LEO Inc. acquired a 60% interest in MARS Inc. on January 1, 2019 for $400,000. Unless otherwise stated, LEO uses the cost method to account for its investment in MARS Inc. On the acquisition date, MARS had common stock and retained earnings valued at $100,000 and $150,000 respectively. The acquisition differential was allocated as follows: $80,000 to undervalued inventory.
$40,000 to undervalued equipment. (to be amortized over 20 years)
The following took place during 2019:
▪ MARS reported a net income and declared dividends of $25,000 and $5,000 respectively.
▪ LEO's December 31, 2019 inventory contained an intercompany profit of $10,000.
▪ LEO's net income was $75,000.
The following took place during 2020:
▪ MARS reported a net income and declared dividends of $36,000 and $6,000 respectively.
▪ MARS' December 31, 2020 inventory contained an intercompany profit of $5,000.
▪ LEO's net income was $48,000.
Both companies are subject to a 25% tax rate. All intercompany sales as well as sales to outsiders are priced to provide the selling company with gross margin of 20%.
What would be the amount of changes to the acquisition differential during 2019?

Question

Quizplus · Accepted Answer

The changes to the acquisition differential during 2019 can be calculated by considering the following:
- MARS reported net income of $25,000, of which LEO would recognize 60% or $15,000.
- MARS declared dividends of $5,000, of which LEO would recognize 60% or $3,000.
- Intercompany profit of $10,000 on LEO's December 31, 2019 inventory would need to be eliminated.
- The undervalued equipment would need to be amortized by $2,000 (=$40,000/20) for the year.
- The undervalued inventory would need to be adjusted by $80,000.

Therefore, the total changes to the acquisition differential in 2019 would be $82,000 (=$15,000 + $3,000 - $10,000 - $2,000 + $80,000). The correct answer is therefore choice (C).

LEO Inc Acquired a 60% Interest in MARS Inc