The Purchase Method
Chapter Seven
Syllabus topic 3, "Accounting for amalgamation – Pooling of interest method and purchase method"
Pages 20 to 22 of 168
In one line
The new firm records what it bought at what it agreed the things were worth, and the gap between that and what it paid is goodwill or capital reserve.
The rule
AS 14's own statement of the object of the method:
The object of the purchase method is to account for the amalgamation by applying the same principles as are applied in the normal purchase of assets. This method is used in accounting for amalgamations in the nature of purchase.
That single sentence answers most questions about the method. Ask what an ordinary business does when it buys a set of assets: it records them at what it agreed to pay for each, and if it paid more for the package than the parts are worth, the excess is goodwill. The purchase method does exactly that.
What crosses, and at what figure
| Item | Recorded in the new firm at |
|---|---|
| Fixed assets | Agreed or fair value |
| Stock, debtors | Agreed value, debtors usually net of an agreed provision |
| Liabilities taken over | Agreed value |
| Reserves of the old firms | Not carried across. They are the partners' claim and are settled with them |
| The difference on the consideration | Goodwill or capital reserve |
The fourth row is the pivot between the two methods. Under pooling the reserves survive; under purchase they do not, because the old partners have been paid for their whole interest, reserves included, in the consideration. Carrying them across as well would credit the same amount twice.
The difference, and its two names
| Which way | What it is | |
|---|---|---|
| Consideration greater than net assets taken over | The firm paid more than the things are worth | Goodwill, an asset |
| Consideration less than net assets taken over | The firm paid less than the things are worth | Capital reserve |
Neither is an error. Goodwill says the business was worth more than its parts, which is the ordinary reason for buying a business rather than a list of assets. A capital reserve says the opposite, and it arises where the sellers were willing to take less than the net worth, usually because they wanted out.
Goodwill in the new firm's books is then dealt with under the goodwill chapter later in this module, where it is either retained or written off against the partners' capitals in the new profit-sharing ratio.
The entries
In the old firm's books, exactly as before: assets and liabilities to realisation, the consideration debited to the new firm, the profit or loss on realisation to the partners in the old ratio, and the settlement.
In the new firm's books, the opening entry:
| Dr | Cr | |
|---|---|---|
| Each asset taken over, at agreed value | x | |
| Goodwill, if the consideration exceeds the net assets | x | |
| To each liability taken over, at agreed value | x | |
| To capital reserve, if the net assets exceed the consideration | x | |
| To each partner's capital account, with the consideration | x |
The Purchase Method
Goodwill and capital reserve never appear together in the same entry for the same firm. One or the other, or neither where the figures agree exactly.
Where two old firms are taken over, compute the difference separately for each. One may throw up goodwill and the other a capital reserve, and they are not netted before being recorded, though they may appear on the same balance sheet.
Realisation profit in the old firm
A point students miss. Under the purchase method the assets are taken over at values different from book values, so the old firm's realisation account shows a profit or loss on realisation, which goes to the old partners in their old profit-sharing ratio.
That profit is not the same thing as goodwill. Realisation profit belongs to the old firm and increases its partners' capitals; goodwill belongs to the new firm and is the excess of what it agreed to pay over what it received. Two different accounts, in two different sets of books.
Why the method exists
Because a purchase has occurred and a purchase is recorded at its price. Where the owners have changed, or the business has been bought to be reorganised, or the parties themselves have struck new values, the old book figures no longer describe anything, and carrying them forward would report a business at numbers nobody agreed to.
The consequences
| Consequence | Why |
|---|---|
| Goodwill may appear on the new balance sheet | The consideration exceeded the net assets |
| The reserves of the old firms disappear | The partners were paid for their whole interest |
| The balance sheet total is higher than under pooling | Revalued assets, and goodwill |
| Later profits are lower | Higher asset values mean higher depreciation |
| Comparison with the old firms' figures breaks | Everything has been restated |
What it does NOT mean
The purchase method is not only for hostile takeovers. It applies whenever any one merger condition fails, including a mere revaluation.
Goodwill is not the realisation profit. Different books, different meaning.
Capital reserve is not a mistake. It is what a bargain purchase looks like.
Agreed value is not always fair value. It is what the parties agreed, and the question supplies it.
Quick revision
- The object is to apply the same principles as a normal purchase of assets.
- Assets and liabilities enter at agreed values; the old firms' reserves do not cross.
- Consideration above net assets = goodwill; below = capital reserve.
- Compute the difference separately for each old firm.
- The old firm shows a realisation profit or loss in the old ratio; that is not goodwill.
- Consequences: higher balance sheet total, lower later profits through higher depreciation, and a break in comparability.
The Purchase Method
Test yourself
1. State the object of the purchase method. To account for the amalgamation by applying the same principles as are applied in the normal purchase of assets.
2. What happens to the old firms' reserves? They are not carried across; the partners have been paid for their whole interest, reserves included, in the consideration, so carrying them over as well would credit the same amount twice.
3. The consideration is Rs 4,60,000 and the net assets taken over Rs 4,80,000. What is recorded? A capital reserve of Rs 20,000, the firm having acquired more than it gave.
4. Distinguish goodwill from the realisation profit. Goodwill arises in the new firm's books as the excess of the consideration over the net assets it received; realisation profit arises in the old firm's books as the excess of the consideration over the book value of what it gave up, and it is credited to the old partners in their old ratio.
5. How does the method affect profits in later years? It lowers them, because the assets are carried at higher agreed values and therefore attract higher depreciation than they would have under pooling.
Answer in one sentence
Explain the purchase method. It is the method used for an amalgamation in the nature of purchase, and its object is to account for the transaction by applying the same principles as a normal purchase of assets, so the new firm records the assets and liabilities it takes over at their agreed values rather than at book values, does not carry across the old firms' reserves because the partners have already been paid for their whole interest in the consideration, and recognises the difference between the consideration and the net assets received as goodwill where it paid more and as a capital reserve where it paid less, that difference being computed separately for each old firm and being a different thing from the profit or loss on realisation which arises in the old firm's own books and belongs to its partners in their old ratio.
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.