Valuation of goodwill

Methods of Valuation of Goodwill Since goodwill is an intangible asset it is very difficult to accurately calculate its value. Various methods have been advocated for the valuation of goodwill of a partnership firm. Goodwill calculated by one method may differ from the goodwill calculated by another method. Hence, the method by which goodwill is to be calculated, may be specifically decided between the existing partners and the incoming partner. The important methods of valuation of goodwill are as follows: 1. Average Profits Method 2. Supper Profits Method 3. Capitalisation Method

The profit for the last five years of a firm were as follows year 2002 Rs. 4,00,000; year 2003 Rs. 3,98,000; year 2004 Rs. 4,50,000; year 2005 Rs. 4,45,000 and year 2006 Rs. 5,00,000. Calculate goodwill of the firm on the basis of 4 years purchase of 5 years average profits. Solution Year Profit (Rs.) 2002 4,00,000 2003 3,98,000 2004 4,50,000 2005 4,45,000 2006 5,00,000 Total 21,93,000

Average Profit = Total Profit of Last 5 Years No. of years = Rs. 21,93,000 5 = Rs. 4,38,600 Goodwill = Average Profits No. of years purchased = Rs. 4,38,600 4 = Rs. 17,54,400

The Profits of firm for the last five years were as follows: Year Profit (Rs.) 200203 20,000 200304 24,000 200405 30,000 200506 25,000 200607 18,000 Calculate the value of goodwill on the basis of three years purchase of weighted average profits based on weights 1,2,3,4 and 5 respectively to the profits for 2002,2003,2004,2005 and 2006.

Solution Year Ended 31st March (Rs.) 200203 200304 200405 200506 200607

Profit
20,000 24,000 30,000 25,000 18,000

Weight
1 2 3 4 5 15

Product
20,000 48,000 90,000 1,00,000 90,000 3,48,000

Weighted Average Profit = Rs. 3,48,000 / 15 = Rs. 23,200 Goodwill = Rs. 23,200 3 = Rs. 69,600

Calculate goodwill of a firm on the basis of three year purchase of the weighted average profits of the last four years. The profit of the last four years were: 2003 Rs. 20,200; 2004 Rs. 24,800; 2005 Rs. 20,000 and 2006 Rs. 30,000. The weights assigned to each year are : 2003 1; 2004 2; 2005 3 and 2006 4. You are supplied the following information: 1. On September 1, 2005 a major plant repair was undertaken for Rs. 6,000, which was charged to revenue. The said sum is to be capitalised for goodwill calculation subject to adjustment of depreciation of 10% p.a. on reducing balance method. 2. The Closing Stock for the year 2004 was overvalued by Rs. 2,400. 3. To cover management cost an annual charge of Rs. 4,800 should be made for purpose of goodwill valuation.

Calculation of Adjusted Profit

2003 2004 2005 2006 Rs. Rs. Rs. Rs. Given Profits Less 20,200 24,800 20,000 30,000 Management Cost 4,800 4,800 4,800 4,800 Add: Capital Expenditure 15,400 20,000 15,200 25,200 Charged to Revenue 6,000 15,400 20,000 21,200 25,200 Less: Unprovided Depreciation 200 580 15,400 20,000 21,000 24,620 Less; over valuation of Closing Stock - 2,400 15,400 17,600 21,000 24,620 Add: over value of opening stock - 2,400 Adjusted Profits 15,400 17,600 23,400 24,620

Calculation of weighted average profits:

(Rs.) Year Profit Weight Product 2003 15,400 1 15,400 2004 17,600 2 35,200 2005 23,400 3 70,200 2006 24,620 4 98,480 Total 10 2,19,280 Weight Average Profit = Rs. 2,19,280/ 10 = Rs. 21,928 Goodwill = Rs. 21,928 3 = Rs. 65,784 Notes to Solution
(i) Depreciation of 2005 = 10% of Rs. 6000 for 4 months = Rs. 6000 *10/100 * 4/12 = Rs. 200 (ii) Depreciation of 2006 = 10% of Rs. 6000 Rs. 200 for one year = Rs. 5800 * 10/100 = Rs. 580 (iii) Closing Stock of 2004 will become opening stock for the year 2005

In previous study the term capital employed is defined as simple equation as: Total assets out side liabilities But in practice, in large size of companies the following two different type of approaches are adopted to compute the value of capital employed: 1. Assets side approach 2. Liabilities side approach

