Final answer:
Hope Company's error in using the fair value through net income method rather than the equity method for its investment in Faith Corporation would result in an incorrect investment account balance and net income figure. The correct equity method would involve adjusting Hope's investment account by its share of Faith's net income minus received dividends.
Step-by-step explanation:
The question relates to the accounting treatment of an investment by Hope Company in Faith Corporation under the equity method versus the fair value through net income method. Hope Company incorrectly applied the fair value method instead of the equity method, which requires adjustments in the investment account and the reported net income.
Under the equity method, Hope should recognize its share of Faith's net income and dividends. Since Faith reported net income of $4,000,000 and declared dividends of $500,000, and Hope owns 30% of Faith, Hope should have added $1,200,000 (30% of $4,000,000) to the investment account and subtracted $150,000 (30% of $500,000) for the dividends received. Instead, Hope recorded the investment at fair value, which likely led to a misstatement.
The effect of this error on Hope's financial statements would be an incorrect value in both the investment account and net income. The investment account may have either an overstatement or an understatement depending upon the fair value at reporting date, compared to the initial purchase price plus the equity method adjustments. Similarly, net income would be misstated because it did not include Hope's share of Faith's net income adjusted for dividends received.