Question

On July 1, 2016, Killearn Company acquired 142,000 of the outstanding shares of Shaun Company for $15 per share. This acquisition gave Killearn a 40 percent ownership of Shaun and allowed Killearn to significantly influence the investee's decisions.

As of July 1, 2016, the investee had assets with a book value of $5 million and liabilities of $890,000. At the time, Shaun held equipment appraised at $245,000 above book value; it was considered to have a seven-year remaining life with no salvage value. Shaun also held a copyright with a five-year remaining life on its books that was undervalued by $800,000. Any remaining excess cost was attributable to goodwill. Depreciation and amortization are computed using the straight-line method. Killearn applies the equity method for its investment in Shaun.

Shaun's policy is to declare and pay a $1 per share cash dividend every April 1 and October 1. Shaun's income, earned evenly throughout each year, was $614,000 in 2016, $654,600 in 2017, and $704,200 in 2018.

In addition, Killearn sold inventory costing $145,800 to Shaun for $243,000 during 2017. Shaun resold $102,000 of this inventory during 2017 and the remaining $141,000 during 2018.

1. Determine the equity income to be recognized by Killearn during each of these years.

2. Compute Killearn's investment in Shaun Company's balance as of December 31, 2018.

(For all requirements, enter your answers in whole dollars and not in millions.)

Answer 1

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Working:
Equity Income 2016
Basic equity accrual ($598,000 × ½ year × 25%)	$614,000*1/2*40%	$                                                                                              122,800
Amortization (½ year—see Schedule 1)	$78,000*1/2	$                                                                                              (39,000)
Equity Income—2016		$                                                                                                83,800
Equity Income 2017
Basic equity accrual	$654,600*40%	$                                                                                              261,840
Amortization (see Schedule 1)		$                                                                                              (78,000)
Deferral of intra-entity profit (see Schedule 2)		$                                                                                              (14,100)
Equity Income—2017		$                                                                                              169,740
Equity Income 2018
Basic equity accrual	$704,200*40%	$                                                                                              281,680
Amortization (see Schedule 1)		$                                                                                              (78,000)
Recognition of deferred profit (see Schedule 2)		$                                                                                                14,100
Equity Income—2018		$                                                                                              217,780
Schedule 1
Acquisition price	142,000*$15	$                                                                                          2,130,000
Book value acquired ($2,925,600 × 25%)	($5,000,000-$890,000)*40%	$                                                                                          1,644,000
Payment in excess of book value		$                                                                                              486,000
Excess payment identified with specific assets:		Amortization	Remaining	Annual
Equipment	$245,000*40%	$                                                                                                98,000	7 yrs.	$         14,000
Copyright	$800,000*40%	$                                                                                              320,000	5 yrs.	$         64,000
Goodwill		$                                                                                                68,000	indefinite	$                   -
Total annual amortization (full year)				$         78,000
Schedule 2
Intra-entity Gross Profit Percentage:
Sales	$                                            243,000	a
Cost of goods sold	$                                            145,800	b
Gross profit	$                                              97,200	a-b=c
Gross profit percentage	40%	c/a
Inventory remaining at December 31, 2017		$                                                                                              141,000
Gross profit percentage		40%
Total profit on intra-entity sale still held by affiliate		$                                                                                                56,400
Investor ownership percentage		25%
Intra-entity gross profit deferred from 2017 until 2018		$                                                                                                14,100
Investment in Shaun—December 31, 2018 balance
Acquisition price		$                                                                                          2,130,000
2016 Equity income (above)		$                                                                                                83,800
2016 Dividends declared during half year	142,000*$1	$                                                                                            (142,000)
2017 Equity income (above)		$                                                                                              169,740
2017 Dividends declared	142,000*$1*2	$                                                                                            (284,000)
2018 Equity income (above)		$                                                                                              217,780
2018 Dividends declared	142,000*$1*2	$                                                                                            (284,000)
Investment in Shaun—12/31/18		$                                                                                          1,891,320