Many equity investments do not require the complete acquisition of investees and their consolidations. Depending on circumstances, companies may account for an equity investment as consolidation, equity method, or fair value method. Generally, an investor accounts for an investment as a consolidated subsidiary when it can exercise control over the subsidiary; however, if the acquirer maintains only significant influence over the investee, it uses the equity method of accounting. If an investor exercises neither control nor significant influence over the acquiree, the proper method of accounting for the investor is the fair value method.
Investors in partnerships, unincorporated joint ventures, and limited liability companies (LLC) generally account for their investments using the equity method of accounting if the investor can exercise significant influence over the investee.
FASB has issued guidance on dealing with equity method accounting for investments. This article expounds on the fundamental concepts of equity method accounting; its objective is to provide an accounting context and a general framework for equity method accounting. It has eschewed a detailed deliberation on tax accounting issues, but it has discussed certain tax accounting concepts that are an integral part of financial accounting. Therefore, the journal entries do not reflect deferred tax assets (DTA) or deferred tax liabilities (DTL).
Relevant Adopted Standards
In January 2014, FASB issued ASU 2014-02, Intangibles—Goodwill and Other (Topic 350): Accounting for Goodwill. This ASU permits privately held companies to elect to amortize goodwill on a straight-line basis over 10 years, or less if the entity demonstrates that another useful life is more appropriate.
In January 2016, FASB issued ASU 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities. This ASU required that companies measure their equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) at fair value, with changes in fair value recognized in net income.
In March 2016, FASB issued ASU 2016-07, Investments—Equity Method and Joint Ventures (Topic 323). Equity investments may qualify to apply the equity method of accounting due to an increase in ownership interest or degree of influence; if so, an investor must adjust the balance of its investments. ASU 2016-07 eliminated the requirement that investors adjust their investments to reflect a balance as if the equity method had been in effect during the previous holding periods.
In January 2017, FASB issued ASU 2017-01, Clarifying the Definition of a Business. This ASU provided a framework for determining whether companies should account for a transaction as an asset acquisition or business combination.
In January 2017, FASB issued ASU 2017-04, Intangibles—Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. This ASU simplified the subsequent measurement of goodwill by eliminating Step 2 from the goodwill impairment test.
In February 2017, FASB issued ASU 2017-05, Other Income—Gains and Losses from the Derecognition of Nonfinancial Assets. This ASU requires that the sale of a financial asset to an equity method investee that is not a customer will result in full recognition of gains or losses; that is, there will be no intra-entity profit elimination for assets remaining on the investee’s books. This standard does not impact profits and losses for transactions with equity method investees that fall within the scope of ASC Topic 606.
In January 2020, FASB issued ASU 2020-01, Investments—Equity Securities (Topic 321), Investments—Equity Method and Joint Ventures (Topic 323), and Derivatives and Hedging (Topic 815)—Clarifying the Interactions between Topic 321, Topic 323, and Topic 815 (a consensus of the FASB Emerging Issues Task Force). This ASU covers the following two topics:
- It clarifies that an entity should consider observable transactions when deciding to apply or discontinue the equity method of accounting and adopt a measurement alternative under ASC Topic 321.
- It clarifies that under ASC 815-10-15-141(a), an entity should not consider whether, upon the settlement of the forward contract or exercise of the purchased option, individually or with existing investments, the underlying securities would be accounted for under the equity method in ASC Topic 323 or the fair value option under Topic 825.
In October 2021, FASB issued ASU 2021-08, Accounting for Contract Assets and Contract Liabilities from Contracts with Customers. This ASU requires an acquirer in a business combination to recognize and measure acquired contract assets and liabilities (usually recorded as deferred revenues) using the revenue recognition guidance in ASC Topic 606 as if it had originated the contracts. The author believes that an investor in an equity method investment should apply these provisions when it calculates its basis difference.
Latest Developments
Since 2018, FASB has appeared to be moving toward a change that would allow companies that buy another business to amortize or write down goodwill impairments to zero over time. In June 2022, FASB halted a four-year effort to revamp how companies account for goodwill, with some board members indicating that the case made for a revision was not strong enough to justify an overhaul.
Criteria for Significant Influence
An investor has significant influence but not control of the investee if the investor holds between 20% and 50% of the voting common stock of an investee, and it does not exercise any control on the subsidiary. FASB considers a significant influence criterion based on the ownership of outstanding securities whose holders possess voting privileges. If an investor has significant influence over the investee, it accounts for its investment under the equity method. Ownership levels as low as 3% may also require the application of the equity method in certain circumstances if the investor exercises significant influence over the investee.
