McGuinn, Inc. owns a 40% interest in Cervantes Co., giving it representation on
ID: 2773796 • Letter: M
Question
McGuinn, Inc. owns a 40% interest in Cervantes Co., giving it representation on the investee’s board of directors. At the beginning of the year, the Equity Investment was carried on McGuinn’s balance sheet at $750,000. During the year, Cervantes reported net income of $240,000 and paid McGuinn a dividend of $48,000. In addition, McGuinn sold inventory to Cervantes , recording a gross profit of $60,000 on the sale. At the end of the year, 25% of the merchandise remained unsold by Cervantes .
Required:
A. Prepare the equity method journal entry to defer the unrealized inventory gross profit.
B. How much income should McGuinn report from Cervantes during the year?
C. What is the balance in the Equity Investment at the end of the year?
Explanation / Answer
Part- A
The total gross profit of selling invesntory McGuinn to Cervantes Co. is $60,000
Of this 25% is unsold by Cervantes which is 0.25*60,000 which is $15,000 which is unrealized
Since the ownership of McGuinn is only 40% in Ceraventus, the total unrealized gross profit for McGuinn will be 40% of $15,000 which is $6,000
Therefore According to equity method on $6,000 of the gross profit should be deferred due to unsold inventory
The below journal enrty will be needed to adjust or correct the equity in the reported net income of the investee(McGuinn Ic)
Equity in Cervantes Inc Dr 6,000
To Investment in Cervantes Inc Cr 6,000
Part - B
Total Income for McGuinn from Ceraventus Ltd. will be the dividend received $48,000 and The gross Profit of the sale $60,000 - unrealized profit adjsuted $6,000
Therefore Total income is 48,000 +60,000 - 6,000 = $102,000
Part -C
Net Income for Ceraventus is 240,000 and out of this 120,000 paid as dividends and assuming another 120,000 will be retained for further growth and out of this 120,000 retained , McGuinn;s share will be 40% which is 48,000
Hence Total equity will be 750,000 + 48,000 + 6,000 ( unrealized gross profit) = $804,000