3.1 The Significance Tests
Rules
3-09, 4-08(g), 8-03(b)(3),1 and 10-01(b)(1)
require registrants to evaluate the significance of an equity method investment in
accordance with the tests in Rule 1-02(w).
Rule 1-02(w) establishes the following three tests to determine the
significance of an investee; however, as discussed further below, not all tests are
applied under each of the aforementioned rules:
- The investment test (see Section 3.1.1).
- The asset test (see Section 3.1.2).
- The income test (which includes an assessment of a pretax income component and a revenue component; see Section 3.1.3).
On the basis of the applicable significance test in Rule 1-02(w), the registrant may
be required to provide:
- Separate financial statements under Rule 3-09.
- Summarized financial information under Rule 4-08(g).
- Summarized income statement information under Rule 10-01(b).
The following table compares the annual requirements for separate financial
statements, the annual requirements for summarized financial information, and the
interim requirements for summarized income statement information under Rules 3-09,
4-08(g), and 10-01(b)(1), respectively:
|
Comparison of Regulation S-X Rules — Annual and Interim
Requirements for Equity Method Investees
| ||||||
|---|---|---|---|---|---|---|
|
Regulation S-X Rule
|
Applicable Period
|
Each Equity Method Investee Individually
|
All Equity Method Investees in Aggregate
|
Significance Test
|
Percent Significant
|
Financial Information of Equity Method Investee
|
|
Rule 3-09
|
Annual
|
X
|
|
>20%
|
Historical financial statements2
| |
|
Rule 4-08(g)
|
Annual
|
X
|
X
|
|
>10%
|
Summarized financial statement information
|
|
Rule 10-01(b)(1)
|
Interim
|
X
|
|
>20%
|
Summarized income statement information
| |
3.1.1 Investment Test
Rule 1-02(w)(1)(i)(C) states, in part,
that an equity method investee is significant if “the registrant’s and its other
subsidiaries’ investments in and advances to the tested
subsidiary exceed 10 percent of the total assets of the registrant and
its subsidiaries consolidated as of the end of the most recently completed
fiscal year” (emphasis added).
Under Rule
3-09(b) and paragraph 2405.3 of the FRM, a
registrant performing the investment test should substitute the 10 percent in
Rule 1-02(w) with 20 percent. If the
results of the investment test exceed 20 percent, the registrant must provide
separate financial statements of the equity method investee in accordance with
Rule 3-09.
Under Rule
4-08(g), if the results of the investment test exceed 10 percent,
a registrant must provide summarized financial information. Rule 4-08(g)
requires a registrant to perform the investment test both individually for each
equity method investee and in the aggregate for all equity method investees (see
Section
3.1.3.7).
In accordance with Rule
10-01(b)(1), the investment test should be performed on interim
financial statements and should only be done on each equity method investee
individually. If the results of the investment test exceed 20 percent,
summarized income statement information should be provided.
Note that on the basis of informal discussions with the SEC
staff, we understand that if the registrant’s investments in, including advances
to, the equity method investee are a negative amount, the absolute value of the
investment should be used to calculate significance under the investment test.
At the 2020 AICPA Conference on Current SEC and PCAOB
Developments, the SEC staff confirmed that in the calculation for the investment
test under Rules 3-09, 4-08(g), and 10-01(b)(1), the total assets of the
registrant should be used as the denominator. This differs from the calculation
of the denominator for determining the significance of business acquisitions and
dispositions, which permits the use of aggregate worldwide market value under
certain conditions.
Example 3-1
Registrant A is filing its Form 10-K for
20X0. It owns a 40 percent equity method investment in
Company B. As of December 31, 20X0:
- Registrant A had consolidated assets of $100 million.
- The carrying value of A’s investment in B was $18 million.
- Registrant A had advanced $7 million to B.
Therefore, B is 25 percent significant
to A: ($18 million + $7 million) ÷ $100 million = 25%.
Advances to B should be included in the numerator in
accordance with Rule 1-02(w)(1)(i)(C).
3.1.2 Asset Test
The asset test in Rule
1-02(w)(1)(ii) states that an equity method investee is
significant when the following condition is met:
[T]he
registrant’s and its other subsidiaries’ proportionate share of the tested
subsidiary’s consolidated total assets . . . exceeds 10 percent of such
total assets of the registrant and its subsidiaries consolidated as of the
end of the most recently completed fiscal year.
When performing the asset test, the registrant should compare
its share of the investee’s assets with the registrant’s consolidated total
assets. Such amounts are generally as of the most recently completed fiscal year
for both the investee and the registrant. The asset test is not applicable under
Rule 3-09 or Rule 10-01(b)(1).
