MCM604_Advanced Financial Accounting

US GAAPS 43 The following are the Extract of the International Accounting Standards and International Financial Reporting Standards, prepared by IASC Foundation staff. (The same has not been approved by the IASB. For the requirements reference must be made to International Financial Reporting Standards.) Other accounting literature, including FASB concepts statements, APB Statements; AICPA Issues Papers; International Accounting Standards Committee Statements; Pronouncements of other professional associations or regulatory agencies ; AICPA Technical Practice Aids; and accounting textbooks, handbooks, and articles. The U.S. Securities and Exchange Commission (SEC) has statutory authority to establish financial accounting and reporting standards for publicly held companies under Securities Exchange Act of 1934. 4.8 Key Words/Abbreviations z AICPA: The AICPA sets generally accepted professional and technical standards for CPAs in many areas. z Financial Accounting Standards Board (FASB): The Financial Accounting Standards Boards (FASB) is private 4.9 Learning Activity 1. Discuss briefly about the Financial Accounting Standard Board (FASB). _________________________________________________________________ _________________________________________________________________ 2. Explain the principles of US GAAP. _________________________________________________________________ _________________________________________________________________ CU IDOL SELF LEARNING MATERIAL (SLM)

44 Advanced Financial Accounting 3. Explain the International Accounting Standards. _________________________________________________________________ _________________________________________________________________ 4.10 Unit End Questions (MCQs and Descriptive) A. Descriptive Type Questions 1. Explain about the components of GAAP. 2. Explain about the accounting standards 31. B. Multiple Choice/Objective Type Questions 1. IAS 42 shows about __________. [a] Investment property [b] Financial Instrument [c] Agriculture [d] None 2. IAS 38 shows about __________. [a] Agriculture [b] Intangible assets [c] Investment property [d] Financial Instrument 3. Revenue comes under __________. [a] IAS 19 [b] IAS 20 [c] IAS 18 [d] IAS 21 Answers 1. [c], 2. [b], 3. [c] CU IDOL SELF LEARNING MATERIAL (SLM)

US GAAPS 45 4.11 References 1. Arulanandam and Raman, Advanced Accountancy, Himalaya Publication House Pvt. Ltd., Edition 2018. 2. Dr. Vishwanathan Reddy and Jayaram Kanzal, Corporate Accounting, Himalaya Publication House Pvt. Ltd., Edition 2019. 3. Dr. S.N. Maheswari, Financial Accounting, Vikas Publication, Edition 2017. 4. S.P. Jain and K.L. Narang, Financial Accounting, Kalyani Publication, Edition 2018. 5. Reddy, K.R. (2000), “Accounting Standards and Gaps in Practices in India”, Management Accountant, ICWAI, April. 6. http://www.mca.gov.in/MinistryV2/accountingstandards1.html 7. http://www.accountingnotes.net/amalgamation/external-reconstruction-and-amalgamation 8. http://www.yourarticlelibrary.com/accounting/problems-accounting/amalgamation-and- external-reconstruction ˆˆˆ CU IDOL SELF LEARNING MATERIAL (SLM)

46 Advanced Financial Accounting UNIT 5 PREPARATION OF COMPANY ACCOUNTS UNDER VARIOUS CIRCUMSTANCES Structure: 5.0 Learning Objectives 5.1 Introduction 5.2 Meaning of Mergers 5.3 Varieties of Mergers 5.4 Meaning ofAcquisitions 5.5 Types ofAcquisitions 5.6 Distinction between Mergers andAcquisitions 5.7 Accounting for Mergers andAcquisitions 5.8 Methods ofAccounting forAmalgamation 5.9 Methods ofAccounting for Mergers andAcquisitions 5.10 Summary 5.11 Key Words/Abbreviations 5.12 LearningActivity 5.13 Unit End Questions (MCQs and Descriptive) 5.14 References CU IDOL SELF LEARNING MATERIAL (SLM)

Preparation of Company Accounts under Various Circumstances 47 5.0 Learning Objectives After studying this chapter, you will be able to: z Explain the preparation of Company Accounts under various circumstances z Understand the introduction to Merger z Learn the concept of varieties of mergers z Learn the concept of acquisition and types of acquisition z Discuss the distinction between mergers and acquisition, accounting for mergers and acquisitions, and methods of accounting. 5.1 Introduction The term ‘merger’ is not defined under the Companies Act, 1956 (“CA 1956”), and under Income Tax Act, 1961 (“ITA”). However, the Companies Act, 2013 (“CA 2013”) without strictly defining the term explains the concept. A ‘merger’is a combination of two or more entities into one; the desired effect being not just the accumulation of assets and liabilities of the distinct entities, but organization of such entity into one business. On 7th November, 2016, Central Government issued a notification for enforcement of sections 230-233, 235-240, 270-288 etc. w.e.f. 15th December, 2016. But still rules were not available till date for CAA. MCA vide notification dated 14th December, 2016 has issued rules, i.e., The Companies (Compromises, Arrangements and Amalgamations) Rules, 2016. These rules will be effective from 15th December, 2016. Consequently, w.e.f. 15th December, 2016 all the matters relating to Compromises, Arrangements, and Amalgamations (hereafter read as “CAA”) will be dealt as per provisions of Companies Act, 2013 and The Companies (Compromises, Arrangements, and Amalgamations) Rules, 2016. Where a compromise or arrangement is proposed for the purposes of or in connection with scheme for the reconstruction of any company or companies, or for the amalgamation of any two or more companies, the petition shall pray for appropriate orders and directions under section 230 read with Section 232 of the Act. CU IDOL SELF LEARNING MATERIAL (SLM)

48 Advanced Financial Accounting Demerger – Means transfer and vesting of an undertaking of a company into another company. Reconstruction – Means re-organization of share capital in any manner, varying the rights of shareholders and/or creditors. Arrangement – All modes of reorganizing the share capital, including interference with preferential and other special rights attached to shares. 5.2 Meaning of Mergers Merger refers to a situation when two or more existing firms combine together and form a new entity. A merger involves the mutual decision of two companies to combine and become one entity; it can be seen as a decision made by two “equals”. Benefits of a Merger The benefits of mergers are as follows: (i) Competition are very limited. (ii) Utilize under utilized market power. (iii) Overcome the problem of slow growth and profitability in the industry. (iv) Achieves diversification. (v) Gain economies of scale and increase income with proportionately less investment. (vi) Utilize underutilized resources – human and physical and managerial skills. (vii) Displace existing management. (viii) Circumvent government regulations. (ix) Reap speculative gains attendant upon new security issue or change in P/E ratio. (x) Create an image of aggressiveness and strategic opportunities, empire building, etc. 5.3 Varieties of Mergers (i) Horizontal Mergers (ii) Vertical Mergers (iii) Concentric Mergers (iv) Conglomerate Mergers CU IDOL SELF LEARNING MATERIAL (SLM)

