Question

Lee, Inc. acquired 30% of Polk Corp.'s voting stock on January 1, 2016 for $100,000. During 2016, Polk earned $40,000 and paid dividends of $25,000. Lee's 30% interest in Polk gives Lee the ability to exercise significant influence over Polk's operating and financial policies. During 2017, Polk earned $50,000 and paid dividends of $15,000 on April 1 and $15,000 on October 1. On July 1, 2017, Lee sold half of its stock in Polk for $66,000 cash. What should the gain on sale of this investment in Lee's 2017 Income Statement be? a) $10,000 b) $16,000 c) $13,750 d) $12,250

Answer 1

D) $12,250

Step-by-step explanation:

Lee's gain = $66,000 - half the carrying value of Lee's investment

Lee must use the equity method because its 30% stake at Polk provided a significant influence over the investee corporation. The equity method requires that Lee recognize its share of undistributed earnings of Polk's income.

The carrying value must include the first dividend of 2017, the second dividend is not included since it occurred after the sales was made. The carrying value = initial purchase - stock ownership(2016 income - 2016 dividends + 50%(2017 income) - first dividends 2017) = $100,000 + 30%($40,000 - $25,000 + 50%($50,000) - $15,000) = $107,500

Lee's gain = $66,000 - $107,500/2 = $66,000 - $53,750 = $12,250