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Pyming Corporation accounts for its 40% investment in Sillabog Company using the equity method. On the date of the original investment, fair values were equal to the book values except for a patent, which cost Pyming an additional $40,000. The patent had an estimated life of 10 years. Sillabog has a steady net income of $20,000 per year and consistently pays out 40% of its net income as dividends to its shareholders. Which one of the following statements is correct?

A) The net change in the investment account for each full year will be a debit of $8,000.
B) The net change in the investment account for each full year will be a debit of $4,800.
C) The net change in the investment account for each full year will be a debit of $800.
D) The net change in the investment account for each full year will be a credit of $800.

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Answer:

C) The net change in the investment account for each full year will be a debit of $800.

Explanation:

Sillabog distributes every year $8,000 (= $20,000 x 40%) as dividends to its shareholders, that leaves $12,000 as retained earnings.

Pyming owns 40% of Sillabog, it is entitled to 40% of the retained earnings = $12,000 x 40% = $4,800.

Pyming paid an additional $40,000 for a patent that has a 10 year useful life, if we apply the straight amortization method, each year Pyming should amortize $4,000 (= $40,000 x 10%) for the patent.

Since Pyming is entitled to $4,800 of Sillabog's retained earnings per year and amortizes $4,000 for the patent it purchased, its investment increases by $800 every year (= $4,800 - $4,000).

Pyming´s investment account is an asset, and since the investment increases, the account should be debited.

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