Chapter 2 — Scope and Scope Exceptions
Chapter 2 — Scope and Scope Exceptions
2.1 Overview
ASC 323-10
15-2 The guidance in the Investments — Equity Method and Joint Ventures Topic applies to all entities.
15-3 The guidance in the Investments — Equity Method and Joint Ventures Topic applies to investments in common stock or in-substance common stock (or both common stock and in-substance common stock), including investments in common stock of corporate joint ventures (see paragraphs 323-10-15-13 through 15-19 for guidance on identifying in-substance common stock). Subsequent references in this Subtopic to common stock refer to both common stock and in-substance common stock that give the investor the ability to exercise significant influence (see paragraph 323-10-15-6) over operating and financial policies of an investee even though the investor holds 50% or less of the common stock or in-substance common stock (or both common stock and in-substance common stock).
This chapter discusses considerations related to scope — that is, which investments should and should not be accounted for under the equity method of accounting.
ASC 323-10 may apply to any entity that has an investment in the common stock
and in-substance common stock of an investee. As
defined in ASC 323-10-20, common stock (or common
shares) is “[a] stock that is subordinate to all
other stock of the issuer.” Holders of common
stock generally have the right to elect members of
the board of directors and to vote on corporate
policy, both of which allow those shareholders to
influence the operating and financial policies of
an investee. Because common stock represents the
residual value of an investee, in the event of
liquidation, common shareholders have rights to a
company’s assets only after all other senior
claims (e.g., those of bondholders, preferred
shareholders, and other debt holders) are paid in
full. In-substance common stock represents an
instrument that, although not in the legal form of
common stock, has characteristics that are
substantively similar to those of common
stock.
Before an investor applies ASC 323-10 to an investment in an investee, it should
evaluate whether any scope exceptions apply (see Section 2.3) and, if not, whether it has the
ability to exercise significant influence over the operating and financial policies
of that investee (see Chapter
3). The equity method of accounting applies only when the investor
has an investment in common stock or in-substance common stock and, accordingly,
should not be used when an investment in common stock (or in-substance common stock)
does not exist, even if the investor holds other investments that allow it to
exercise significant influence over the investee. However, if the investor holds
both common stock (or in-substance common stock) and other investments, it should
consider the rights provided by all such instruments in evaluating whether, in
combination, they permit the investor to exercise significant influence over the
investee.
Many of the provisions in ASC 323-10 apply to investments in the common stock of corporations (including corporate joint ventures), as well as to investments in noncorporate entities, such as partnerships, LLCs, unincorporated joint ventures (see Section 2.2), and any other form of legal entity.
Corporate and unincorporated joint ventures (collectively, “joint ventures”) are
a common form of business enterprise. Although an investor in a joint venture will
generally account for its investment in a joint venture the same way it would for
any other equity method investment under ASC 323-10, there are some nuances, which
are discussed in Chapter
10.
2.2 Investments in Partnerships, Unincorporated Joint Ventures, and LLCs
ASC 323-10
15-5 The guidance in the Overall Subtopic does not apply to any of the following:
- An investment in a partnership or unincorporated joint venture (also called an undivided interest in ventures), see Subtopic 323-30
- An investment in a limited liability company that maintains specific ownership accounts for each investor as discussed in Subtopic 272-10.
ASC 323-30
25-1 Investors in unincorporated entities such as partnerships and other unincorporated joint ventures
generally shall account for their investments using the equity method of accounting by analogy to Subtopic
323-10 if the investor has the ability to exercise significant influence over the investee.
An investor should first consider ASC 810-10 to evaluate whether the investee
should be consolidated, regardless of its ownership percentage. (See Deloitte’s Consolidation
Roadmap to determine whether the guidance in ASC 810-10 applies to
the investment.) If an investor determines that the investee should not be
consolidated, the investor should consider the guidance in ASC 323-10 or other
guidance as appropriate.
Investments in partnerships (general or limited), unincorporated joint ventures,
and LLCs that maintain specific ownership accounts for each investor are excluded
from the scope of ASC 323-10. However, if an investor has the ability to exercise
significant influence over these types of investments, it generally should apply the
principles of accounting for equity method investments by analogy to ASC 323-10. In
addition, ASC 970-323 provides similar guidance relative to various forms of
investments in real estate development projects.1 However, the presumed level of ownership interest that allows an investor to
exercise significant influence over an investee for these types of entities differs
from the presumed levels of ownership for corporations. This topic is further
discussed in Section
3.2.
2.2.1 Limited Liability Companies
ASC 323-30
35-3 An investment in a limited liability company that maintains a specific ownership account for each
investor — similar to a partnership capital account structure — shall be viewed as similar to an investment
in a limited partnership for purposes of determining whether a noncontrolling investment in a limited
liability company shall be accounted for in accordance with the guidance in Topic 321 or the equity
method.
ASC 272-10
05-2 A limited liability company generally has the following characteristics:
- It is an unincorporated association of two or more persons.
