What does the acquisition of a business mean?
While dealing with partnership accounts, we have seen that a sole proprietorship or a partnership firm, doing business more or less on the same line, may be converted into a firm in order to get the advantage of securing the economy and to avoid competition. Similarly, a sole trader or a firm sells the business to a company or converts it into a company, in order to derive mainly the benefit of limited liability and of increased capital. In other words, the Joint Stock Company may be formed for the purpose of acquiring a running business of a sole trader or a partnership firm. At present, by the acquisition of a business, we mean and are concerned with the accounting entries involved in the purchase of a business of a non-corporate body by a corporate body.
Again, the business of a sole trader or a firm may be converted into a company or the business may be sold to an existing company. In both cases, the transaction becomes a business acquisition or business purchase. The company, which acquires or purchases the business of another, is called Purchaser or Vendee (Purchasing Company) and the seller is called Vendor.
The Vendor firm (which sells the business) and the purchasing company will have to agree about the price to be exchanged for the acquisition of a business. The purchase price or the purchase consideration is the price payable by the purchasing company to the Vendor concern as a consideration for the business taken over. Such price is determined by an agreement between the Vendor and the Vendee. The price can be paid by the purchasing company in cash or in shares or in debentures.
Calculation of Purchase Consideration
In certain cases, the purchase price is paid by a lump sum. In such a case, there arises the necessity to compare the lump sum with the net tangible assets taken over in order to whether the price paid is lower or higher than the value of net tangible assets.
Methods to calculate the purchase consideration
There are mainly two methods to calculate the purchase consideration:
(A) Net Asset Method
By this method, the purchase price arrived at by adding up the value of all assets taken over less the amount of liabilities taken over by the vendee i.e., purchasing company. For instance, X and Y a firm whose tangible assets are valued at $2,00,000 and liabilities at $45,000, then the net assets or net tangible assets is $1,55,000. Normally, the purchase price and the net assets may be equal. But in many cases, the two figures may be different.
(B) Net Payment Method
By this method, the purchase price is arrived at by adding up the various payments made by the purchasing company. For instance, a purchasing company discharges the purchase price by the issue of 1,000 shares of $100 each, 200 debentures of $100 each and a cash payment of $30,000. Then the purchase price is $1,50,000 ($1,00,000 + $20,000 + $30,000).
Goodwill or Capital Reserve
The purchase price must be compared with the net assets acquired. If the amount paid is excess of net assets acquired, then the excess amount is to be debited to Goodwill. In certain cases the amount paid may be less than the net assets acquired, then the excess amount i.e., the capital profit is to be credited to Capital Reserve.
When the value of net assets is calculated, it must be remembered that the revised values of assets and liabilities are taken into account. If revised values are not given in the problem, then the book values are considered. When the entire business is handed over, liabilities along with assets including Cash at Bank and in hand are taken over by the purchasing company. Here the liabilities mean external liabilities (the amount payable to third parties) and assets mean non-fictitious assets. It may be noted that there may be either capital loss or capital gain. If there is a gain, then there cannot be a loss: similarly, if there is a loss, then there cannot be a gain, out of the same transaction.
Method of accounting treatment in the acquisition of a business
There are two methods of accounting treatment in business acquisition: (A) New set of books are opened and (B) the same set of books are continued.
(A) New set of books are opened
The following are the entries recorded by the purchasing company:
Note: If the purchase price exceeds the net assets, the excess amount is debited to Goodwill Account; and if the net assets exceeds the purchase price, the excess amount is credited to Capital Reserve.
Note: Any difference between the totals of debit and credit is debited to Goodwill Account or credited to Capital Reserve Account.
B.K. Limited registered with a capital of $10,00,000 in Equity shares of $10 each, acquired the business of John Brothers. The Balance Sheet of the firm at the date of acquisition was as under.
The assets and liabilities were subject to the following revaluation:
- (a) Machinery and Furniture to be depreciated at 10% and 15% respectively.