Under Rule
4-08(g), the asset test is performed both individually for each
equity method investee and in the aggregate for all equity method investees. If
the significance of an equity method investee, individually or as part of an
aggregated group, is more than 10 percent, the registrant’s financial statements
must include summarized financial information for all equity method investees,
which may be presented separately for each equity method investment or on a
combined basis (see Section 2.3.1 for more
information).
Example 3-2
Individual Equity Method Investee
As of December 31, 20X0, Registrant A
has consolidated assets of $50 million and owns a 40
percent equity investment in Company B, which has
consolidated assets of $20 million on that date. The
asset test calculation is as follows:
- Registrant A’s proportionate share of B’s consolidated assets = $8 million ($20 million × 40%).
- Registrant A’s consolidated assets = $50 million.
- Significance = 16 percent.
Since the results of the asset test
exceed the 10 percent threshold, A must provide
summarized financial information for B under Rule
4-08(g).
Example 3-3
Multiple Equity Method Investees
As of December 31, 20X0, Registrant A
owns a 30 percent equity method investment in Company B
and a 40 percent equity method investment in Company C.
On that date, consolidated assets of A, B, and C were
$100 million, $14 million, and $18 million,
respectively.
The asset test calculation for B is as
follows:
- Registrant A’s proportionate share of B’s consolidated assets = $4.2 million ($14 million × 30%).
- Registrant A’s consolidated assets = $100 million.
- Significance = 4.2 percent.
The asset test calculation for C is as
follows:
- Registrant A’s proportionate share of C’s consolidated assets = $7.2 million ($18 million × 40%).
- Registrant A’s consolidated assets = $100 million.
- Significance = 7.2 percent.
Individually, B and C are not
significant to A at the 10 percent level. However, the
percentage for B and C in the aggregate is 11.4
percent.
Since the aggregate test results exceed
the 10 percent threshold, summarized financial
information for both B and C must be provided in a
footnote to A’s financial statements. Registrant A may
present summarized financial information of B and C
separately or on a combined basis (in most
circumstances).
3.1.3 Income Test
The income test in Rule 1-02(w)(1)(iii) includes the following two components:
- The income component — Under Rule 1-02(w)(1)(iii)(A)(1), the income component is determined by comparing the absolute values of (1) the registrant’s proportionate share of the investees “income or loss from continuing operations before income taxes (after intercompany eliminations) attributable to the controlling interest” (pretax income or loss from continuing operations) and (2) the registrant’s pretax income or loss from continuing operations.
- The revenue component — Under Rule 1-02(w)(1)(iii)(A)(2), if both the registrant and the investee have material revenue in each of the two most recently completed fiscal years, the revenue component is calculated by comparing the registrant’s proportionate share of the investee’s revenue with the registrant’s revenue. If either the registrant or the investee does not have material revenue for each of the two most recently completed fiscal years, only the income component should be used. A registrant may be able to average its income for the income component when the revenue component is not applicable (see Section 3.1.3.3).
An equity method investee is considered significant to a
registrant under the income test in Rules 3-09 and 10-01(b)(1) if the results of both the
income component and, when applicable, the revenue component exceed 20 percent.
If either component does not exceed 20 percent, the registrant does not
need to provide financial statement or summarized income statement information
under the income test (but may need to do so under the asset test or investment
test).
Under Rule 4-08(g),
the income test is performed both (1) individually for each equity method
investee and (2) in the aggregate for all equity method investees. An equity
method investee is considered significant under the income test in Rule 4-08(g)
if both the income component and the revenue component, when applicable, exceed
10 percent. If the equity method investees are significant in the aggregate, the
summarized financial information must include all equity method investees. For a
discussion of whether such information may be aggregated for presentation
purposes, see Section 2.3.1.
Although Rule 1-02(w)(1)
refers to eliminating intercompany transactions in the computation of
significance, paragraph
2410.6 of the FRM notes that a registrant should not eliminate intercompany transactions when
determining the significance of an equity method investee since such an investee
is not consolidated.
The application of the revenue component should reduce
situations in which the results of the income tests are considered to be
anomalous as a result of unusual or nonrecurring adjustments or charges such as
an impairment or a litigation settlement. However, if a registrant believes that
the income test results in a requirement to provide more information than is
necessary to reasonably inform investors, the registrant may consider
preclearing this issue with the SEC staff. See paragraph 2435.2 of the FRM for more information.
3.1.3.1 Income Component
The income component is determined by comparing the absolute
values of (1) the registrant’s proportionate share of the investee’s pretax
income or loss from continuing operations and (2) the registrant’s own
pretax income or loss from continuing operations.
We refer to “income or loss from continuing operations before income taxes .
