What is purchase consideration and explain two methods for calculating purchase consideration ?

Purchase consideration is the amount which is paid by the transferee company for the purchase of the business of the transferor company. In other words consideration for amalgamation means me aggregate of the shares and other securities issued and payment in cash or other assets by the transferee company to the shareholders of the transferor company. It should not include the amount of liabilities taken over by the transferee company, which will be paid directly by this company.

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Payments made to debenture-holders should not be considered as part of purchase consideration. While determining the amount of purchase consideration special care should be given to the valuation of assets and liabilities of the transferor company. The calculation of purchase consideration is very important and may be calculated in the following ways :

2 Methods

(i) Lump Sum Method. When the transferee company agrees to pay a fixed sum to the transferor company, it is called a lump sum payment of purchase consideration. For example, if X Ltd. purchases the business of Y Ltd. and agrees to pay Rs. 25,00,000 in all, it is an example of lump sum payment.


(ii) Net Worth (or Net Assets) Method. According to this method, the purchase consideration is calculated by calculating the net worth of the assets taken over by the Transferee company. The net worth is arrived at by adding the agreed value of assets taken over by the transferee company minus agreed value of liabilities to be assumed by the transferee company. While calculating purchase consideration under this method the following points merit attention.

(a) The term ‘Assets’ will always include cash in hand and cash at bank unless otherwise specified but shall not include fictitious assets as preliminary expenses, discount on the issue of shares or debentures, underwriting commission, debit balance of Profit & Loss Account etc.

(b) If a particular asset is not taken over by the transferee company, it should not be included in the purchase consideration.

(c) The term ‘Liabilities’ will mean all liabilities to third parties (i.e. excluding company and shareholders).

(d) The term ‘trade liabilities’ will include trade creditors and bills payable. It will exclude other liabilities to third party as bank overdraft, debentures, outstanding expenses, tax liability etc.

(e) If a fund or portion of a fund denotes liability to third parties, the same must be included in the liability as staff provident fund, workmen’s savings bank account, workmen’s’ profit sharing fund, workmen’s’ compensation fund (upto the amount of claim, if any).

(f) The ‘term liabilities’ will not include past accumulated profits or reserves such as general reserve, dividend equalization fund, reserve fund, sinking fund, capital reserve, share premium account, capital redemption reserve account, profit and loss account etc. as these are payable to shareholders and not to third parties,

(g) The term ‘business’ will always mean both the assets and the liabilities.

(h) If any liability is not taken over by the transferee company, the same should not be included in the purchase consideration.

(i) Goodwill (being an intangible asset) value agreed to be paid by the transferee company is added in the purchase consideration.

(j) The consideration for the amalgamation should include any non-cash element at fair value. In case of issue of securities, the value fixed by the statutory authorities may be taken to be the fair value. In case of other assets, the fair value may be determined by reference to the market value of the assets given up. Where the market value of the assets given up cannot be reliably assessed, such assets may be valued at their respective net book values.

(k) Where the scheme of the amalgamation provides for an adjustment to the consideration contingent on one or more future events, the amount of the additional payment should be included in the consideration if payment is probable and a reasonable estimate of the amount can be made. In all other cases, the adjustment should be recognized as soon as the amount is determinable [see Accounting Standard (AS) 4, Contingencies and Events Occurring After the Balance Sheet Date]

(l) Treatment of Reserves Specified in a Scheme of Amalgamation. Where the scheme of amalgamation sanctioned under a statue prescribes the treatment to be given to the reserves of the transferor company after amalgamation, the same should be followed.

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