Companies often have equity ownership in other companies or ventures that do not require them to consolidate them under either the voting interest model or the variable interest model. To appropriately account for these smaller investments, the company will need to determine if they qualify for the equity method of accounting. Equity method investments fall within the scope of ASC 323, Investments- Equity Method and Joint Ventures. The equity method of accounting allows an investor to measure investments in common stock or other eligible investments by recognizing its share of the economic resources underlying those investments. Typically, the equity method applies to investors with 50% or less of the voting shares but with significant influence over an investee’s operating and financial policies. This article specifically discusses the accounting for equity method investments.

Scope

ASC 323 applies to investments in common stock or in-substance common stock that allow the company to exercise significant influence over the investee. This includes investments in corporate joint ventures, which are separate legal entities under the joint control of the parties through their respective equity investments. The purpose of a corporate joint venture is to share in the risks and rewards of developing something new and to pool together resources. In-substance common stock must have essentially the same rights as common stock (e.g., subordination, risk and rewards, obligation to transfer value). ASC 323 does not apply to investments in partnerships, limited liability companies, and unincorporated joint ventures.

Generally, significant influence exists for investments that have 20% or more of the investee’s voting stock and does not exist for investments of less than 20% of the voting stock. However, an analysis needs to be performed for investments below 20% to determine if the investor can exert significant influence over the operating and financial policies of the investee.

In accordance with ASC 323-10-15-8, an investment of less than 20% does not have the ability to exercise significant influence, unless such ability can be demonstrated, which is a higher hurdle than for investments of more than a 20% interest. An investor should consider all relationships and interests in an investee, including ways an investor might influence the operating and financial policies of an investee. ASC 323-10-15-6 provides a list of indicators to consider when evaluating whether or not a company has the ability to exercise significant influence over the operating and financial policies of an investee, including, but not limited to:

• Representation on the board of directors
• Participation in policy-making processes
• Sharing of managerial personnel
• Material intra-entity transactions
• Technological dependency
• The concentration of ownership by an investor in relation to the other shareholdings

All facts and circumstances around the investment should be considered, including special rights (e.g., veto rights, kick-out rights, etc.).

The determination of an equity method investment should be reassessed if the terms of the investment change, there is a significant change in the investee’s capital structure, or the company obtains an additional interest in the investment or decreases its investment.

Initial Measurement and Recognition

The equity method investment is initially measured at cost, similar to asset acquisitions under ASC 805-50-30. The investment is recorded on the date that the company has both acquired the investment and determined that it has the ability to exercise significant influence over the investee. The costs included in the measurement are limited to incremental direct costs of acquiring the investment. Commitments to fund the investee in the future are not included in the cost. Guarantees to third parties on behalf of the investee should be recorded under ASC 460 and would initially increase the investment amount. If an equity method investment is acquired as part of a business combination, the investment should be recognized at its fair value on the date of acquisition. Any contingent consideration should be included in the cost basis of the investment if it is required to be recognized under other guidance that is not ASC 805 (e.g., it is a derivative under ASC 815). If the equity method investment was acquired by exchanging nonmonetary consideration, and the counterparty is not a customer, the cost of the investment would be measured at the fair value of the nonmonetary consideration given or the fair value of the equity method investment if that is more reliably measurable.

Basis Differences

While the equity method investments are presented on the balance sheet as a single item, the company will need to identify and account for any basis differences. Basis differences are when there is a difference between the cost basis above and the proportional interest in the investee’s underlying net assets. The company will need to account for the basis differences as if the investee were a consolidated subsidiary. To identify these differences, the company will need to allocate the cost to the individual asset and liabilities through a hypothetical purchase price allocation (similar to business combinations), where most of the assets and liabilities are measured at fair value. Any excess cost over the proportional fair value of the net assets acquired is considered goodwill (“equity method goodwill”). Basis differences are tracked offline in “memo” accounts.

Subsequent Recognition

At each reporting period, the equity method investment will be adjusted for the company’s share of the investee’s financial activity and other investor-level adjustments.

Investee’s earnings or losses

The company will need to multiply its percentage holding of the investee’s common stock by the net income or loss of the investee each reporting period. The company’s share of earnings or losses from its investment will be shown in its income statement as a single amount.

Elimination of intra-entity profits

Any intra-entity profits with the investee should be eliminated until they are realized with third parties (e.g., inventory is sold through to the third party). If the intra-entity arms-length transaction does not involve an asset that remains on the books, then the intra-entity profit does not need to be eliminated.

Amortization/accretion of basis differences

The basis differences related to the net assets acquired should be amortized or depreciated and included in the company’s share of earnings or losses of the investee. Equity method goodwill is not amortized unless the company adopts the private company goodwill accounting alternative to amortize goodwill over 10 years. Any disposals or impairments at the investee level should be evaluated as part of the company’s outside basis.

Investee’s other comprehensive income

If the investee records a change in other comprehensive income, the company should record the proportionate change to its investment, with the offset to its other comprehensive income. The company should not record investee losses in excess of its investment. When the company sells a portion of its investment, it should recognize a gain or loss, with the company’s related portion of cumulative other comprehensive income included in the gain or loss.

Capital transactions with the investee

The company may have additional investments which increase its ownership interest. If the increase in ownership does not give the company a controlling financial interest, the increase should be recognized at cost, and the basis differences must be recalculated. If it decreases its ownership, the company accounts for the transaction as a sale, reducing the carrying amount of its investment and recognizing a gain or loss recognized in earnings. If the company receives cash as a dividend, it reduces the carrying amount of its investment.

Investee accounting basis

The investee’s financial statements should reflect US GAAP. If the investee has different accounting policies than the company, its financials are not adjusted to conform to the company’s accounting policies if they were prepared in accordance with US GAAP. If the investee’s financial statements have a different fiscal year-end, its financials do not need to be adjusted if its fiscal year-end is not more than three months different than the company’s fiscal year-end. Sometimes the investee does not prepare US GAAP financials on a timely basis. When there is a lag (not to exceed 93 days), the company can use the investee’s most recent financial statements. If the investee’s financial statements are in a reporting currency different from the company’s, the company should translate the investee’s financial statements and recognize the translation adjustment in its other comprehensive income.

Losses in excess of the carrying amount

If the company’s share of losses in an investee exceeds the carrying amount of its investment, the company should generally discontinue applying the equity method of accounting and not record additional losses unless: 1) it has guaranteed obligations of the investee, 2) it is committed to providing further support or 3) it is expected that the investee will return to profitability imminently. However, additional losses should be tracked even if they are not recorded. The company would only resume the equity method of accounting when the investee returns to profitability and its share of the profits covers all of the company’s unrecorded net losses.

Impairment

The unit of account for the company’s impairment purposes is the investment as a whole. The company is required to assess whether any changes in circumstance indicate the carrying amount of the investment is not recoverable. These include:

• Evidence that the investment is not recoverable
• The investee is not able to sustain earnings
• The fair value of the investment is less than the carrying amount
• Other investors start reducing or getting rid of their investments

If the fair value of the equity method investment is less than its carrying value, and the impairment is other-than-temporary, the company should reduce the carrying value of its investment to its fair value, with the charge recognized through the equity in earnings of the investee. To evaluate whether the impairment is other-than-temporary, the length of time the fair value is less than the carrying amount, the investee’s financial condition and forecasts, as well as the intent and ability of the company to hold the investment, should be taken into consideration.