- Its members have limited personal liability for the obligations or debts of the entity.
- It is classified as a partnership for federal income tax purposes.
05-3 Limited liability companies have characteristics of both corporations and partnerships but are dissimilar from both in certain respects. The following discussion compares characteristics typical of many limited liability company structures with characteristics of corporations or partnerships; however, those characteristics may not be present in all limited liability company structures.
05-4 Like a corporation, the members (that is, owners) of a limited liability company generally are not personally liable for the liabilities of the limited liability company. However, like a partnership, the members of [a] limited liability company — rather than the entity itself — are taxed on their respective shares of the limited liability company’s earnings. Unlike a limited partnership, it is generally not necessary for one owner (for example, the general partner in a limited partnership) to be liable for the liabilities of the limited liability company. Also, unlike a limited partnership in which the general partner manages the partnership, or a corporation in which the board of directors and its committees control the operations, owners may participate in the management of a limited liability company. Members may participate in a limited liability company’s management but generally do not forfeit the protection from personal liability afforded by the limited liability company structure. In contrast, the general partner of a limited partnership has control but also has unlimited liability, whereas the limited partners have limited liability like the members of a limited liability company. Additionally, all partners in a general partnership have unlimited liability. Like a partnership, financial interests in most limited liability companies may be assigned only with the consent of all of the limited liability company members. Like a partnership, most limited liability companies are dissolved by death, bankruptcy, or withdrawal of a member.
As stated in ASC 272-10-05-3, LLCs may “have characteristics of both
corporations and partnerships but are dissimilar from both in certain respects.” EITF Issue 03-16 discussed how LLCs were included in the scope of the guidance
and addressed the similarities and differences between LLCs and limited
partnerships. When assessing whether the investment in an LLC should be
accounted for under the equity method, an investor must first determine whether
the LLC is more akin to a corporation or a partnership. In making that
determination, the investor should consider whether the LLC maintains specific
ownership accounts for each investor. A specific ownership account is one in
which an individual investor’s capital transactions (e.g., contributions and
distributions) and share of LLC profits and losses are allocated in a manner
similar to the way they would be in a partnership capital account structure. The
manner in which an LLC is taxed is often an indicator of whether the LLC is
structured with separate capital accounts. If the LLC is taxed in a manner
similar to a partnership, specific ownership accounts are maintained for each
investor. However, if the LLC is taxed in a manner similar to a corporation,
equity is often indistinguishable among owners, and an investor’s interest in
such entities is similar to a common shareholder’s interest in a
corporation.
2.2.1.1 LLC That Maintains Specific Ownership Accounts
If an investor has an investment in an LLC that maintains specific ownership
accounts for each investor, the investment should be evaluated in the same
manner as one in a partnership (see Section 2.2.2). The same evaluation
would be performed for an investment in an entity other than a partnership
or LLC if that entity also maintains a specific ownership account structure
(such as a common trust fund).
See Section 3.2.3 for further discussion of the evaluation of significant influence over an investee that has the legal form of a partnership.
2.2.1.2 LLC That Does Not Maintain Specific Ownership Accounts
If an investor has an investment in an LLC that does not maintain specific ownership accounts for each
investor, the investment should be evaluated in the same manner as one in a corporation.
See Section 3.2.1 for further discussion of the evaluation of significant influence over an investee that
has the legal form of a corporation.
It should be noted that ASC 810-10 specifically requires an investor to consider multiple factors
when assessing whether the LLC more closely resembles a corporation or partnership. However, the
evaluation under ASC 323-10 considers only whether a specific ownership account structure exists.
2.2.2 Limited Partnership Interests in Partnerships and Similar Entities
ASC 970-323
25-6 The equity method of accounting for investments in general partnerships is generally appropriate for
accounting by limited partners for their investments in limited partnerships. A limited partner’s interest
may be so minor that the limited partner may have virtually no influence over partnership operating
and financial policies. Such a limited partner is, in substance, in the same position with respect to the
investment as an investor that owns a minor common stock interest in a corporation, and, accordingly, the
limited partner should account for its investment in accordance with Topic 321.
Investments in partnerships and similar entities (e.g., unincorporated joint ventures or LLCs that
maintain specific ownership accounts for each investor) are accounted for under the equity method
of accounting in accordance with ASC 970-323-25-6 unless the investor’s interest is “so minor that the
limited partner may have virtually no influence over partnership operating and financial policies.” While
the guidance in ASC 970-323 is specific to real estate partnerships, ASC 323-30-S99-1 clarifies the
SEC’s view that “investments in all limited partnerships should be accounted for pursuant to paragraph
970-323-25-6.” Therefore, we believe that it is appropriate for investors to apply this guidance to all
partnerships and similar entities (not only real estate investees).
See Section 3.2.3 for further discussion of the presumed levels of ownership that allow an investor in a
partnership or other similar entities to exercise significant influence.