. . attributable to the controlling interests” as pretax income from
continuing operations. Paragraph
2410.3 of the FRM states, in part:
The numerator is
calculated based on the registrant’s proportionate share of the pre-tax
income from continuing operations reflected in the separate financial
statements of the investee prepared in accordance with U.S. GAAP for the
period in which the registrant recognizes income or loss from the
investee under the equity method adjusted for any basis differences. In
determining the basis differences that should be included for this test,
the registrant should consider ASC 323-10-35-34 and ASC
323-10-35-32A.
A registrant may present various items in its income
statement on a net of tax basis. Thus, it may be required to make certain
adjustments before performing the income component. For example, a
registrant, investee, or both may, in their separate financial statements,
present equity in earnings (or losses) of their own equity method investees
or income or loss attributable to noncontrolling interests on a net-of-tax
basis. In such instances, the registrant must recompute both items on a
pretax basis, as a component of pretax income or loss from continuing
operations.
Neither the registrant nor the investee should adjust pretax
income or loss from continuing operations to exclude any special or
nonrecurring items, such as restructuring charges or impairments. In
addition, if a registrant or an investee has existed for less than 12
months, its pretax income from continuing operations should not be
annualized when the income component is performed.
Example 3-4
Registrant A has a 30 percent
ownership interest in equity method investee B. Both
A and B have calendar year-ends. The table below
shows the consolidated statement of operations for
A; assume that the earnings from B and the net
income attributable to the noncontrolling interest
are presented on a pretax basis.
When calculating the denominator of
the income component, Registrant A computes its
income (loss) before taxes by using one of the two
approaches below. As seen in the calculations below,
both approaches yield the same result; the
difference lies in the starting points of the
calculations.
Approach
1:
Approach
2:
When computing the numerator of the income component, the
registrant should not use the amount recorded for the equity method
investee’s income or loss within the registrant’s financial statements.
Rather, the pretax net income (loss) from the equity method investees’
financial statements should be used in the numerator of the income
component.
Other items for a registrant to consider when computing the
numerator of the income component include:
-
Basis differences — The amount an investor pays to acquire an equity method investment (upon initial acquisition or the subsequent acquisition of additional interests) is often different from the investor’s proportionate share of the carrying value of the investee’s underlying assets and liabilities. This difference is generally referred to as a “basis difference.” ASC 323-10-35-5 specifies that after initial measurement, a registrant should make adjustments to the investor’s share of the investee’s earnings or losses (and corresponding adjustments to the carrying value of the equity method investment) for amortization or accretion of basis differences. When calculating the income component, the registrant should adjust the investor’s proportionate share of the investee’s pretax income to include these basis difference adjustments. For a discussion of initial and subsequent measurements of basis differences, see Sections 4.5 and 5.1.5.2 of Deloitte’s Roadmap Equity Method Investments and Joint Ventures.Example 3-5Registrant X purchases a 40 percent interest in Investee Z for $2 million and applies the equity method of accounting. The book value of Z’s net assets is $3.5 million, and X’s proportionate share of book value is $1.4 million ($3.5 million × 40%) as of the acquisition date. As a result, the difference between X’s proportionate share of the carrying value of Z’s net assets and the cost paid to acquire its investment is $0.6 million ($2.0 million – $1.4 million). After applying the acquisition method of accounting, X identifies the following basis differences:As of the investment’s acquisition date, X determines that the remaining useful lives of the fixed assets and intangible assets are 20 years and 30 years, respectively.Subsequent Impact of Basis Differences on X’s Equity Method Earnings From ZAssume the following:
- Registrant X and Investee Z have calendar year-ends.
- As reported on its financial statements, Z’s pretax income is $1 million for the year after the investment’s acquisition date.
- Registrant X’s pretax income was $5 million for the corresponding year.
- Registrant X has determined that the revenue component of the income test is not applicable.
- Goodwill is not amortized.
Below is a calculation of X’s equity method earnings for the period:As shown above, the basis differences attributable to Z’s fixed assets and intangible assets are amortized over their estimated remaining useful lives, resulting in adjustments to X’s proportionate share of Z’s earnings for the period. The $80,000 related to equity method goodwill is not amortized; however, it should be assessed for impairment along with the entire equity method investment in accordance with ASC 323-10-35-32 and 35-32A.Income Component of Income Test CalculationIn determining whether Z is significant under the income component, X performs the following calculation:On the basis of the results of the income component calculation ($376,000 ÷ $5,000,000), X’s investment in Z is not significant under Rule 3-09, Rule 4-08(g), or Rule 10-01b)(1). -
Periods to be included — In calculating the numerator of the income component, a registrant should use only the amount for the period during which it has significant influence over the investee (i.e., in a year when significant influence is either attained or lost). For example, when calculating the numerator during the year of acquisition of an equity method investment, a registrant would only use its proportionate share of the pretax income from continuing operations of the equity method investment for the portion of the year in which it held such investment (e.g., from the date of acquisition to the end of the fiscal year). Similarly, during a year of disposition of an equity method investment, a registrant would calculate the numerator by using the portion of the year in which it held the equity investment (e.g., the beginning of the fiscal year through the date of disposition) as disclosed in note 2 to paragraph 2410.3 of the FRM. Note that when calculating the income component in the year an equity method investment is either acquired or disposed, the registrant should use the entire fiscal year as the denominator.Example 3-6Assume the same facts as in the example above, except that Registrant X acquired Investee Z on June 30 of the calendar year. The basis differences would only have to be adjusted for six months of the year because X only had significant influence over Z from the date of acquisition to the fiscal year-end.
