Question

American Politics Property Inc. (APP) has been incorporated with the purpose to buy, develop and hold a commercial property in Niagara, Ontario. APP will buy the property for $900,000 and build a small office building at an expected cost of $2,100,000. Mr. Biden is the owner of Biden Developments Inc. (BDI). BDI will invest $900,000 in APP for 30% of its common shares. It will finance this investment through a loan of $675,000 and the sale of common shares to Ms. Harris for $225,000.

Mr. Trump, a private investor, will invest $2,100,000 in APP for a 70% interest in APP. According to the terms of the shareholders’ agreement, Mr. Biden and Mr. Trump must agree on all major operating, financing and investment decisions of APP. If not, the property will be sold on the open market and APP will be wound up.

Mr. Biden has approached you to advise him on how BDI should account for its investment in APP. He was considering using the cost method. The bank that will provide the debt financing to BDI requires a debt-to-equity ratio of no more than 3:1.

REQUIRED: a. How should BDI’s investment in APP be reported on the financial statements of BDI? Provide arguments to support your recommendations.

b. What impact will the adoption of the reporting method have on BDI’s debt-to-equity ratio, relative to using the cost method? Explain.

Answer 1

Answers:

a. BDI's investment in APP should be reported using the equity method on the financial statements of BDI. The equity method is appropriate when an investor has significant influence over the operating and financial policies of an investee, but does not have control or majority ownership. In this case, Mr. Biden and Mr. Trump must agree on all major decisions of APP, indicating significant influence.

Under the equity method, BDI initially records its investment in APP at cost, which is $900,000. Subsequently, BDI will recognize its share of APP's earnings or losses on its income statement and adjust the carrying value of its investment accordingly. BDI will also record its share of any dividends received from APP as a reduction of the investment balance.

The equity method reflects the economic substance of BDI's investment in APP and provides a more accurate representation of BDI's financial position and performance. It aligns with the underlying purpose of the investment, which is to generate returns from APP's operations and financial results. Additionally, the equity method ensures comparability with other entities that use similar reporting methods.

b. The adoption of the equity method, as opposed to the cost method, will have an impact on BDI's debt-to-equity ratio. The debt-to-equity ratio is calculated by dividing total debt by total equity and is a measure of financial leverage. Using the equity method, BDI will record its investment in APP as part of its equity on the balance sheet.

Assuming BDI's only significant liability is the loan of $675,000, the adoption of the equity method will increase BDI's equity by the amount of its investment in APP, which is $900,000. Consequently, the total equity will increase, and the debt-to-equity ratio will decrease. This is because the equity method treats the investment in APP as part of BDI's capital structure, rather than a separate asset.

By reducing the debt-to-equity ratio, BDI's financial position may appear stronger and more favorable to lenders or investors. It indicates a lower level of financial risk and greater reliance on equity financing. This may improve BDI's ability to meet the bank's requirement of a debt-to-equity ratio no more than 3:1 and enhance its financial stability.