In business purchase accounting, the meaning of purchase consideration is the price that is paid for the acquisition of another company.
This price can be paid in cash, shares, or other assets. The purchase consideration is used to determine the value of the assets and liabilities acquired in the purchase.
Limited liability companies often purchase other businesses for several reasons. For example, Facebook purchased Instagram to have a more significant influence on social media.
Because new assets are added to the limited liability company, there is a specific accounting treatment for business purchases. In this article, we will explore one concept in particular: purchase consideration.
Purchase Consideration
Suppose one company purchases another business as a going concern (that is, the business will continue to operate for eternity). In that case, it can pay for it using one or more of the following methods:
- Cash: In the first scenario, the acquirer company settles the due payment to the selling company’s owners in cash form. This is a rare scenario as the following two methods are more common.
- Shares: In this option, the transferee company offers some of its shares to the owners of the business that is being purchased (transferee company). It helps the company to keep funds in its own hands to maintain liquidity.
- Debentures: The limited liability company may offer some of its debentures to business owners.
The following two things must be kept in mind when the price of the business is being determined:
- The assets bought are stated at different values in the books of the limited company and the books of the selling business. This is because they are revalued to reflect their current worth in the market. This value is known as the fair value of the assets.
The price paid by the limited company for the business is known as the purchase consideration. In many cases, the purchase consideration is not the same as the net assets bought, and the difference must be recorded in the books of account.
The difference is known as positive goodwill if the purchase consideration is greater than net assets. However, the difference is known as negative goodwill if the purchase consideration is lower than the net assets. The accounting treatment for each of these types of goodwill is different.
Methods of Calculating Purchase Consideration
Calculating the purchase consideration is an important step in any business acquisition or merger. It refers to the total amount that a buyer agrees to pay for acquiring a particular business, including all its assets and liabilities. The calculation of purchase consideration can be complex and involves various methods depending on the nature of the deal.
The following three methods are most popular in computing the purchase consideration when a business takes over another one:
Net Assets Method
The net asset method is a common approach used to calculate the purchase consideration for mergers and acquisitions. Under this method, the value of a company is determined by subtracting its liabilities from its assets. This gives an estimated value of the company’s net assets, which can be used as a basis for determining how much one party should pay to acquire it.
The formula of Purchase Consideration Under the Net Assets Method = Agreed value of assets taken over – The agreed value of liabilities taken over
One advantage of using the net asset method is that it provides a clear and objective way to determine the value of a company. It takes into account all of its assets and liabilities, rather than just focusing on revenue or earnings. However, there are some limitations to this approach as well. For example, it may not take into account intangible assets like brand reputation or intellectual property that can be difficult to quantify.
Payments Method
It refers to the way buyers pay for goods or services they acquire from a seller. Several payment methods are in use, such as cash, checks, credit cards, debit cards, online payments, and mobile payments. The choice of payment method depends on various factors like convenience, security, cost-effectiveness, and availability.
Share Exchange Method
This method involves exchanging shares of the acquiring company for shares of the target company. The exchange ratio is determined by dividing the value of the acquiring company’s share by that of the target company’s share.
The share exchange method is used in cases where both companies are publicly traded and have similar market capitalizations. It helps to avoid cash payments, which can be expensive for the acquiring company. The target shareholders receive shares in a larger and more diversified entity while retaining their ownership interest.
However, this method may not be suitable for all transactions as it can result in dilution for existing shareholders if too many new shares are issued. Additionally, there may be tax implications for shareholders who receive new shares in exchange for their old ones. Overall, companies must carefully consider the pros and cons before deciding on using this method to calculate purchase consideration.
Conclusion
Purchase consideration is the amount that a buyer company promises to pay to the company which is being sold or merged to another company. Purchase consideration is often approximated to the net value of the asset and paid in different forms which can be in cash or in kind. It includes cash paid or any type of shares or securities issued to the transferor company. Net asset, payment method and share exchange method are some of the most practical ways to calculate the value of purchase consideration.
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