Chapter 3 — Applying the Equity Method of Accounting

3.2 General Presumption

ASC 323-10

15-7 Determining the ability of an investor to exercise significant influence is not always clear and applying judgment is necessary to assess the status of each investment.

An investor may have investments in an investee that include common stock or in-substance common stock and instruments other than common stock (e.g., preferred stock, warrants, or debentures). The equity method of accounting is applicable only when the investor has an investment in common stock or in-substance common stock and, accordingly, should not be applied when an investment in 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 and other investments, it should consider the rights provided by all such instruments in evaluating whether, in combination, they provide it with the ability to exercise significant influence over the investee. In addition, as further discussed in Section 3.2.6, only existing voting rights should be considered.

Example 3-1

Entity A holds the following interests in Corporation B:

Common stock representing 15 percent of the voting rights in B.
Preferred stock that does not meet the requirements to be considered in-substance common stock that provides A with two of the five seats on B’s board of directors.
In evaluating whether A has significant influence over B, A must use judgment and consider the rights provided by all such instruments.

The ability to exercise significant influence over the operating and financial policies of an investee is primarily driven by an investor’s ownership interest and the associated voting rights held through its investment in the investee’s common stock. The presumed levels of ownership that provide the investor with the ability to exercise significant influence vary depending on the legal form of the investee.

The table below summarizes presumed levels of ownership for each legal form of an investee that typically allow an investor to exercise significant influence. Intended as a general guide, the table does not establish bright lines at specific ownership levels (e.g., the difference between a 20 percent and a 19.9 percent investment in common stock or in-substance common stock or both may not be substantive). Therefore, evaluating an investor’s ability to exert significant influence requires judgment, and the investor should evaluate all facts and circumstances when determining how to account for any investment.

Table 3-1 Presumed Levels of Ownership Based on the Legal Form of the Investee That Generally Allow an Investor to Exercise Significant Influence

Legal Form of an Investee	Roadmap Discussion	Investment in Common Stock or In-Substance Common Stock (Assuming Consolidation Is Not Required)
Legal Form of an Investee	Roadmap Discussion	5% or Less	More Than 5% but Less Than 20%	20% or More
Corporations (other than joint ventures)	Section 3.2.1	Rebuttable presumption exists that an investor does not have significant influence.		Rebuttable presumption exists that an investor does have significant influence.
LLCs that do not maintain specific ownership accounts (e.g., similar to partnership capital accounts)	Section 3.2.2	Rebuttable presumption exists that an investor does not have significant influence.		Rebuttable presumption exists that an investor does have significant influence.
LLCs that do maintain specific ownership accounts (e.g., similar to partnership capital accounts)	Section 3.2.2	Equity method required unless interest is “so minor” (per ASC 323-30-S99-1) that investor has virtually no influence (generally less than 3 percent), in which case the investor should generally account for the interest under ASC 321. In certain instances, it may be acceptable to account for investments of less than 3 to 5 percent under the equity method, depending on the facts and circumstances.	Equity method required.
Partnerships and unincorporated joint ventures	Section 3.2.3	Equity method required unless interest is “so minor” (per ASC 323-30-S99-1) that investor has virtually no influence (generally less than 3 percent), in which case the investor should generally account for the interest under ASC 321. In certain instances, it may be acceptable to account for investments of less than 3 to 5 percent under the equity method, depending on the facts and circumstances.	Equity method required.
General partnership interests in partnerships	Section 3.2.4	Equity method required.
Entity that meets the definition of corporate joint venture (i.e., shared control)	Section 3.2.5	Equity method required.

In the case of corporations and LLCs that do not maintain specific ownership accounts, a presumption may exist that an investor has the ability to exercise significant influence, but such a presumption may be overcome (see Section 3.3.1 for conditions indicating lack of significant influence). Similarly, a presumption may not exist if an investor does not meet the levels of ownership described above; however, that ownership interest, in combination with other interests and indicators (see Section 3.3), may indicate that the investor has the ability to exercise significant influence. Each of the types of investments described in the table above is discussed further below.

3.2.1 Corporations

ASC 323-10

15-8 An investment (direct or indirect) of 20 percent or more of the voting stock of an investee shall lead to a presumption that in the absence of predominant evidence to the contrary an investor has the ability to exercise significant influence over an investee. Conversely, an investment of less than 20 percent of the voting stock of an investee shall lead to a presumption that an investor does not have the ability to exercise significant influence unless such ability can be demonstrated. The equity method shall not be applied to the investments described in this paragraph insofar as the limitations on the use of the equity method outlined in paragraph 323-10-25-2 would apply to investments other than those in subsidiaries.

