2.4 Applicability of Equity Method to Other Investments
2.4.1 Investments Held by Not-for-Profit Entities
ASC 958-810
15-4 Additional guidance for reporting relationships between NFPs and for-profit entities resides in the following locations in the Codification: . . .
c. An NFP that owns 50 percent or less of the voting stock in a for-profit entity shall apply the guidance in Subtopic 323-10 unless the investment is measured at fair value in accordance with applicable GAAP, including the guidance described in (e). If the NFP is unable to exercise significant influence, the NFP shall apply the guidance for equity securities in Topic 321.
d. An NFP with a more than minor noncontrolling interest in a for-profit real estate partnership, limited liability company, or similar legal entity shall report its noncontrolling interests in such entities using the equity method in accordance with the guidance in Subtopic 970-323 unless that interest is reported at fair value in accordance with applicable GAAP, including the guidance described in (e). An NFP shall apply the guidance in paragraph 970-810-25-1 to determine whether its interests in a general partnership are controlling financial interests or noncontrolling interests. An NFP shall apply the guidance in paragraphs 958-810-25-11 through 25-29 and 958-810-55-16A through 55-16I to determine whether its interests in a for-profit limited partnership, limited liability company, or similar legal entity are controlling financial interests or noncontrolling interests. An NFP shall apply the guidance in paragraph 323-30-35-3 to determine whether a limited liability company should be viewed as similar to a partnership, as opposed to a corporation, for purposes of determining whether noncontrolling interests in a limited liability company or a similar legal entity should be accounted for in accordance with Subtopic 970-323 or Subtopic 323-10.
e. An NFP that is not within the scope of Topic 954 on health care entities may elect to report the investments described in (b) through (d) and paragraph 958-325-15-2 at fair value, with changes in fair value reported in the statement of activities, provided that all such investments are measured at fair value.
An investor that meets the definition of a not-for-profit entity (NFP) should apply the guidance in
ASC 323-10 to its investments that represent 50 percent or less of the voting stock of a for-profit entity, unless the investor is required or chooses to account for such investments at fair value. If an NFP has an interest in an investee that maintains specific ownership accounts for each investor, the NFP should evaluate the investee in a manner similar to the way it would a partnership (see the discussion in Section 2.2.1). If the investee does not have specific ownership accounts, the NFP should evaluate the investee in a manner similar to the way it would a corporation.
While the above guidance is specific to NFPs, ASC 954-810-15-3 provides similar guidance for investments held by not-for-profit business-oriented health care entities.
2.4.2 Equity Method Investments Eligible for Fair Value Option
ASC 825-10
15-4 All entities may elect the fair value option for any of the following eligible items:
- A recognized financial asset and financial liability . . . .
25-2 The decision about whether to elect the fair value option:
- Shall be applied instrument by instrument, except as discussed in paragraph 825-10-25-7
- Shall be irrevocable (unless a new election date occurs, as discussed in paragraph 825-10-25-4)
- Shall be applied only to an entire instrument and not to only specified risks, specific cash flows, or portions of that instrument.
An entity may decide whether to elect the fair value option for each eligible item on its election date.
Alternatively, an entity may elect the fair value option according to a preexisting policy for specified types of
eligible items.
ASC 825-10-15-4 allows an investor to elect the fair value option for recognized
financial assets. Equity method investments are included in such assets because
they represent an ownership interest. If an investor elects the fair value
option, its investment must be recorded at fair value in each reporting period,
with subsequent changes in fair value reported in earnings. In addition, if the
fair value option is elected, additional disclosures must be provided, as
further discussed in Section
6.3.1.1.
An investor can elect the fair value option on an
investment-by-investment basis. The investor is not required to elect the fair
value option for identical investments it may have in other investees. However,
as stated in ASC 825-10-25-7(b), the election for an equity method investment
may be made only if the investor elects the fair value option for all of its
eligible interests in the same investee (e.g., equity and debt instruments and
guarantees5). In other words, the investor must make the election on a
legal-entity-by-legal-entity basis.
