Applying the Equity Method under ASU 2016-07

ASU 2016-07’s Main Provisions

ASU 2016-07 applies to “all entities that have an investment that becomes qualified for the equity method of accounting as a result of an increase in the level of ownership interest or degree of influence.” In other words, it applies to investor entities whose ability to significantly influence an investee entity is not achieved in a single transaction, and which have been applying the fair-value method prior to making required use of the equity method.

Previous accounting guidance required that when an investment qualifies for the use of the equity method as a result of an increase in the investor entity’s level of ownership, the investor must retroactively adjust the investment, results of operations, and retained earnings. Moreover, these adjustments must be made on a “step-by-step” basis, as if the equity method had been in effect since the date of the first investment date. ASU 2016-07, which is effective for fiscal years beginning after December 15, 2016, for all entities, eliminates this requirement and instead requires that the investor entity simply add the cost of the additional ownership interest, to the current basis of its previously held interest as of the date that the investment qualifies for the equity method.

Many investor companies that have been applying the previous guidance have, prior to the point of achieving the ability to exercise significant influence over the investee, been recognizing changes in the fair value of their available-for-sale investments as unrecognized holding gains/losses through “other comprehensive income”—a component of stockholders’ equity. Therefore, ASU 2016-07 further requires that, at the date the investment qualifies for use of the equity method of accounting, an investor recognize through earnings any such accumulated other comprehensive income (AOCI). This requirement differs from the prior practice of reporting such a gain/loss simply as a prior-period adjustment. It is therefore important to note that this new requirement could potentially impact an investor entity’s decision as to whether or not to make additional equity investments (i.e., the new accounting requirement may have unintended economic consequences). The change from fair value accounting to ASU 2016-07 has a current-period income effect, be it favorable or unfavorable.

As Stephen Zeff noted in his landmark article “The Rise of ‘Economic Consequences’” (Journal of Accountancy, December 1978, http://bit.ly/2hVrWlB), economic consequences are to be expected from the promulgation of new accounting standards. This particular change—reporting the unrealized gains or losses as current income rather than a prior period adjustment—could potentially affect entities’ economic decisions, and there appears to be little or no discussion of this potential unintended effect. Interestingly, ASU 2016-07 contains no such reference to this particular economic consequence, only unrelated concerns from some respondents that the change would increase the likelihood of future impairment recognition on the part of the investor entity.

The New Requirements: A Hypothetical Example

On January 1, 2015, Pie Company acquired 10% of the voting common stock of Slice Co. for $100,000 cash. Pie’s management was not of the opinion that the company had the ability to exercise significant influence over Slice; therefore, Pie made use of the fair value method in accounting for this investment in available-for-sale securities. On January 1, 2017, Pie acquired an additional 20% of Slice’s voting common stock, paying an additional $260,000. Pie now has the ability to significantly influence Slice’s operations; accordingly, use of the equity method of accounting is now required.

From 2015 through 2017, Slice reported net income, paid cash dividends, and reported fair values at January 1 as provided in Exhibit 1. Since Pie has been applying the fair value method of accounting throughout 2015 and 2016, its 2015 and 2016 income statements have reported dividend revenue from the Slice investment of $4,000 and $6,000, respectively (i.e., 10% of Slice’s dividend distributions). Similarly, Pie’s balance sheets have been reporting the investment at the 12/31/15 and 12/31/16 respective fair values of $120,000 and $130,000 (10% of Slice’s total fair value at each date). As required, the change in the fair value of the investment was reported by Pie as an unrealized cumulative holding gain of $20,000 in its 2015 balance sheet, and likewise for an additional $10,000 in its 2016 balance sheet, making for a cumulative amount of $30,000 in the stockholders’ equity section of its 12/31/16 balance sheet.

On January 1, 2017, Pie reached the point of being able to exercise significant influence over Slice’s operations and therefore was required under the previous guidance to restate its prior years’ accounting as if the equity method had applied since the initial investment in Slice. Towards this end, Exhibit 2 provides comparative journal entries in which the first column represents the actual journal entries recorded by Pie during 2015 and 2016. These entries reflect Pie’s appropriate use of the fair value method of accounting for its investment in Slice. The second column reflects the journal entries that Pie would have recorded during 2015 and 2016 had the equity method of accounting been applied initially, and the third reflects the previous requirement to restate the investor’s accounts accordingly.

FASB’s decision to include this financial reporting topic in its Simplification Initiative seems well justified when one considers that all of the restatement entries in Exhibit 2 become unnecessary under the new requirements. Rather, on January 1, 2017, Pie would merely add the $260,000 cost of acquiring the additional 20% ownership of Slice to its previously recognized $130,000 interest and adopt the equity method on a prospective basis. It thus seems clear that FASB has satisfied stakeholders’ requests to simplify what they viewed as needless complexity.

Implications to Financial Statement Preparers, Auditors, and Users

The objective of the retrospective treatment of the equity method was to ensure that the investor company’s financial reporting maintained year-to-year comparability. With the elimination of the requirement to retrospectively apply the equity method, however, one might argue that financial statement comparability is thereby reduced and that the usefulness of financial statements is perhaps compromised.

Furthermore, there will be differences in the amounts recorded specifically for the investment under the two methods. In the illustrated example, if Pie uses the provisions of ASU 2016-07, the value recognized for its investment in Slice is $390,000. On the other hand, if Pie were to use the prior standard, its investment in Slice would instead be $379,000. The new accounting requirement therefore has a valuation impact on the investor entity’s balance sheet, the materiality of which depends on the given investment scenario. Despite this obvious valuation impact, stakeholders have indicated a preference for the change to the new accounting. In ASU 2016-07, FASB notes:

From the perspective of preparers and auditors, the benefits seem clear. The new requirement does indeed offer simplification and, in so doing, reduces the likelihood of financial reporting error. With respect to the specific implications to external auditors, audit programs will require a minor modification to focus on the need to make the kind of prospective application of the equity method called for. As previously noted, however, the stated benefits do come with some costs. When an investor entity changes its accounting to the equity method, the provisions required under the new standard result in changes in the investment valuation, perhaps to the extent that year-to-year comparability may be compromised. Also, an entity’s investment strategies could be affected by the aforementioned income effects that ASU 2016-07 could generate. Still, FASB has likely succeeded in its stated goal of simplification.