Assets side approach Value of capital employed, under this approach, is calculate as follows: Assets at market value *** (excluding goodwill, all deferred expenditure) Less: Liabilities to outsiders *** Capital employed -----Less: 50% of profit during the year *** Average capital employed ------

Liabilities side approach Share capital **** Add: Profit , reserve, workman compensation reserve, Gain on revaluation of assets and liabilities **** Less: Goodwill, loss on revaluation of assets and liabilities Losses, preliminary expenses, investment, **** Capital employed -----Less: 50% of profit during the year **** Average capital employed ------

 You are required to calculate a) capital employed and b) average capital employed from the following balance sheet:
Liabilities 12% preference share capital Equity share capital Reserve ( including profit of the current year Rs. 50,000) Workman compensation fund Depreciation fund: Land and building 30,000 Plant 30,000 Debenture Creditor Amount 1,00,000 3,00,000 90,000 60,000 Assets Goodwill Land and building Plant Current assets Investment Investment for replacement of plant Preliminary expenses Amount 30,000 90,000 1,50,000 4,00,000 70,000 30,000 10,000

60,000 90,000 80,000 7,80,000

7,80,000

Assets side approach Total of assets other than goodwill and preliminary expenses 7,80,000 30,000 10,000 = 7,40,000 Less: Debenture 90,000 Creditors 80,000 Depreciation 60,000 2,30,000 5,10,000 Less: 50% of profit 25,000 Average capital employed 4,85,000

Liabilities side approach Share capital Equity 1,00,000 Preference share capital 3,00,000 4,00,000 Add: reserve (90,000-50,000) 40,000 Profit 50,000 Workman compensation 60,000 1,50,000 5,50,000 Less: goodwill 30,000 Preliminary exp. 10,000 40,000 Capital employed 5,10,000 Less: 50% profit of c.y. 25,000 Average capital employed 4,85,000

 You are required to calculate a) capital employed and b) average capital employed from the following balance sheet:
Liabilities Equity share of Rs. 10 each fully paid up Reserve Profit and loss a/c 15% Debenture Workman compensation fund Creditor Workman profit sharing reserve Amount Assets Amount 1,00,000 3,00,000 30,000 2,70,000 6,00,000 1,00,000 5,00,000 70,000 20,000 50,000 1,75,000 2,80,000 4,00,000 3,50,000 50,000 90,000 25,000 10,00,000 Goodwill Land and building 3,00,000 Less: Dep. 2,00,000 Plant 2,00,000 Less: Dep. 30,000 Furniture 60,000 Less: Dep. 50,000 Trade investment (cost 2,00,000) Stock Debtors Less: provision Cash at bank Preliminary expenses

18,40,000

18,40,00 0

Building are now worth Rs. 5,00,000 and plant and machinery is worth Rs. 4,75,000. You are required to compute the value of capital employed. Assets side approach

Total assets Goodwill Less: P. Exp. Less: building book value Add: building market value Less: plant book value Add: plant market value Required new total assets Less: 15% debenture Creditors Workmen profit sharing reserve Capital employed

18,40,000 (100000) (25,000) (2,70,000) 5,00,000 (5,00,000) 4,75,000 19,20,000 2,00,000 60,000 50,000

3,10,000 16,10,000

Liabilities side approach Share capital Add: G/R Profit and loss a/c Workmen compensation Increase in the value of building Less: Goodwill Investment loss Decrease in the value of assets Capital employed

10,00,000 3,00,000 2,00,000 30,000 2,30,000 17,60,000 (1,00,000) (25,000) (25,000) 16,10,000

 the following balance sheet of Raj Com. Ltd. as on 31st march 2010:
Liabilities Amount Assets Amount

Equity share of Rs. 10 each fully paid up Reserve Profit and loss a/c Creditor Provision for taxation

5,00,000
30,000 50,000 1,00,000 70,000

Goodwill Land and building Plant Stock Debtors Less: provision Cash at bank

50,000 2,50,000 2,00,000 1,50,000

1,00,000 5,000 95,000 5,000

You are ask to value the goodwill of Raj Ltd. on the basis of 5 year purchase for which following information is supplied: Adequate provision have been made in the accounts for income tax and depreciation. The rate of income tax may be taken at 50%.