2.2.3 General Partnership Interests in Partnerships
ASC 970-810
25-3 If a limited partnership does not meet the conditions in paragraph 810-10-15-14 and, therefore, is not a variable interest entity, limited partners shall evaluate whether they have a controlling financial interest according to paragraph 810-10-15-8A. The guidance in Subtopic 810-10 on consolidation shall be used to determine whether any limited partners control the limited partnership:
- If no single partner controls the limited partnership, the general and limited partners shall apply the equity method of accounting to their interests, except for instances when a limited partner’s interest is so minor that the limited partner may have virtually no influence over partnership operations and financial policies (see paragraph 323-30-S99-1).
- Subparagraph superseded by Accounting Standards Update No. 2015-02.
- If a single limited partner controls the limited partnership, that limited partner shall consolidate the limited partnership and apply the principles of accounting applicable for investments in subsidiaries in Topic 810.
If a partnership is not a variable interest entity (VIE) or if a partnership is a VIE but the general partner (GP) is not the primary beneficiary, the GP should account for its interest in the partnership under the equity method.
2.2.4 Corporate Joint Ventures
All joint venture investments in which an investor shares in joint control, whether they are incorporated or unincorporated, should be accounted for under the equity method without regard to the investor’s ownership percentage.
Footnotes
1
See ASC 970-323-25-3 through 25-8.
2.3 Scope Exceptions
ASC 323-10
15-4 The guidance in this Topic does not apply to any of the following:
- An investment accounted for in accordance with Subtopic 815-10
- An investment in common stock held by a nonbusiness entity, such as an estate, trust, or individual
- Subparagraph superseded by Accounting Standards Update No. 2012-04.
- Subparagraph superseded by Accounting Standards Update No. 2012-04.
- Subparagraph superseded by Accounting Standards Update No. 2012-04.
- An investment in common stock within the scope of Topic 810
- Except as discussed in paragraph 946-323-45-2, an investment held by an investment company within the scope of Topic 946.
ASC 323-30
15-4 This Subtopic does not provide guidance for investments in limited liability companies that are required to
be accounted for as debt securities pursuant to paragraph 860-20-35-2.
One of the steps in the determination of whether an investment is subject to the equity method of
accounting is an evaluation of whether the investment meets one of the scope exceptions to the
requirements in ASC 323-10.
There are certain investments for which the equity method of accounting generally does not apply,
even though an investor may have the ability to exercise significant influence over an investee. The
determination of whether an investment is within the scope of ASC 323-10 may require judgment and
should be based on an evaluation of all facts and circumstances.
2.3.1 Investments Accounted for in Accordance With ASC 815-10
An investment that is a derivative within the scope of ASC 815-10 is generally
accounted for at fair value and, accordingly, is not within the scope of ASC
323-10.
2.3.2 Investments in Common Stock Held by a Nonbusiness Entity
If an investment is held by a nonbusiness entity, such as an estate, trust, or
individual (even if that investment allows the investor to exercise significant
influence over the investee), the nonbusiness entity is not required to use the
equity method to account for an investment in common stock. Accounting for such
investments at fair value in accordance with ASC 321 (unless the measurement
alternative is elected)2 may better depict the financial position and changes in the financial
position of nonbusiness entities, especially given the diverse nature of such
entities. However, a nonbusiness entity is not precluded from applying the
equity method of accounting if its investment permits it to exercise significant
influence over the investee and does not constitute a controlling financial
interest. The use of the equity method of accounting by a nonbusiness entity is
a policy election, and if elected, should be applied consistently for similar
investments. However, the equity method of accounting would generally be applied
to investments held by a nonbusiness entity for long-term operating purposes (as
opposed to a portfolio or similar investment).
2.3.2.1 Investments Held by Real Estate Investment Trusts
Real estate investment trusts (REITs) are typically formed as trusts, associations, or corporations and are
considered business entities (rather than nonbusiness entities) because they have business activities in
the form of income-producing real estate or real estate–related assets and are capitalized through the
use of a combination of equity and borrowed capital. Since REITs are considered business entities, in the
absence of another scope exception, their investments should be analyzed to determine whether the
equity method of accounting under ASC 323-10 should be applied.
In some cases, a REIT, to retain its qualification as such, will establish a
service corporation to perform services for the REIT or for third parties.
As discussed above, such corporations are considered business entities and
are within the scope of ASC 323-10. However, a REIT should consider the
factors in ASC 974-323-25-1 and the facts and circumstances of each
investment to determine whether it has the ability to exercise significant
influence over a service organization and therefore should apply the equity
method of accounting to its investment in the service corporation (see
Section
3.4.1).
2.3.3 Investments in Common Stock Within the Scope of ASC 810
It would be inappropriate for an investor to use the equity method of accounting
to account for an investment in common stock that represents a controlling
financial interest. Such an investment should be consolidated in accordance with
ASC 810-10. This topic is discussed in Deloitte’s Consolidation Roadmap.