Preparation of Company Accounts under Various Circumstances 49 (i) Horizontal Mergers Horizontal mergers are combinations of firms engaged in the same business. This is a merger occurring between companies in the same industry. Horizontal merger is a business consolidation that occurs between firms who operate in the same space, often as competitors offering the same good or service. Horizontal mergers are common in industries with fewer firms as competition tends to be higher and the synergies and potential gains in market share are much greater for merging firms in such an industry. Example: A merger between Coca-Cola and the Pepsi beverage division, for example, would be horizontal in nature. The goal of a horizontal merger is to create a new, larger organization with more market share. Because the merging companies' business operations may be very similar, there may be opportunities to join certain operations, such as manufacturing and reduce costs. (ii) Vertical Mergers Vertical mergers are combination of different firms engaged in activities complimentary to each other like supply of raw materials, production of goods and marketing. For example, combination of firms engaged in mining of iron ore, and iron and steel company. A vertical merger occurs when two or more firms, operating at different levels within an industry's supply chain, merge operations. Most often the logic behind the merger is to increase synergies created by merging firms that would be more efficient operating as one. Example: A vertical merger joins two companies that may not compete with each other, but exist in the same supply chain. An automobile company joining with a parts supplier would be an example of a vertical merger. Such a deal would allow the automobile division to obtain better pricing on parts and have better control over the manufacturing process. The parts division, in turn, would be guaranteed a steady stream of business. (iii) Concentric Mergers Concentric mergers are combination of firms related to each other in terms of customer groups or customer functions or alternative technologies. For example: combination of firms producing televisions, washing machines and kitchen appliances. CU IDOL SELF LEARNING MATERIAL (SLM)

50 Advanced Financial Accounting (iv) Conglomerate Mergers Conglomerate mergers are the combination of firms unrelated to each other in terms of customer groups, customer functions and alternative technologies. For example: combination of a publishing company and an automobile company. There are two types of conglomerate mergers: pure and mixed. Pure conglomerate mergers involve firms with nothing in common, while mixed conglomerate mergers involve firms that are looking for product extensions or market extensions. Example: A leading manufacturer of athletic shoes merges with a soft drink firm. The resulting company is faced with the same competition in each of its two markets after the merger as the individual firms were before the merger. 5.4 Meaning of Acquisitions Acquisition refers to the acquiring of ownership right in the property and asset without any combination of companies. Thus, in acquisition two or more companies may remain independent, separate legal entity but there may be change in control of companies. 5.5 Types of Acquisitions Horizontal Acquisition Two companies come together with similar products/services. By merging, they are expanding their range but are not essentially doing anything new. Vertical Acquisition Two companies join forces in the same industry but they are at different points on the supply chain. They become more vertically integrated by improving logistics, consolidating staff and perhaps reducing time to market for products. A clothing retailer who buys a clothing manufacturing company would be an example of a vertical merger. Conglomerate Acquisition Two companies in different industries join forces or one takes over the other in order to broaden their range of services and products. This approach can help reduce costs by combining back office activities as well as reduce risk by operating in a range of industries. CU IDOL SELF LEARNING MATERIAL (SLM)

Preparation of Company Accounts under Various Circumstances 51 Concentric Acquisition In some cases, two companies will share customers but provide different services. An example would be Sony who manufacture DVD players but who also bought the Columbia Pictures movie studio in 1989. Sony was now able to produce films to be able to be played on their DVD players. Indeed, this was a key part of the strategy to introduce Sony Blu-Ray DVD players. 5.6 Distinction between Mergers and Acquisitions MERGER ACQUISITION 1. The merger means the fusion of two or more 1. When one entity purchases the business of than two companies voluntarily to form a new another entity, it is known as acquisition. company. 2. The mutual decision of the companies going 2. Friendly or hostile decision of acquiring and through mergers. acquired companies. 3. Minimum number of companies involved is 3. 3. Minimum number of companies involved is 2. 4. To decrease competition and increase 4. For instantaneous growth. operational efficiency. 5. Generally, the size of merging companies 5. The size of the acquiring company will be is more or less same. more than the size of acquired company. 6. Legal formalities are more. 6. Legal formalities are less. 5.7 Accounting for Mergers and Acquisitions Amalgamation in the Nature of Merger (a) All the assets and liabilities of the transferor company become, after the amalgamation, the assets and liabilities of the transferee company, i.e., the company into which transferor company is amalgamated. (b) Shareholders holding not less than 90% of the face value of the equity shares of the transferor company (other than the equity shares already held therein, immediately before the amalgamation, by the transferee company or its subsidiaries or their nominees) transferee company by virtue of the amalgamation. CU IDOL SELF LEARNING MATERIAL (SLM)

52 Advanced Financial Accounting (c) The consideration for the amalgamation receivable by those equity shareholders of the transferor company who agree to become the equity shareholders of the transferee company is discharged by the transferee company wholly by the issue of equity shares in the transferee company. (d) The business of the transferor company is intended to be carried on, after the amalgamation, by the transferee company. (e) 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 (a) The assets and liabilities of the transferor company is incorporate in the books of transferee company at adjusted values. (b) All the assets and liabilities of the transferee company do not become the liabilities of the transferee company after amalgamation. (c) Shareholders holding not less than 90% of the face value of the equity shares of the transferor company do not become equity shareholders of the transferee company by virtue of the amalgamation. (d) This type of amalgamation is in effect a mode by which one company acquires another company. 5.8 Methods of Accounting for Amalgamation The different methods of accounting for amalgamation are as follows: 1. The Pooling of Interest Method. 2. Purchase Method. 1. The Pooling of Interest Method The pooling of interest method, all assets and liabilities of transferor company will be incorporated in the books of transferee company. The use of this method is confined to the ‘merger’ type of amalgamation. The following are the salient features of this method: CU IDOL SELF LEARNING MATERIAL (SLM)

Preparation of Company Accounts under Various Circumstances 53 (i) In the books of the transferee company, all the assets, liabilities and reserves of the transferor company should be recorded at their existing carrying amounts and in the same form as at the date of amalgamation. The exception is the adjustments need to follow uniformity in accounting policies. (ii) If any conflicting accounting policies are followed by the transferor and transferee companies on the date of amalgamation, the effects on the financial statements of any changes in the accounting policies should be reported in accordance with AS 5 ‘Prior period and extraordinary items and changes in accounting policies.’ (iii) The balance of the profit and loss account of the transferor company should be aggregated with the corresponding balance of the transferee company or it may be transferred to the general reserve account. (iv) All the reserves of the transferor company are merged with reserves of the same title in the transferee company. If similar reserve does not exit in the transferee company, the have to be separately shown. Thus, general reserve is merged with general reserve, capital reserve is merged with capital reserve. If there is dividend equalisation reserve in the transferor company and no such reserve exists in the transferor company and no such reserve exists in the transferee company, it should be separately shown in the transferee company’s books. (v) Any excess amount paid as purchase consideration as shown by the difference between the amount recorded as share capital issued and other amounts paid as purchase price to transferor company’s shareholders and he amount of share capital of the transferor company should be adjusted in reserves. Pooling of interests method has no specific effect on the books of the transferor company. 2. Purchase Method In the case of purchase method, only assets and liabilities taken over by transferee company, will be incorporated in the books of transferee company. CU IDOL SELF LEARNING MATERIAL (SLM)

54 Advanced Financial Accounting When amalgamation is considered to be an amalgamation in the nature of purchase, it should be accounted for under the purchase method whose main features are as given below: (i) In the books of the transferee company, the assets and liabilities taken over from transferor company should be incorporated either: (a) at their existing carrying amounts or alternatively, (b) the consideration should be allocated to individual identifiable assets and liabilities on the basis of their fair values on the date of amalgamation. (ii) Transferor company’s reserves, whether capital or revenue or arising on revaluation, other than statutory reserves should not be recorded in the transferee company’s books. (iii) However, statutory reserves in the transferor company’s books, if they should be continued for some specific future period, should be recorded in the transferee company’s books. The corresponding debit should be to ‘Amalgamation Adjustment account’. When the continuance of the reserve is not required, a reserve entry can be passed to close the reserve as well as ‘Amalgamation Adjustment Account.’ Till such time, the ‘Amalgamation Adjustment Account’ is shown on the assets side of Balance sheet under the heading ‘Miscellaneous Expenditure’. (iv) Purchase consideration paid by the shares or debentures issued, showing face value, premium and discount on issue separately. (v) If the purchase consideration agreed to be paid exceeds the net assets taken over, the excess amount should be debited to ‘Goodwill Account.’ If the amount of consideration is less than the value of the net assets acquired the difference should be treated as ‘Capital Reserve.’ (vi) The goodwill arising on amalgamation should be written off to the profit and loss account in a systematic manner over manner over its useful life. Normally, the period to write off the goodwill should not exceed five years, unless a longer period can be justified. CU IDOL SELF LEARNING MATERIAL (SLM)

