A corporation using the equity method of accounting for its investment in a 40 percent-owned investee, which earned $20,000 and paid $5,000 in dividends, made the following entries:

 A corporation using the equity method of accounting for its investment in a 40 percent-owned investee, which earned $20,000 and paid $5,000 in dividends, made the following entries:

Account Title    Debit    Credit
Investment in Investee    8,000    
Income from Investee         8,000
Account Title    Debit    Credit
Cash    2,000    
Dividend Revenue         2,000
What effect will these entries have on the investor’s statement of financial position?

Multiple Choice

Investment in the investee will be overstated, retained earnings will be understated.


Investment in the investee will be overstated, retained earnings will be overstated. Correct

Investment in the investee will be understated, retained earnings will be understated.


Financial position will be fairly stated.

Explanation

Under the equity method, dividends by the investee are recorded with a credit to the investment account, not to dividend revenue. By wrongly classifying this entry, the investment is overstated, and retained earnings are also overstated.

(Financial position will be fairly stated.) Incorrect. Because the dividend entry was recorded incorrectly, the financial position will not be correctly stated.
(Investment in the investee will be overstated, retained earnings will be understated.) Incorrect. Because the dividends were recorded as dividend revenue, retained earnings would be overstated.
(Investment in the investee will be understated, retained earnings will be understated.) Incorrect. Currently, the investment is overstated because the dividends declared should have resulted in a reduction to the investment account.