When a business, such as a partnership firm, is converted into a company or taken over by another entity, the purchase consideration refers to the amount payable by the purchasing company to the selling entity (partners of the firm) in exchange for the business’s assets and liabilities.
Lump Sum Method
Under the Lump Sum Method, a fixed amount is mutually agreed upon by both parties (the seller and the buyer) as the total purchase consideration. This method is straightforward and does not involve detailed valuation of individual assets and liabilities.
Features
- No need to compute individual asset or liability values.
- The agreed lump sum amount is considered as the purchase consideration.
- This method is generally used when the parties want a quick transaction without detailed valuation.
Example
A partnership firm agrees to sell its business to a company for a lump sum of ₹15,00,000. This amount is the purchase consideration, and no further valuation of assets and liabilities is necessary.
Net Assets Method
In the Net Assets Method, the purchase consideration is calculated as the difference between the total assets taken over by the company and the total liabilities assumed by the company. This method involves valuing each asset and liability at its fair value.
Formula
Purchase Consideration = Total Assets Taken Over − Total Liabilities Assumed
Steps
- List all assets being transferred to the purchasing company.
- Assign fair values to each asset (considering appreciation or depreciation).
- List all liabilities being transferred.
- Deduct the total liabilities from the total value of assets to arrive at the purchase consideration.
Example
- Assets taken over by the company:
- Fixed Assets: ₹20,00,000
- Inventory: ₹5,00,000
- Debtors: ₹4,00,000
- Liabilities taken over by the company:
- Creditors: ₹6,00,000
- Loan: ₹3,00,000
Purchase Consideration = (20,00,000 + 5,00,000 + 4,00,000) − (6,00,000 + 3,00,000) = 29,00,000 − 9,00,000 = ₹20,00,000
In this case, the purchase consideration is ₹20,00,000.
Net Payment Method
Under the Net Payment Method, the purchase consideration is determined as the total amount payable by the company to the selling entity. This includes payments made in cash, shares, or other securities.
Steps
- Determine the mode of payment (cash, equity shares, preference shares, debentures, etc.).
- Calculate the total value of payments to be made by the purchasing company.
- Add up the values of all forms of payment to arrive at the purchase consideration.
Example
A company agrees to take over a partnership firm and makes the following payments:
- Cash payment: ₹10,00,000
- Issue of equity shares (1,000 shares at ₹100 each): ₹1,00,000
- Issue of preference shares (500 shares at ₹200 each): ₹1,00,000
Purchase Consideration = 10,00,000 + 1,00,000 + 1,00,000 = ₹12,00,000
Thus, the total purchase consideration payable by the company is ₹12,00,000.
Comparison of Methods
Method | Basis | Formula/Approach | Use Case |
---|---|---|---|
Lump Sum Method | Agreed fixed amount | Agreed lump sum | When quick valuation and agreement is needed |
Net Assets Method | Fair valuation of assets and liabilities | Assets – Liabilities | When accurate valuation of assets/liabilities is required |
Net Payment Method | Total payment by the company | Sum of cash + shares + securities issued | When purchase consideration involves multiple modes of payment |
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