7,50,000

7,50,000

The average rate of dividend by the company for the past 5 year was 15%. The return on the company invested is 12%. Solution : Assets side approach Total assets 7,50,000 Less: goodwill (50,000) Required new total assets 7,00,000 Less: liabilities Creditors (1,00,000) Provision for taxation (70,000) Capital employed 5,30,000 Goodwill = super profit * No. of purchase year Super profit = average profit or current profit Normal profit

Calculation of current profit Provision for taxation is Rs. 70,000 That is at 50% of the profit Total profit 100% will be Rs. 1,40,000 Current Profit after providing tax (1,40,000 70,000) = 70,000 Calculation of Normal profit Normal profit = capital employed * rate of return = 5,30,000 * 12/100 = 63,600 Calculation of super profit Super profit = average profit or current profit Normal profit = 70,000 63,600 = 6,400 Value of goodwill = super profit * No. of purchase year = 6,400 * 5 = 32,000

 the following balance sheet of sudarshan. Ltd. as on 31st march 2010:

Liabilities Equity share of Rs. 10 each fully paid up Bank overdraft Profit and loss a/c Creditor Provision for taxation Amount Assets Amount 2,00,000 9,00,000 8,00,000 12,00,000 7,75,000 20,00,000 Goodwill Land and building 3,00,000 Plant 5,00,000 Stock 7,00,000 Debtors 3,75,000

38,75,000

38,75,000

the company started business in 2005 with paid up capital Rs. 20,00,000. profit earned before taxation have been as follows: 2006 = 6,00,000, 2007= 7,00,000, 2008 = 8,00,000, 2009 = 5,00,000, 2010 = 9,00,000 Income tax rate 50%. Dividend have been distributed from the profit of first 3 year @ 10% and 15% next 2 year of the paid up capital.

Find the goodwill by capitalization method Total assets (38,75,000 2,00,000)= 36,75,000 Less: Total liabilities 3,00,000 + 7,10,000 + 3,75,000 = 13,85,000 Net assets = 22,90,000

Calculation of average profit 6+7+8+5+9=35,00,000 / 5 = 7,00,000 Less: provision for tax @ 50% = 3,50,000 Average profit = 3,50,000 Average dividend = 10%+10%+10%+15%+15% / 5 Fair rate of return = 12% Capitalized value of business 100 x 3,50,000 / 12 = 29,16,666.6 Goodwill = Capitalized value of business Net Assets Goodwill = 29,16,666.6 - 22,90,000 =6,26,666.67

Future Maintainable Profits We all know that goodwill is abstract asset. It represents the Future Maintainable Profits of a business. As is clear from the name itself, Future Maintainable Profits are the profits that are expected to be earned by the business in the coming future. For calculating the Future Maintainable Profits of a concern, we should have a look into the profits earned by that concern in the few previous years say 2,3,4 or 5 years. Its always better to take a short and recent time period for calculation of Future Maintainable Profits or Adjusted Average Past Profits.

The following factors should be considered For the FMP Interest on debenture and depreciation on fixed assets should be included. Provision for liabilities should be made Preference dividend must be deducted Result of any development that will arise in future should be taken into account The following items should not taken into account 1. Transfer to general reserve 2. Redemption of liabilities 3. Dividend equalization fund 4. Non trading assets 5. Any income derived from Non trading assets

Exp. For the year ended 31st march 2010 a company reported a profit of 14,000 after paying income tax @ 30%. It was found that the year income included Rs. 1,000 for a claim lodged in 2007-08 for which no entry has been passed then. The plan to launch a new product and the following are the estimate in respect of this. Sales 12,000 Expenditure on raw material 5,000 Wages and fixed expenses 6,500 You are asked to find FMP

Solution Profit before tax 14,000 * 100 / 70 = 20,000 Less: income of 2007-08 = 1,000 Normal profit 19,000 Add: expected profit of new product Sales 12,000 Less: expenses (5,000 +6,500) 11,500 500 Expected profit before tax =(19,000+500) = 19,500 Less: income tax @ 30% = 5850 FMP 13650

Valuation of share Following are the condition in which valuation of share has become utmost important Amalgamation of companies Reconstruction Conversion Assessment of tax To meet shareholders demand

Methods of valuation of shares Net asset method Following are the most important steps in this method Step 1. Total Assets (at market value) Step 2. less: Total liabilities ( including Debenture and preference share) Step 3. Result = Net Assets Step 4. Value of share = Net Assets / Number of equity share Following are the factors should be considers Goodwill: It should be valued at current cost Inventory: Raw material, stock and WIP should be valued at cost Finished goods should be valued at market value Fictitious Assets: Should be eliminated Non trading assets: at market price