If an investor holds more than a 20 percent interest (directly or indirectly, as discussed in Section 3.2.6) in an investee that has a legal form of a corporation, it is presumed that the investor has the ability to exercise significant influence in the absence of evidence to the contrary (see Section 3.3.1). Similarly, if the same investor holds less than a 20 percent interest in an investee, it may, in combination with other indicators, have the ability to exercise significant influence over that investee (see Section 3.3).

3.2.2 Limited Liability Companies

As discussed in Section 2.2.1, an investment in an LLC that does not maintain specific ownership accounts for each investor should be evaluated in the same manner as an investment in a corporation, which is further discussed in the previous section. An investment in an LLC that does maintain specific ownership accounts for each investor should be evaluated in the same manner as an investment in a partnership, which is further discussed in the next section.

3.2.3 Partnerships and Unincorporated Joint Ventures

ASC 323-30 — SEC Materials — SEC Staff Guidance

SEC Staff Announcement: Accounting for Limited Partnership Investments

S99-1 The following is the text of SEC Staff Announcement: Accounting for Limited Partnership Investments.

The SEC staff’s position on the application of the equity method to investments in limited partnerships is that investments in all limited partnerships should be accounted for pursuant to paragraph 970-323-25-6. That guidance requires the use of the equity method unless the investor’s interest “is so minor that the limited partner may have virtually no influence over partnership operating and financial policies.” The SEC staff understands that practice generally has viewed investments of more than 3 to 5 percent to be more than minor.

In EITF Topic D-46 (codified in ASC 323-30-S99-1), the SEC acknowledged that, in practice, investments in limited partnerships of more than 3 percent to 5 percent have generally been viewed as “more than minor” and thus are subject to the equity method. Because profits and losses are allocated to individual partner accounts, the partner’s share of earnings is allocated for income tax purposes, and the nature of partnership interests usually gives rise to some degree of influence (stated or unstated), it is presumed that either consolidation or the equity method should be used to account for all partnership interests. This approach de-emphasizes significant influence, instead requiring the equity method of accounting because it enables noncontrolling investors to reflect the underlying nature of their investments.

Because the SEC staff refers to a range of “3 to 5 percent” in EITF Topic D-46, investments of more than 3 percent to 5 percent have generally been viewed as “more than minor.” Thus, any investment of more than 5 percent is subject to the equity method, and any investment from 3 percent to 5 percent should be accounted for under the equity method unless the presumption of significant influence is overcome. However, an investment of less than 3 percent is typically considered “minor” and therefore may be accounted for at fair value in accordance with ASC 321 (unless the measurement alternative is elected)1 or under the equity method in accordance with ASC 970-323-25-6.

In a speech at the 2019 AICPA Conference on Current SEC and PCAOB Developments, then OCA Professional Accounting Fellow Erin Bennett provided the SEC’s perspectives on assessing whether an investor’s interest is “more than minor” in an LLC structure with separate capital accounts or whether it is so minor that the investor may have virtually no influence over the LLC’s operating and financial policies.

Ms. Bennett noted that when evaluating whether an entity’s interest is more than minor, the SEC staff assesses LLC structures with separate capital accounts in the same manner as partnerships under ASC 323-30-35-3. She described a consultation in which the registrant held a 25 percent interest in the member units of an LLC with separate capital accounts. The registrant argued that the “virtually no influence” threshold did not apply to its investment since this threshold was (1) intended for real estate companies with “less complicated fact patterns” and (2) not appropriate for an investment whose nature and intent were “passive.” Accordingly, the registrant believed that it would be more appropriate to evaluate the indicators of significant influence. Ms. Bennett provided the following insights into the staff’s position and ultimate objection to the registrant’s view:

For investments in limited partnerships, the SEC staff has stated that the equity method should be applied unless the investor’s interest is so minor that the investor may have virtually no influence over partnership operating and financial policies, with practice generally viewing investments of more than 3-5% to be more than minor.

A recent consultation with OCA focused on whether the equity method should be applied to a registrant’s investment in a limited liability company (LLC). The registrant held over 25% of the LLC’s member units, which were entitled to a preferential allocation of profits. The registrant did not have board representation or voting rights over key operating and financial decisions, but did have certain limited rights, most of which were protective in nature. Furthermore, the registrant had significant ongoing commercial arrangements with the LLC.

