On January 1,20X1,Big Company (Big)bought 30% of the outstanding stock of Little Company (Little)for $110,000 which provided Big with the ability to significantly influence the decisions of Little.Little reported assets of $400,000 and liabilities of $100,000 on that date.As part of its analysis before buying these shares,Big determined that Little owned a patent that had not been recorded despite having a remaining useful life of five years and a value of $20,000.During 20X1,Little reported net income of $70,000 and paid cash dividends of $30,000.What investment income should Big report for 20X1?
A) $9,000
B) $19,800
C) $17,000
D) $21,000

Question

Quizplus · Accepted Answer

First, we need to calculate the carrying value of Little's assets and liabilities after taking into account the unrecorded patent:
Assets = $400,000 + $20,000 = $420,000
Liabilities = $100,000

Therefore, Little's equity = $320,000.

Big's investment in Little is $110,000, which is significantly more than 30% of Little's equity ($96,000 = 30% x $320,000). Therefore, Big has significant influence over Little, and should account for the investment using the equity method.

Under the equity method, Big's share of Little's net income would be:
$70,000 x 30% = $21,000

However, Big only received $30,000 in dividends from Little, which suggests that Little did not distribute all of its earnings. Therefore, some of the earnings must be attributed to the increase in Little's equity, and should not be recognized by Big as investment income.

To calculate the portion of Little's earnings that should be recognized by Big, we need to use the formula:
Share of Little's earnings - Dividends received = Increase in Big's investment

$21,000 - $30,000 = ($9,000)

Therefore, Big should recognize investment income of $9,000 for 20X1.

The correct answer is B.

On January 1,20X1,Big Company (Big)bought 30% of the Outstanding Stock