Question

Seely Company purchased 42,000 shares of common stock of Otto Corporation as a long-term investment for $1,000,000. During the year, Otto Corporation reported a net income of $300,000 and paid dividends of $100,000.

Assuming that the 42,000 shares represent a 15% interest in Otto Corporation:

1. Prepare the journal entry to record the investment in Otto stock.

2. Prepare any entries that Seely Company should make in accounting for its investment in Otto stock during the year.

3. What is the balance of the Stock Investments account on Seely Company's books at the end of the year?

Answer 1

1. To record the initial investment in Otto stock, Seely Company would make the following journal entry:

Debit: Stock Investments (Otto Corporation) $1,000,000

Credit: Cash $1,000,000

2. Since the 42,000 shares represent a 15% interest in Otto Corporation, Seely Company can use the equity method to account for its investment. Under the equity method, the investor recognizes its share of the earnings and losses of the investee in the periods when these earnings and losses are also reflected in the investee's financial statements. The investor will also decrease its investment by the amount of dividends received from the investee.

Otto Corporation reported a net income of $300,000. Seely Company's share is 15% of that, or $45,000. Otto Corporation paid dividends of $100,000. Seely Company's share is 15% of that, or $15,000.

The entries Seely Company should make are:

Debit: Stock Investments (Otto Corporation) $45,000

Credit: Investment Income $45,000

and

Debit: Cash $15,000

Credit: Stock Investments (Otto Corporation) $15,000

3. The balance of the Stock Investments account at the end of the year would be the initial investment plus the share of net income, less the share of dividends. That's $1,000,000 + $45,000 - $15,000 = $1,030,000.