Calculating the Purchase Price of an Equity Investment: A Case Study

Calculating the Purchase Price of an Equity Investment: A Case Study

Let's unravel a common accounting problem: figuring out the purchase price of an equity investment.

Scenario: On January 2, 2018, Pharoah Company acquired 25% of the outstanding common stock of Jobs, Inc. Pharoah Company uses the equity method to account for this investment. During 2018, Jobs, Inc. reported a net income of $1,180,000 and distributed $500,000 in dividends. After applying the equity method throughout 2018, the ending balance in Pharoah Company's 'Investment in Jobs, Inc.' account on December 31, 2018, stood at $920,000.

Objective: Determine the purchase price Pharoah Company paid for its investment in Jobs, Inc.

Solution:

1. Understanding the Equity Method: The ending balance of $920,000 in the 'Investment in Pharoah Company' account signifies Pharoah Company's proportionate share (25%) of Jobs, Inc.'s net assets at the end of 2018, calculated using the equity method.

2. Calculating Total Equity: We can determine Jobs, Inc.'s total equity by dividing the ending balance in the investment account by Pharoah Company's ownership percentage:

   Total Equity of Jobs, Inc. = Ending Balance in Investment / Ownership Percentage Total Equity of Jobs, Inc. = $920,000 / 0.25 = $3,680,000

3. Factoring in Net Income and Dividends: Net income increases equity, while dividends decrease it. We can calculate Jobs, Inc.'s retained earnings at the end of 2018:

   Retained Earnings of Jobs, Inc. = Total Equity - Net Income + Dividends Retained Earnings of Jobs, Inc. = $3,680,000 - $1,180,000 + $500,000 = $3,000,000

4. Determining the Purchase Price: The purchase price is equivalent to Pharoah Company's portion of Jobs, Inc.'s equity at the time of purchase. Since the company was acquired at the beginning of the year before any dividends or net income were recorded, we can assume the retained earnings represent the equity at the time of purchase.

   Purchase Price = Retained Earnings of Jobs, Inc. = $3,000,000

Therefore, Pharoah Company paid $3,000,000 for its investment in Jobs, Inc.