Question

Hope Company bought 30% of Faith Corporation in the beginning of 2021. Hope's purchase price of $3,000,000 equaled 30% of the book value of Faith's net identifiable assets, which also equaled 30% of the fair value of Faith. During 2021, Faith reported net income in the amount of $4,000,000 and declared and paid dividends in the amount of $300,000. At the end of 2021, Faith’s fair value was $12,000,000. Hope mistakenly accounted for the investment using the fair value through net income method instead of using the equity method. What effect would this error have on the investment account and net income, respectively, for 2021?

Answer 1

1.)	Investment Account
	Should be Under Equity Method
		Amount $
	Purchase Cost	3,000,000
	Add: Equity Income(4,000,000 x 30% )	1,200,000
	Less: Dividend received (300,000 x 30% )	90,000
	Investment account balance at end of 2021	4,110,000
	Done under fair value through Net Income
	Investment account balance at end of 2021	$ 3,600,000
	(12,000,000 x 30% )
	Effect of Error
	Investment account has been understated by	$ 510,000
	( 4,110,000 - 3,600,000 )
2.)	Net income
	Should be Under Equity Method
	Equity Income(4,000,000 x 30% )	$ 1,200,000
	Done under fair value through Net Income
	Unrealized holding gain	$ 600,000
	(3,600,000 - 3,000,000 )
	Effect of Error
	Net Income has been understated by	$ 600,000
	(1,200,000 - 600,000 )