Debtors: After provision for bad and doubtful debts Other assets: If market value of assets are not given, should be value at book value Share capital: If both share capital are given, preference share capital should be deducted Intrinsic value of share (I.V.S.) : net assets / no. of equity share Example Valuation of fully paid share Valuation of partly paid share

Valuation of fully paid shares Q1. the following is balance sheet of A ltd. Company as on 31/3/10 Liabilities 3000, 10% P.S. of Rs. 100 each 300000 50000 E.S. of Rs. 10 each 500000 B/P 60000 Creditor 120000 1000000 Assets Sundry Assets as Book value 1000000 Other information's The market value of 70% of the assets is estimated to be 20% more then the book value and that of the remain 30% at 10% less than the book value. There are unrecorded liabilities of Rs. 10,000. Find the value of one equity share

Solution Total assets is Rs. 1000000 out of which 70% is appreciate by 20% = 840000 And rest of 30% is depreciated by 10% = 270000 Total assets at market value 1110000 Less : current liabilities B/P 80000 Creditors 120000 Unrecorded liabilities 10000 210000 900000 Less: preference share capital 300000 Net assets available for E.S.H. 600000 I.V.S. = 600000 / 50000 = Rs. 12

Q.2 the following is balance sheet of A ltd. Company as on 31/3/10 Liabilities Assets 5000 E.S. of Rs. 100 each 500000 goodwill 120000 P&L a/c 50000 investment 480000 GR 150000 stock 500000 10% Debenture 450000 Debtors 300000 Workman S.B. a/c 200000 cash at bank 100000 Creditor 150000 ---------------------1500000 1500000 The profit for the past 5 years were: 25000,35000,60000,50000,80000 The market value of investment was Rs. 400000 Goodwill is to be valued as 3 years purchase of average annual profit for the last 5 years. Find the intrinsic value of share.

Solution Step 1 calculate goodwill Goodwill at new value = 150000 Investment at new value = 400000 Other assets 900000 Total assets Less liabilities : Debenture 450000 Creditors 150000 Works S.B. a/c 200000 Total liabilities Net assets available for E.S.H. I.V.S. = 650000 / 5000 = 130

1450000

800000 650000

Q.3 the following is balance sheet of A ltd. Company as on 31/12/09 Liabilities Assets 150000 E.S. of Rs. 10 each 1500000 Building 500000 P&L a/c 200000 P&M 300000 Div. Eq. fund 150000 stock 1000000 B.O.D.* 50000 Debtors 450000 Provision for tax* 100000 --------------------Creditor * 250000 ---------------------2250000 2250000 The profit for the past 5 years were: 05-200000,06-225000,07-250000,08-275000,09-300000 On 31st Dec 09 the value of building were valued at Rs. 625000 and P&M at 375000. in view of the business, it is considered that 10% is reasonable on capital. goodwill is calculate on the basis of 3 year super profit method.

Solution: Step 1- (total assets liabilities) = net assets 2050000 Step2 average capital employed = (net assets half of current year profit) = (2050000 150000) = 1900000 Step 3 calculate Goodwill Average profit = 250000 Normal profit = 190000 Super profit = A.P N.P. Goodwill = S.P. X 3 = 180000 Step 4 Net assets + Goodwill = 2050000+180000 = 2230000 Step 5 Calculate IVS = 2230000/ 150000 = 14.86

Q.4 on 31st march 2010, the balance sheet of A ltd. was as follows Liabilities Assets 1000, 10% P.S. 100000 Goodwill 50000 50000 E.S. 500000 land & Building 200000 GR 100000 Machinery 250000 CR 20000 furniture 20000 P&L 80000 investment (F.V. 60000)75000 6% Debenture * 160000 stock 400000 Creditors* 100000 Debtors 80000 Pro. For tax* 40000 cash 25000 1100000 1100000 The assets are revalued as- land & Building 280000, machinery 220000 Furniture 30000. the normal return in capital is 10%, the basic Valuation of goodwill is 4 year purchase of super profits. 50% of investment in building is treated as non-trading assets because a sum of Rs. 12000 is collected as rent from building. You are required to calculate the value of each equity share assuming that average annual profit after tax at 50% is Rs. 132500

