Question

An investor owns 25% of an investee, and accounts for its investment using the equity method. At the beginning of the year, the Equity Investment was reported on the investor's balance sheet at $1,500,000. During the year, the investee reported net income of $600,000 and paid dividends of $150,000. In addition, the investor sold inventory to the investee, realizing a gross profit of $180,000 on the sale. At the end of the year, 30% of the inventory remained unsold by the investee.

a. Provide the equity method journal entries required for the year

Description	Debit	Credit
AnswerAdditional paid-in-capitalCashCommon stockEquity incomeEquity investment	Answer	Answer
AnswerAdditional paid-in-capitalCashCommon stockEquity incomeEquity investment	Answer	Answer
To record the recognition of equity income.
AnswerAdditional paid-in-capitalCashCommon stockEquity incomeEquity investment	Answer	Answer
AnswerAdditional paid-in-capitalCashCommon stockEquity incomeEquity investment	Answer	Answer
To record deferred profits in ending inventory.
AnswerAdditional paid-in-capitalCashCommon stockEquity incomeEquity investment	Answer	Answer
AnswerAdditional paid-in-capitalCashCommon stockEquity incomeEquity investment	Answer	Answer
To record receipt of dividends.

b. What is the balance of the Equity Investment at the end of the year?

$Answer

c. Assume that the inventories are all sold in the following year, that the investee reports $675,000 of net income. How much equity income will the investor report for the following year?

$Answer

Answer 1

Investment of 25% in Investee company so It can be called that there is associate company relationship.

A. Journal Entries

	Particulars	Debit	Credit
1	Investment in Associate	1,500,000
	Bank		1,500,000
	(Being Investment in Associate - 25% share of Investee co.)
2	Investment in Associate	150,000
	Net Income on Investment		150,000
	(Being recognition of earning on Equity Investment - 25% share)
3	Bank A/c	37,500
	Investment in Associate		37,500
	(Being receipt of Dividend - 25% share)
4	Investment Income	13,500
	Investment in Associate		13,500
	(Being recognition of unrealized profit in ending inventory - 25% share)

B. Balance of Equity Investment

	Particulars	Amount
	Balance of Equity Investment at start of the year	1,500,000
Add	Net Income on Investment (600,000 * 25%)	150,000
Less	Dividend (150000 * 25%)	-37,500
Less	Unrealized Profit (180000 * 30% * 25%)	-13,500
	Balance of Equity Investment at the End of the year	1,599,000

Explanation

25% share in Net Income is recognized as Income and it increase value of investment.

25% share in Dividend is recognized as receipt and it decrease value of investment, As dividend is given out of Net Income only.

25% share is Unrealized profit is recognized as decrease in Income and decrease in Investment. As 30% of inventory is unsold so profit portion on this inventory reduces doesn't realizes profit and hence reduce profit.

Gross Profit - 180,000

There is 30% unsold inventory, so Total unrealized profit is 180,000 * 30% = 54,000

And 25% share in unrealized profit is 54000 * 25% = 13,500

C. Assume that the inventories are all sold in the following year

Net Income for following Year - 675,000

25% share in Net Income (675,000 * 25%)	168,750
Reversal of unrealized profit	13,500
Equity Income for the year	182,250

Here in the following year, balance inventories are sold and hence full profit is realized now. So earlier entry of unrealized profit is now reversed. Hence, now it increases income and investment value.