Objectives
At the end of this lecture you will be able to:
§ Explain the reasons for absorption in businesses
§ Describe the implication of absorption to a new business
§ Prepare books of accounts for the new business
Contents
§ Motives behind absorption of companies
§ Absorption a Practical illustration
§ Preparation of books of account of a vendor company
§ Preparation of Financial Statements of a new company after
Absorption
1.1 Introduction
This
topic has a relationship with amalgamation; because the two are under one
umbrella of ‘business combination’. Meaning involving a joining force and
enjoying a combination of two entities.
Where
one company acquires the business of another then later company going into
liquidation and its separate existence being terminated, the transaction is
described as amalgamation by absorption. Usually the purchasing company
acquires the whole undertaking i.e. he takes over the whole of the assets and
also discharges the liabilities but in some cases only the assets are
transferred and the liabilities being paid by the vendor company.
In
absorption, one company will be purposely taken over completely by another
company and it disappears completely. The shareholders are paid their cash and
they leave the business. This is slightly different from amalgamation when two
companies decide to join power, and they intentionally form another company,
which is stronger than the two separate companies
1.2 Purchase Consideration on Absorption
A
practical point which arises in absorption is that, the vendor company’s
business may be a valuable one and the sale of it results in a profit to
shareholders. Such profit may arises due to:
a)
Higher price being paid for higher than the amount at which it stands in the
market. (Goodwill)
b)
Reserves being no longer required
c)
The market value of the purchasing company shares being greater than their
nominal value.
With
the purchasing company however, different considerations arise and the shares
issued in payment must be dealt with on the basis of their nominal value.
For
example:
If
company X whose £1 shares stand at a premium, of 50tshs per share, purchases
the undertaking of Company Y for Tshs150,000. Payable in fully paid 1000/=
shares and the net assets acquired at tshs230,000. The purchasing company
apparently makes a profit of Tshs. 80,000/= as it acquires assets worth that
amount in excess of the purchase price. The real effect of the transaction is
that Company X issues shares of the total nominal value of 150,000 at a premium
of 80,000/= and the later amount must be credited to the premium on shares
account. The true intrinsic value of a
share is not its nominal value but its market value. i.e the price a t which it
may be bought or sold. And it will be seen that, the shareholders of the vendor
company receive approximately the true value of the assets transferred.
1.3 Illustration:
Engineers
Ltd Company agreed to acquire Goodwill and assets other than cash of Metals Ltd
as at 31 January 2007. A summary of the statement of financial position of
Metals Ltd in 2007 was as follows
Goodwill
5,000,000
Land
and Buildings 6,700,000
Inventory 10,400,000
Accounts
Receivables 3,800,000
Cash
in hand
2,800,000
Assets
total 89,000,000
Share
capital of Tshs.1 fully paid for 50,000,000
General
reserve 18,000,000
Profit
and Loss 9,000,000
Accounts
Payables 2,000,000
Total
89,000,000
The
consideration payable by engineers Ltd was agreed as follows:
(i)
A cash payments equal
to Tshs. 0.5 for every Tshs. 1 ordinary
share in Metal Ltd
(ii)
The issue of Tshs.
80,000 ordinary shares fully paid in Engineers Ltd having an agreed value of
Tshs. 1.25 per share
(iii)
The issue of such an
amount of fully paid 6% debentures to Engineers Ltd at Tshs. 96,000 as it is
sufficient to be charged the 8% debentures
of Metal Ltd at Tshs. 120,000
(iv)
The liabilities of
Metals Ltd other than debenture were discharged by that company
(v)
When computing the
agreed consideration, the directors of Engineers valued Land, Buildings and
Plant at Tshs. 115,000,000; Inventory at 9,000,000 and Accounts Receivables at
the amount stated on the book value of Metals Ltd subject to an allowance of 5%
to cove doubtful debts.
(vi)
On the sale of its
Assets, Metals Ltd went into voluntary liquidation. The ordinary shareholders
receiving cash and ordinary shares in Engineers Ltd as repayments of their
capital in Metals Ltd.
Required:
a) Prepare
journal entries to record the acquisitions in the books of Engineers Ltd
b) Close
off the books of Metals Ltd
Solution
Calculation
of Purchase Price Tshs
Cash
payments Tshs.0.5 x 50,000,000 . 25,000,000
Ordinary
shares Tshs. 1.00 (80,000,000 x
1.25/=) 100,000,000
6%
Debentures 10,000,000/100 = 100
x120 12,000,000
137,000,000
Closing
Entries in the books of Metals Ltd
Dr.
|
Cr.
|
|
Realisation
account
Goodwill
Land, buildings and Plant
Inventory
Accounts receivables
|
86,200,000
|
5,000,000
67,000,000
7,400,000
3,800,000
|
Engineers
Ltd
Realisation
|
137,000,000
|
137,000,000
|
Bank
Ordinary
Shares in Engineers Ltd
Debentures
in Engineers Ltd
Engineers Ltd
|
25,000,000
100,000,000
12,000,000
|
137,000,000
|
Accounts
Payables
Bank
|
2,000,000
|
2,000,000
|
Ordinary
Share capital
General
Reserve
Profit
and Loss
Realisation
Sundry Shareholders
|
50,000,000
18,000,000
48,000,000
9,000,000
|
125,800,000
|
8%
Debentures
Realisation
Sundry Shareholders
|
10,000,000
2,000,000
|
12,000,000
|
Sundry
shareholders
Ordinary shares in Engineers Ltd
Bank
|
125,000,000
|
100,000,000
25,000,000
|
Sundry
debenture holders
6% debentures in Engineers Ltd
|
12,000,000
|
12,000,000
|
Recording
Acquisitions in the Books of Engineers Ltd
Dr
|
Cr
|
|
Goodwill
Land,
buildings and Plant
Inventory
Accounts
receivables
Provision for doubtful debts
Liquidators of Metals Ltd
|
9,390,000
115,000,000
9,000,000
3,800,000
|
190,000
137,000,000
|
Liquidators
of Metals Ltd
Discounts
on debentures
6% Debentures
Ordinary share capital
Share Premium
Bank
|
137,000,000
500,000
|
12,500,000
80,000,000
20,000,000
25,000,000
|
1.4 Summary of the Topic
In this topic we have explained the
reasons for absorption in businesses, and the distinction between amalgamation
and absorption. In absorption, one company dies completely but in amalgamation
the new company will be formed and it will always have the owners of the
liquidated company. The implication of absorption to a new business is the
existence of one new business after it has totally taken over/buying the other
business
The preparation of the books
of accounts for the new business is similar to that one of amalgamation where a
purchase consideration will be discussed and paid either in cash or in shares.
There are reasons for absorption to both the seller and the purchasing company