Pal Corp.'s Year 1 dividend income included only part of the dividend received from its Ima Corp. investment. The balance of the dividend reduced Pal's carrying amount for its Ima investment. This reflects that Pal accounts for its Ima investment by the:
a.
Equity method, and Ima incurred a loss in Year 1.
b.
Equity method, and its carrying amount exceeded the proportionate share of Ima's market value.
c.
Cost method, and only a portion of Ima's Year 1 dividends represent Pal's earnings after Pal's acquisition.
d.
Cost method, and its carrying amount exceeded the proportionate share of Ima's market value.
Explanation
Choice “c” is correct. The facts indicate a portion of the dividends were considered income and a portion a return of capital. This implies the cost method and dividends in excess of earnings.
Rule: Under the cost method, dividends (not earnings) are reflected as income by the investor. The cost basis investment account is reduced only if:
Shares of stock are sold, or
Cumulative dividends exceed cumulative earnings (a return of capital), or
Subsidiary incurs losses that substantially reduced net worth.
Choice “d” is incorrect. Cost method investments are not adjusted for changes in market value but that does not explain the portion of the dividend not recognized in income.
Choice “a” is incorrect. Under the equity method, 100% of the dividends paid would reduce the investment account.
Choice “b” is incorrect. 100% of the dividends are considered a reduction of the investment account under all circumstances when using the equity method.
I get the answer, but disagree with why choice “d” is incorrect. It says “not adjusted for changes in market value”. Per the book it says “the basis is adj to FV as required for marketable equity securities, which in this case is treated as an available for sale security. Thoughts anyone ?
BEC - 5/26/2013 75
REG - 8/31/2013 82
AUD - 11/24/2013 74, 2/9/2014 92
FAR - 5/25/2014 85
NY CPA
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