Problem
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.
Task
1. How should BDI's investment in APP be reported on the financial statements of BDI? Provide arguments to support your recommendations.
2. What impact will the adoption of the reporting method have on BDI's debt-to-equity ratio, relative to using the cost method? Explain.