Absorption of Company is a way of business arrangement in which an existing company takes over the business of the another entity. The entity who gets absorbed goes into the liquidation process. The payment for such absorption to the old entity can be made either in cash or in shares or mixture of both.
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The absorbed company continue to run operations as it was doing before the absorption and staff continue to work under the new management. If any type of fund is being maintained for the employees of the company, it is taken over by the purchasing company.
There are so many reasons of absorption. One of them is that due to the formation of the new company, it will not get the reputation in the market as the old one. So, that is why, purchasing company absorbs an existing company to using its strength to exploit the opportunities exists in the market.
Puchase Consideration in Absorption of Companies
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In absorption questions, students face difficulties in computing the amount of Purchase Consideration. That is why, we have list down the various circumstances so that this difficulty can be removed and make sure you get full marks in the examination hall.
1. Lump Sum Amount – when in the question, purchasing question agrees to pay the vendor company, a lump sum amount, then t his will be taken as Purchase Consideration.
2. Net Asset – If the lump sum payment is not made by the purchasing company, then we have to calculate the net worth of assets taken. Net worth of the asset is calculated as follows:
Value of assets as mutually agreed xxx
Less: Value of liabilities as mutually agreed (xxx)
Purchase Consideration xxx
3. Net Payment – if the absorption invloves payments to shareholders, debenture holders and creditors of the absorbed company. The payment may be in the form of cash, shares and debentures. Purchase consideration is computed as follows:
| Payment to the shareholder of absorbed company | ||
| Shares in purchasing company Debentures issued Cash paid | xxx xxx xxx | xxx |
| Payment to the debenture holders of absorbed company | ||
| Shares in purchasing company Debentures issued Cash paid | xxx xxx xxx | xxx |
| Payment to the liabilities such as Accounts Payable of absorbed company | ||
| Shares in purchasing company Debentures issued Cash paid | xxx xxx xxx | xxx |
4. Value of Shares – if the purchasing company is buying the vendor company on the basis of the value offered per share. For example, Beta company has 20,000 shares. The company Cone approached Beta and offered $ 20 per share which the management has approved and signed the absorption agreement.
Purchase consideration = 20,000 x 20 = $ 400,000
Absorption of companies journal entries
The vendor company needs to close its accounts. In order to do so, there main accounts are opened which are:
- Realisation Account
- Purchasing Company Account
- Shareholders Account
Accountant need to pass on following journal entries in the books of liquidating (vendor) company:
| Date | Particular | Debit | Credit |
| 1 | Realization account Asset taken over (at balance sheet value) (to record transfer of assets to the Realization account) | xxx | xxx |
| 2 | Liabilities taken over (at balance sheet value) Realization account (to record transfer of liabilities to the Realization account) | xxx | xxx |
| 3 | Purchasing company account (amount of purchase consideration) Realization account (to record purchase consideration received) | xxx | xxx |
| 4 | Share in purchasing company account Debenture in purchasing company account Cash Purchasing company account (amount of purchase consideration)(to close the account of purchasing company) | xxx xxx xxx | xxx |
| 5 | Realization account Cash (to record the payment of liquidation expense if any) | xxx | xxx |
| 6 | Capital account Retained earnings account General reserve account Share premium account Shareholders account (to record transfer of equities in to the shareholder account) | xxx xxx xxx xxx | xxx |
| 7 | Shareholders account Share in purchasing company account Debenture in purchasing company account Cash Realization account (balancing figure) (to close shareholder account) | xxx | xxx xxx xxx xxx |
Example
The balance sheet of Alpha on 31st Dec, 2011 is as follows:
| Total assets | $1,000,000 |
| Share capital $100 each) | 600,000 |
| Profit & Loss account | 240,000 |
| Creditors | 160,000 |
After detailed discussion, it was decided that the Alpha should be absorbed into Beta . In order to complete the process of absorption, Beta will issue 4 shares of $100 each for three shares held in the Alpha. All liabilities and assets were taken over by the Beta at the book value.
