Pinkerton Inc.owns 10% of Sable Company.In the most recent year,Sable had net earnings of $40,000 and paid dividends of $6,000.Pinkerton's accountant mistakenly assumed Pinkerton had considerable influence over Sable and used the equity method instead of the cost method.What is the impact on the investment account and net earnings,respectively?

Question

Quizplus · Accepted Answer

Under the equity method, Pinkerton would recognize its share of Sable's net earnings, increasing the investment account and its net earnings. However, dividends received would reduce the investment account but not affect net earnings. Since Pinkerton owns only 10% and presumably does not have significant influence, it should have used the cost method, under which dividends received increase net earnings and have no effect on the investment account. Thus, using the equity method instead of the cost method leads to an overstatement of both the investment account (due to recognizing 10% of Sable's net earnings) and net earnings (since dividends under the equity method do not count as net earnings, but under the cost method, they would).