-
Registrants’ adjustments to their investment — As noted in paragraph 2410.3 of the FRM, the numerator of the income component should not be adjusted for items recorded by the registrant that are related to its investment in the equity method investees, such as “impairment charges [related to nonbasis differences] at the investor level, gains/losses from stock sales by the registrant; dilution gains/losses from stock sales by the investee, preferred dividends.”
The financial statements of an investee that a registrant is
required to file under Rule 3-09 may
differ from those used by the registrant to calculate its equity in the
investee’s income or loss. For example, as noted in paragraph 2410.7
of the FRM, “when a registrant and an investee have different fiscal years
or when they have the same fiscal year, but the registrant computes its
equity in the income or loss of the investee on a consistent one quarter (or
less) lag basis,” the registrant should determine significance by using the
same period of the investee’s financial results that it uses to record its
equity in the income or loss of the investee.
Example 3-7
Registrant A has a December 31
fiscal year-end and an equity method investee,
Company B, that has a June 30 fiscal year-end.
Registrant A consistently recognizes
its equity in B’s income by using the investee’s
results for the 12 months ended September 30 on a
three-month lag. In this case, A calculates the
significance tests in Rule 3-09 by using B’s results
for the 12 months ended September 30. If B is
significant, its financial statements for the 12
months ended June 30 would satisfy the requirements
of Rule 3-09 because those are the annual financial
statements that B would be required to present under
Rules 3-01 and 3-02 if it were a registrant (see
Section 2.2.4.1.3).
3.1.3.2 Revenue Component
If both the registrant and the investee have material
revenue in each of the two most recently completed fiscal years, the revenue
component is calculated by comparing (1) the registrant’s proportionate
share of the investee’s revenue with (2) the registrant’s revenue.
The revenue component applies when a registrant and the
investee have revenue that is material to their respective financial
statements. At the 2020 AICPA Conference on Current SEC and PCAOB
Developments, the SEC staff indicated that in most cases, it should be
readily apparent whether a registrant and investee have material revenue in
each of the two most recently completed fiscal years. Therefore, a detailed
analysis of materiality in accordance with SAB Topic 1.M would not be required. However, when
determining whether the revenue component applies, the registrant should
evaluate whether its or the investee’s revenue is so low that the revenue
component would be meaningless in the assessment of the investee’s
significance. At the 2022 AICPA & CIMA Conference on Current SEC and
PCAOB Developments, the SEC staff further clarified that the determination
of whether an investee has material revenue is separate from that for the
registrant. The registrant and each investee should be evaluated
individually in such a determination.
When calculating the revenue component, the registrant
should not adjust revenue to exclude any special or nonrecurring items.
Example 3-8
Both Income and Revenue Exceed 20 Percent
Registrant A is filing its Form 10-K
for 20X1. It owns a 40 percent equity method
investment in Company B. For its fiscal year ended
December 31, 20X1, A had consolidated revenue of
$100 million and consolidated pretax income from
continuing operations (including B’s equity
earnings) of $10 million. For its fiscal year ended
December 31, 20X1, B had revenue of $90 million and
pretax income from continuing operations of $8
million. For simplicity, assume that there are no
basis differences, which may affect the calculation
of the income component, and that both A and B have
material revenue in each of the two most recently
completed fiscal years.
Registrant A’s 40 percent share of
B’s revenue for the year ended December 31, 20X1, is
$36 million ($90 million × 40%), and A’s 40 percent
share of B’s pretax income from continuing
operations for the year ended December 31, 20X1, is
$3.2 million ($8 million × 40%).
The revenue component is 36 percent
significant ($36 million ÷ $100 million = 36%), and
the income component is 32 percent significant ($3.2
million ÷ $10 million = 32%). Since the results of
the income test exceed 20 percent, B is significant
under both Rules 3-09 and 4-08(g).
Example 3-9
Only Income or Revenue Test Exceeds 20
Percent
Assume the same facts as in the
example above, except that Company B had revenue of
$45 million. Therefore, A’s 40 percent share of B’s
revenue for the year ended December 31, 20X1, is $18
million ($45 million × 40%).