However, ASC 323-10 may apply to majority-owned legal entities (1) that are not
consolidated because of the exclusions of ASC 810-10-15-10, (2) if the minority
shareholder or shareholders have certain approval or veto rights qualifying as
substantive participating rights under ASC 810-10-25-1 through 25-14, or (3) if
the majority shareholder is determined not to be the primary beneficiary of a
VIE under ASC 810-10-25-38 through 25-41. In such instances, the equity method
would apply if an investor exercises significant influence over the
majority-owned subsidiary. In the rare circumstance that an investor owning a
majority of a subsidiary does not exercise significant influence over that
subsidiary, the investment would be accounted for under ASC 321 at fair value
(unless the measurement alternative is elected).3
2.3.4 Investments Held by Investment Companies Within the Scope of ASC 946
ASC 946-323
45-1 Except as discussed in the following paragraph, use of the equity method of accounting by an investment company is not appropriate. Rather, those noncontrolling ownership interests held by an investment company shall be measured in accordance with guidance in Subtopic 946-320, which requires investments in debt and equity securities to be subsequently measured at fair value.
45-2 An exception to the general principle in the preceding paragraph occurs if the investment company has an investment in an operating entity that provides services to the investment company, for example, an investment adviser or transfer agent (see paragraph 946-10-55-5). In those cases, the purpose of the investment is to provide services to the investment company rather than to realize a gain on the sale of the investment. If an investment company holds a noncontrolling ownership interest in such an operating entity that otherwise qualifies for use of the equity method of accounting, the investment company should use the equity method of accounting for that investment, rather than measuring the investment at fair value.
2.3.4.1 Investor Is an Investment Company
If an investor qualifies as an investment company under ASC 946,4 it is precluded from using the equity method to account for an
investment in an investee, irrespective of whether the investee is an
investment company. Investment companies account for their investments in
operating companies (other than those providing services to the investment
companies as described below) at fair value in accordance with the
specialized accounting guidance in ASC 946, regardless of whether the
investment companies have the ability to exercise significant influence over
the investees. An investment company that has an investment in an entity
that is providing services to the investment company, such as an investment
adviser or a transfer agent, should apply the equity method of accounting if
all other criteria are met.
2.3.4.2 Investor Is Not an Investment Company
An investor that has an interest in an investment company but is not itself an investment company
under ASC 946 should apply the equity method of accounting if all other criteria are met.
2.3.5 Investments in Certain Securitization Entities
ASC 860-20
35-2 Financial assets, except for instruments that are within the scope of Subtopic 815-10, that can
contractually be prepaid or otherwise settled in such a way that the holder would not recover substantially
all of its recorded investment shall be subsequently measured like investments in debt securities classified
as available for sale or trading under Topic 320. Examples of such financial assets include, but are not limited
to, interest-only strips, other beneficial interests, loans, or other receivables. Interest-only strips and similar
interests that meet the definition of securities are included in the scope of that Topic. Therefore, all relevant
provisions of that Topic (including the disclosure requirements) shall be applied. See related implementation
guidance beginning in paragraph 860-20-55-33.
Investments in certain securitization entities (whether in the form of an LLC, partnership, trust, or similar
entity) that can be contractually settled in such a way that the investor may not recover substantially
all of its recorded investment are outside the scope of the equity method of accounting and are instead
accounted for as debt securities under ASC 320 (i.e., classified as available-for-sale (AFS) or trading
securities) or as a derivative within the scope of ASC 815-10, if applicable.
Footnotes
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
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.
2.5 Investments in In-Substance Common Stock
2.5.1 Characteristics of In-Substance Common Stock
ASC 323-10
15-13 For purposes of this Topic, in-substance common stock is an investment in an entity that has risk and reward characteristics that are substantially similar to that entity’s common stock. An investor shall consider all of the following characteristics when determining whether an investment in an entity is substantially similar to an investment in that entity’s common stock:
- Subordination. An investor shall determine whether the investment has subordination characteristics that are substantially similar to that entity’s common stock. If an investment has a substantive liquidation preference over common stock, it is not substantially similar to the common stock. However, certain liquidation preferences are not substantive. An investor shall determine whether a liquidation preference is substantive. For example, if the investment has a stated liquidation preference that is not significant in relation to the purchase price of the investment, the liquidation preference is not substantive. Further, a stated liquidation preference is not substantive if the investee has little or no subordinated equity (for example, common stock) from a fair value perspective. A liquidation preference in an investee that has little or no subordinated equity from a fair value perspective is nonsubstantive because, in the event of liquidation, the investment will participate in substantially all of the investee’s losses.
