What amount should Iberia recognize in its 2009 income statement as a result of its investments in Midland and Odessa?

Bryan Stephenson is an equity analyst and is developing a research report on Iberia Corporation at the request of his supervisor. Iberia is a conglomerate entity with significant corporate holdings in various industries. Specifically, Stephenson is interested in the effects of Iberia’s investments on its financial performance and has decided to focus on two investments: Midland Incorporated and Odessa Company.

Midland Incorporated

On December 31, 2007, Iberia purchased 5 million common shares of Midland Incorporated for 80 million. Midland has a total of 12.5 million common shares outstanding. The market value of Iberia’s investment in Midland was 89 million at the end of 2008 and 85 million at the end of 2009. For the year ended 2008, Midland reported net income of 30 million and paid dividends of 10 million. For the year ended 2009, Midland reported a loss of 5 million and paid dividends of 4 million.

During 2010, Midland sold goods to Iberia and reported 20% gross profit from the sale. Iberia sold all of the goods to a third party in 2010.

Odessa Company

On January 2, 2009, Iberia purchased 1 million common shares of Odessa Company as a long-term investment. The purchase price was 20 per share and on December 31, 2009, the market price of Odessa was 17 per share. The decline in value was considered temporary. For the year ended 2009, Odessa reported net income of 750 million and paid a dividend of 3 per share. Iberia considers its investment in Odessa as an investment in financial assets.

In addition, Iberia has a number of foreign investments, so Stephenson’s supervisor has asked him to draft a report on accounting methods and ratio analysis. The following are statements from Stephenson’s research report.

Statement 1: Under U.S. GAAP, firms are required to use proportionate consolidation to account for joint ventures.

Statement 2: In general, if the parent’s consolidated net income is positive, the equity method reports a higher net profit margin than the acquisition method.

What amount should Iberia recognize in its 2009 income statement as a result of its investments in Midland and Odessa?
A . 1 million profit.
B . 2 million profit.
C . 3 million loss.

View Answer

Answer: A

Explanation:

Since Iberia owns 40% of Midland (5 million shares owned / 12.5 million total shares outstanding), the equity method is used. Under the equity method, Iberia reports its pro-rata share of Midland’s net income (5 million loss x 40% = 2 million loss). Changes in market value are ignored under the equity method.

Iberia’s investment in Odessa is classified as available-for-sale since the investment is considered long-term. Dividend income from available-for-sale securities is recognized in the income statement (3 dividend x 1 million shares = 3 million). The changes in market value are reported in shareholders’ equity.

Investment income from Midland and Odessa is 1 million (3 million dividend income from Odessa – 2 million pro-rata loss from Midland). (Study Session 5, LOS 21.a)