Equity investments and fair market value

Question

a) Lee, Inc. acquired 30% of Polk Corp.'s voting stock on January 1, 2017 for $100,000. Lee’s investment in Polk gives Lee the ability to exercise significant influence over Polk’s operating and financial policies. During 2017, Polk earned $40,000 of net income The fair market value of Lee’s investment in Polk at December 31, 2017 is $110,000.

How would you prepare all 2017 journal entries for Lee related to this investment in Polk?

b) On July 1, 2017, Denver Corp. purchased 3,000 shares of Eagle Co.’s 18,000 outstanding shares of common stock for $20 per share. During 2017, Eagle paid $40,000 in dividends to its common stockholders. Eagle’s net income for the year ended December 31, 2017 was $120,000. Eagle’s common shares were trading at $25 per share at December 31, 2017.

How would you prepare all 2017 journal entries for Denver related to this investment in Eagle?

Answer 1

Considerations:

For purposes of valuing and reporting these securities, we have 2 options:

Equity Method and Fair Value Method

Equity Method

-generally used if

20-50% ownership

Significant influence

(ability to alter a company’s dividend policy)

Fair Value Method

less than 20% ownership

Applications:

Equity Method

-dividends paid reduce investment value

-no unrealized gains or losses

-proportionate share of

 net income or loss of investee

Fair Value Method

-unrealized gains or losses if

 stock goes up or down

-dividend paid recorded as revenue

Outcome:

a)

30% ownership

Equity Method

Jan 01  Stock Investments                          100,000

Cash                                                            100,000

           to record purchase of 30% of Polk voting stock

Dec 31 Stock Investments ($40,000 x 30%) 12,000

                Investment Revenue                                    12,000

           to record 30% equity in Polk net income

b)

3,000 shares/18,000 outstanding shares = approximately16.7% ownership

Fair Value Method

Jul 01  Stock Investments (3,000 x $20)     60,000

                Cash                                                               60,000

           to record purchase of 3,000 shares of Eagle stock

Dec 31 Fair Value Adjustment                     15,000

                Unrealized Gain or Loss                              15,000

           to record unrealized gain on Eagle stock