Preparation of Company Accounts under Various Circumstances 55 5.9 Methods of accounting for Mergers and Acquisitions The various steps for calculating of mergers and acquisitions are as follows: A. Calculation of Purchase Consideration B. Ascertainment of Discharge of Purchase Consideration C. Closing Entries in the Books of Vendor or Transferor Company. D. Opening Entries in the Books of Purchasing or Transferee Company. A. Purchase Consideration According to AS 14, “purchase consideration is the aggregate of the shares and other securities issued and the payment made in the form of cash or other assets by the transferee company to the shareholders of the transferor company.” Methods of Calculating Purchase Consideration 1. Lumpsum Method. 2. Net Payments Method. 3. Net Assets Method. 4. Intrinsic Value method. The methods are explained below: 1. Lumpsum Method When the purchase consideration amount is mentioned in the problem, then the lump sum method is used for finding purchase consideration. Under this method, no further calculation is required. A lump sum amount may be stated as purchase consideration. Example: A Ltd. purchases the business of B Ltd. for a consideration of ` 10,00,000. Illustration - 1 Total purchase is ` 2,60,000 which is to be discharged by issue of 16,000 equity shares of ` 10 each and ` 1,00,000 in cash. Show the purchase consideration. CU IDOL SELF LEARNING MATERIAL (SLM)

56 Advanced Financial Accounting Solution: Calculation of Purchase Consideration: Payment to Shareholders ` 1. Equity Shares 16,000 Equity shares of ` 10 each (16,000 × 10) 1,60,000 2. Cash 1,00,000 Purchase Consideration 2,60,000 2. Net Payment Method Under this method, purchase consideration is calculated by adding all payments (in the form of cash, shares and debentures in the new company) to be made to the liquidator of the vendor company. This method can be adopted only when all modes of payment are given in the question. If some payment is missing in the question, this method cannot be adopted. While determining the purchase price under the ‘Net payment’ method, the following are to be noted: 1. The assets and liabilities taken over by the purchasing company and the values at which they are taken over are not relevant to compute the purchase price. 2. All payments agreed upon should be added, whether it is for equity shareholders or preference shareholders. 3. If any liability is ‘Taken over’ by purchasing company to be discharged later on, such amount should not be deducted or added while computing purchase price. 4. Even if liquidation expenses of the selling company are agreed to be paid by the purchasing company, they should not be added to purchase price. Illustration - 2 Balance Sheet of A Ltd. shows the following on 31-3-2018: 1,00,000 equity shares of ` 10 each fully paid ` 10,00,000 50,000 5% preference shares of ` 10 each fully paid ` 5,00,000 6% debentures ` 5,00,000 CU IDOL SELF LEARNING MATERIAL (SLM)

Preparation of Company Accounts under Various Circumstances 57 B Ltd. acquired A Ltd. on the same date and agreed to pay the following: (a) 50,000 equity shares of ` 10 @ ` 12 each, 30,000, 8% preference shares of ` 10 each and 7% debentures to the extent of ` 2,00,000 to the equity shareholders of A Ltd. (b) 30,000 equity shares of ` 10 @ ` 12 each and 20,000, 8% preference shares of ` 10 each to the 5% preference shareholders of A Ltd. Calculate Purchase Consideration. Solution: In the books of A Ltd. Calculation of Purchase Consideration Particulars ` (a) Payment to Equity Shareholders 1. Equity shares (50,000 × ` 12 each) 6,00,000 2. 8% Preference shares (30,000 × ` 10 each) 3,00,000 3. 7% Debentures 2,00,000 (b) Payment to Preference Shareholders 1. Equity shares (30,000 × ` 12 each) 3,60,000 2. 8% Preference shares (20,000 × ` 10 each) 2,00,000 Total Purchase Consideration 16,60,000 3. Net Asset Method Under this method, the amount of purchase consideration is determined on the basis of assets and liabilities taken over at agreed values. If nothing is mentioned about the values at which assets and liabilities are taken over, then the book values of assets and liabilities are to be taken. The purchase consideration is determined as follows: Purchase consideration = Assets taken over at agreed value – Liabilities taken over at agreed values. CU IDOL SELF LEARNING MATERIAL (SLM)

58 Advanced Financial Accounting Net assets method has to be followed when full information is not given about payments to different ‘claimants’in selling company. The following relevant points are to be noted while ascertaining the purchase price under the net assets method. 1. When a company takes over another company or the ‘business’ of another company, it implies that both assets and liabilities are taken over. 2. The term ‘Assets’ taken over includes cash and bank balances also. However, losses shown on the assets side of balance sheet are not to be taken as assets. 3. Any specific assets not taken over should be ignored while computing the purchase price. 4. ‘Liabilities’ includes all amounts due to third parties. 5. ‘Trade liabilities’ include Creditors and Bills payable. Other liabilities like bank overdraft, tax payable and outstanding expenses are not a part of trade liabilities. 6. Accumulated profits do not form part of liabilities, they belong to the shareholders. 7. If any ‘fund’ or portion of ‘fund’ denotes liability to third parties, it has to be included in the ‘liabilities’. Examples are Staff Provident fund, workmen’s savings Bank Account, Workmen’s Profit Sharing Fund, etc. 8. Liabilities ‘not taken over’ should be excluded from the computation of net assets. Illustration - 3 Calculate the purchase consideration. Total assets at book values = ` 5,00,000 Assets are taken over at 10% less than book values Total liabilities = ` 2,00,000 Liabilities not taken over = ` 50,000 Liquidation expenses of ` 5,000 is to be borne by the purchasing company. Solution: Assets taken over (5,00,000 – 50,000) 4,50,000 Less: Liabilities taken over (2,00,000 – 50,000) 1,50,000 Purchase Consideration 3,00,000 CU IDOL SELF LEARNING MATERIAL (SLM)

Preparation of Company Accounts under Various Circumstances 59 Illustration - 4 Calculate the purchase consideration: Total assets at book value ` 2,50,000 Assets taken over at 10% less than book value Total liabilities ` 1,00,000 Liabilities not taken over ` 25,000 Liquidation expenses of ` 5,000 is to be borne by the purchasing company. Solution: Calculation of Purchase Consideration Particulars ` Total Assets at Book Value 2,50,000 Less: 10% Less than Book Value 25,000 Total Assets 2,25,000 Total Liabilities 1,00,000 Less: Liabilities not taken 25,000 Total Liabilities 75,000 Purchase Consideration: Assets – Liabilities = (2,25,000 – 75,000) 1,50,000 4. Intrinsic Value Method In the net asset method, purchase consideration is calculated on the basis of net assets of the vendor company. The purchase consideration is discharged in the form of shares, cash, etc. Sometimes, a student is asked to calculate the intrinsic value of shares of both companies and determine the ration of exchange of the shares between the vendor company and purchasing company. Intrinsic value of shares is calculated as follows: Intrinsic value per share = Net assets available to equity shareholders Number of equity shares CU IDOL SELF LEARNING MATERIAL (SLM)