The revenue component is 18 percent
significant ($18 million ÷ $100 million = 18%), and
the income component is 32 percent significant ($3.2
million ÷ $10 million = 32%). Both components must be met for the test to
indicate significance. Since the revenue component
is below 20 percent, both tests are not met and B is
not significant under Rule 3-09. However, since both
components do exceed 10 percent, B is significant
under Rule 4-08(g).
Example 3-10
Cannot Use the Revenue Component
Assume the same facts as in
Example 3-8, except that Company B
only had revenue for the year ended December 31,
20X1. Because B did not have material revenue in
each of the two most recently completed fiscal
years, the revenue component is not applicable.
Assume also that A determined that it is not
required to use income averaging (see Section
3.1.3.3).
Since B is significant at the 32
percent level for the income component ($3.2 million
÷ $10 million = 32%), B is significant under both
Rules 3-09 and 4-08(g).
3.1.3.3 Using Income Averaging
Generally, a registrant’s pretax income from continuing
operations in the annual financial statements for the most recently
completed audited fiscal year (e.g., the financial statements filed in the
registrant’s current-year annual report) is used to perform the income
component. Sometimes, however, an average of the registrant’s pretax income
from continuing operations for five fiscal years must be used.
Rule
1-02(w)(1)(iii)(B)(2) states:
Compute the test using the average described
[herein] if the revenue component in paragraph
(w)(1)(iii)(A)(2) of this section does not apply and the
absolute value of the registrant’s and its subsidiaries’
consolidated income or loss from continuing operations before income
taxes . . . attributable to the controlling interests for the most
recent fiscal year is at least 10 percent lower than the average of
the absolute value of such amounts for each of its last five fiscal
years.
Accordingly, a registrant should first determine whether the
revenue component applies. If both the registrant and the investee have
material revenue in each of the two most recently completed fiscal years, the registrant would not be able to apply income
averaging. If either the registrant or the investee does not have
material revenue for each of the two most recently completed fiscal years,
income averaging is required to be applied. See Section 3.1.3.2 for a discussion of
what is considered material revenue.
If the revenue component does not apply, a registrant should
calculate its average income to determine whether such an amount should be
used in the denominator of the income component.
To calculate average income for the last five fiscal years,
a registrant must use absolute values for periods in which a pretax loss was
incurred. That is, if a registrant reports a pretax loss from continuing
operations in any year within the five-year period, it should use the
absolute value in such years when calculating the numerator for this
average. The denominator for this average should remain at 5. The registrant
should then determine whether its income or the absolute value of its loss
(if a loss is reported) for its most recently completed fiscal year is more
than 10 percent lower than its five-year average income. If the registrant’s
income or the absolute value of its loss for its most recently completed
fiscal year is at least 10 percent lower than its five-year average income,
the registrant should use its average income in the denominator of the
income component.
Income averaging only applies to a registrant. Therefore,
the rule cannot be used to average pretax income from the continuing
operations of an equity method investee (the numerator of the income
component).
As noted in paragraph 2410.5
of the FRM, the equity income or loss of the equity method investee should
be included in the registrant’s income in the determination of whether the
registrant may apply income averaging.
Example 3-11
Registrant A owns a 40 percent equity method
investment in Company B. It has a December 31 fiscal
year-end and is filing its Form 10-K for 20X4.
Company B, which is not a registrant and also has a
December 31 fiscal year-end, did not generate
revenue for the year ended December 31 of 20X3 or
20X4. Therefore, the revenue component does not
apply.
Registrant A’s pretax income from continuing
operations for the previous five years is as
follows:
- 20X0 — $4 million.
- 20X1 — $6 million.
- 20X2 — $5 million.
- 20X3 — ($1 million).
- 20X4 — $1 million.
Registrant A’s equity in B’s pretax
loss from continuing operations for the year ended
December 31, 20X4, was $0.8 million.
Registrant A’s average pretax income from continuing
operations for this five-year period is calculated
as follows:
Because A’s current-year income of
$1 million is 10 percent or more lower than its
average income of $3.4 million for the last five
fiscal years, it must use its five-year average
income when performing the income component.
3.1.3.4 Registrant or Equity Method Investee Has a Loss
As discussed in paragraph
2015.9 of the FRM, if either a registrant or an equity
method investee has incurred a pretax loss from continuing operations, the
registrant should use the absolute value of this loss when performing the
income component.