- Risks and rewards of ownership. An investor shall determine whether the investment has risks and rewards of ownership that are substantially similar to an investment in that entity’s common stock. If an investment is not expected to participate in the earnings (and losses) and capital appreciation (and depreciation) in a manner that is substantially similar to common stock, the investment is not substantially similar to common stock. If the investee pays dividends on its common stock and the investment participates currently in those dividends in a manner that is substantially similar to common stock, then that is an indicator that the investment is substantially similar to common stock. Likewise, if the investor has the ability to convert the investment into that entity’s common stock without any significant restrictions or contingencies that prohibit the investor from participating in the capital appreciation of the investee in a manner that is substantially similar to that entity’s common stock, the conversion feature is an indicator that the investment is substantially similar to the common stock. The right to convert certain investments to common stock (such as the exercise of deep-in-the-money warrants) enables the interest to participate in the investee’s earnings (and losses) and capital appreciation (and depreciation) on a substantially similar basis to common stock.
- Obligation to transfer value. An investment is not substantially similar to common stock if the investee is expected to transfer substantive value to the investor and the common shareholders do not participate in a similar manner. For example, if the investment has a substantive redemption provision (for example, a mandatory redemption provision or a non-fair-value put option) that is not available to common shareholders, the investment is not substantially similar to common stock. An obligation to transfer value at a specious future date, such as preferred stock with a mandatory redemption in 100 years, shall not be considered an obligation to transfer substantive value.
15-14 If an investment’s subordination characteristics and risks and rewards of ownership are substantially
similar to the common stock of the investee and the investment does not require the investee to transfer
substantive value to the investor in a manner in which the common shareholders do not participate
similarly, then the investment is in-substance common stock. If the investor determines that any one of the
characteristics in the preceding paragraph indicates that an investment in an entity is not substantially similar
to an investment in that entity’s common stock, the investment is not in-substance common stock. If an
investee has more than one class of common stock, the investor shall perform the analysis described in the
preceding paragraph and the following paragraph (if necessary) by comparing its investment to all classes of
common stock.
15-15 If the determination about whether the investment is substantially similar to common stock cannot be
reached based solely on the evaluation under paragraph 323-10-15-13, the investor shall also analyze whether
the future changes in the fair value of the investment are expected to vary directly with the changes in the fair
value of the common stock. If the changes in the fair value of the investment are not expected to vary directly
with the changes in the fair value of the common stock, then the investment is not in-substance common stock.
Over time, the type and form of investment vehicles have expanded beyond basic voting common stock to include convertible debt, preferred equity securities, options, warrants, interests in unincorporated entities, complex licensing and management arrangements, and a host of other financial instruments. EITF Issue 02-14 (codified in ASC 323-10) noted:
These investment vehicles can convey — by contract, articles of incorporation, indenture, or other means —
any combination of rights, privileges, or preferences including (a) the right to vote with common stockholders,
(b) the right to appoint members of the board of directors, (c) substantive participating rights . . . , (d) protective
rights . . . , (e) cumulative and participating dividends, and (f) liquidation preferences.
Some of these rights may give an investor the ability to exercise significant
influence over the operating and financial policies of an investee without
holding an investment in the investee’s voting common stock. When an investment
in other than common stock (debt, preferred equity securities, etc.) has all the
factors in ASC 323-10-15-13, it is considered to be “in-substance” common stock,
and the investor should apply the equity method if it also has significant
influence over the investee. If the investment does not have all the factors in
ASC 323-10-15-13, it would not be within the scope of ASC 323-10, and the equity
method of accounting would be inappropriate even if the holder of the investment
has significant influence over the investee.
Examples of investments that may have the characteristics of in-substance common stock include convertible stock or warrants (with no barriers to exercise), stock with a nonsubstantive liquidation preference, and participating stock redeemable at the holder’s option. Examples of investments that would generally not be considered in-substance common stock include mandatorily redeemable stock, stock with an embedded non-fair-value put option, stock with a substantive liquidation preference, and nonparticipating, nonconvertible preferred stock.
An investor may also hold an instrument (such as a call or a put option) that gives it the ability to purchase or sell the voting common stock of an investee at some point. In evaluating whether such instruments represent in-substance common stock, an investor must first determine whether the put
or call option is a freestanding instrument. If the instrument is not freestanding, the investor should further determine whether the put or call option is an embedded feature within a host arrangement
that requires bifurcation and separate accounting. The equity method of accounting does not apply to either a freestanding instrument or bifurcated embedded feature since those instruments are accounted for in accordance with ASC 815 (see Section 2.3). Put and call options, as well as other instruments that are not accounted for under ASC 815 (i.e., the host instrument), may have the characteristics in ASC 323-10-15-13 and therefore represent in-substance common stock.
ASC 323-10 contains examples that illustrate the evaluation of whether an investment is in-substance common stock (see Sections 2.5.1.1 through 2.5.1.3). Each example assumes that the investor is not required to consolidate the investee under ASC 810-10, that it has the ability to exercise significant influence over the operating and financial policies of the investee (see Chapter 3), and that its investment does not meet the definition of a derivative instrument under ASC 815.
