Mr. Mercury, Inc. bought 25% of Hermes Corp.’s outstanding common stock on January 2, 2018, for $500,000. The carrying amount of Hermes’ net assets at the purchase date totaled $1,500,000. Fair values and carrying amounts were the same for all items except for plant and inventory, for which fair values exceeded their carrying amounts by $80,000 and $40,000, respectively. The plant has a ten-year life. All inventory was sold during 2018. During 2018, Hermes reported net income of $200,000 and paid a $20,000 cash dividend. There is no impairment of goodwill during 2018. Assume that Mr. Mercury uses the equity method to account for this investment. What amount should Mr. Mercury report in its income statement from its investment in Hermes for the year ended December 31, 2018?

$38,000

Explanation:

The amount that Mr. Mercury should report in its income statement from its investment in Hermes for the year ended December 31, 2018 will be the share of profit from Hermes and the adjustment of fair values for additional depreciation on plant and stock

Hermes reported net income of $200,000

Mercury's share of Hermes profit $50,000 (i.e. 25% of $200,000)

Additional depreciation on plant = 80,000 / 10 years  x 25% = $2000

Share of excess of fair value on inventory = $40,000 x 25% = $10,000

Therefore amount to be reported under equity accounting in income statement = $50,000 - $2,000 - $10,000 = $38,000

Investment revenue = $38,000

Explanation:

Since Mercury uses the equity method to record the original journal entry to record the purchase of 25% of the share should have been:

Dr Investment in Hermes 500,000

    Cr Cash 500,000

After one year, Hermes earned $200,000 in net income, but it also sold inventory that had a carrying value $40,000 lower than fair market value and equipment with a lower carrying value also depreciated by $80,000. So the net income must be adjusted = $200,000 - $40,000 - ($80,000 x 10%) = $152,000. The journal entry to record the adjusted income should be   ($152,000 x 25%):

Dr Investment in Hermes 38,000

    Cr Investment revenue 38,000

Since dividends were distributed, then the journal entry should be ($20,000 x 25%):

Dr Cash 5,000

    Cr Investment in Hermes 5,000

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