Hope Company bought 30% of Faith Corporation in the beginning of 2013. Hope's purchase price equaled 30% of the book value of Faith's net identifiable assets, which also equaled 30% of the fair value of Faith. During 2013, Faith reported net income in the amount of $4,000,000 and declared and paid dividends in the amount of $500,000. Hope mistakenly accounted for the investment as available for sale instead of using the equity method. What effect would this error have on the investment account and net income, respectively, for 2013?

Question

Quizplus · Accepted Answer

Under the available for sale method, the investment account is recorded at fair value on the balance sheet, but unrealized gains and losses are recorded in other comprehensive income (OCI) and not included in net income for the period. Therefore, the investment account would be understated by $1,050,000 (30% of $3,500,000 - 30% of $4,200,000), but net income would not be affected as the unrealized gain of $700,000 would be recorded in OCI.

Hope Company Bought 30% of Faith Corporation in the Beginning