Retail Energy Corporation paid $1,300,000 on January 1, 2020, to purchase 32% of the outstanding shares of Natural Gas Limited. In 2020 Natural Gas Limited reported $450,000 of net income and paid $100,000 in dividends. If this investment is accounted for using the equity method of accounting, what will be the impact on the books of Retail Energy Corporation?

Question

Quizplus · Accepted Answer

The equity method of accounting requires that the investment be initially recorded at cost and then adjusted for the investor's share of the investee's net income or loss and dividends. Retail Energy Corporation's initial investment was $1,300,000 for 32% of Natural Gas Limited's outstanding shares, which means the investee's total outstanding shares are valued at $4,062,500 ($1,300,000 / 0.32).

Retail Energy Corporation's share of Natural Gas Limited's net income is $144,000 ($450,000 x 0.32). Therefore, Retail Energy Corporation will record income of $144,000 on its books in 2020.

The Investment account will be increased by Retail Energy Corporation's share of Natural Gas Limited's net income, which is $144,000. The Investment account will also be decreased by Retail Energy Corporation's share of Natural Gas Limited's dividends, which is $32,000 ($100,000 x 0.32). The net increase to the Investment account will be $112,000 ($144,000 - $32,000). Therefore, choice D is incorrect because the Investment account will not be increased by the full amount of Retail Energy Corporation's share of Natural Gas Limited's net income. The correct answer is choice C.

Retail Energy Corporation Paid $1,300,000 on January 1, 2020, to Purchase