FASB believes that the following indicators reflect the ability of an investor to exercise significant influence (ASC 323-10-15-6 to -11):
- Board of directors representation and participation in policy-making processes
- Material intra-entity transactions and technological dependency
- Interchange of managerial personnel and extent of ownership.
This list, however, is not all-inclusive, and companies should consider all relevant facts and circumstances. SEC Professional Fellow Paul Kepple, at the 1999 Annual National AICPA Conference on Current SEC Developments, commented that the starting point to evaluate a significant influence is the investor’s common stock ownership in the investee. However, the SEC, however, does not necessarily apply a bright-line test for the application of equity method accounting.
Goodwill and Bargain Purchase Price
The amount an investor pays to acquire an equity method investment can be different from its proportionate share of the carrying value of the investee’s underlying assets and liabilities (ASC 323-10-35-34) that is the “basis difference.” If the acquirer cannot attribute such a basis difference to specific assets and liabilities that it has acquired, it reflects it as “equity method goodwill.”
Under certain circumstances, the investor’s share of an investee’s net assets is higher than consideration paid. If the investor cannot attribute the negative basis difference to any specific assets or liabilities, it recognizes it as “bargain purchase price” or “negative goodwill.” ASC 323-10-35-13 implicitly requires that companies treat any negative goodwill in equity method investments consistent with the consolidation accounting model. Thus, companies recognize any excess fair value of the identifiable net assets over the cost of the equity method investment in earnings on investment date, consistent with FASB’s business combination guidance (ASC 805-30-25-2).
Amortization of goodwill may be deductible in some tax jurisdictions. Companies recognize tax benefits arising from the excess of the tax-deductible goodwill, which results in recognition of DTA similar to any other temporary differences (ASC 805-740-25-9). However, the recognition of DTL for financial reporting goodwill in excess of tax-deductible goodwill is prohibited [ASC 740-10-25-3(d)].
Tax Considerations
Acquisition of a subsidiary may create tax basis differences (different from financial basis differences) that could be temporary or not temporary. Tax basis differences result in future taxable or deductible amounts upon recovery of the related assets or settlement of related liabilities. If so, they create temporary differences that result in recognition of DTA and DTL (ASC 805-740-25-2,-3). There are two types of tax basis differences: inside and outside.
Inside basis differences.
Investees reflect the DTAs and DTLs resulting from temporary differences between the carrying amounts of their pre-tax assets and liabilities and their tax bases in their financial statements. Therefore, they make all their DTA and DTL adjustments for inside basis differences before publishing their financial statements.
Outside basis differences.
Investors may have a basis difference between the carrying amounts of their equity method investments and their corresponding tax basis. FASB has imposed a restriction on recognition of DTA for investments in foreign or domestic subsidiaries; it only allows recognition of DTA for a contingent payment arrangement if it is apparent it will be reversed in the future (ASC 740-30-25-9 to -14). Thus, the occurrence of DTA in an equity method investment is rare. On the other hand, FASB provides for reporting DTL for the excess of the financial reporting basis of domestic or foreign investment over its tax basis.
Initial Measurement of Equity Method Investments
The equity method requires an investor to record its investment initially at cost (ASC 323-10-30-2 and ASC 805-50-30). An investor, however, may have a “basis difference” between the cost of its investment and the underlying equity in the net assets of an acquired investee. Investors account for the basis differences as adjustments to the bases of the assets acquired, goodwill, and other intangible assets as if the equity method investees were consolidated subsidiaries (ASC 323-10-35-13). Nevertheless, an equity method investment always appears as a single-line item on investors’ balance sheets (dubbed a “one-line consolidation”). The following illustration clarifies this concept:
An investor invests $1,000 in an investee for 25% of its net assets. The investor determines that it should account for this investment under the equity method of accounting. The initial measurement reflects that there are basis differences of $300 in this transaction, consisting of $100 unrecorded intangible assets (customer relationship) and $200 goodwill.
The investor records this transaction initially as follows:
Although the investor’s carrying amount reflects its cost, the investee reflects the underlying assets and liabilities at its own historical cost basis. Therefore, usually a difference exists between the investor’s carrying amount of an equity method investment and its proportionate share of the investee’s net assets.
