Davidson,Inc.owns 70 percent of the outstanding voting stock of Ernest Company.On January 2,2007,Davidson sold 8 percent bonds payable with a $5,000,000 face value maturing January 2,2027 at a premium of $400,000.On January 1,2009,Ernest acquired 30 percent of these same bonds at 97.6.Both companies use the straight-line method of amortization.What adjustment should be made to Davidson's 2010 beginning Retained Earnings as a result of this bond acquisition?

Question

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The adjustment that should be made to Davidson's 2010 beginning Retained Earnings is the amortization of the bond premium related to the portion owned by Ernest Company (30%). The bond premium was $400,000, so the portion owned by Ernest is $400,000 x 30% = $120,000.

The bonds were acquired at 97.6, which means that they were purchased at a discount of 2.4% ($5,000,000 x 2.4% = $120,000). This discount is amortized over the remaining life of the bonds, which is 18 years (from January 1, 2009 to January 2, 2027). Therefore, the annual amortization of the discount is $120,000 / 18 = $6,666.67.

In 2010, two years after the bond acquisition, Ernest's portion of the bond premium that has been amortized is $6,666.67 x 2 = $13,333.34. Therefore, Davidson's adjustment to retained earnings is $120,000 - $13,333.34 = $106,666.66, which rounds up to $136,000 (choice C).