As discussed previously (see Section 3.1.3.1), a registrant that
presents equity in the earnings or losses of an equity investee, net of tax
(in a manner consistent with Rule 5-03(b)(12)), generally must
include such equity, on a pretax basis, in pretax income or loss from
continuing operations when performing the income component. However,
Rule
1-02(w)(1)(iii)(B)(1) states that if either the
registrant or the equity method investee, but not both, has incurred a loss
in the year for which the income component is calculated, the registrant
should exclude the equity in the investee’s income or loss from the
registrant’s pretax income or loss from continuing operations when
performing the computation.3 As noted in paragraph 2410.5 of the FRM, “[i]f a registrant
qualifies to use income averaging and the tested equity method investee
incurred a loss, then, pursuant to computational note 1 to [Rule] 1-02(w),
the registrant’s equity in the income or loss of the investee should be
excluded from the income of the registrant when computing [its] average
income.”
Example 3-12
Only the
Registrant Has a Pretax Loss From Continuing
Operations
Registrant A is filing its Form 10-K
for 20X0. Its fiscal year-end is December 31, and it
has no noncontrolling interests. Registrant A owns a
40 percent equity method investment in Company B.
For the fiscal year ended December
31, 20X0, B had $10 million in pretax income from
continuing operations. Registrant A’s share of B’s
pretax income from continuing operations is $4
million ($10 million × 40%). No other amounts are
recorded in A’s income statement in connection with
its investments in B.4 Registrant A determined that it is not
required to use income averaging.
For the fiscal year ended December
31, 20X0, A presented the following in its income
statement (in millions):
Registrant A’s pretax loss from
continuing operations is calculated as follows:
Because A incurred a pretax loss from continuing
operations while B earned pretax income from continuing operations, A must
apply the guidance in Rule
1-02(w)(1)(iii)(B)(1) and must exclude its
share of B’s pretax income from continuing
operations in determining the denominator used in
the income component under Rules 3-09 and 4-08(g),
as follows:
Using the absolute values, A
performs the following calculations for the income
component:5
Note that if A qualified to use
income averaging, since B incurred a loss,
computational note 1 to Rule 1-02(w) indicates that
A’s equity in B’s loss would be excluded from A’s
income in the computation of A’s average income.
Conversely, Rule
1-02(w)(1)(iii)(B)(1) would also apply if B
incurred a pretax loss from continuing operations
and A earned pretax income from continuing
operations.
Example 3-13
Both the Registrant and the Equity Method Investee
Have Pretax Losses From Continuing
Operations
Registrant A is filing its Form 10-K for 20X0. Its
fiscal year-end is December 31, and it has no
noncontrolling interests. It owns a 40 percent
equity method investment in Company C. For the
fiscal year ended December 31, 20X0, C had a pretax
loss from continuing operations of $20 million.
Registrant A’s share of C’s pretax
loss from continuing operations is $8 million ($20
million × 40%). No other amounts are recorded in A’s
income statement in connection with its investments
in C.6 Registrant A determined that it is not
required to use income averaging.
For the fiscal year ended December 31, 20X0, A
presented the following in its income statement (in
millions):
Registrant A’s pretax loss
from continuing operations is calculated as follows
(in millions):
Since both the registrant and the
equity method investee incurred losses, A’s share of
C’s pretax loss from continuing operations should be
included in A’s pretax loss from continuing
operations when the significance test is
performed.
Using the absolute values, A
performs the income test calculation as follows:7
3.1.3.5 Registrant Is a Successor to a Predecessor Company
Sometimes, a registrant is a successor to a predecessor
company or presents financial statements that include predecessor and
successor results. Examples include (1) the adoption of fresh-start
accounting after emergence from bankruptcy or (2) the use of pushdown
accounting to reflect a change in basis because of an acquisition of the
company. In these situations, a registrant may not have a full year of
income statement data reflecting the successor results. For example, if
pushdown accounting was applied, the period before the change in basis
represents the predecessor period and the period after the change in basis
represents the successor period. Note that the periods before the change and
after the change in basis are separately presented because of their lack of
comparability.
Addressing this issue at the June
2006 AICPA SEC Regulations Committee joint meeting with
the SEC staff, the staff indicated that only the successor registrant period
should be used in the application of the income test. Registrants that wish
to use pro forma results for the full year were encouraged to consider
preclearing this approach with the SEC staff.
Example 3-14
Registrant A has an equity method
investee, Company B, and both entities have December
31 fiscal year-ends. Registrant A applied fresh
start accounting on September 1, 20X0. In
calculating the denominators of the revenue and
income components for the year ended December 31,
20X0, A can only use the revenue and income results
for the period from September 1, 20X0, through
December 31, 20X0. However, in calculating the
numerators of the revenue and income components, A
should use B’s results for the 12 months ended
December 31, 20X0, which increases the likelihood
that the investee will be deemed significant for the
period.