- (b) Premises should be appreciated by 20%.
- (c) Make provision for bad debts on debtors at 2.5%.
- (d) Goodwill of the firm valued at $24,000.
- (e) The purchase consideration was to be discharged as follows:
- (i) Allotment of 10,000 Equity shares of $10 each at $12 each.
- (ii) Allotment of 500 10% Debentures of $100 each at a discount of $10 each.
- (iii) Balance in cash.
You are required to show journal entries in the books of the Company and prepare the Balance Sheet.
Computation of Purchase Consideration:
Journal entries in the books of B.K. Limited
Balance Sheet of B.K Limited as on ……..
Vendor’s Debtors and Creditors
Sometimes, the book debts and trade liabilities belonging to the vendor are not taken over by the purchasing company. This is because, complete recovery of the amount against book debts may not be possible and trade liabilities may be more than the estimated figure. Thus there arises a risk in taking over the vendor’s debtors and creditors.
In certain cases, the purchasing company takes over the book debts on a guarantee given by the vendor for their realization. An agreed amount is retained against the Vendor Guarantee Account. The amount is adjusted against the purchase price. That is, the purchase price is paid after deducting the guarantee amount. If the full amount is realized, the guarantee amount is returned; if not, the Guarantee Account is debited to the extent of loss and the balance is paid. The purchasing company may charge a nominal commission for the job done on behalf of the vendor.
Alternative to the above, the purchasing company takes the responsibility of collection of debtors and paying off the creditors, as an agent for the vendor. For this service, the company charges a commission at an agreed rate. The entries to be passed by the purchasing company in such a case are as follows:
Alternatively, when no record is maintained in the books of the purchasing company, only the receipts and payments on behalf of the vendor are recorded in vendor’s Current Account. The journal entries are:
A Limited Company acquired the business of Mr. David with the exception of his trade debts and trade liabilities. The Company, however, agreed to collect his debts amounting to $1,00,000 and pay off his creditors amounting to $45,000. All the sums due from his debtors were collected except $3,000 bad debts ad $2,000 allowed as cash discount. The creditors were paid $43,000 in full settlement. The Company agreed to do this job against a commission of 2% on the amounts collected; 1% on payments made.
Show the Ledger accounts assuming that the amount due to vendor was paid off. Ignore interest.
Acquisition of business by Continuing the Same Set of Books
Sometimes on the conversion of a business into a Company, no new set of books is opened but the purchasing company decides to continue with the same set of books. In such a case, the books of the old business are converted into the books of the Company by passing certain adjustments and transfer entries. There will be no closing entries in the books of the old firm nor opening entries in the books of the company. However, the following points may be kept in mind.
- When it is agreed to revalue the assets and liabilities for the acquisition of a business, Revaluation Account may be opened to incorporate the changes in the values of assets and liabilities. The Revaluation Account, as in “Admission of a Partner” is closed by transferring to Capital Accounts.
- The assets and liabilities, which are not taken over by the company are transferred to Capital Accounts.
- Close the undistributed profits to Capital Accounts in profits sharing ratio.
- Close the adjusted Capital Accounts by debiting and Share Capital is credited.
A and B carrying on business in partnership, sharing profits and losses in the ratio of 3:2, wish to dissolve the firm and sell the business to a limited company on 31st December when the firm’s Balance Sheet as under:
A Limited Company with an authorized capital of $3,00,000 in Equity shares of $10 each, is registered to purchase the above business on the following terms:
- Goodwill is valued at $30,000.
- Furniture and stock are evaluated at $6,000 and $85,000 respectively.
- Debtors are subject to 5% provision.
The auto is not required by the company and A takes over it at an agreed valuation of $8,000.
The purchase consideration is satisfied by the issue of Equity shares of $10 each at par.
Show the journal entries and Balance Sheet of the company assuming that the same set of books is continued.
Balance Sheet as on 31st December