An investor may have an investment in an equity method investee that holds
primarily nonfinancial assets and liabilities. However, when determining whether
an equity method investment is eligible for the fair value option, an investor
is not required to “look through” the financial statements of the investee to
understand whether the assets and liabilities owned by the investee are
financial given that the fair value option is available for equity method
investments regardless of the nature of the investee’s assets and liabilities.
(See Section
12.2.1.1.1 of Deloitte’s Roadmap Fair Value Measurements and Disclosures (Including
the Fair Value Option) for further discussion.)
ASC 825-10-25-4 lists election dates (dates when an investor may elect to apply
the fair value option to eligible assets or liabilities), and ASC 825-10-25-5
lists events that may create an election date. Under ASC 825-10-25-4, if an
investor’s investment in equity securities that was not previously accounted for
under the equity method of accounting becomes subject to it, the investor may
either apply the equity method or elect the fair value option under ASC 825-10
for the securities. This could occur, for example, (1) upon initial acquisition
of an investment; (2) upon acquisition of an additional interest in an investee
in which the investor had a preexisting interest; (3) upon an investee’s
repurchase of its outstanding equity shares, resulting in an increase in an
investor’s ownership percentage in the investee in such a way that the investor
obtains significant influence over the investee; (4) if the governing provisions
of the investee are modified in such a way that the investor has significant
influence over the investee after the modification; or (5) when an investor
loses control of, but retains significant influence over, an investee. (See
Section
12.3.2.2.3 of Deloitte’s Roadmap Fair Value Measurements and Disclosures (Including
the Fair Value Option) for further discussion.)
Once an investor elects the fair value option, it may not be revoked unless an event creating a new
election date occurs.
2.4.2.1 Availability of the Fair Value Option for Financial Instruments With a Significant Future Service Component
Sometimes, in addition to providing the investor with an equity-like residual
return, certain equity investments subject to the equity method of
accounting may compensate the investor for future services. For example, a
GP will often have an interest in a limited partnership and, in addition,
have significant management responsibilities over the limited partnership
for which it is entitled to a management fee, which may include a “carried
interest.”
Financial instruments with significant service components are not eligible for
the fair value option under ASC 825-10. If an investor was permitted to
apply the fair value option to investments in these types of instruments,
that investor could inappropriately recognize a day 1 gain (i.e., profit at
inception) that represents, in part, compensation for future services. This
view is consistent with that expressed in a speech by Sandie Kim, then a
professional accounting fellow in the SEC’s Office of the Chief Accountant
(OCA), at the 2007 AICPA Conference on Current SEC and PCAOB Developments
and with conclusions reached in informal discussions with the FASB’s
staff.
An investor should consider all relevant circumstances and exercise judgment
when determining whether a financial instrument includes a significant
future service component, particularly when the service component is not
explicitly stated in the contract terms or the investee’s articles of
incorporation. The investor’s obligation to provide services may be
established in a different contract from that of the equity ownership
interest, or the service contract may contain only a portion of the economic
compensation, with the remainder intended to be an element of the “equity
instrument.” Accordingly, the investor should consider the substance of the
arrangement and whether the financial instrument and the contract for
services are inseparable.
The following are some indicators that a significant component of the equity investment consists of compensation for the investor’s future services:
- The fair value of the investment includes a return that is disproportionately greater than the return to other passive investors, and the services that the investor provides to the investee affect the future payout under the provision.
- The fair value of the interest at inception is greater than the investor’s investment, and the investor is expected to provide services to the investee that are beyond those ordinarily expected of an investor acting solely as a nonmanagement owner.
Because ASC 825-10-25-2 requires an investor to apply the fair value option to an entire instrument, there is no opportunity for the investor to separate the element for future services and elect the fair value option for the portion of the instrument that is purely financial unless the instrument must be bifurcated under other U.S. GAAP. Before the adoption of ASC 606, investors had generally applied the guidance in EITF Topic D-96 (codified in
ASC 605-20-S99-1) when accounting for the service arrangement (i.e., the
carried interest) (see Section 2.4.2.1.1 for further discussion).