It is important to note that EITF Issue 02-14 provided the initial guidance on the evaluation of in-substance common stock. Paragraph 5 of EITF Issue 02-14
states, in part:
This Issue does not apply to investments
accounted for under Statement 133, non-corporate entities accounted for
under SOP 78-9, or to limited liability companies that maintain “specific
ownership accounts” for each investor as discussed in Issue No. 03-16,
“Accounting for Investments in Limited Liability Companies.
We believe that the EITF Issue 02-14 scoping guidance continues to be applicable
and, accordingly, the in-substance common stock guidance in ASC 323-10-15-3
through 15-5 should be applied only to investments in corporations. Thus, it
would not apply, for example, to investments in partnerships, LLCs, trusts, or
other unincorporated entities that maintain specific ownership accounts (see
Section 2.2) or
to investments within the scope of ASC 815 (see Section 2.3).
2.5.1.1 Subordination
ASC 323-10
Case A: Subordination Substantially Similar to Common Stock
55-3 Investor organized Investee and acquired all of the common stock of Investee on January 1, 2003. On January 1, 2004, Investee sells 100,000 shares of preferred stock to a group of investors in exchange for $10,000,000 ($100 par value; liquidation preference of $100 per share). The fair value of the entity’s common stock is approximately $100,000 on January 1, 2004.
55-4 In this Case, the stated liquidation preference is equal to the fair value of the preferred stock. However, the fair value of the common stock ($100,000), if compared with the fair value of the preferred stock, indicates that Investee has little or no common stock from a fair value perspective. An investor should therefore conclude that the liquidation preference is not substantive and that the subordination characteristics of its preferred stock investment are substantially similar to the subordination characteristics of Investee’s common stock. The investor should also evaluate whether the preferred stock has the characteristics in paragraph 323-10-15-13(b) through 15-13(c), and paragraphs 323-10-15-14 through 15-15 (if necessary) to reach a conclusion about whether the preferred stock is in-substance common stock.
Case B: Subordination Not Substantially Similar to Common Stock
55-5 Assume the same facts and circumstances as in Case A, except that the fair value of Investee’s common
stock is approximately $15,000,000 on January 1, 2004.
55-6 In this Case, the stated liquidation preference is equal to the fair value of the preferred stock. In addition,
Investee has adequate subordinated equity from a fair value perspective (more than little or no subordinated
equity) to indicate that the liquidation preference is substantive. An investor therefore should conclude
that the subordination characteristics of its preferred stock investment are not substantially similar to the
subordination characteristics of Investee’s common stock. Accordingly, the preferred stock investment is not
in-substance common stock. Evaluation of the characteristics in paragraph 323-10-15-13(b) through 15-13(c)
and paragraphs 323-10-15-14 through 15-15 is not required.
To determine whether a liquidation preference is substantive, an investor should
consider the significance of the stated liquidation preference in relation
to the purchase price of the investment as well as the significance of the
fair value of the subordinated equity (i.e., common stock) of the investee.
Said differently, a stated liquidation preference is not considered
substantive if the investee has little or no subordinated equity from a fair
value perspective. The table below summarizes indicators (not all inclusive)
of whether an investment’s subordination characteristics are substantially
similar to those of common stock.
Substantially Similar | Not Substantially Similar |
|---|---|
|
|
2.5.1.2 Risks and Rewards of Ownership
ASC 323-10
Case C: Investment Expected to Participate in Risks and Rewards of Ownership
55-7 Investor purchases a warrant in Investee for $2,003,900 on July 1, 20X4. The warrant enables Investor to
acquire 100,000 shares of Investee’s common stock at an exercise price of $1.00 per share (total exercise price
of $100,000) on or before June 30, 20X5; the warrant does not participate in dividends. The fair value of the
common stock is approximately $21.00 per share. The warrant is exercisable at any time. Investor does not
expect Investee to declare dividends before exercise.
55-8 Investor should evaluate whether the warrant is expected to participate in Investee’s earnings (and losses) and capital appreciation (and depreciation) in a manner that is substantially similar to common stock. To evaluate the extent to which the warrant is expected to participate with the common shareholders in Investee’s earnings (and losses), Investor should evaluate whether the warrant allows Investor to currently participate in dividends on a basis substantially similar to common stock. In this Case, Investor does not participate in dividends. Investor, however, can exercise the warrant (convert into common stock) at any time, thereby enabling Investor to participate in Investee’s earnings (and losses) on an equivalent basis to common stock. Because Investor does not expect Investee to declare dividends before exercise, Investor participates in Investee’s earnings in a manner substantially similar to common stock. In addition, warrants that are exercisable into common stock are designed to participate equally with the common shareholders in increases in the Investee’s fair value. Therefore, the warrant participates in Investee’s capital appreciation.