60 Advanced Financial Accounting Net assets = Total Assets (excluding fictitious assets) – All Outside Liabilities and Preference share capital. Illustration - 5 X Ltd. agrees to amalgamate Y Ltd. The balance sheets of the two companies are given below. Balance Sheet of X Ltd. Liabilities ` Assets ` Share capital – 15,000 shares of Fixed assets 2,00,000 ` 10 each 1,50,000 Reserve Fund 85,000 Investments 50,000 Profit & Loss A/c 65,000 Current Assets 1,70,000 7% Debentures 50,000 Current Liabilities 70,000 4,20,000 4,20,000 Balance Sheet of Y Ltd. Liabilities ` Assets ` Share capital: 10,000 shares Fixed Assets 90,000 of ` 10 each 1,00,000 Current Assets 80,000 Reserve Fund 13,000 General Reserve 7,000 Current Liability 50,000 1,70,000 1,70,000 Find out the ratio of exchange of shares on the basis of intrinsic value. CU IDOL SELF LEARNING MATERIAL (SLM)

Preparation of Company Accounts under Various Circumstances 61 Solution: Calculation Intrinsic Value of Shares Particulars X Ltd. Y Ltd. ` ` Assets: Fixed Assets 2,00,000 90,000 Investments 50,000 – Current Assets 1,70,000 80,000 Total Assets 4,20,000 1,70,000 Less: Liabilities: Debentures Current liabilities 1,20,000 50,000 Total Liabilities 3,00,000 1,20,000 Intrinsic Value per Share 3,00,000 1,20,000 15,000 10,000 = ` 20 = ` 12 Calculation of ratio of exchange: LCM of intrinsic values of shares = ` 60 Therefore, 3 shares of X Ltd. = ` 60 5 shares of Y Ltd. = ` 60 Thus, the intrinsic values of exchange are 3 shares of X Ltd. for every 5 shares of Y Ltd. Hence, X Ltd. will issue 6,000 shares (10,000 × 3/5) towards purchase consideration. CU IDOL SELF LEARNING MATERIAL (SLM)

62 Advanced Financial Accounting B. Discharge of Purchase Consideration Under the net payment method, the discharge of purchase consideration is same as calculation of purchase consideration. Under the net assets method and lump sum method, the discharge of purchase consideration based on the information in the problem must be ascertained. When the problem is not having any information about discharge of purchase consideration, it should be assumed that purchase consideration is discharged by issue of equity shares of purchasing company. Problems on Purchase Consideration and Discharge of Purchase Consideration Illustration - 6 Calculate the purchase consideration from the following. (i) Value of assets as per balance sheet ` 25,12,750. (ii) Agreed value of assets taken over ` 18,21,570 (iii) Liabilities as per balance sheet ` 3,21,570. (iv) Liabilities not taken over ` 21,570. Solution: Calculation of Purchase Consideration Particulars ` Assets taken over: Agreed value of assets taken over (A) 18,21,570 Liabilities taken over: Liabilities as per balance sheet 3,21,570 Less: Liabilities not taken over 21,570 Liabilities taken over (B) 3,00,000 Purchase Consideration (A – B) 15,21,570 CU IDOL SELF LEARNING MATERIAL (SLM)

Preparation of Company Accounts under Various Circumstances 63 Illustration - 7 Bhoomika Ltd. is taken over by Chaitra Ltd. on the following terms: The assets and liabilities of Bhoomiak Ltd., shall be valued at ` 30,00,000 and `10,00,000 respectively. ` 5,000 shall be paid in cash and the balance of consideration shall be discharged by issue of shares of ` 10 each at a premium of 50%. Show the calculation of purchase consideration and also state the number of shares issued to the shareholders of Bhoomika Ltd. Solution: Calculation of Purchase Consideration Particulars ` Agreed value of asset taken over 30,00,000 Less: Liabilities taken over 10,00,000 Purchase Consideration 20,00,000 Statement showing Discharge of Purchase Consideration Mode of discharge ` Payment of Cash 5,000 Issue of share 10 each at ` 15 per share 19,95,000 Purchase Consideration 20,00,000 * No. of issued shares = 19, 95, 000 = 1,33,000 15 CU IDOL SELF LEARNING MATERIAL (SLM)

64 Advanced Financial Accounting Illustration - 8 Bindu Ltd. was agreed to be acquire by Indu Ltd. as on 31.3.2018 on this date the balance sheet of Bindu Ltd. was as follows: Liabilities ` Assets ` 50000 Equity shares of Fixed Assets 9,00,000 ` 10 each 5,00,000 Current Assets 2,00,000 General Reserve 2,00,000 Profit and Loss A/c 1,50,000 5% Debenture 1,20,000 Sundry Creditors 1,30,000 11,00,000 11,00,000 Indu Ltd. agreed to acquire fixed assets at 10% more than the book value but current assets were valued only at ` 1,50,000. The purchase consideration was paid 50% in equity shares of ` 10 each and balance in cash. Determine the purchase consideration and also show the discharge of purchase consideration. Solution: Calculation of Purchase Consideration Particulars ` (A) Assets taken over Fixed Assets 9,90,000 (9,00,000 × 10% = 90,000 + 9,00,000) Current Assets 1,50,000 Total Assets 11,40,000 CU IDOL SELF LEARNING MATERIAL (SLM)

Preparation of Company Accounts under Various Circumstances 65 (B) Liabilities taken over 5% Debentures 1,20,000 Sundry Creditors 1,30,000 Total liabilities 2,50,000 Purchase Consideration (A – B) 8,90,000 Discharge of Purchase Consideration Issue of 44,500 Equity Shares of ` 10 each 4,45,000 Balance in Cash 4,45,000 Purchase Consideration 8,90,000 Illustration - 9 Following are the Balance Sheet of C Ltd. and D Ltd. as at 31.03.2018. Liabilities C Ltd. D Ltd. Assets C Ltd. D Ltd. ` ` `` Equity share capital 1,50,000 1,50,000 Land and Buildings 1,00,000 1,50,000 (15,000 shares) Plant and Machinery 1,50,000 1,25,000 Reserves and Surplus 50,000 1,00,000 Debtors 25,000 50,000 12% Debentures 1,00,000 1,00,000 Stock 75,000 75,000 Creditors 60,000 60,000 Cash 10,000 10,000 3,60,000 4,10,000 3,60,000 4,10,000 C Ltd. and D Ltd. amalgamate their business and form a new company called DC Ltd. The assets of both the companies are valued as follows: CU IDOL SELF LEARNING MATERIAL (SLM)

66 Advanced Financial Accounting Fixed assets 25% more Stock 15% less and Debtors 10% less The purchase consideration is discharged by the issue to both companies, sufficient number of equity shares of ` 10 each in DC Ltd. at an agreed value of ` 12.50 per share. Calculate purchase consideration and state the number of equity shares issued to each company. Solution: Calculation of Purchase Consideration Particulars C. Ltd. D. Ltd. `` Assets taken over: Land & Buildings 1,25,000 1,87,500 Plant & Machinery 1,87,500 1,56,250 Stock 63,750 63,750 Debtors 22,500 45,000 Cash 10,000 10,000 4,08,750 4,62,500 Less: Liabilities taken over: 12% Debentures 1,00,000 1,00,000 Creditors 60,000 60,000 Purchase Consideration 2,48,750 3,02,500 Number of Equity Shares issued 2,48,750 3,02,500 12.5 12.5 19,900 24,200 CU IDOL SELF LEARNING MATERIAL (SLM)

