On January 1, 2000, Mega Corp. acquired 10% of the outstanding voting stock of Penny, Inc. On January 2, 2001, Mega gained the ability to exercise significant influence over Penny by acquiring an additional 20% of Penny's outstanding stock. No goodwill or depreciation as the two purchases were made at prices proportionate to the value assigned to Penny's net assets, which equaled their carrying amounts. For the years ended, December 31, 2000 and 2001, Penny reported the following:

                       2000     2001

Dividends paid $200K   $300K

Net income      600K     650K

In 2001, what amounts should Mega report as current year investment income and as an adjustment, before income taxes, to 2000 investment income?

Answer: 195K and 40K respectively

My question is why do you subtract the $200K div's paid from the $600K net income in 2000 (600-200=400x10%=40K) but you don't subtract the div's from net income in 2001? I think the answer should be $105K and 40K, which was an answer choice by the way, but the incorrect one.

Under the cost method, dividends count as income:

Cash DR xxx

Dividend Revenue CR xxx

 Under the equity method, dividends have no effect on income (they reduce the investment account balance):

Cash DR XXX

Investment acct. CR xxx

You have to retroactively amend prior years to reflect equity method treatment, so you have to reverse dividends recognized as income in prior years under the cost (or initial value) method:

Dividend Revenue DR xxx

Investment acct. CR. xxx

 In the current year, the dividends would not have been recorded as income, as the equity method applied from the beginning of the year. Thus no adjustment to income is necessary in the current year.