Question

On July 1, 2016, Killearn Company acquired 88,000 of the outstanding shares of Shaun Company for $13 per share. This acquisition gave Killearn a 25 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 $3 million and liabilities of $74,400. At the time, Shaun held equipment appraised at $364,000 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 $972,000. 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 $598,000 in 2016, $639,600 in 2017, and $692,400 in 2018.

In addition, Killearn sold inventory costing $91,200 to Shaun for $152,000 during 2017. Shaun resold $92,000 of this inventory during 2017 and the remaining $60,000 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.

Answer 1

(Compute equity balances for three years. Includes intra-entity inventory transfer)

Part a.

        Equity Income 2016

              Basic equity accrual ($598,000 × ½ year × 25%)......................................         $74,750

              Amortization (½ year—see Schedule 1)...................................................        (30,800)

                    Equity Income—2016.........................................................................         $43,950

        Equity Income 2017

              Basic equity accrual ($639,600 × 25%)...................................................         $159,900

              Amortization (see Schedule 1).................................................................           (61,600)

              Deferral of intra-entity profit (see Schedule 2).......................................            (6,000)

                    Equity Income—2017.......................................................................           $92,300

        Equity Income 2018

              Basic equity accrual ($692,400 × 25%)...................................................         $173,100

              Amortization (see Schedule 1).................................................................           (61,600)

              Recognition of deferred profit (see Schedule 2).....................................               6,000

                    Equity Income—2018.......................................................................         $117,500

Schedule 1—Acquisition Price Allocation and Amortization

        Acquisition price       (88,000 shares × $13)                          $1,144,000

        Book value acquired ($2,925,600 × 25%)                                  731,400

        Payment in excess of book value                                             $412,600

                                                                                                                   Remaining   Annual        

        Excess payment identified with specific assets:                                    Life    Amortization

            Equipment ($364,000 × 25%)                                  $91,000           7 yrs.       $13,000

            Copyright ($972,000 ×25%)                                   243,000           5 yrs.         48,600

            Goodwill                                                                    78,600    indefinite                -0-

       Total annual amortization (full year)                                                                    $61,600

        Schedule 2—Deferral of Intra-entity Gross Profit

       Intra-entity Gross Profit Percentage:

    Sales                                                                              $152,000

    Cost of goods sold                                                            91,200

    Gross profit                                                                    $ 60,800

    Gross profit percentage: $60,800 ÷ $152,000 = 40%

        Inventory remaining at December 31, 2017.................................................               $60,000

        Gross profit percentage ...............................................................................                  × 40%

        Total profit on intra-entity sale still held by affiliate...................................               $24,000

        Investor ownership percentage.....................................................................                  ×25%

        Intra-entity gross profit deferred from 2017 until 2018..............................                $ 6,000

Part b.

        Investment in Shaun—December 31, 2018 balance

        Acquisition price..........................................................................................         $1,144,000

        2016 Equity income (above)........................................................................                43,950

        2016 Dividends declared during half year (88,000 shares × $1.00) (88,000)

        2017 Equity income (above)........................................................................                92,300

        2017 Dividends declared (88,000 shares × $1.00 × 2)................................            (176,000)

        2018 Equity income (above)........................................................................             117,500

        2018 Dividends declared (88,000 shares × $1.00 × 2)................................           (176,000)

                  Investment in Shaun—12/31/18........................................................            $957,750