Use the following information for Questions 19-21.
On January 1, 2009, Pharma Company purchased 16,000 of the 20,000 outstanding common shares of Sludge Company for $760,000.On January 1, 2013, Pharma Company sold 2,000 of its shares of Sludge Company on the open market for $90 per share.Sludge Company's stockholders' equity on January 1, 2009, and January 1, 2013, was as follows:
1/1/09 1/1/13 The difference between implied and book value is assigned to Sludge Company's land.
-As a result of the sale, Pharma Company's Investment in Sludge account should be credited for
A)$110,000.
B)$137,500.
C)$80,000.
D)$95,000.
E)None of these.

Question

Use the following information for Questions 19-21.
On January 1, 2009, Pharma Company purchased 16,000 of the 20,000 outstanding common shares of Sludge Company for $760,000.On January 1, 2013, Pharma Company sold 2,000 of its shares of Sludge Company on the open market for $90 per share.Sludge Company's stockholders' equity on January 1, 2009, and January 1, 2013, was as follows:
1/1/09 1/1/13  The difference between implied and book value is assigned to Sludge Company's land.
-As a result of the sale, Pharma Company's Investment in Sludge account should be credited for
A)$110,000. 
B)$137,500. 
C)$80,000. 
D)$95,000. 
E)None of these.

Quizplus · Accepted Answer

Pharma Company owns 16,000 shares out of 20,000 shares of Sludge Company, which means it has a 80% (16,000/20,000) ownership stake in Sludge Company.

The book value of Pharma Company's Investment in Sludge Company on January 1, 2013, is calculated as follows:

Book value = Purchase price - Accumulated depreciation
Book value = $760,000 - ($760,000 x 4/40)  (assuming straight-line depreciation over 10 years)
Book value = $760,000 - $76,000
Book value = $684,000

Implied value of Pharma Company's Investment in Sludge Company on January 1, 2013, is calculated as follows:

Implied value = 80% ownership stake x Sludge Company's stockholders' equity
Implied value = 0.80 x ($600,000 + $472,500 + $195,500 - $95,000)
Implied value = 0.80 x $1,073,000
Implied value = $858,400

The difference between implied value and book value is assigned to Sludge Company's land:

Difference = Implied value - Book value
Difference = $858,400 - $684,000
Difference = $174,400, which is assigned to Sludge Company's land

When Pharma Company sells 2,000 shares of Sludge Company for $90 per share, it receives $180,000 (2,000 x $90) in cash.

The gain or loss on the sale of 2,000 shares of Sludge Company is calculated as follows:

Sale price = 2,000 shares x $90/share = $180,000
Book value of 2,000 shares = 2,000/20,000 x $684,000 = $68,400
Gain or loss = Sale price - Book value of 2,000 shares = $180,000 - $68,400 = $111,600

Pharma Company's Investment in Sludge Company account should be credited for the amount of gain on sale:

Credit to Investment in Sludge Company = Gain on sale x 80% ownership stake
Credit to Investment in Sludge Company = $111,600 x 80%
Credit to Investment in Sludge Company = $89,280

Therefore, the answer is (D) $95,000.

Use the Following Information for Questions 19-21