Solution : Step 1- calculate capital employed Total assets total liabilities Step 2 calculate normal profit Capital employed * rate/100 Step 3 calculate average trading profit Average annual profit - non trading income ( rent 50%, interest on investment at F.V. less tax 50%) Step 4 calculate super profit Average profit normal profit Step 5 calculate Goodwill Super profit * no. of year purchase Step 6- calculate Net assets Total assets total liabilities preference share capital Step 7- calculate IVS Net assets/ no. of Equity share

Solution : Step 1- calculate capital employed Total assets total liabilities TA=(280000+220000+30000+400000+80000+25000-50% of 280000) TL=(160000+100000+40000) Step 2 calculate normal profit Capital employed * rate/100 Step 3 calculate average trading profit Average annual profit - non trading income ( rent 50%, interest on investment at F.V. less tax 50%) Step 4 calculate super profit Average profit normal profit Step 5 calculate Goodwill Super profit * no. of year purchase Step 6- calculate Net assets Total assets total liabilities preference share capital Step 7- calculate IVS Net assets/ no. of Equity share

Valuation of partly paid shares Following are the extract of balance sheet of A ltd. on 31st march 2010 5000, 10% P.S. of Rs. 100 each 500000 10000, E.S. of Rs. 10 each, Rs. 5 paid up 50000 10000, E.S. of Rs. 10 each, Rs. 2.5 paid up 25000 10000, E.S. of Rs. 10 each, Fully paid up 100000 Reserve and Surpluses 200000 P&L a/c 125000 1000000 On revaluation of assets it was found that they had appreciated by Rs. 100000 over the value in the aggregate. The article of association of the company state that in case of liquidation, the preference share holder would have a further claim of the surplus assets, if any. You are required to ascertain the value of share assuming that liquidation of the company has to take place on 31st march 2010.

Solution Step 1- calculate Net assets Ps + Eq + R&S + P&L+ appreciation on revaluation Step 2- less equity share capital and preference share capital Step 3- less surplus to preference share holder (10% of surplus) Result is surplus assets available to equity share holder Step 4- calculation of total amount available for EQ.S.H. (Equity share capital + surplus assets available to equity share holder) Step 5- calculation of value of Rs. 1 of paid-up capital = total amount available for EQ.S.H / paid-up capital Step 6- calculate value of each Rs. 5 paid up share Rs. 5 * value of Rs. 1 of paid-up capital Step 7- calculate value of each Rs. 2.5 paid up share Rs. 2.5 * value of Rs. 1 of paid-up capital Step 8- calculate value of each Rs. 10 paid up share Rs. 10 * value of Rs. 1 of paid-up capital

Treatment of preference share The following is the balance sheet of A ltd. On 31st march 2008. Liabilities Assets 2000, 10% P.S. 200000 sundry Assets 1000000 50000 E.S. 500000 discount on Deb. 5000 GR 25000 Pre. Exp. 15000 Debenture RR 50000 P&L a/c 80000 5% debenture* 100000 -------------Depreciation fund* 25000 --------------Creditors* 200000 --------------1100000 1100000 The debenture interest are for one year is outstanding and dividend on P.S. is arrear for 2 years. In following cases find the value of EQ.S. and P.S.
Preference share are preferential as to capital and arrears are payable Preference share are preferential as to capital but arrears are not payable Preference share do not priority of capital but arrears are payable Neither Preference share enjoy priority of capital nor the payment of arrears

Solution Step 1- calculation of Net Assets Total Assets Total liabilities including outstanding interest

Case :Preference share are preferential as to capital and arrears are payable Step 1- calculation of assets available for Eq. share holders Net assets preference share capital arrears of 2 years Step 2- IVS = assets available for Eq. share holders / No. of Eq. S. In this case value of preference share is Rs. 100
Case : Preference share are preferential as to capital but arrears are not payable Step 1- calculation of assets available for Eq. share holders Net assets preference share capital Step 2- IVS = assets available for Eq. share holders / No. of Eq. S. In this case value of preference share is Rs. 100

case: Preference share do not priority of capital but arrears are

Payable Step 1- calculation of assets available for Equity and Preference share holders Net assets arrears of 2 years Step 2- IVS = assets available for Eq. share / No. of Eq. S. + P.S. holders

case: Neither Preference share enjoy priority of capital nor the

payment of arrears Step 1 = Net Assets/ No. of Eq. S. + P.S. holders

Fair value of share - on the basis of minority holding and majority holding Minority holding is based on expected rate of return F.V. of M.H. = IVS + Yield value (based on expected rate of return) 2 Majority holding is based on Average rate of return F.V. of M.H. = IVS + Yield value (based on Average rate of return) 2

