I had this question in the Becker simulated final exam. I am confused about why the they took the DRD (20%) on the earnings AND the dividend? I thought it would just be taken on the dividend....Help.

On January 1, 1996, Pesto & Co. purchased 35% of the voting common stock of Surry Co. and appropriately accounted for the investment by the equity method.  During 1996, Surry reported earnings of $200,000 and paid dividends of $40,000.  Pesto's current enacted income tax rate is 28%.  In addition:

•     The dividends received from Surry are eligible for the 80% dividends received deduction.

•     The income tax rate enacted for future periods is 30%.

In Pesto's December 31, 1996, balance sheet the deferred income tax liability should be:

Choice 4 is correct.

                          EQUITY                                                                         COST

                                                                 Dividends →                      $ 40,000

                         $ 200,000                           ← Earnings

                         x        35%                         Ownership                        x       35%

                            70,000                         Parent Reports                      14,000

                         x        20%                Dividend Rec. Deduct                x       20%

                                                         (100% - 80% = 20%)                           

                            14,000                        Taxable income                        2,800

                         x        30%                          Tax Rate                         x       30%

                         $    4,200                             $3,360 =                         $     840

                                                     Deferred income tax liability

I guess I am confused on why the $200,000 is being treated as dividends. I thought that for the financial statements, you would have dividend income of 14,000 (40,000*35%) and for taxes you would have dividend income $2,800 (40,000*35%*20%DRD).

OHHH...sorry. Just did the math and I get the same answer this way. (14,000-2800=11,200*30%=3,360) The way it was worded was confusing me I guess.