Subsequent Measurement of Equity Method Investments
After the initial measurement, the carrying amount of an equity method investment may increase or decrease to reflect the investor’s share of earnings or losses in its investment account (ASC 323-10-35-4). An investor typically presents its share of gains or losses from its equity method investment in its income statement and investment account on a single line. It discontinues applying the equity method if the balance of its investment account has declined to zero due to the investee’s losses (ASC 323-10-35-20). The following illustration clarifies the above concept:
An investor has 25% interest in an investee and accounts for its investment based on the equity method. The investee has a net income of $200 for the period. Furthermore, there was a $10 amortization for the acquired intangible assets and a $20 goodwill impairment. Moreover, assume that the investee is a foreign subsidiary and its functional currency is a foreign currency. The investor incurs cumulative translation adjustment (CTA) in other comprehensive income (OCI) due to foreign exchange (FX) fluctuations of $16 (credit). The investor records a corresponding proportionate increase or decrease in its equity method investment for an increase or decrease in OCI (ASC 323-10-35-18).
The investor reflects the following journal entry:
Intra-Entity Transactions
ASC 323 requires investors to incorporate certain adjustments to the carrying amount of their investments to determine the net income associated with such investments. These adjustments include the elimination of intra-entity profits and losses in certain cases until realized by the investor or investee as if the investee were consolidated (ASC 323-10-35-7).
Sale of assets downstream transactions.
Investors may sell (downstream transactions) or purchase (upstream transactions) assets to or from investees. Such assets are not the output of an entity’s ordinary activities. ASC 323 requires that investors and investees engage in these activities as arm’s length transactions.
Downstream transaction example. An investor sold equipment with a book value of $700 for $1,000 to an investee as an arm’s-length transaction at the beginning of the year (a downstream transaction). The remaining life of the equipment is 10 years, and the investee does not intend to sell the equipment and plans to depreciate it on a straight-line basis for its remaining useful life.
The investor concludes the transaction is the sale of a nonfinancial asset within the scope of ASC 610-20 (ASU 2017-05), and it has transferred control of the equipment to the investee, under the control criteria in ASC 606 and ASC 810. Thus, the investor recognizes the gain from the sale of the property immediately and does not defer any profit nor adjust its equity method earnings for this intra-entity sale (ASC 610-20-32-2).
The journal entry for this transaction for year 1 is as follows:
Revenue recognition in upstream transactions.
The transactions between an investor and an investee could be subject to ASC 606—that is, if the item sold is an output of an entity’s ordinary activities, the investor will eliminate its proportionate share of the profit from intra-entity transactions until that profit is realized in transactions with third parties (ASC 323-10-35-7).
Equity method accounting is a one-line consolidation; thus, the details reported in the investor’s financial statements are not the same as the consolidated financial statements under ASC 810-10. Consolidation typically eliminates all intra-entity transactions, but the equity method accounting eliminates only the intra-entity profits and losses on assets, which are on the books of an investor or an investee (ASC 323-10-35-8).
Upstream transaction example. An investee sells $1,000 of its product with a 20% profit margin to its investor (an upstream transaction) in an arm’s-length transaction. The investor has 25% equity interest in the investee. The investor sells 70% of the products purchased from the investee to third parties with a 10% profit margin. At the investor’s balance sheet date, the investor holds $300 of inventory for which the investee has recorded a corresponding gross profit of $60 (ASC 323-10-55-29). This transaction is within the scope of ASC 606 and not subject to ASU 2017-05.
The journal entries for this transaction are as follows:
Eliminating Entry Under the Equity Method
We should note that these types of transactions often impact multiple periods until the transaction cycle is fully complete.
Investee’s dividends and distributions.
Investors recognize the dividends they receive from investees as a reduction in the carrying amount of their investments rather than as dividend income.
Changes “to and from” the Equity Method of Accounting
An investor might have an existing equity interest in an investee and acquire an additional equity interest or dispose of part of its interest, resulting in a change to its ownership. If an investor adopts equity method accounting, it does not need to apply it retrospectively (ASU 2016-07). Thus, if an investor initially accounts for its investment under a different method and now qualifies for the equity method of accounting, it can account for the equity method of accounting on a prospective basis (ASC 323-10-35-33).
Changes from consolidation to the equity method.
An investor may sell part of its interest in a 100% owned foreign equity investment but maintain its significant influence. Consider the example of an initial investment of $1,000, and a sale price of $1,200 for 70% of investment. The investor has recorded $400 (credit) in retained earnings and $100 (credit) in CTA/OCI (due to FX translation) in its consolidated financial statements. The investee had $2,000 in assets and $1,500 in liabilities.
