Question

(I have ONE hour)

On January 1, 2020, Pearl Corporation purchased 36,000 of the 120,000 outstanding common shares of Krab Corporation, paying $32 per share cash. During the year, Krab Corporation paid $1.10 per share cash dividends and at the end of the year, Krab Corporation reported $840,000 of net income. At the end of 2020, the market value of the Krab Corporation common stock is $36 per share.

Part A:

Short Answer

1. Pearl Corporation must use the equity method of accounting. Why?
2. Why is the equity method never used when shares of preferred stock are purchased as an investment?
   1. List two events that provide "evidence" that an investor corporation is exerting significant influence over another corporation when 20-50% of the outstanding common shares are purchased.  

Part B:

Give the general journal entries for Pearl Corporation to account for this investment in Krab using the equity method of accounting.

General Journal
Account Titles (debits)	Account Titles (credits)	DR	CR

Part C:

Indicate the names and balances of the investment related-accounts to be reported on Pearl Corporation's 2020 financial statements.

Income Statement:		Balance Sheet:
Name of Account	Amount	Name of Account	Amount

Part D:

Short Answer

1. Why doesn't Pearl Corporation have to prepare consolidated financial statements?
2. What are consolidated financial statements?
3. If you are looking at a consolidated balance sheet and see the account "Non-Controlling Interest", what does the balance of that account represent?

Answer 1

Part A:

Pearl Corporation holds 36000/120000 = 30% of the outstanding common shares of Krab Corporation. Since, Pearl's shareholding in Krab exceeds 20%, Pearl is considered to have significant influence over Krab and hence is required to account for its investment in Krab by using the equity method.

Preferred stock does not give the holders any voting rights or any influence over the investee company and hence the equity method is never used for accounting of investment in preferred stock.

Two events providing evidence of an investor exerting significant influence over the investee are:

1. The investor has representation on the board of directors of the investee company.

2. The investor participates in policy making of the investee company.

Part B:

General Journal
Account Titles (Debits)	Account Titles (Credits)	DR	CR
Equity investment in Krab Corporation (36000 x $32)		1152000
	Cash		1152000
Cash (36000 x $1.10)		39600
	Equity investment in Krab Corporation		39600
Equity investment in Krab Corporation (30% x $840000)		252000
	Investment revenue		252000

Part C:

Income Statement:		Balance Sheet:
Name of Account	Amount	Name of Account	Amount
Investment revenue	$    252,000	Equity Investments	$ 1,364,400

Equity Investments = $1152000 - $39600 + $252000 = $1364400

Part D:

Since the shareholding of Pearl Corporation in Krab Corporation is less than 50%, Pearl does not have control over Krab Corporation and hence, it does not have to prepare consolidated financial statements.

Consolidated financial statements are the financial statements of the parent company (investor with > 50% shareholding) and its subsidiary company (investee company over which parent has control) which are combined together and reported as a single entity.

Non-controlling interest is the minority interest or the interest of the shareholders holding less than 50% of the outstanding shareholding with no control.