says the new firm takes it over |
| Provision for doubtful debts | Not a debt at all; it reduces debtors on the asset side |
A liability taken over at an agreed value is deducted at the AGREED value. The rule that agreed values govern is not confined to assets. Where the buyer takes creditors of Rs 96,000 at Rs 82,000, the consideration deducts Rs 82,000, and the Rs 14,000 rebate raises the consideration by that much.
Worked, and it checks itself.
A firm's books show building Rs 2,00,000, stock Rs 1,00,000 and debtors Rs 60,000, besides cash which is not taken over, and creditors Rs 96,000. The buyer values the building at Rs 2,40,000, the stock at Rs 90,000 and the debtors at Rs 54,000 after a ten per cent provision, and agrees to take over the creditors at Rs 82,000.
| Rs | |
|---|---|
| Building, agreed | 2,40,000 |
| Stock, agreed | 90,000 |
| Debtors, agreed | 54,000 |
| Agreed value of assets taken over | 3,84,000 |
| Rs | |
|---|---|
| Agreed value of assets taken over | 3,84,000 |
| Less: creditors, at the agreed figure | (82,000) |
| Purchase consideration | 3,02,000 |
And the realisation account still uses BOOK values on both sides, which is the point students miss.
| Rs | |
|---|---|
| Realisation A/c, debited with assets at book value | 3,60,000 |
| Realisation A/c, credited with creditors at book value | 96,000 |
| Realisation A/c, credited with the purchase consideration | 3,02,000 |
| Profit on realisation | 38,000 |
Prove it the other way.
| Rs | |
|---|---|
| Gain on the assets, 3,84,000 less 3,60,000 | 24,000 |
| Gain on the creditors, 96,000 less 82,000 | 14,000 |
| Profit on realisation | 38,000 |
The two agree, and they must. The rebate is a gain to the old firm's partners, and it reaches them through a larger consideration, not through a separate entry.
Method two: net payment
Add up everything the new firm agrees to give the partners of the old firm.
| Capital credited in the new firm | x |
| Cash paid | x |
| Any other asset or security given | x |
| = Purchase consideration | x |
Three rules.
Take the amounts actually agreed, not what the net assets happen to be worth.
Ignore the values of the individual assets and liabilities entirely. Under this method they do not enter the computation; they enter the entries afterwards.
Include payments to the partners only. A payment the new firm makes to a creditor of the old firm is the discharge of a liability it assumed, not a payment for the business.
Purchase Consideration: the Methods of Computing It
Which method to use
The question decides, and it decides by what it gives you.
| The question states | Use |
|---|---|
| Revised or agreed values for the assets and liabilities taken over | Net assets |
| The capital to be credited to each partner, or the cash and shares to be given | Net payment |
| Both | Both, and the difference is goodwill or capital reserve |
Where the question names the method, use the one it names even if the other looks easier. The marks are for the method as much as the figure.
When the two differ
Where the question gives enough for both and the answers differ, that is not an error; it is the point.
| Meaning | |
|---|---|
| Net payment exceeds net assets | The new firm paid more than the things were worth. The excess is goodwill |
| Net assets exceed net payment | The new firm paid less than the things were worth. The shortfall is capital reserve |
Under the purchase method those two words are where the difference lands. Under pooling there is no such difference to land, because both sides are recorded at existing book values and any adjustment goes to reserves.
The four items students get wrong
| Item | Where it goes |
|---|---|
| A liability not taken over, for instance a bank loan the old firm keeps | Out of the computation; the old firm discharges it in its own realisation account |
| An asset not taken over, for instance cash retained | Out of the computation; it goes to the partners |
| Realisation expenses borne by the old firm | Not part of the consideration; a debit in the realisation account |
| Partners' capitals and reserves in the old balance sheet | Never deducted; they are the owners' claim, not a liability |
What it does NOT mean
The purchase consideration is not the total of the old balance sheet. It is the net of what was taken over.
It is not the amount paid to creditors. It is the amount given to the partners.
The two methods are not alternatives to choose between at will. The question's data decide.
Quick revision
- Consideration = the aggregate of everything given to the owners, in any form.
- Net assets method: agreed value of assets taken over less agreed value of liabilities taken over.
- Net payment method: capital credited plus cash plus anything else given to the partners.
- Only what is taken over counts, on either side.
- Never deduct partners' capitals or reserves.
- Where both can be computed and they differ: payment above assets is goodwill, payment below assets is capital reserve.
- Payments to creditors are the discharge of a liability assumed, not consideration.
Test yourself
1. Define purchase consideration. The aggregate of the capital credited, shares or securities issued and payments made in cash or other assets by the acquiring firm to the partners of the old firm for the business taken over.
Purchase Consideration: the Methods of Computing It
2. Under the net assets method, is a bank loan the new firm refuses to take deducted? No. Only liabilities actually taken over are deducted; one that is not taken over is left with the old firm and discharged in its realisation account.
3. Why are partners' capitals never deducted? Because they are the owners' own claim on the firm and not a liability to an outsider, so deducting them computes something that is not the consideration.
4. The net payment is Rs 5,00,000 and the net assets Rs 4,80,000. What is the difference? Goodwill of Rs 20,000, because the new firm has agreed to give more than the net assets taken over are worth.
5. Which method do you use if the question gives the agreed values of the assets? The net assets method; if it gives the capital to be credited and the cash to be paid, the net payment method; and if it gives both, compute both, because the difference is goodwill or capital reserve.
Answer in one sentence
How is the purchase consideration computed? It is the aggregate of everything the new firm gives to the partners of the old firm, and it is arrived at either by the net assets method, taking the agreed value of the assets taken over and deducting the agreed value of the liabilities taken over, counting only what actually passes and never deducting the partners' own capitals or reserves, or by the net payment method, adding the capital credited to each partner, the cash paid and anything else given, ignoring the individual asset and liability values entirely; the question's data decide which applies, and where both can be computed the excess of the payment over the net assets is goodwill while the shortfall is a capital reserve.
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.