55-9 Investor should also evaluate whether the warrant is expected to participate in Investee’s capital depreciation in a manner substantially similar to common stock. An investor has alternatives for making this evaluation. In this Case, Investor could compare the current fair value of Investee’s common stock with the fair value of the warrant (on an equivalent unit basis) to determine whether the warrant is exposed to capital depreciation in a manner that is substantially similar to the entity’s common stock. The current fair value of the Investee’s common stock of $21.00 is substantially similar to the current fair value of each warrant of $20.04 (on an equivalent unit basis). Therefore, the warrant’s expected participation in Investee’s capital depreciation is substantially similar to the common shareholders’ participation. This comparison of fair values is different from the paragraph 323-10-15-15 evaluation that is performed (if necessary) to determine whether the future changes in fair value of the investment are expected to vary directly with the changes in the fair value of the entity’s common stock.
55-10 Accordingly, Investor should conclude that, before exercise, the warrants are expected to participate in Investee’s earnings (and losses) and capital appreciation (and depreciation) in a manner that is substantially similar to common stock. Investor should also evaluate whether the warrant has the characteristics in paragraph 323-10-15-13(a) and 323-10-15-13(c) and paragraphs 323-10-15-14 through 15-15 (if necessary) to reach a conclusion about whether the warrant is in-substance common stock.
Case D: Investment Not Expected to Participate in Risks and Rewards of Ownership
55-11 Investor purchases a warrant in Investee for $288,820 on July 1, 20X4. The warrant enables Investor to acquire 100,000 shares of Investee’s common stock at an exercise price of $21.00 per share (total exercise price of $2,100,000) on or before June 30, 20X5; the warrant does not participate in dividends. The fair value of the common stock is approximately $21.00 per share. The warrant is exercisable at any time. Investor does not expect Investee to declare dividends before exercise.
55-12 Investor should evaluate whether the warrant is expected to participate in Investee’s earnings (and losses) and capital appreciation (and depreciation) in a manner that is substantially similar to common stock. To evaluate the extent to which the warrant is expected to participate with the common shareholders in Investee’s earnings (and losses), Investor should evaluate whether the warrant allows Investor to currently participate in dividends on a basis substantially similar to common stock. In this Case, Investor does not participate in dividends. Investor, however, can exercise the warrant (convert into common stock) at any time, thereby enabling Investor to participate in Investee’s earnings (and losses) on an equivalent basis to common stock. Because Investor does not expect Investee to declare dividends before exercise, Investor participates in Investee’s earnings in a manner substantially similar to common stock. In addition, warrants that are exercisable into common stock are designed to participate equally with the common shareholders in increases in Investee’s fair value. Therefore, the warrant participates in Investee’s capital appreciation.
55-13 Investor should also evaluate whether the warrant is expected to participate in Investee’s capital
depreciation in a manner substantially similar to common stock. An investor has alternatives for making this
evaluation. In this Case, Investor could compare the current fair value of Investee’s common stock with the
current fair value of the warrant (on an equivalent unit basis) to determine whether the warrant is exposed to
capital depreciation in a manner that is substantially similar to the entity’s common stock. The current fair value
of the Investee’s common stock of $21.00 is substantially different from the current fair value of each warrant
of $2.88 (on an equivalent unit basis). Therefore, the warrant’s expected participation in Investee’s capital
depreciation is substantially different from the common shareholders’ participation. This comparison of fair
values is different from the paragraph 323-10-15-15 evaluation that is performed (if necessary) to determine
whether the future changes in fair value of the investment are expected to vary directly with the changes in the
fair value of the entity’s common stock.
55-14 Accordingly, Investor should conclude that, before exercise, the warrants are not expected to participate
in Investee’s earnings (and losses) and capital appreciation (and depreciation) in a manner that is substantially
similar to common stock and, accordingly, the warrants are not in-substance common stock. Evaluation of the
characteristics in paragraph 323-10-15-13(a) and 323-10-15-13(c) and paragraphs 323-10-15-14 through 15-15
is not required.
To determine whether an investment is substantially similar to common stock, the investor should
assess whether the investment is expected to participate in the earnings (and losses) and capital
appreciation (and depreciation) in a manner substantially similar to how an investment in the investee’s
common stock would participate. The table below summarizes indicators (not all inclusive) of when an
investment has risks and rewards of ownership that are substantially similar to those of common stock.
Substantially Similar | Not Substantially Similar |
|---|---|
|
|
The participation in dividends is a relevant indicator only if the investor expects the investee to pay
dividends to its common shareholders (e.g., during the warrant’s exercise period).
2.5.1.3 Obligation to Transfer Value
ASC 323-10
Case E: Investee Not Obligated to Transfer Substantive Value
55-15 Investor purchases redeemable convertible preferred stock in Investee for $2,000,000. The investment can be (a) converted into common stock valued at $2,000,000 or (b) redeemed for $10,000 at the option of the Investor. The common shareholders do not have a similar redemption feature.
55-16 Investor should evaluate whether exercise of the $10,000 redemption feature obligates Investee to transfer substantive value to Investor and whether the common shareholders do not participate in a similar manner. In this Case, the $10,000 redemption feature is not substantive. Accordingly, Investor should conclude that redeemable convertible preferred stock does not require Investee to transfer substantive value to Investor and that common shareholders do not participate. Investor should also evaluate whether the redeemable convertible preferred stock has the characteristics in paragraph 323-10-15-13(a) through 15-13(b) and paragraphs 323-10-15-14 through 15-15 (if necessary) to reach a conclusion about whether the redeemable convertible preferred stock is in-substance common stock.
