The term incremental method refers to an approach used to allocate a lump-sum sale to one or more classes of securities. If the fair market value of a security is unknown, the incremental method requires the proceeds from the sale to first be allocated to those securities with a known market value; the remainder is then allocated to the security with an unknown value.
Normally, companies will sell common stock, bonds, and preferred shares separately. This allows the company to accurately allocate the proceeds received to each class of security on its balance sheet. Occasionally, a company will bundle two or more classes of securities in exchange for a lump sum payment of cash or even an asset. A lump-sum sale of securities oftentimes occurs when one company acquires another.
Transactions involving a lump-sum sale present the company with an accounting challenge, since the proceeds from the sale must be allocated to each class of security on the company's balance sheet. Generally, there are two methods a company can use to calculate this allocation: the proportional and incremental methods.
The preferred approach to this allocation is the proportional method. However, if the fair market value of a security involved in a lump-sum sale is unknown, the incremental method should be used. With the incremental method, the value of the lump-sum purchase is first allocated to securities with known market values. The remaining value of the transaction is then allocated to the security with an unknown market value. Note: If the fair market value of more than one security is unknown, the allocation to each class of security may be arbitrary.
Company XYZ has agreed to sell its transformer business to Company A. Company A has offered Company XYZ 20,000 shares of its common stock with a market value of $40.00 per share, along with 2,000 shares of preferred stock with an unknown market value. Company A values the transformer business at $1,000,000. Since the value of preferred stock is unknown, Company A's accounting department will use the incremental method to allocate the purchase price as shown in the table below.