Required:
Pass journal entries in the books of
a. Alpha, B. Beta
Solution
| Shares in Beta (8,000 x 100) | $800,000 |
| If 03 old shares, so new shares = 4 | |
| If 01 old shares, so new shares = 4/3 | |
| If 6,000 old shares, so new shares = 4/3 x 6,000 = 8,000 shares |
Alpha Company
Closing Entries
| Description | Debit | Credit |
| Realization account | 1,000,000 | |
| All assets | 1,000,000 | |
| Creditors | 160,000 | |
| Realization account | 160,000 | |
| Receivable from Beta | 800,000 | |
| Realization account | 800,000 | |
| Shares in Beta | 800,000 | |
| Receivable from Beta | 800,000 | |
| Share capital | 600,000 | |
| Profit & Loss account | 240,000 | |
| Realization account | 40,000 | |
| Shareholders | 800,000 | |
| Shareholders | 800,000 | |
| Shares in Beta | 800,000 |
Beta Company
Journal Entries
| Description | Debit | Credit |
| All assets | 1,000,000 | |
| Capital reserve | 40,000 | |
| Creditors | 160,000 | |
| Payable to Alpha | 800,000 | |
| Payable to Alpha | 800,000 | |
| Share capital | 800,000 |
Example
The following balance appeared in the balance sheet of YKT as on 30 June 2013:
| Assets | Equities | ||
| Cash | 20,000 | Accounts payable | 20,000 |
| Accounts receivables | 60,000 | Bonds payable | 100,000 |
| Inventory | 160,000 | Ordinary Share capital $10 each | 600,000 |
| Land & building | 240,000 | Reserves – general | 160,000 |
| Plant & machinery | 400,000 | Retained earnings | 120,000 |
| Goodwill | 120,000 | ||
| Total | 1,000,000 | Total | 1,000,000 |
YKT is absorbed by another company DS on the terms and conditions given below:
- Accounts payable is to be cleared by YKT.
- All assets will be taken at book values except cash.
- The purchase consideration for the absorption deal is as follows:
- A cash payment of $ 4 for every share of YKT.
- The issue of one share of $ 10 each in DS for every share held in YKT. (The market value of the share is $ 12.5).
- 1100 Bonds will be issued at $ 100 each in DS to enable the YKT in discharging its bonds at a premium of 10 {1bb28fb76c3d282be6cfd0391ccf1d9529baae691cd895e2d45215811b51644c}.
Required
- Compute the value of purchase consideration.
- Pass on necessary entries in the books of YKT and DS.
Solution
Purchase consideration
Shares in DS (60,000 X 12.5) 750,000
Bonds in DS Company (1100 x 100) 110,000
Payment in cash (60,000 x 4) 240,000
Purchase consideration 1100,000
YKT
Journal Entries – For Closing
| Description | Debit | Credit |
| To close all asset accounts, following entry is passed on: | ||
| Realization account | 980,000 | |
| Accounts receivables | 60,000 | |
| Inventories | 160,000 | |
| Plant & machinery | 400,000 | |
| Land & building | 240,000 | |
| Good will | 120,000 | |
| To record the payments of accounts payable, we will pass on this entry: | ||
| Accounts payable | 40,000 | |
| Cash | 40,000 | |
| Now, we will record purchase consideration: | ||
| Receivable from DS | 1100,000 | |
| Realization account | 1100,000 | |
| To record amount received from DS, we will pass this entry: | ||
| Shares in DS | 750,000 | |
| Cash | 240,000 | |
| 10% bonds in DS | 110,000 | |
| Receivable from DS | 1100,000 | |
| To record interest on bonds, the following entry is passed on: | ||
| Realization account | 10,000 | |
| Interest on bonds | 10,000 | |
| To record close of bond with interest over it: | ||
| Interest on bonds | 100,000 | |
| Bonds payable | 10,000 | |
| Bondholders | 110,000 | |
| To record distribution of bonds to bondholders | ||
| Bondholders | 110,000 | |
| 10% bonds in DS | 110,000 | |
| To record transfer of equities to shareholders | ||
| Share capital | 600,000 | |
| Retained earnings | 120,000 | |
| General reserve | 160,000 | |
| Realization account | 110,000 | |
| Shareholders | 990,000 | |
| To record distribution of cash & shares to shareholders: | ||
| Shareholders | 990,000 | |
| Cash | 750,000 | |
| Shares in DS | 240,000 |
DS Company
Journal Entries
| Description | Debit | Credit |
| To record the taking over of the assets of YKT: | ||
| Accounts receivable | 980,000 | |
| Inventories | 60,000 | |
| Land & building | 160,000 | |
| Plant & machinery | 400,000 | |
| Goodwill | 240,000 | |
| Payable to YKT | 120,000 | |
| To record issue of shares, bond and cash payment: | ||
| Payable to YKT | 1100,000 | |
| Share capital | 750,000 | |
| 10% bond payable | 240,000 | |
| Cash | 110,000 |