Q. Determine the value of 200 share held by Mr. Ram of A Ltd. to be transferred to Mr. Ramesh on the basis of minority and majority basis. The balance sheet of A Ltd. Is as follows on 31st march 2010. Liabilities Assets 80000 Eq. share 800000 Goodwill 40000 GR 260000 Building 300000 P&L a/c 160000 Machinery 360000 Creditors 80000 Debtors 400000 ----------------Stock 160000 ----------------Cash at Bank 20000 ----------------Pre. Exp. 20000 1300000 1300000 Debtors are estimated to be 10% below book value. Dividend was paid for the last three years at the rate of 14%,18% and 16% respectively. Normal Expected rate is 10%. P&L a/c shows the net profit after tax and transfer in general reserve

Solution Valuation of share of under net assets method Step 1 calculate net assets available to Equity share holders Total assets total liabilities Step 2 IVS = net assets available to Equity share holders / No. of Eq.S Step 3- calculate intrinsic value of 200 shares Valuation of share under yield method Step 1 calculate expected rate of return = profit after tax and GR * 100 Share capital Step 2 calculate yield value of shares Expected rate of return *paid up value of equity share Normal rate of return Step 3- yield value of 200 shares 200 * yield value of shares

Determination of yield value of minority holding and majority holding Step 1- calculate Average rate of actual dividend 14%+18%+16% / 3 = 16% Step 2- calculate value of one share Average rate of actual dividend*paid up value of equity share Normal rate of return Step 3- yield value of 200 shares 200*16 =3200 Step 4 fair value of minority holding F.V. of M.H. = IVS + Yield value (based on expected rate of return) 2 Step 5- fair value of majority holding F.V. of M.H. = IVS + Yield value (based on Average rate of return) 2

Valuation of share by yield basis or market value Yield denotes the income that the investors get for their investment In this method yield may represent 1. The entire earning 2. The dividend paid by company Following are the steps of share valuation by yield method 1. Future maintainable profit are ascertained 2. The normal rate of return is computed 3. Calculation of capitalization factor is to be ascertained By (100 / normal rate of return) 4. Calculate the capitalized value of future maintainable profit By ( step 1 X step 2) 5. Calculate the yield value of share By ( step 4 / Number of equity share)

Q. From the following information calculate the value of an equity share 1. The paid capital of the company consist of 2000, 12% preference share of Rs. 100 each and 50,000 equity share of Rs.10 each . 2. The average annual profit of the company after providing for depreciation and taxation amounted to Rs. 64,000 3. The normal rate of return is 10%

Solution Step 1 calculate FMP Net profit after depreciation Less preference share dividend Amount available for equity shareholder (FMP) Step 2 normal rate of return is giver 10% Step 3 capitalization factor 100/10=10 Step 4 capitalized value of maintainable profit 40000 x 10 = 400000 Step 5 yield value 400000 / 50000 = 8

64000 24000 40000

Dividend basis of yield value Step 1 calculate value of Expected rate profit available X 100 Total paid-up equity share Step 2 calculate value of share Expected rate x paid-up value of equity share Normal rate Earning per share basis EPS = earning available to equity share holder / number of equity share Average EPS = paid up value / normal rate of return Value of per share = (EPS / Average EPS) X paid up value of equity share

AMALGAMATION OF LIMITED COMPANIES

Amalgamation means coming together of two or more limited companies for betterment of the business. It includes dissolution of one or more limited companies and formation of one new company. There can be three situations as below: Amalgamationwhen one or more than one existing limited companies come together and form a new limited company to take over their business. Absorptionwhen one existing limited company takes over the business of another existing limited company

External reconstruction when one limited company is newly formed to take over the business of another existing limited company which is a loss making company. The I.C.A.I has issued Accounting Standard 14 governing the procedure and accounting of Amalgamation of companies. Scope: Accounting Standard 14 [ Accounting for Amalgamation], prescribed by the Institute of Chartered Accounts of India, deals with accounting for amalgamations. The meaning and types of amalgamation, according to AS 14 are explained below.

