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 at each reporting period, with subsequent changes in fair value reported in earnings. In addition, electing the fair value option requires additional disclosures, which are 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 Services 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 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 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 considerations 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 (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 the single line item equity investment presentation). 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 public business entity (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

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.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.