Preparation of Company Accounts under Various Circumstances 67 C. Journal Entries in the Books of Vendor or Transferor Company Journal Entries in the Books of Transferor or Vendor Company 1. For transfer of all assets taken over by the transferee company: Realization Account Dr. To Assets Account 2. For transfer of all liabilities taken over by the transferee Co.: Liabilities Account Dr. To Realization Account. 3. For purchase consideration due: Transferee Company’s Account Dr. To Realization Account. 4. On receiving purchase consideration: Equity Shares in Transferee Company A/c Dr. Preference Shares in Transferee Company A/c Dr. Bank A/c Dr. To Transferee Company 5. For the sale of assets not taken over by the transferee company: Bank Account Dr. To Realization Account 6. For payment of liabilities not taken over by the transferee company: Realization Account Dr. To Bank Account 7. For preference share capital due: (a) If it payable at par: Preference Share Capital Account Dr. To Preference Shareholder’s Account CU IDOL SELF LEARNING MATERIAL (SLM)

68 Advanced Financial Accounting (b) Payable at a premium: Preference Share Capital Account Dr. Realization Account Dr. To Preference Shareholder’s Account (c) Payable at a discount: Dr. Preference Share Capital Account To Realization Account To Preference Shareholder’s Account 8. For closing realization account: (a) If profit: Realization Account Dr. To Equity Shareholder’s Account (b) If loss: Equity Shareholder’s Account Dr. To Realization Account 9. For transferring of equity share capital, reserves and surplus, etc. Equity Share Capital Account Dr. General Reserves Account Dr. Profit & Loss (Profit). Account Dr. Debenture Redemption Fund Dr. Dividend Equalization Reserve Dr. Securities Premium Account Dr. Accident Compensation Fund Dr. Shares Forfeited Account Dr. Other Reserve or Fund Account Dr. To Equity Shareholder’s Account CU IDOL SELF LEARNING MATERIAL (SLM)

Preparation of Company Accounts under Various Circumstances 69 10. For transferring of preliminary expenses, underwriting commission, discount on issue of shares and debentures and Profit & Loss Account (loss), etc. Equity Shareholder’s Account Dr. To Preliminary Expenses Account To Discount on Issue of Shares and Debentures Account To Profit & Loss Account (Loss) To Underwriting Commission Account 11. For the receipt of purchase consideration: Equity Shares in Transferee Company Account Dr. Preference Shares in Transferee Company Account Dr. Bank Account Dr. To Transferee Company Account 12. For the final payment to equity shareholders: Equity Shareholder’s Account Dr. To Equity Shares in Transferee Company Account To Bank Account 13. For the final payment to preference shareholders: Preference Shareholder’s Account Dr. To Preference Shares in Transferee Company Account To Bank Account To Debentures Account (if any) CU IDOL SELF LEARNING MATERIAL (SLM)

70 Advanced Financial Accounting D. Journal Entries in the Books of Purchasing or Transferee Company (Pooling of Interest Method) I. Journal Entries in the Books of Transferee Company When amalgamation in the nature of merger and under pooling of interest method. 1. On amalgamation of business: Business Purchase Account Dr. To Liquidators of Transferor Company Account 2. For recording assets, liabilities and reserves: Assets Account Dr. General Reserves (Capital Loss) Account Dr. To Creditors Account To Bills Payable Account To Profit & Loss Account To Business Purchase Account To General Reserve (Capital Gain) Account To Reserves (Other than General Reserve) Account 3. For discharge of purchase consideration: Liquidator of Transferor Company Account Dr. Discount on Issue of Share Account Dr. To Bank Account To Equity Share Capital Account To Preference Share Capital Account To Debentures Account To Securities Premium Account CU IDOL SELF LEARNING MATERIAL (SLM)

Preparation of Company Accounts under Various Circumstances 71 4. For making payment to debentures and other liabilities of transferor company: Debentures (Creditors) Account Dr. Discount on Issue of Debentures Account Dr. To Debentures Account To Premium on Issue of Debentures Account 5. If liquidation expenses are paid by the transferee company: General Reserve or Profit & Loss Account Dr. To Bank Account 6. For the formation expenses of the transferee company: Preliminary Expenses Account Dr. To Bank Account Illustration - 10 On 1st April, 2018, A Ltd. and B Ltd. were amalgamated into C Ltd. on the basis of the following balance sheet. Liabilities A Ltd. B Ltd. Assets A Ltd. B Ltd. Paid-up Capital 2,24,000 1,75,000 Goodwill 80,000 32,000 Creditors 5,000 6,000 Buildings 50,000 60,000 Reserve 8,000 12,000 Plant 41,000 10,000 P&L Account 11,000 4,000 Stock 42,000 33,000 Debtors 23,000 40,000 Cash 12,000 22,000 2,48,000 1,97,000 2,48,000 1,97,000 CU IDOL SELF LEARNING MATERIAL (SLM)

72 Advanced Financial Accounting Additional Information: (a) Buildings of both companies to be written down by 10%. (b) Provide 5% Reserve for bad debts on debtors of both the companies. (c) Goodwill to be valued at 3 years purchase of last 2 years average profits. The profits were: 31.3.2017 31.3.2018 A Ltd. 13,000 18,000 B Ltd. 4,000 6,000 (d) The entire amount of purchase consideration was discharged by the allotment of equity shares in C Ltd. (e) C Ltd. agrees to take over the remaining assets and liabilities at book values. Prepare necessary ledger accounts in the books of A Ltd. and B Ltd. and give the opening Journal Entries of C Ltd. and closing Journal Entries in the books of A Ltd. and B Ltd. under business purchase method. Solution: Note: Since the assets and liabilities are not taken over at the book value, it is not a case of amalgamation in the nature of merger. 1. Calculation of Amount of Goodwill Total Profit Average profit = No.of Years A Ltd. = 31,000 = 15,500 B Ltd. = 10,000 = 5,000 22 Goodwill = Average profit × 3 year’s purchase A Ltd. = 15,500 × 3 = 46,500 B Ltd. = 5,000 × 3 = 15,000 CU IDOL SELF LEARNING MATERIAL (SLM)

Preparation of Company Accounts under Various Circumstances 73 2. Calculation of Purchase Consideration (Net Assets Method) A Ltd. B Ltd. Assets taken over values: Goodwill 46,500 15,000 Buildings 45,000 54,000 Plant 41,000 10,000 Stock 42,000 33,000 Debtors 21,850 38,000 Cash 12,000 22,000 Less: Liabilities agreed 2,08,350 1,72,000 Creditors 5,000 6,000 Purchase Consideration 2,03,350 1,66,000 3. Discharge of Purchase Consideration A Ltd. B Ltd. Issue of equity share in C Ltd. 2,03,350 1,66,000 In the Books of A Ltd. [Transferor Company] Realisation Account Particulars Amount Particulars Amount 5,000 To Goodwill 80,000 By Creditors 2,03,350 To Buildings 50,000 By C Ltd. Account 39,650 To Plant 41,000 By Equity Shareholder’s Account To Stock 42,000 (Loss) CU IDOL SELF LEARNING MATERIAL (SLM)

