Investment in Common Stock: Differential Method (Part 1)

Companies invest in other companies all the time. In advanced accounting, students learn how to account for the buyer’s investment in the purchased company. If the buyer and the seller consolidate their financials, advanced accounting addresses how the purchase is presented in the combined financials.

Buying a controlling interest in another company:

Assume that Basic Jeans, a clothing manufacturer, buys 80% of the outstanding common stock of Hollywood Jeans for $310,000. The purchase makes Basic Jeans the controlling interest. Someone else- another owner or group of owners- represents the non-controlling interest. In this case, the non-controlling interest owns 20% of Hollywood Jeans.

Basic Jean’s total fair market value:

Since Basic paid $310,000 for 80% of the company, Hollywood Jeans’ total value is $387,500 ($310,000/ 80%). You can think of it this way: If you pay $310,000 for 80% of the company, you would pay a total of $387,500 for the entire company.

What did you buy? Equity section of the balance sheet:

When Basic writes a check to purchase Hollywood, the firm is buying the firm’s equity. Specifically, Basic is buying Hollywood’s common stock and retained earnings- line items in Hollywood’s balance sheet.

Here is Hollywood’s equity:

Common stock                $200,000

Retained earnings            $100,000

Total Equity                   $300,000

The differential:

The differential is the company’s total fair market value, less the equity section of the balance sheet. Here’s the differential calculation:

Fair market value               $387,500

Equity                               $300,000

Differential                       $87,500

In part 2, I will explain how to account for the differential. In the meantime, I hope this video is helpful:

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