Question

Case 2-2 LO2,4,6 Floyd's Specialty Foods Inc. (FSFI) operates over 60 shops throughout Ontario. The company was founded by George Floyd when he opened a single shop in the city of Cornwall. This store sold prepared dinners and directed its products at customers who were too busy to prepare meals after a long day at work. The concept proved to be very successful, and more stores were opened in Cornwall. Recently, new stores were opened in five other Ontario cities. Up to the current year, the shares of FSFI have been owned entirely by Floyd. However, during this year, the company suffered severe cash flow problems, due to too rapid expansion exacerbated by a major decline in economic activity. Profitability suffered and creditors threatened to take legal action for long-overdue accounts. To avoid bankruptcy, Floyd sought additional financing from his old friend James Connelly. who is a majority shareholder of Cornwall Autobody Inc. (CAI), a public company. Subsequently, CAI paid $950,000 cash to FSFI to acquire enough newly issued shares of common stock for a one-third interest. At the end of this year. CAI's accountants are discussing how they should properly report this investment in the company's financial statements One argues for maintaining the asset at original cost, saying, "What we have done is to advance money to bail out these stores. Floyd will continue to run the organization with little or no attention to us, so in effect we have lent him money. After all, what does anyone in our company know about the specialty food business? My guess is that as soon as the stores become solvent. Floyd will want to buy back our shares." Another accountant disagrees, stating that the equity method is appropriate. "I realize that our company is not capable of running a specialty food company. But the requirements state that ownership of over 20% is evidence of significant influence. A third accountant supports equity method reporting for a different reason. "If the investment gives us the ability to exert significant influence, that is all that is required. We don't have to actually exert it. One-third of the common shares certainly give us that ability." Page 78 Required How should CAI report its investment? Your answer should include a discussion of all three accountants positions.

refer to the cpa handbook please

Answer 1

An investor that holds an individual financial interest, or a combination of voting and nonvoting financial interests that includes an investment in common stock or in-substance common stock, and is able to exercise significant influence over the operating and financial policies of the investee would generally account for that investment using the equity method.

CAI has purchased newly issued shares of common stock and has acquired 33% interest in FSFI. As a result, it can be presumed that CAI can exert significant influence (and not control) over the financial decisions that FSFI makes.

Even if CAI has only advanced loan to bail out FSFI, it has accumulated enough equity ownership to exercise significant influence. If CAI's only intention was to bail out FSFI and extend credit, it would have advanced a loan or a similar credit facility to FSFI.

Also, it is inconsequential if FSFI is not an expert in running a sepaciality food company. Only the fact that CAI has an ownership of over 20% in FSFI does not necessiate the use of equity method accounting. The fact that CAI has the ability to exert significant influence over the key decisions of FSFI requires it to account for its investment in FSFI by using the equity method of accounting. An ownership of more than 20% is only a factor that suggests the ability of the acquirer to exert signifcant influence over the company whose shares it acquires. Significant influence may also be exerted by way of other arrangements like influence over the board of directors etc.

As a result, accountant 3 is correct and CAI must account for its inevestment in FSFI using the equity method of accounting.