Question

On August 1, 2015, KLM acquired 45% of Investee Company and is the largest shareholder of Investee Company. During 2015, Investee reported net income of $86,000. On December 1, 2015, Investee Company declared and paid $8,000 in dividends. At December 31, 2015, the market value of the stock was $3,000 lower than the purchase price. In 2015, there was no beginning balance in the SFVA account.

KLM mistakenly recorded the transactions using the fair market value method, instead of using the equity method of accounting.

What effect would this error have upon the net income of KLM shown on the December 31, 2015 income statement? Ignore tax considerations.

		Understated by 17,625
		Understated by 38,100
		Understated by 18,825
		None of the other answer choices is correct.
		Understated by 15,525
		Understated by 19,125
		Understated by 12,525

Answer 1

Under Equity method the Dividend received is reduced from the value of the investment and share in net income of the investee is added to Investment and credited to Income statement as Investment revenue ($86,000 x 45%)=$38,700. The fair market value is not considered.

However, under fair market value method the dividend received is accounted for as Dividend income ($8,000 x 45%) =$3,600 and market value adjustment would have been debited to income statement by $3,000

Hence effect of error = $38,700 -$3,600 +$3,000 =$38,100

Hence correct answer is option Understated by 38,100