In applying the equity method, income is recognized by the investor when earned by the investee. Subsequent dividend collections are not reported as revenue by the investor but rather as a reduction in the size of the investment account to avoid including the income twice. To illustrate, assume that Big Company buys 40 percent of the outstanding stock of Little Company on January 1, Year One, for $900,000. No evidence is present that provides any indication that Big lacks the ability to exert significant influence over the financing and operating decisions of Little. Thus, application of the equity method is appropriate. During Year One, Little reports net income of $200,000 and pays a total cash dividend to its stockholders of $30,000. What recording is appropriate for an investor when the equity method is applied to an investment?
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On Big’s income statement for Year One, investment income—Little is shown as $80,000. Because the equity method is applied, the reader knows that this figure is the investor’s ownership percentage of the income reported by the investee. At the end of Year One, the investment in Little account appearing on Big’s balance sheet reports $968,000 ($900,000 + 80,000 – 12,000). This total does not reflect fair value as with investments in trading securities and available-for-sale securities. It also does not disclose historical cost. Rather, the $968,000 asset balance is the original cost of the shares plus the investor’s share of the investee’s subsequent income less any dividends received. Under the equity method, the asset balance is a conglomerate of numbers.
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