74 Advanced Financial Accounting To Debtors 23,000 To Cash 12,000 2,48,000 2,48,000 C Ltd. Account Particulars Amount Particulars Amount To Realisation 2,03,350 By Equity Shares in C Ltd. A/c 2,03,350 2,03,350 2,03,350 Equity Shareholder’s Account Particulars Amount Particulars Amount To Equity Share in C Ltd. 2,03,350 By Equity Share Capital 2,24,000 To Realisation Account 39,650 By Reserves 8,000 By P/L Account 11,000 2,43,000 2,43,000 Equity Share in C Ltd. Account Particulars Amount Particulars Amount To C Ltd. Account 2,03,350 By Equity Sharehold’ers Account 2,03,350 2,03,350 2,03,350 In the Books of B Ltd. [Transferor Company] Realisation Account Particulars Amount Particulars Amount To Goodwill 32,000 By Creditors 6,000 To Buildings 60,000 By C Ltd. Account 1,66,000 CU IDOL SELF LEARNING MATERIAL (SLM)

Preparation of Company Accounts under Various Circumstances 75 To Plant 10,000 By Equity Shareholders Account 25,000 To Stock 33,000 To Debtors 40,000 To Cash 22,000 1,97,000 1,97,000 C Limited Account Particulars Amount Particulars Amount To Realisation Account 1,66,000 By Equity Shares in C Ltd. 1,66,000 1,66,000 1,66,000 Equity Shareholder’s Account Particulars Amount Particulars Amount To Realisation Account 25,000 By Equity Share Capital 1,75,000 To Equity Shares in C Ltd. Account 1,66,000 By Reserves 12,000 By P&L Account 4,000 1,91,000 1,91,000 Equity Shares in C Ltd. Account Particulars Amount Particulars Amount To C Ltd. Account 1,66,000 By Equity Shareholder’s Account 1,66,000 1,66,000 1,66,000 CU IDOL SELF LEARNING MATERIAL (SLM)

76 Advanced Financial Accounting In the Books of C Limited [Transferor Company] Journal Entries Sl. No. Particulars LF Dr. Cr. 1 Business Purchase Account Dr. 3,69,350 To Liquidator’s of A Ltd. 2,03,350 To Liquidator’s of B Ltd. 1,66,000 (Being purchase consideration due) 2 GoodwillAccount Dr. 61,500 Building Account Dr. 99,000 Plant Account Dr. 51,000 Stock Account Dr. 75,000 Debtors Account Dr. 59,850 Cash Account Dr. 34,000 To Creditors Account 11,000 To Business Purchase Account 3,69,350 (Being assets and liabilities taken over) 3 Liquidator’s of A Ltd. Account Dr. 2,03,350 Liquidator’s of B Ltd. Account Dr. 1,66,000 To Equity Shares Capital Account 3,69,350 (Being payment of purchase consideration) CU IDOL SELF LEARNING MATERIAL (SLM)

Preparation of Company Accounts under Various Circumstances 77 5.10 Summary The term ‘merger’ is not defined under the Companies Act, 1956 (“CA 1956”), and under Income Tax Act, 1961 (“ITA”). However, the Companies Act, 2013 (“CA 2013”) without strictly defining the term explains the concept. A ‘merger’is a combination of two or more entities into one; the desired effect being not just the accumulation of assets and liabilities of the distinct entities, but organization of such entity into one business. Merger refers to a situation when two or more existing firms combine together and form a new entity. A merger involves the mutual decision of two companies to combine and become one entity; it can be seen as a decision made by two \"equals\". Acquisition refers to the acquiring of ownership right in the property and asset without any combination of companies. Thus in acquisition two or more companies may remain independent, separate legal entity but there may be change in control of companies. The pooling of interest method, all assets and liabilities of transferor company will be incorporated in the books of transferee company. When the purchase consideration amount is mentioned in the problem, then the lump sum method is used for finding purchase consideration. Under this method, no further calculation is required. A lump sum amount may be stated as purchase consideration. Net assets method has to be followed when full information is not given about payments to different ‘claimants’ in selling company. Two companies in different industries join forces or one takes over the other in order to broaden their range of services and products. This approach can help reduce costs by combining back office activities as well as reduce risk by operating in a range of industries. CU IDOL SELF LEARNING MATERIAL (SLM)

78 Advanced Financial Accounting 5.11 Key Words/Abbreviations z Merger: A ‘merger’ is a combination of two or more entities into one. z Horizontal Mergers: Horizontal mergers are combinations of firms engaged in the same business. z Vertical Mergers: Vertical mergers are combination of different firms. z Amalgamation: The business of the transferor company is intended to be carried on, after the amalgamation, by the transferee company. z Lumpsum Method: The lump sum method is used for finding purchase consideration. 5.12 Learning Activity 1. What entries would be made in the books of the Purchasing Company when it takes over debtors and creditors of the vendor firm for collection and settlement? _________________________________________________________________ _________________________________________________________________ 2. What is Absorption? How would you ascertain the purchase consideration when shares are held mutually? _________________________________________________________________ _________________________________________________________________ 3. What are the opening journal entries in the books of the purchasing company? Use imaginary figures. _________________________________________________________________ _________________________________________________________________ CU IDOL SELF LEARNING MATERIAL (SLM)

Preparation of Company Accounts under Various Circumstances 79 5.13 Unit End Questions (MCQs and Descriptive) A. Descriptive Type Questions 1. What is Absorption? How does it differ from Amalgamation? 2. Define Purchase Consideration. Explain the methods of ascertaining it. 4. Distinguish between Internal and External Reconstruction. 6. What is meant by acquisition? 7. The Balance Sheet of M Ltd. shows the following on 31-3-2012: 1,00,000 equity shares of `10 each fully paid `10,00,000 50,000 5% preference shares of `10 each fully paid `5,00,000 6% debentures ` 5,00,000 N Ltd. acquired M Ltd. on the same date and agreed to pay the following: (a) 50,000 equity shares of ` 10 @ ` 12 each, 30,000, 8% preference shares of ` 10 each and 7% debentures to the extent of ` 2,00,000 to the equity shareholders of M Ltd. (b) 30,000 equity shares of ` 10 @ ` 12 each and 20,000, 8% preference shares of ` 10 each to the 5% preference shareholders of M Ltd. Calculate Purchase Consideration. Ans: Total purchase consideration 16,60,000 8. United ltd. agreed to take over Bharat Ltd. from 31.12.05. The paid up capital of Bharat Ltd. was 12,000 shares of ` 50 each. The purchase price was discharged by the allotment to the shareholders of the vendor company of the share of ` 100 (90 paid up) of the United Ltd. for every two shares in Bharat Ltd. Shareholders of 100 shares did not agree for absorption. These dissentient shareholders are paid out at ` 70 per share. CU IDOL SELF LEARNING MATERIAL (SLM)

80 Advanced Financial Accounting Calculate the purchase consideration and pass journal entries for payment made to dissentient share holders and close their account. Ans: Journal entries 9. A Ltd and B Ltd decided to amalgamate on 31-12-2013. On that date, the position was: A. Co. Net Assets ` 38,700 Net Liabilities ` 12,900 B Co. Net Assets ` 28,440 Net liabilities ` 7,440 The share capital of the Combined Co, is to be ` 2,400 preference shares of ` 10/- each and balance in equity shares of ` 5/- each fully paid. The allocation of the shares between A Co. and B Co. is equal except that the surplus capital of any company to be discharged in preference shares. Calculate purchase consideration and show the details of distribution of shares. Ans: Purchase Consideration 21,000 B. Multiple Choice/Objective Type Questions 1. When two are more existing companies combine together to form a new company, it is called __________. [a] Internal reconstruction [b] External reconstruction [c] Amalgamation [d] Absorption 2. Amalgamation involving two or more companies requires the approval of __________. [a] Board of Directors [b] Shareholders [c] Debtors [d] Court CU IDOL SELF LEARNING MATERIAL (SLM)