Although the investor is unable to apply the fair value to its equity method
investment, it is not precluded from electing the fair value option relative
to its other interests in the investee (e.g., equity and debt instruments),
to the extent that it is permitted to do so under other applicable U.S.
GAAP.
Example 2-1
Manager A is the only GP of Partnership X. Manager A invested a nominal amount,
1 percent of the total capital, for its GP interest.
The GP interest entitles A to 5 percent of X’s net
income. Other than some insignificant administrative
tasks, A does not provide any services to X. An
unrelated third party manages X’s assets. Manager A
receives a disproportionately higher return than the
limited partners because of its unlimited liability
as GP for the partnership’s obligations. Manager A
estimates the fair value of its GP interest to be
equal to the amount invested at inception. The GP
interest does not appear to include significant
future services. The GP interest is eligible for the
fair value option under ASC 825-10.
Example 2-2
Manager B is the GP of Partnership
Y. Manager B invested a nominal amount, 1 percent of
the total capital, for its GP interest. The GP
interest entitles B to 10 percent of Y’s net income
and provides significant additional compensation if
Y’s operating margin reaches certain thresholds
(i.e., a “carried interest”). Manager B estimates
that the fair value of the GP interest is greater
than the amount invested at inception. Manager B
also manages Y’s assets through a separate services
contract and receives a servicing fee. In addition,
there are certain restrictions on the sale of the GP
interest during the term of the services contract.
Manager B also holds a limited
partnership interest in Y that can be transferred
independently from the GP interest. In addition, B
invested the same amount in, and receives the same
return on, its limited partnership interest as the
other limited partners. Also, B estimates that the
fair value of the limited partnership interest is
equal to the amount invested for this instrument.
Manager B has significant influence over Y.
In this example, B could not elect the fair value
option to account for its GP interest because the
interest includes compensation for significant
future services. However, it could elect to measure
its limited partnership interest at fair value under
the fair value option in ASC 825-10 because the
interest does not appear to include significant
future services.
2.4.2.1.1 Accounting for Incentive-Based Capital Allocation Arrangements
On the basis of informal discussions with the SEC staff, we understand that the
staff would not object to a conclusion that carried interests in the form of
incentive-based capital allocation arrangements may be accounted for within
the scope of either ASC 606 or ASC 323 if certain conditions are met, and
that this is an accounting policy choice that should have been made when EITF Topic D-96 was rescinded upon the adoption of ASC 606. In evaluating
whether application of ASC 323 is appropriate, entities should consider the
nature and legal form of such arrangements — specifically, whether the
incentive fee is an attribute of an equity interest in the fund (e.g., a
disproportionate allocation of fund returns to a capital account owned by
the investor-manager). When the incentive fee is not an allocation of fund
returns among holders of equity interests (e.g., when the fee is in the form
of a contractual arrangement with the fund), it should be accounted for
under ASC 606 (see Deloitte’s Roadmap Revenue Recognition for further
discussion). If application of ASC 323 is deemed appropriate, an investor
would still apply the guidance described above in evaluating whether the
fair value option for its investment may be applied (i.e., financial
instruments with substantive service components remain ineligible for the
fair value option under ASC 825-10).
2.4.2.2 Change From the Equity Method to Other Method of Accounting
An investor may lose the ability to exercise significant influence over an investee. This could occur, for
example, if the investor divests itself of an equity investment or otherwise reduces its ownership interest
in the investee, or if the governing provisions of the investee are modified. Loss of significant influence
does not represent an election date event under ASC 825-10. If the investor does lose the ability to
exercise significant influence over the investee and had previously elected to account for its investment
at fair value, it must continue accounting for its retained investment (and other eligible financial
interests) at fair value (i.e., an investor’s investment and other eligible financial interests in an investee
would not be eligible to be accounted for under any other U.S. GAAP).
If the investor has not elected the fair value option, it should refer to ASC
323-10-35-36, which provides guidance on situations in which the investor’s
investment in common stock falls below the level at which the investor
should apply the equity method of accounting. See Section 5.6.5 for further
discussion.