3.1.3.6 Fair Value Option Elected for Investee
Rule 3-09 was written
before the codified guidance in ASC 825-10 provided an option for
registrants to account for investments in equity method investees by using
the fair value method. Therefore, the SEC staff has provided guidance in the
FRM for registrants that have elected the fair value option for investments
that qualify for the equity method of accounting. As noted in paragraph 2400.4
of the FRM, “[a] registrant that accounts for an equity method investment
using fair value in accordance with ‘Financial Instruments,’ ASC 825
must disclose the information required by ASC 323-10-50-3(c) (i.e.,
summarized financial information or separate financial statements).” See
also paragraph
2435.3 of the FRM for information about the potential
need to include a quantitative and qualitative analysis in MD&A when an
investee accounted for under the fair value option is material to an
understanding of results of operations, financial position, or cash
flows.
Paragraph
2435.2 of the FRM states, in part, that “the staff
believes that the income test should be computed using as the numerator the
change in the fair value reflected in the registrant’s statement of
comprehensive income rather than the registrant’s equity in the earnings of
the investee computed as if the equity method had been applied.”
At the 2021 AICPA & CIMA Conference on Current SEC and PCAOB
Developments, the SEC staff noted that when applying the income test to
equity method investees for which a registrant has elected the fair value
option in accordance with ASC 825-10-15-4, the registrant should calculate
the income and revenue components as follows:
- Income component — Determine by using the change in the investee’s fair value reflected in the registrant’s income statement.
- Revenue component — Determine by using the registrant’s proportionate share of the investee’s revenue (i.e., the registrant’s ownership interest in the investee multiplied by the investee’s revenue).
Example 3-15
Registrant A is filing its Form 10-K
for 20X1. It owns a 30 percent equity method
investment in Company B, for which it has elected
the fair value option. For its fiscal year ended
December 31, 20X1, A had consolidated revenue of
$100 million and consolidated pretax income from
continuing operations (including the change of $8
million in B’s fair value from 20X0 to 20X1) of $32
million. For its fiscal year ended December 31,
20X1, B had revenue of $20 million.
Registrant A’s 30 percent share of
B’s revenue for the year ended December 31, 20X1, is
$6 million ($20 million × 30%), and B’s change in
fair value is $8 million for the year ended December
31, 20X1. No other amounts are recorded in A’s
income statement in connection with its investment
in B. For simplicity, assume that there are no basis
differences and that both A and B have material
revenue in the two most recently completed fiscal
years.
The revenue component is 6 percent
significant ($6 million ÷ $100 million = 6%), and
the income component is 25 percent significant ($8
million ÷ $32 million = 25%). Since only the income
component, and not the revenue component, exceeds 20
percent, B is not significant under Rule 3-09 or
Rule 4-08(g).
3.1.3.7 Testing Two or More Equity Method Investees Under Rule 4-08(g)
When determining the significance of equity method investees
in accordance with Rule 4-08(g), the
tests are applied both individually to each equity method investee and in
the aggregate for any combination of equity method investees.
If the income component is performed for two or more equity
method investees under Rule 4-08(g), the registrant is not permitted to
aggregate equity method investees that are reporting losses with those that
are reporting income. Rule
1-02(w)(1)(iii)(B)(3) states, in part:
Entities reporting losses must not be aggregated
with entities reporting income where the test involves combined
entities, as in the case of determining whether summarized financial
data must be presented.
Accordingly, a registrant must separately combine (1) the pretax income from
continuing operations of all equity method investees that are reporting
income and (2) the pretax loss from continuing operations of all equity
method investees that are reporting losses.
Similarly, in the computation of the revenue component, it
would be appropriate to separately combine (1) revenue of all equity method
investees that are reporting income and (2) revenue of all equity method
investees that are reporting losses.
Example 3-16
Registrant R is filing its Form 10-K for 20X0. It has
investments in Company A, Company B, Company C, and
Company D, all of which are accounted for under the
equity method.
- For its fiscal year ended December 31, 20X0, R had consolidated pretax income from continuing operations (including equity in pretax income or losses from continuing operations of equity method investees) of $2,000 and revenue of $10 million.
- For its fiscal year ended December 31, 20X0,
R’s proportionate share of pretax income/(losses)
from continuing operations and revenue for each
company was as follows:
Assume that no basis differences are
recorded in R’s income statement in connection with
its investments in A, B, C, and D.8 In addition, R and all its investees have each
had material revenue in the two most recently
completed fiscal years.
Income Component
Individual
Basis
Aggregate Basis
Although no investee individually meets the 10
percent threshold on the revenue or income
component, the significance of C and D in the
aggregate exceeds 10 percent on both the income and
revenue component. Therefore, R’s financial
statements must include summarized financial
information in accordance with Rule 4-08(g). Note
that the summarized information must cover all
equity investees (i.e., A, B, C, and D).