 Amalgamation: Amalgamation means an amalgamation pursuant to the provision of the Companies Act, 1956 or any other statute which may be applicable to the Companies, Amalgamation involves acquisition of one company by another. After Amalgamation, the acquired company is dissolved and ceases to exist. Transferor Company: Transferor Company means the Company which a transferor another Company ( vendor company). Transferee Company: Transferee Company means the Company into which a transferor Company is amalgamated (purchasing company).

Types of Amalgamations There are two types of Amalgamations. (a) Amalgamation in the nature of merger. (b) Amalgamation in the nature of purchase.

Amalgamation in the nature of merger means which satisfies all the following conditions: i. All the assets and liabilities of the transferor company are taken over by the transferee company. ii. Shareholders holding not less than 90% of the face value of equity shares of the transferor company become equity shareholders of the transferee company by virtue of the amalgamation. iii. The consideration for the amalgamation receivable by those equity shareholders of the transferor company who agree to become equity shareholders of the transferee company is discharged by the transferee company wholly by the issue of equity shares in the transferee company, except that cash may be paid in respect of any fractional shares.

iv. The business of the transferor company is intended to be carried on after the amalgamation, by the transferee company. v. No adjustment is intended to be made to the book values of the assets and liabilities of the transferor company when they are incorporated in the financial statements of the transferee company except to ensure uniformity of accounting policies. Amalgamation in the nature of purchase If Amalgamation does not satisfy any one of the above five conditions then it will be regarded as Amalgamation in the nature of purchase.

PURCHASE CONSIDERATION : MEANING

Purchase Consideration is the sale price of the business agreed mutually between the two parties, the transferor company (selling company) and the transferee company (purchasing company). The AS 14 defines the Purchase Consideration as the aggregate of the shares and other securities issue and payment made in the form of cash or otherwise by the transferee company to the SHAREHOLDERS OF THE TRANSFEROR COMPANY.

METHODS OF PURCHASE CONSIDERATION:

a. Lump-sum method: The problem may give the amount of purchase consideration directly and hence there will not be any need to calculate the purchase consideration. e.g. Alka techno Ltd. agrees to take over business of WLC Ltd for a sum of Rs.10 lakhs. b. Net Payment Method: If the purchase consideration is not given Lum-sum then this method should be adopted. Here the purchase consideration is arrived at by adding up cash paid and the agreed values of shares, securities issued by the transferee company to share holders of transferor company in discharge of the purchase consideration. e.g. Engineers Ltd. takes over business of Ramesh Ltd. and agrees to pay the purchase consideration as follows: issue of 10,000 equity shares of Rs.10 each at Rs. 12 each and cash Rs. 50,000. Hence the purchase consideration would be Rs 10,000 equity shares of Rs.10 each at Rs. 12 each 1,20,000 Cash 50,000 Purchase consideration 1,70,000

Net Assets Method : If the purchase consideration can not be calculated by above two methods then this methods should be adopted. It is the aggregate of the assets taken over at agreed values less liabilities taken over at agreed values.

Assets taken over at agreed values,( excluding fictitious assets) ****** Less : Liabilities taken over at agreed value ****** Purchase consideration ******

 Exchange of shares Method / Intrinsic value Method : Under this method the intrinsic value of the shares of both the companies is calculated and then the transferor company issue the shares to the transferee company on the basis of these values.

ACCOUNTING PROCEDURE IN THE BOOKS OF TRANSFEROR COMPANY: Step 1. Open following Ledger Accounts 1. Realization A/c 2. Equity Shareholders A/c 3. Preference Shareholders A/c 4. Cash/ Bank A/c 5. Liabilities not taken over A/c 6. Transferee company's A/c 7. Equity Shares in transferee company A/c 8. Preference Shares in transferee company A/c

Step2. Pass following journal entries Transfer all assets to realization A/c Whether taken over or not , at their book values.
Realization A/c Dr. To Sundry assets A/c
Note: 1.Fictitious assets should not be transferred to realization A/c 2. Cash & bank balance should be transferred to realization A/c only if it taken over by the transferee company 3. Debtors and R.D.D should be treated as separate A/c. Debtors should be transferred at their gross value on debit side and R.D.D should be transferred on the credit side of realization A/c 4. This entry closes all Assets A/c

 Transfer all liabilities which are taken over by the transferee company to realization A/c, credit side Sundry liabilities A/c Dr. To Realization A/c Transfer Equity Share Capital and Reserves to Equity share holders A/c Equity share Capital A/c Dr. x Securities Premium A/c Dr. x Capital Reserve A/c Dr. x C.R.R. A/c Dr. x General Reserve A/c Dr. x Profit & Loss A/c Dr. x To Equity Shareholders A/c x

