Investment in Common Stock: Differential Method- Part 2

In part one, Basic Jeans bought 80% of Hollywood Jeans. You calculated the fair market value of the entire company. Next, you noted Hollywood Jean’s total equity. The difference between the fair market value and the equity is the differential. You’ll now decide how to account for the differential.

Fair market value of the net assets:

You need one more calculation to account for the differential. Hollywood’s net assets represents assets less liabilities. Now, you normally account for assets and liabilities are historical cost (what you paid for the assets, for example). However, the fair market value of your assets and liabilities may be different. Here are a few examples:

1-    Computer software with a book value (cost less depreciation) of $3,000 has a fair market value of only $1,000. Technology improvements have reduced the fair value of the asset.

2-    Land with a cost of $5,000 has a fair market value of $7,000. The land is more valuable, because of a highway exit ramp built near the land. The land now has easier access from the highway- which increases the value of the land.

Net Assets (assets less liabilities) is also equal to equity. The basic balance sheet equation is (assets – liabilities = equity, or assets = liabilities + equity). However, the fair market value of net assets can be different from equity.

Assume that the fair market value of the assets is $350,000. Now, plug that information into the other data you have so far:

Fair market value- consideration paid       $387,500 (Based on 80% purchased)

Fair market value- assets and liabilities     $350,000

Equity                                                    $300,000

Components of the differential:

In part 1, you saw that the differential is $87,500 (consideration of $387,500 less the $300,000 equity). You account for the differential in two parts:

·            Consolidated balance sheet: The difference between the equity (net assets) and the fair market value of Hollywood Jean’s net assets is $50,000 ($350,000 less $300,000). When you consolidate the financial statements for Basic Jeans and Hollywood Jeans, you list Hollywood Jean’s net assets at their fair market values. In consolidation, net assets will be $50,000 higher than before. You’ve addressed $50,000 of the differential.

·            Goodwill: The difference between the fair market value of Hollywood Jeans (based on the consideration paid for 80%) and the fair market value of the net assets is goodwill. Practically speaking, Basic Jeans wanted to buy Hollywood Jeans so badly that it was willing to pay more than fair market value. Maybe Hollywood had a patent, a brand name or reputation that Basic thought had great value. So, they paid more. The remaining $37,500 of differential is posted to Goodwill in consolidation.

Part 3 will provide the journal entries in consolidation. In the meantime, here’s a video that may help explain the concept:

http://www.youtube.com/watch?v=cfZ568erLg4

Your comments are welcome! For live chats on some of the toughest accounting topics, go to my website listed below.

Thanks!

Ken Boyd

St. Louis Test Preparation

(cell) (314) 913-6529

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Author/ Cost Accounting for Dummies (John Wiley and Sons) March 2013