Preparation of Company Accounts under Various Circumstances 81 3. Amalgamation comes under Section __________ of the Companies Act, 1956. [a] 495 [b] 494 [c] 496 [d] 497 4. Which shareholders becomes the equity shareholder of the transferee company by the virtue of amalgamation? [a] Shareholders holding not less than 90% of the face value [b] Shareholders holding not less than 70% of the face value [c] Shareholders holding not less than 80% of the face value [d] Shareholders holding not less than 60% of the face value 5. Which of the following statement is false? [a] All assets and liabilities are to be taken over by purchasing company [b] Purchase consideration should be issued to the shareholders of the selling company in shares only [c] Assets and liabilities taken over should be shown in purchasing company at their book value [d] None of the above 6. Amalgamations in the nature of purchase includes – [a] All the assets and liabilities of the selling company may not be taken over [b] Selling companies business may or may not be carried on in future [c] All assets and liabilities are to be taken over by purchasing company [d] Both [a] and [b] CU IDOL SELF LEARNING MATERIAL (SLM)

82 Advanced Financial Accounting 7. Under which method the purchase price to be paid to shareholders may be mentioned in the agreement directly? [a] Shares exchange method [b] Lump sum method [c] Net payment method [d] Net assets method 8. Which of the following points to be noted while determining the purchase price under the ‘Net payment’ method? [a] The value of the assets and liabilities that are taken over by the purchasing company are relevant to compute the purchase price [b] The value of the assets and liabilities that are taken over by the purchasing company are not relevant to compute the purchase price [c] All payments agreed upon should be deducted [d] All of the above 9. Under which method the specific assets not taken over should be ignored while computing the purchase price? [a] Net payment method [b] Lump sum method [c] Net assets method [d] Lump sum method 10. The exchange ratio is generally determined on the basis of __________. [a] Net assets [b] Intrinsic value [c] Purchase price [d] Shares CU IDOL SELF LEARNING MATERIAL (SLM)

Preparation of Company Accounts under Various Circumstances 83 11. Under which consideration the purchasing company receives amount of cash, shares and debentures as a part of purchase price? [a] Computation of purchase consideration [b] Form of consideration [c] Both [a] and [b] [d] None 12. When two or more companies are liquidated is called as – [a] Absorption [b] External reconstruction [c] Amalgamation [d] All of the above 13. What are the points to be noted while recording transaction in the books of the purchasing and selling companies? [a] All the tangible and intangible assets including cash and bank balance [b] Liabilities includes all the amounts due to outsiders, excluding the shareholders [c] Liabilities includes all the amounts due to outsiders, including the shareholders [d] Both [a] and [b] 14. Accounting standards of Amalgamations is – [a] AS 20 [b] AS 14 [c] AS 5 [d] AS 3 15. Pooling of Interest method is used to account for Amalgamations in the nature of – [a] Purchase [b] Merger [c] Sale [d] None CU IDOL SELF LEARNING MATERIAL (SLM)

84 Advanced Financial Accounting Answers 1. [c], 2. [d], 3. [b], 4. [a], 5. [d], 6. [d], 7. [b], 8. [b], 9. [c], 10. [b], 11. [b], 12. [c], 13. [d], 14. [b], 15. [b] 5.14 References 1. Arulanandam and Raman, Advanced Accountancy, Himalaya Publication House Pvt. Ltd., Edition 2018. 2. Dr. Vishwanathan Reddy and Jayaram Kanzal, Corporate Accounting, Himalaya Publication House Pvt. Ltd., Edition 2019 3. Dr. S.N. Maheswari, Financial Accounting, Vikas Publication, Edition 2017. 4. S.P. Jain and K.L. Narang, Financial Accounting, Kalyani Publication, Edition 2018. 5. Reddy, K.R. (2000), “Accounting Standards and Gaps in Practices in India”, Management Accountant, ICWAI, April. 6. http://www.mca.gov.in/MinistryV2/accountingstandards1.html 7. https://www.icaew.com/technical/by-country/north-america/us/accounting-in-us/us-gaap 8. https://www.ifrs.org/issued-standards/list-of-standards/ 9. http://www.accountingnotes.net/final-accounts/final-accounts-of-the-companies-with- solutions-accounting 10. http://www.accountingnotes.net/amalgamation/external-reconstruction-and-amalgamation 11. http://www.yourarticlelibrary.com/accounting/problems-accounting/amalgamation-and- external-reconstruction ˆˆˆ CU IDOL SELF LEARNING MATERIAL (SLM)

External Reconstruction 85 UNIT 6 EXTERNAL RECONSTRUCTION Structure: 6.0 Learning Objectives 6.1 Introduction 6.2 External Reconstruction 6.3 How to Value anAcquisition? 6.4 Sources of Gains fromAcquisitions 6.5 Valuation Procedures External Reconstruction 6.6 Summary 6.7 Key Words/Abbreviations 6.8 LearningActivity 6.9 Unit End Questions (MCQs and Descriptive) 6.10 References 6.0 Learning Objectives After studying this unit, you will be able to: z Learn the concept of Pooling of Interest Method z Discuss how to value an acquisition z Explain the sources of gains from acquisition z Discuss the Valuation Procedure of External Reconstruction CU IDOL SELF LEARNING MATERIAL (SLM)

86 Advanced Financial Accounting 6.1 Introduction External reconstruction takes place when an existing company goes into liquidation for the express purpose of selling its assets and liabilities to a newly formed company which is generally owned and named alike. It is similar to amalgamation though not exactly the same. In external reconstruction, a new company is formed for the purpose of taking over the business of an existing sick company which has incurred huge losses and is facing financial difficulties. Existing company is wound up by selling its business to the newly formed company which is generally similarly named and owned by the same shareholders to a great extent 6.2 External Reconstruction External reconstruction takes place when an existing company goes into liquidation for the express purpose of selling its assets and liabilities to a newly formed company which is generally owned and named alike. External reconstruction is similar to amalgamation in the nature of purchase, the books of the transferor company are closed and in the books of the transferee company, the purchase of the business is recorded. Objectives of External Reconstruction (i) The main objective of external reconstruction is to reorganize the financial structure of the company. (ii) In external reconstruction, only one existing company is involved. (iii) In external reconstruction, a new company is certainly formed. CU IDOL SELF LEARNING MATERIAL (SLM)

External Reconstruction 87 Difference between Absorption and External Reconstruction The differences between Absorption and External Reconstruction are: Absorption External Reconstruction 1. It does not involve the formation of a new 1. It necessarily involves the formation of company. a new company. 2. Here, one existing company takes over the 2. Here, the purchasing company takes over business of one or more existing companies. the business of only one company. 3. It is the case of combination of companies. 3. It is not the case of combination of companies. 6.3 How to Value an Acquisition? The following are examples of business valuation methods: 1. Liquidation value: Liquidation value is the amount of funds that would be collected if all assets and liabilities of the target company were to be sold off or settled. Generally, liquidation value varies depending upon the time allowed to sell assets. If there is a very short-term “fire sale,” then the assumed amount realized from the sale would be lower than if a business were permitted to liquidate over a longer period of time. 2. Real estate value: If a company has substantial real estate holdings, they may form the primary basis for the valuation of the business. This approach only works if nearly all of the assets of a business are various forms of real estate. Since most businesses lease real estate, rather than owning it, this method can only be used in a small number of situations. 3. Book value: Book value is the amount that shareholders would receive if a company’s assets, liabilities, and preferred stock were sold or paid off at exactly the amounts at which they are recorded in the company’s accounting records. It is highly unlikely that this would ever actually take place, because the market value at which these items would be sold or paid off might vary by substantial amounts from their recorded values. CU IDOL SELF LEARNING MATERIAL (SLM)