Case F: Investee Obligated to Transfer Substantive Value
55-17 Investor purchases redeemable convertible preferred stock in Investee for $2,000,000. The investment can be (a) converted into common stock valued at $2,000,000 or (b) redeemed for $2,000,000 at the option of the Investor. The common shareholders do not have a similar redemption feature. Investor expects that Investee will have the ability to pay the redemption amount.
55-18 Investor should evaluate whether exercise of the $2,000,000 redemption feature obligates Investee to transfer substantive value to Investor and whether the common shareholders do not participate in a similar manner. In this Case, the $2,000,000 redemption feature is substantive because the redemption amount is substantive as compared to the fair value of the investment and, based on Investor’s expectation as of the date that the investment was made, Investee has the ability to pay the redemption amount. Accordingly, Investor shall conclude that redeemable convertible preferred stock requires Investee to transfer substantive value to Investor and that common shareholders do not participate. Accordingly, the redeemable convertible preferred stock is not in-substance common stock. Evaluation of the characteristics in paragraph 323-10-15-13(a) through 15-13(b) and paragraphs 323-10-15-14 through 15-15 is not required.
If the investee is expected to transfer substantive value to an investor and the common shareholders do not participate in a similar manner, an investment is not considered to be substantially similar to common stock. The table below summarizes indicators (not all inclusive) of when an investment is substantially similar to common stock.
Substantially Similar | Not Substantially Similar |
|---|---|
|
|
Only substantive provisions should be considered in the evaluation. Thus, provisions to transfer value
should be evaluated carefully to determine whether they are substantive. For example, as stated in
ASC 323-10-15-13(c), “[p]referred stock with a mandatory redemption in 100 years, shall not be
considered an obligation to transfer substantive value,” since an obligation to transfer value at a date
so far into the future is not considered to be substantive. Further, if, as of the date an investment
was made, an investee does not have the ability to pay the amount to which the investor is (or will be)
entitled, the provision would not be substantive.
2.5.2 Initial Determination and Reconsideration Events
ASC 323-10
15-16 The initial determination of whether an investment is substantially similar to common stock shall be
made on the date on which the investor obtains the investment if the investor has the ability to exercise
significant influence over the operating and financial policies of the investee. That determination shall be
reconsidered if any of the following occur:
- The contractual terms of the investment are changed resulting in a change to any of its characteristics described in paragraph 323-10-15-13 and the preceding paragraph. An expected change in the contractual terms of an investment that are provided for in the original terms of the contractual agreement shall be considered for purposes of the initial determination under paragraph 323-10-15-13 and not as a reconsideration event. However, a change in the form of the investment (for example, debt to equity or preferred stock to another series of stock) is a reconsideration event.
- There is a significant change in the capital structure of the investee, including the investee’s receipt of additional subordinated financing.
- The investor obtains an additional interest in an investment in which the investor has an existing interest. As a result, the method of accounting for the cumulative interest is based on the characteristics of the investment at the date at which the investor obtains the additional interest (that is, the characteristics that the investor evaluated to make its investment decision), and will result in the investor applying one method of accounting to the cumulative interest in an investment of the same issuance.
15-17 The determination of whether an investment is similar to common stock shall not be reconsidered solely
due to losses of the investee.
15-18 If an investor obtains the ability to exercise significant influence over the operating and financial
policies of an investee after the date the investor obtained the investment, the investor shall perform an initial
determination, pursuant to paragraphs 323-10-15-13 and 323-10-15-15, using all relevant and necessary
information that exists on the date that the investor obtains significant influence.
An investor must perform its initial evaluation of whether its investment represents in-substance
common stock when it determines that it has the ability to exercise significant influence over the
operating and financial policies of an investee (see Chapter 3 for further discussion of significant
influence). This date may be after the date its initial investment was acquired.
The investor should continually monitor events and circumstances to determine whether its initial
conclusion should be reconsidered. This reassessment should be performed only if one of the events in
ASC 323-10-15-16 occurs. Although investee losses can significantly change (i.e., reduce or eliminate) the
investee’s capital structure, the investor should not reconsider its initial determination solely because of
such losses (see Section 5.2 for further discussion).
At the time of the initial determination and of any subsequent reassessment, an investor should perform its evaluation on the basis of all facts and circumstances. Accordingly, the investor would consider its cumulative interest in the investee as opposed to only those interests that were recently acquired. The total fair value of an investment as of the date of a reconsideration event should be used in the reconsideration analysis. As a result of the occurrence of a reconsideration event, and on the basis of the investor’s reassessment at that time, an investment that was previously determined not to be in-substance common stock may become in-substance common stock (or vice versa).