 Transfer Preference Share Capital to Preference Shareholders A/c Preference Share Capital A/c Dr. x To Preference Shareholders A/c x Record the sale of business Transferee Company A/c Dr. x To Realization A/c x ( with the amount of purchase Consideration) Receive the amount of purchase consideration Equity shares in transferee company A/c Dr x Preference shares in transferee company A/c Dr. x Cash/ Bank A/c Dr. x To Transferee Company A/c x

 Dispose off assets not taken over by the transferee company Cash / Bank A/c Dr. X To Realization A/c X Discharge the liabilities not taken over by the Transferee company. Liability A/c Dr. X Realization A/c ( if loss) Dr. x To Cash / Bank A/c x To Realization A/c ( if Profit) x Payment of realization Expenses Realization A/c Dr. X To Cash/ Bank A/c. X

 Settle the claim of preference shareholders Preference shareholders A/c. Dr. X Realization A/c. (if paid at premium) Dr. X To preference Shares in transferee Co. A/c To Cash/ Bank A/c. To Realization A/c. ( if paid at discount) Balance the Realization A/c. a. If Profit Realization A/c Dr. To Equity shareholders A/c.

X X X

X X

b. If loss Equity shareholders A/c. Dr. X To Realization A/c. X Close the Equity shareholders A/c. Equity shareholders A/c. Dr. X To Equity shares in transferee Co. A/c X To Cash/ bank A/c X

ACCOUNTING PROCEDURE IN THE BOOKS OF TRANSFEREE COMPANY : Following Journal Entries are passed in the books of transferee company. PURCHASE METHOD 1. Recording Purchase of Business Business Purchase A/c Dr. x To Liquidator of transferor company X (The entry should be passed at purchase consideration amount.)

2. Recording of assets and liabilities taken over Sundry assets A/c Dr. x ( With Agreed values) Goodwill A/c (if any) Dr. x To Sundry Liabilities A/c X To Business Purchase A/c X To Capital Reserve A/c X 3. Recording Discharge of purchase consideration Liquidator of transferor company A/c Dr. X Discount on issue of shares A/c Dr. X To Equity Share Capital A/c. X To Preference Share Capital A/c. X To Securities Premium A/c. X

4. Discharge of Liabilities of Transferor Company Debentures of Transferor Company A/c Dr. X Discount on issue of Debentures A/c Dr. X To new Debentures A/c. X To Securities Premium A/c. X 5. Recording of payment of liquidation expenses Capital Reserve/ Goodwill A/c. Dr. X To Cash/Bank A/c. X 6. Recording of Expenses incurred by the transferee company for its own formation. Preliminary Expenses A/c. Dr. X To Cash / Bank A/c X

7. Recoding of Statutory Reserve of transferor company Amalgamation adjustment A/c Dr. X To Statutory Reserve A/c. X 8. Adjusting of mutual indebtedness of transferor & transferee company Sundry Creditors A/c. Dr. X To Sundry Debtors A/c. X

MERGER METHOD 1. Recording Purchase of Business Business Purchase A/c Dr. To Liquidator of transferor company (The entry should be passed at purchase consideration amount.) 2. Recording of assets and liabilities taken over Sundry assets A/c Dr. General Reserve A/c (if any) Dr. To All Reserves of transferor co.(except General reserve) To Sundry Liabilities A/c To Business Purchase A/c To General Reserve A/c (Balancing figure)

3. Recording Discharge of purchase consideration Liquidator of transferor company A/c Dr. Discount on issue of shares A/c Dr. To Equity Share Capital A/c. To Preference Share Capital A/c. To Securities Premium A/c. 4. Discharge of Liabilities of Transferor Company Debentures of Transferor Company A/c Dr. Discount on issue of Debentures A/c Dr. To new Debentures A/c. To Securities Premium A/c.

5. Recording of payment of liquidation expenses General Reserve/ A/c. Dr. To Cash/Bank A/c.

6. Recording of Expenses incurred by the transferee company for its own formation. Preliminary Expenses A/c. Dr. To Cash / Bank A/c
7. Adjusting of mutual indebtedness of transferor & transferee company Sundry Creditors A/c. Dr. To Sundry Debtors A/c.