88 Advanced Financial Accounting 4. Multiplier analysis: It is quite easy to compile information based on the financial information and stock prices of publicly-held companies, and then convert this information into valuation multiples that are based on company performance. These multiples can then be used to derive an approximate valuation for a specific company. 5. Discounted cash: flows One of the most detailed and justifiable ways to value a business is through the use of discounted cash flows. Under this approach, the acquirer constructs the expected cash flows of the target company, based on extrapolations of its historical cash flow and expectations for synergies that can be achieved by combining the two businesses. A discount rate is then applied to these cash flows to arrive at a current valuation for the business. 6. Comparison analysis: A common form of valuation analysis is to comb through listings of acquisition transactions that have been completed over the past year or two, extract those for companies located in the same industry, and use them to estimate what a target company should be worth. The comparison is usually based on either a multiple of revenues or cash flow. Information about comparable acquisitions can be gleaned from public filings or press releases, but more comprehensive information can be obtained by paying for access to any one of several private databases that accumulate this information. 7. IPO valuation: A privately-held company whose owners want to sell it can wait for offers from potential acquirers, but doing so can result in arguments over the value of the company. The owners can obtain a new viewpoint by taking the company public in the midst of the acquisition negotiations. This has two advantages for the selling company. First, it gives the company’s owners the option of proceeding with the initial public offering and eventually gaining liquidity by selling their shares on the open market. Also, it provides a second opinion regarding the valuation of the company, which the sellers can use in their negotiations with any potential acquirers. CU IDOL SELF LEARNING MATERIAL (SLM)

External Reconstruction 89 6.4 Sources of Gains from Acquisitions The gains from an acquisition may result from one or more of the following five categories: 1. Revenue enhancement: Increased revenues may come from marketing gains, strategic benefits, and increased market power. Marketing gains arise from more effective advertising, economies of distribution, and a better mix of products. Strategic benefits represent opportunities to enter new lines of business. 2. Cost reductions: A larger firm may be able to operate more efficiently than two smaller firms, thereby reducing costs. Horizontal mergers may generate economies of scale. This means that the average production cost will fall as production volume increases. A vertical merger may allow a firm to decrease costs by more closely coordinating production and distribution. 3. Lower taxes: Tax gains in mergers may arise because of unused tax losses, unused debt capacity, surplus funds, and the write-up of depreciable assets. The tax losses of target corporations can be used to offset the acquiring corporation’s future income. These tax losses can be used to offset income for a maximum of 15 years or until the tax loss is exhausted. Only tax losses for the previous three years can be used to offset future income. 4. Changing capital requirements: Acquiring firms may be able to more efficiently utilize working capital and fixed assets in the target firm, thereby reducing capital requirements and enhancing profitability. This is particularly true if the target firm has redundant assets that may be divested. 5. Lower cost of capital: The cost of debt can often be reduced when two firms merge. The combined firm will generally have reduced variability in its cash flows. Therefore, there may be circumstances under which one or the other of the firms would have defaulted on its debt, but the combined firm will not. This makes the debt safer, and the cost of borrowing may decline as a result. CU IDOL SELF LEARNING MATERIAL (SLM)

90 Advanced Financial Accounting 6.5 Valuation Procedures External Reconstruction 1. External Reconstruction in the Nature of Purchase (Purchase Method) (a) External Reconstruction in the Nature of Purchase (Purchase Method) with Statutory Reserve. Illustration - 1 Bharath Limited was absorbed by India Limited on 31.3.2018 on which date the Balance Sheet of Bharath Limited was as follows: Liabilities ` Assets ` Equity Share Capital 6,00,000 Buildings 4,00,000 5% Preference Share Capital 4,00,000 Plant 2,00,000 Sundry Creditors 1,10,000 Current Assets 2,00,000 Development Rebate Reserve 3,50,000 40,000 P&L Account 11,50,000 11,50,000 India Limited took over buildings at ` 3,00,000, Plant at ` 1,40,000 and Stock at ` 60,000. The purchase consideration is to be satisfied by the issue of 8% Preference Shares of ` 100 each and Equity Shares of ` 10 each in 3 : 2 ratio. The Preference Shareholders are to be settled in full by the allotment of new Preference Shares. Sundry debtors realised ` 1,50,000 and ` 1,00,000 was paid to Sundry Creditors in full settlement (There were no other current assets). Cost of liquidation ` 10,000. Development Rebate Reserve is a Statutory Reserve to be continued to 2 more years. Prepare necessary ledger accounts in the books of Bharath Limited. Opening Journal Entries of India Limited and its Balance Sheet. CU IDOL SELF LEARNING MATERIAL (SLM)

External Reconstruction 91 Solution: Working Notes: 1. Calculation of Purchase Consideration (Net Assets Method): ` Assets taken over values: Buildings 3,00,000 Plant 1,40,000 Stock 60,000 Purchase consideration 5,00,000 2. Mode of Payment of Purchase Consideration (a) 8% Preference Shares of ` 100 each (5,00,000 × 3 / 5) 3,00,000 2,00,000 (b) Equity Shares of `10 each (5,00,000 × 2 / 5) 5,00,000 Total In the Books of Bharath Limited Ledger Accounts Dr. Realisation Account Cr. Particulars Amount Particulars Amount To Buildings A/c To Plant A/c 4,00,000 By Sundry Creditors A/c 1,50,000 To Current Assets A/c To Cash A/c (Creditors paid) 2,00,000 By Development Rebate Reserve 40,000 To Cash A/c (Expenses) 2,00,000 By India Ltd. A/c 5,00,000 1,00,000 By Cash A/c (Debtors realised) 1,50,000 10,000 By Preference Shareholders A/c 1,00,000 By Equity Shareholder’s A/c (Loss) 10,000 9,10,000 9,10,000 CU IDOL SELF LEARNING MATERIAL (SLM)

92 Advanced Financial Accounting Dr. India Limited Account Cr. Particulars To Realisation Account Amount Particulars Amount 5,00,000 By Preference Shares in India Ltd. 3,00,000 By Equity Shares in India Ltd. 2,00,000 5,00,000 5,00,000 Dr. Equity Shareholder’s Account Cr. Amount Particulars Amount Particulars 6,00,000 To P&L A/c 3,50,000 By Equity Share Capital A/c To Realisation A/c 6,00,000 To Equity Shares in India Ltd. A/c 10,000 To Cash A/c (Balancing figure) 2,00,000 30,000 6,00,000 Dr. Preference Shareholder’s Account Cr. Particulars Amount Particulars Amount To 8% Preference Share Capital A/c 3,00,000 5% Preference Share Capital A/c 4,00,000 To Realisation A/c 1,00,000 4,00,000 4,00,000 Dr. Cash Account Cr. Particulars Amount Particulars Amount To Balance b/d – By Realisation A/c 1,10,000 To Realisation A/c 1,50,000 By Realisation A/c 10,000 By Equity Shareholder’s A/c 30,000 1,50,000 1,50,000 CU IDOL SELF LEARNING MATERIAL (SLM)