Investor’s deconsolidation journal entry is as follows (ASC 810-10-45-22 to -45-24):
The following journal entry reflects the restating retained earnings and CTA/OCI as if the investor had accounted for it, based on the equity method. ASU 2016-07 is not applicable in this example because the percentage ownership has decreased (rather than increased):
The following journal entry reflects the partial sale of investment (ASC 323-10-35-39) and (ASC 830-30-40-1 and -40-1A):
Change from equity method to fair value method.
If an investor sells part of its interest in a foreign equity investment and loses its significant influence, it would change from the equity method of accounting to the fair value method. The investor would then release the pro rata share of the CTA/OCI into earnings, and the remainder becomes part of the fair value method for the investment (ASC 323-10-35-39).
Consider an example where the investor has a 40% equity investment in a foreign entity with a book value of $4,600 (the original amount of investment was $4,000) and accounts for it based on the equity method. The investor records a $400 (credit) as CTA/OCI and $200 (credit) in its retained earnings. The investor sells 75% of its interest ($4,000 × 75% = $3,000) to a third party for $6,000 and accounts for the remaining 10% based on fair value method for $2,000.
The journal entries for this transaction are as follows:
Change from fair value method to equity method.
If an investor accounts for the investment in the common stock of an investee based on the fair value method of accounting and increases its level of ownership, it may qualify to use the equity method (ASC 323-10-35-4). In January 2016, FASB issued ASU 2016-01, which requires companies to measure all their cost method investments at fair value through earnings.
Consider an example where an investor acquires 10% equity in a foreign investee for $1,000 and accounts for it under the fair value method. The fair value of this investment at the end of the period is $1,100. The investor acquires an additional 10% investment in the investee for $1,100 at the end of the period and determines that it should account for the investment based on the equity method because it has significant influence over the investee.
The journal entries for this transaction at acquisition and the end of the period are as follows:
The investor adds the cost of acquiring the additional interest in the investee to the current basis of its investment (ASC 323-10-35-33). FASB’s guidance requires the investor to adopt the equity method prospectively (ASU 2016-07). Investors do not reflect any FX fluctuation in CTA/OCI under the fair value method; however, when they commence investment accounting under the equity method, they will reflect FX translation in the CTA/OCI account.
Change from equity method to consolidation.
ASC 805-10-25-9 describes a “step acquisition” as a business combination whereby an acquirer that had an equity investment in a foreign entity subsequently obtains control by increasing its percentage of ownership interest. In a step acquisition, the acquirer remeasures its gains and losses at each stage in the acquisition and reflects them in earnings. The guidance views the original equity investment and subsequent acquisition as two distinct events; thus, it requires a full release of CTA to earnings.
Consider an example where the investor has a 40% equity investment in a foreign entity, which has a book value of $4,600, and accounts for it based on the equity method. The investor has $400 (credit) as CTA/OCI and $200 (credit) in its retained earnings. The investor acquires the remaining 60% of the investee’s equity for $8,000.
In this example, all the CTA/OCI related to equity investment in the foreign entity would be released into earnings as part of the remeasurement gain or loss recognition (ASC 830-30-40), because FASB views this as two different transactions: sale of equity investment and acquisition of a controlling interest (Josef Rashty, “Foreign Currency Matters–New Guidance for Derecognition of Cumulative Translation Adjustment,” The CPA Journal, March 2014).
The journal entry for this transaction is as follows:
Change in percentage of ownership in equity method.
An investor may decrease its interest in an equity method investment while maintaining significant influence. Upon a partial disposition (under ASU 2017-05), the investor reduces the carrying amount of its equity method investment and CTA/OCI related to equity method investment proportionately for the interest sold. The investor may also recognize a gain or loss for the difference between the proceeds and the carrying amount of the equity method investment sold (ASC 323-10-35-35).
On the contrary, if the investor’s percentage of ownership increases but the investor continues to use the equity method, it will retain its CTA/OCI and continue to calculate the CTA/OCI based on the new percentage of ownership.
A Complex Topic
This article discussed the fundamentals of the equity method accounting for investments. A comprehensive discussion of equity method accounting is beyond the scope of this article. The objective is to at least highlight some rudimentary issues related to this complex area of accounting. This article wittingly avoided excessive details on some technical issues. Readers may want to refer to the FASB and other accounting literature for a more comprehensive discussion.
CPAs who have had exposure to equity method accounting will hopefully find that the above discussion comports with their thoughts and presumptions. Those less familiar with the topic may benefit from the concise and brief examples above that can explain this complicated area of accounting.
