[rlsrapp]

I came across this question and do not understand the answer. Hoping someone can help…

On January 1, 20X1, Point, Inc. purchased 10% of Iona Co.’s common stock. Point purchased additional

shares bringing its ownership up to 40% of Iona’s common stock outstanding on August 1, 20X1. During

October 20X1, Iona declared and paid a cash dividend on all of its outstanding common stock. How

much income from the Iona investment should Point’s 20×1 income statement report?

a. 10% of Iona’s income for January 1 to July 31, 20X1, plus 40% of Iona’s income for August 1 to

December 31, 20X1.

b. 40% of Iona’s income for August 1 to December 31, 20X1 only.

c. 40% of Iona’s 20X1 income.

d. Amount equal to dividends received from Iona.

Answer: A

I am confused as to how the answer is A. Once Point owns 40%, shouldn’t they use the equity method? Under the equity method, a cash dividend is no longer recorded as income, right? The cash dividend should just reduce the investment. Can anyone help? Thank you!

[So FAR So Good]

Your assessment of cost method vs. equity method seems correct, but I feel like you're missing a key point in there.

Cost method, as you pointed out, you treat sort of like a marketable security and then book dividend income on your financials when it is received.

Equity method, you treat the investment account like a bank account. You value at FV initially (your “deposit”), mark it up for net income at the subsidiary based on your percentage ownership (consider this similar to bank interest), then reduce the balance by dividends (don't consider these reinvested, consider them dividend payouts or withdrawals from your bank account).

So for Equity method, let's say you had 25% ownership of a company who has net income of 100 and dividend income of 80 (remember div income doesn't appear on their I/S, as it is a reduction of stockholders' equity) – here is the entry to recognize that

Dr. Cash $20
Dr. Investment 5
Cr. Income from Subsidiary $25

You book income and take up the value for 25% of 100, but then you receive a cash dividend and book a decrease to your investment of 25% of the 80.

Choice A is correct – remember that they are talking about the subsidiary's income, which does NOT include dividends, as those are a reduction of stockholders' equity at the Sub.

F - 91 (6/5/2016)
A - 7/30/2016
R - 10/8/2016
B - 12/10/2016

[MaLoTu]

I agree with So FAR, they are asking about equity earnings. In the beginning of the year they would not have had equity earnings, but they have to go back to the beginning of the year and treat the investment with the equity method because they later acquired the additional percentage.

Additionally, if there are comparative FS, I am pretty sure that the previous year has to be restated to show the current method for the investment.

You are right that they do not count dividends as income under the equity method, under the equity method dividends reduce the investment in investee account.

[Anonymous]

Simple Answer, you only owned 10% before you purchased additional 30%… so you can only benefit 10% of the income using equity method from Jan 1-July 30…

[rlsrapp]

So FAR So Good – I understand now! Thank you! I WAS missing an important part of the equity method – but I have it now.
Thank you to everyone who joined in on the conversation.
And I noticed So FAR So Good is taking the exam….Today???? BEST of luck. You sound like you know your stuff 🙂

[Author]

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