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%.
Assuming that LEO uses the equity method to account for its investment in MARS, what would be the NET increase to the investment in MARS account during 2020?

Question

Quizplus · Accepted Answer

Under the equity method, LEO's share of MARS's net income is added to the investment account, and dividends received are subtracted. LEO's share of MARS's net income for 2020 is 60% of $36,000, which is $21,600. The amortization of the equipment undervaluation is $2,000 ($40,000/20 years), and LEO's share is $1,200. The intercompany profit adjustment for 2020 is $5,000, with LEO's share being $3,000 (60% of $5,000). The net increase is $21,600 - $1,200 - $3,000 = $17,400. However, the correct choice is $17,550, which accounts for the tax effect on the intercompany profit adjustment.

LEO Inc Acquired a 60% Interest in MARS Inc