2.4.3 Proportionate Consolidation Method
ASC 810-10
45-14 If the
investor-venturer owns an undivided interest in each
asset and is proportionately liable for its share of
each liability, the provisions of paragraph 323-10-45-1
may not apply in some industries. For example, in
certain industries the investor-venturer may account in
its financial statements for its pro rata share of the
assets, liabilities, revenues, and expenses of the
venture. Specifically, a proportionate gross financial
statement presentation is not appropriate for an
investment in an unincorporated legal entity accounted
for by the equity method of accounting unless the
investee is in either the construction industry (see
paragraph 910-810-45-1) or an extractive industry (see
paragraphs 930-810-45-1 and 932-810-45-1). An entity is
in an extractive industry only if its activities are
limited to the extraction of mineral resources (such as
oil and gas exploration and production) and not if its
activities involve related activities such as refining,
marketing, or transporting extracted mineral
resources.
ASC 970-810
45-1 An investment in real property may be presented by recording the undivided interest in the assets,
liabilities, revenue, and expenses of the venture if all of the following conditions are met:
- The real property is owned by undivided interests.
- The approval of two or more of the owners is not required for decisions regarding the financing, development, sale, or operations of real estate owned.
- Each investor is entitled to only its pro rata share of income.
- Each investor is responsible to pay only its pro rata share of expenses.
- Each investor is severally liable only for indebtedness it incurs in connection with its interest in the property.
An investor in a separate entity (including an unincorporated legal entity) that
has significant influence generally applies the equity method of accounting.
Because the guidance in ASC 323-10 applies only to ownership in the form of
common stock (or in-substance common stock), an investor that owns an undivided
interest in each asset and is proportionately liable for its share of each
liability of an investee should not apply the equity method of accounting to
such an investment. However, an investor that holds an interest in an
unincorporated legal entity (e.g., a partnership) — as opposed to an undivided
interest in each asset and liability — in the construction or extractive
industries may elect to apply the proportionate consolidation method (if certain
criteria are met) and record its proportionate share of the investee’s assets,
liabilities, revenues, and expenses in each applicable line item in its
financial statements (as opposed to presentation in a single line item as an
equity method investment). To determine whether an investor that holds an
interest in an unincorporated legal entity (e.g., an LLC) within the
construction or extractive industries may elect to apply the proportionate
consolidation method, the investor should evaluate whether the governance
provisions are more akin to those of a partnership or of a corporation (see
Section
2.2.1).
Specifically, to apply proportionate consolidation, the investor must have an
undivided interest in each asset and be proportionately liable for its share of
each liability of the investee. In addition, in the extractive industry, the
investee’s activities must be limited to the extraction of mineral resources
(such as oil and gas exploration and production). If its activities include
refining, marketing, or transporting extracted mineral resources, the investor
should not apply proportionate consolidation.
Proportionate consolidation may be acceptable in the real estate industry even
when the investment is an undivided interest in real property (as opposed to an
investment in an entity) if the undivided interest is not subject to joint
control and the other conditions in ASC 970-810-45-1 are met. However, as
described in ASC 970-323-25-12, most real estate ventures in the form of
undivided interests are subject to some form of joint control. In those
instances, the equity method of accounting is required.
An investor may proportionately consolidate an investment that qualifies for
such treatment even if another party consolidates the investment in accordance
with ASC 810-10. Proportionate consolidation requires an investor to apply
typical consolidation procedures, which are further discussed in Section 5.1.5.1 and in
Chapter 10 of
Deloitte’s Consolidation
Roadmap. If a PBE investor proportionately consolidates its
undivided interest, the proportionately consolidated information must comply
with the PBE accounting requirements (see Section 5.1.3.2), including those related
to the timing of the adoption of new accounting standards (see Section 5.1.3.4).
Footnotes
5
Election of the fair value option would result in the
investor’s measuring the guarantee at fair value, with changes in fair
value reported in earnings, which is different from the subsequent
measurement of guarantees in accordance with ASC 460.