3.1.3.8 Determining When Summarized Income Statement Information Is Required
Paragraph 2400.2 of the FRM states, in part, that
“[Rule 3-09] does not require separate interim financial
statements. Instead, [Rule 10-01(b)(1)] requires certain summarized interim
statement of comprehensive income information of the investee if it is
significant.”
Rule
10-01(b)(1) and paragraph 2420.7 of the FRM
provide guidance on performing the income and investment tests under Rule
1-02(w) to determine whether the equity method investee is significant in
the interim period. According to paragraph 2420.7:
- When performing the income test, a registrant should use the year-to-date interim period statement of comprehensive income included in the quarterly report rather than either the most recent quarterly-period results or the results for the most recently completed fiscal year.
- When performing the investment test, a registrant should use both (1) the most recent balance sheet included in the filing (which should correspond to the year-to-date interim date used in the income test computation) and (2) the most recently completed fiscal-year-end balance sheet included in the quarterly report (see Sections 1.1 and 3.1).
If the results of either the income or investment test
exceed the 20 percent significance level, the summarized income statement
information should be presented for investees that are significant for both
the current and prior years’ comparative year-to-date periods.
Example 3-17
Registrant A owns a 40 percent
equity method investment in Company B, which would
be required to file quarterly financial information
if it were a registrant. Both A and B have calendar
year-ends. As of December 31, 20X0, B was not
significant to A; therefore, A was not required to
provide separate financial statements for B under
Rule 3-09 or B’s summarized financial information
under Rule 4-08(g).
As of June 30, 20X1, A reports the
following in its quarterly financial statements:
- Consolidated assets of $2 million.
- Registrant A’s investment in B was $0.5 million.
- Pretax income from A’s continuing operations for the six months ending June 30, 20X1 (including equity in earnings of B), is $700.
- Registrant A’s interest in the pretax income from B’s continuing operations for the six months ending June 30, 20X1, is $100.
- Registrant A’s revenue for the six months ending June 30, 20X1, is $3 million.
- Registrant A’s interest in B’s revenue for the six months ending June 30, 20X1, is $0.65 million.
For simplicity, assume that there are no basis
differences and that A and B both have material
revenue in the two most recently completed fiscal
years.
The results of the year-to-date
interim-period income test indicate that B’s
significance to A is as follows:
- $100 ÷ $700 = 14 percent of pretax income from continuing operations.
- $0.65 million ÷ $3 million = 22 percent of revenue.
Therefore, B is not significant to A
at the 20 percent level because both the revenue and income components must
be met for the test to indicate significance.
Although B was not significant to A
at the 20 percent level on the basis of the results
of the investment test as of December 31, 20X0, B is
significant to A at the 20 percent level on the
basis of the results of the investment test as of
June 30, 20X1 ($0.5 million ÷ $2 million = 25%).
Therefore, A must include summarized income
statement information of B in its interim financial
statements included in its quarterly report. Such
information would be provided for the year-to-date
period ended June 30, 20X1, as well as the
comparative prior year-to-date period. See Section
2.4 for a discussion of the summarized
financial information that should be included.
Footnotes
1
See Section 2.5 for a discussion of the SEC reporting
requirements for SRCs under Rule 8-03.
2
The annual financial statements of a
significant equity method investee must be audited
for the periods in which one of the applicable
significance tests exceeds 20 percent. The financial
statements may be unaudited for periods in which the
equity method investee is not significant.
3
A registrant may be required to use income averaging
in accordance with paragraph 2015.8 of the
FRM regardless of whether it reports income or loss in its most
recent annual period. See Section 3.1.3.3 for more
information about how a registrant should use average income when
performing the income test.
4
See Section 3.1.3.1
for guidance on determining the numerator of the
income component under Rule 3-09.
5
See footnote 2.
6
See Section 3.1.3.1
for guidance on performing the income test for
equity method investees under Rule 3-09.
7
See footnote 2.
8
See Section 3.1.3.1
for guidance on determining whether any
adjustments to the numerator are required for
other amounts related to the equity method
investee that are recorded directly by the
registrant (such as impairment charges and
preferred stock dividends).
9
If either the registrant or
the equity method investee incurred a pretax loss
from continuing operations in the fiscal year used
to perform the income test, the registrant should
use the absolute value of this loss when
performing the income test. See Section
3.1.3.4 for further discussion about
performing the income test when the registrant or
the equity method investee has a loss in the
fiscal year.
10
This excludes the investee’s
pretax loss from the denominator because the
investee had a pretax loss while the registrant
had pretax income. See further discussion in
Section 3.1.3.4.
11
See footnote 8.
12
See footnote 9.
13
See footnote 8.
14
See footnote 9.