A parent corporation that uses the equity method of accounting for its investment in a 40 percent owned subsidiary, which earned $20,000 and paid $5,000 in dividends, made the following entries: $$\begin{array} { | l | l | l | }
\hline \text { Investment in Associate } &8,000 & \
\hline \text { Investment revenue } & & 8,000\
\hline \text { Cash } & 2,000 & \
\hline \text { Dividend revenue } & & 2,000\
\hline
\end{array}$$ What effect will these entries have on the parent's balance sheet?

Question

A parent corporation that uses the equity method of accounting for its investment in a 40 percent owned subsidiary, which earned $20,000 and paid $5,000 in dividends, made the following entries: $$\begin{array} { | l | l | l | } 
\hline \text { Investment in Associate } &8,000 & \
\hline \text { Investment revenue } & & 8,000\
\hline \text { Cash } & 2,000 & \
\hline \text { Dividend revenue } & & 2,000\
\hline
\end{array}$$ What effect will these entries have on the parent's balance sheet?

Quizplus · Accepted Answer

The entries overstate the investment because only $8,000 is recorded as investment revenue from the $20,000 earnings (40% of $20,000 = $8,000, which is correctly recorded), but the dividend entry incorrectly treats the received dividends as revenue rather than a reduction in the investment account. The correct treatment for dividends under the equity method is to reduce the investment account, not recognize dividend revenue. This mistake leads to overstating both the investment account and retained earnings, as dividends are not income but distributions of income already recognized under the equity method.

A Parent Corporation That Uses the Equity Method of Accounting