Question

Hope Company bought 30% of Faith Corporation in the beginning of 2013. Hope's purchase price equaled 30% of the book value of Faith's net identifiable assets, which also equaled 30% of the fair value of Faith. During 2013, Faith reported net income in the amount of $4,000,000 and declared and paid dividends in the amount of $500,000. Hope mistakenly accounted for the investment as available for sale instead of using the equity method. What effect would this error have on the investment account and net income, respectively, for 2013?

Answer 1

If Hope mistakenly accounted for the investment as available for sale instead of using the equity method, it would not recognize the net income of $4,000,000 from Faith Corporation for 2013.

Step-by-step explanation:

If Hope mistakenly accounted for the investment as available for sale instead of using the equity method, it would have a specific effect on the investment account and net income for 2013.

Under the available for sale method, any changes in the fair value of the investment are recorded as unrealized gains or losses in the investment account. However, under the equity method, the investor recognizes its share of the investee's earnings as income.

In this case, since Faith reported net income of $4,000,000 in 2013, if Hope had used the equity method, it would have recognized 30% of this amount as its share of the earnings. But since Hope mistakenly accounted for the investment as available for sale, it would not recognize the $4,000,000 as income. Instead, it would only record any changes in the fair value of the investment.