Purchase Consideration, Worked Both Ways
Chapter Five
Syllabus topic 4, "Computation of Purchase consideration"
Pages 15 to 16 of 168
The question
P and Q are partners sharing profits equally. Their balance sheet as at 31 March 2027 is:
| Liabilities | Rs | Assets | Rs |
|---|---|---|---|
| Creditors | 90,000 | Land and building | 2,00,000 |
| Bank loan | 60,000 | Plant and machinery | 1,50,000 |
| General reserve | 50,000 | Stock | 1,00,000 |
| Capital: P | 2,40,000 | Debtors | 90,000 |
| Capital: Q | 1,60,000 | Cash | 60,000 |
| Total | 6,00,000 | Total | 6,00,000 |
The firm amalgamates into PQR & Co. The new firm takes over all the assets except the cash, and the creditors. The bank loan is not taken over. The assets are taken at: land and building Rs 2,60,000; plant and machinery Rs 1,30,000; stock Rs 95,000; debtors at book value less a provision of Rs 5,000. The creditors are taken over at book value. The new firm credits P with capital of Rs 3,30,000 and Q with Rs 1,70,000.
Compute the purchase consideration by both methods and explain the difference.
Method one: net assets
Take the agreed values, and only of what is taken over.
| Assets taken over | Rs |
|---|---|
| Land and building | 2,60,000 |
| Plant and machinery | 1,30,000 |
| Stock | 95,000 |
| Debtors, Rs 90,000 less provision Rs 5,000 | 85,000 |
| Total assets taken over | 5,70,000 |
| Rs | |
|---|---|
| Assets taken over | 5,70,000 |
| Less: creditors taken over | 90,000 |
| Purchase consideration, net assets method | 4,80,000 |
Three items are absent from that computation and each absence is deliberate.
The cash of Rs 60,000 is not there, because the new firm did not take it. It stays with the old firm and goes to the partners.
The bank loan of Rs 60,000 is not there, because the new firm did not assume it. The old firm must discharge it out of its own resources.
The general reserve of Rs 50,000 and the two capitals are not there, because they are the partners' own claim and not liabilities to outsiders. Deducting them would compute something that is not the consideration.
Method two: net payment
Add up what the new firm agreed to give the partners.
| Rs | |
|---|---|
| Capital credited to P | 3,30,000 |
| Capital credited to Q | 1,70,000 |
| Purchase consideration, net payment method | 5,00,000 |
Nothing else enters. No asset value, no liability, no cash, because under this method the computation looks only at what was promised to the partners.
The difference
| Rs | |
|---|---|
| Purchase consideration by net payment | 5,00,000 |
| Less: net assets taken over | 4,80,000 |
| Goodwill | 20,000 |
Read that as a sentence. The new firm agreed to give P and Q capital of Rs 5,00,000 for a set of assets and liabilities worth Rs 4,80,000. It paid Rs 20,000 more than the things were worth, and it paid it for the business rather than for the things - which is what goodwill is.
Had the figures run the other way - a payment of Rs 4,60,000 against net assets of Rs 4,80,000 - the difference of Rs 20,000 would be a capital reserve, the new firm having acquired more than it gave.
Purchase Consideration, Worked Both Ways
Which figure the entries use
This is where students go wrong after getting both numbers right.
In the OLD firm's books, the purchase consideration is the figure the new firm owes it, and that is the net payment, Rs 5,00,000. It is debited to the new firm and credited to realisation.
In the NEW firm's books, the assets and liabilities come in at their agreed values, and the balancing figure is goodwill. So the opening entry is:
| Dr, Rs | Cr, Rs | |
|---|---|---|
| Land and building | 2,60,000 | |
| Plant and machinery | 1,30,000 | |
| Stock | 95,000 | |
| Debtors | 85,000 | |
| Goodwill | 20,000 | |
| To Creditors | 90,000 | |
| To P's capital | 3,30,000 | |
| To Q's capital | 1,70,000 | |
| Total | 5,90,000 | 5,90,000 |
The entry balances because goodwill is the plug, and that is precisely what the two methods together have computed.
The check to run
Add the debits and the credits of the opening entry. They come to Rs 5,90,000 each. If they do not, one of three things has happened: an asset not taken over has been included, a liability not taken over has been assumed, or the goodwill has been computed against the wrong consideration.
In short
- Net assets method: Rs 5,70,000 of assets less Rs 90,000 of creditors = Rs 4,80,000.
- Net payment method: Rs 3,30,000 plus Rs 1,70,000 = Rs 5,00,000.
- The difference of Rs 20,000 is goodwill.
- Cash and the bank loan are excluded from everything, because neither was taken over.
- Reserves and capitals are never deducted.
- The old firm's books use the net payment; the new firm's books use the agreed values with goodwill as the balancing figure.
Answer in one sentence
Compute the purchase consideration and explain the difference between the methods. By the net assets method it is the agreed value of the assets taken over, Rs 5,70,000, less the creditors taken over, Rs 90,000, giving Rs 4,80,000, the cash and the bank loan being excluded because neither passes and the reserve and capitals being excluded because they are the partners' own claim; by the net payment method it is the capital credited to the partners, Rs 3,30,000 to P and Rs 1,70,000 to Q, giving Rs 5,00,000; and the excess of Rs 20,000 that the second shows over the first is goodwill, being the amount the new firm has agreed to give for the business over and above the value of the things it received, which appears as the balancing debit in the opening entry of the new firm.
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.