In performing its evaluation of whether the equity method applied to its investment, the registrant first concluded that its investment in the LLC was similar to an investment in a limited partnership because the LLC was required to maintain specific ownership accounts for each member. The registrant noted that the limited partnership guidance states that investors in partnerships should apply the equity method if the investor has the ability to exercise significant influence. The registrant also considered the staff’s position that the application of the equity method to investments in limited partnerships should be applied unless the investor’s interest is so minor that the limited partner may have virtually no influence over partnership operating and financial policies. The registrant observed that the “virtually no influence” guidance cited in the SEC staff’s position was originally written in the context of investments in real estate companies with less complicated fact patterns than the registrant’s facts. The registrant believed that the nature and intent of its investment was truly passive, such that an assessment of the overall significant influence indicators was more relevant, irrespective of the form of the ownership. Therefore, based on the complex terms of its investment, including no voting rights and a preferential profit allocation, the registrant concluded that it did not have significant influence and the equity method did not apply. The registrant also believed that not applying the equity method would better reflect the economics of its investment.

In this fact pattern, the staff objected to the registrant’s conclusion that the equity method did not apply. The staff concluded that the staff’s longstanding position on the application of the equity method to investments in limited partnerships should be applied. Given the registrant’s significant ownership interest, certain limited rights other than protective rights, and ongoing commercial arrangements, the staff concluded the registrant had more than “virtually no influence” over the LLC. [Footnotes omitted]

Note that while the guidance in EITF Topic D-46 is intended for public entities, in practice, it is generally applied to investments held by nonpublic entities.

3.2.4 General Partnership Interest in Partnerships

If a GP does not control the partnership, it should account for its investment in the partnership under the equity method of accounting, regardless of its ownership percentage (see Section 2.2.3).

3.2.5 Corporate Joint Ventures

All joint venture investments in which the investor shares in joint control, incorporated or unincorporated, should be accounted for under the equity method without regard to the investor’s ownership percentage.

3.2.6 Potential Voting Rights

ASC 323-10

15-9 An investor’s voting stock interest in an investee shall be based on those currently outstanding securities whose holders have present voting privileges. Potential voting privileges that may become available to holders of securities of an investee shall be disregarded.

An investor may hold certain rights that allow it to acquire additional voting interests in an investee. For example, an investor may have a call option to purchase additional equity in an investee that is not a partnership, or a limited partner may have the contractual right to purchase partnership interests held by other partners. Potential voting rights may also exist through other types of securities that are convertible into voting interests (e.g., convertible securities).

In the determination of whether significant influence exists, ASC 323-10-15-9 applies only to “[a]n investor’s voting stock interest” and not to potential voting interests, such as stock options, convertible debt, or derivatives thereof. However, ASC 323-10-15-13 lists several characteristics that might indicate that an investment (other than an investment in common stock) is in-substance common stock (see Section 2.5). Therefore, when determining whether the use of the equity method is appropriate, an investor should consider investments in common stock and investments that are in-substance common stock, which may include, but not be limited to, the following:

As stated in Section 3.2, if an investor holds both common stock and other investments (including in-substance common stock), it should consider the rights afforded by all such instruments in evaluating whether, in combination, they provide it with the ability to exercise significant influence over an investee. To be considered in the assessment, such voting rights must be currently exercisable.
An investor with an investment that qualifies as in-substance common stock may be able to exercise its voting rights on an as-if-converted basis or may be precluded from exercising voting rights until the in-substance common stock is converted into common stock. In the latter instance, despite the investment’s qualifying as in-substance common stock, such voting rights would not be considered in the assessment of significant influence because they are not currently exercisable (i.e., the voting rights are contingent upon conversion).

Example 3-2

Entity A holds a 15 percent voting common stock interest in Entity B, as well as convertible preferred stock that will allow it to acquire an additional 10 percent voting common stock interest in B in three years. Entity A’s ownership of the convertible preferred stock, if converted, would give A a 25 percent voting common interest in B. However, this would not lead to a presumption that A exercises significant influence over B given that A’s investment in convertible preferred stock does not provide it with exercisable voting rights because of the time restriction and the requirement to convert the instrument to exercise the voting rights.

Although the convertible preferred stock may qualify as in-substance common stock in three years when the conversion feature becomes exercisable, A would continue to be precluded from considering the potential voting rights in assessing significant influence at that time because A will possess such voting rights only upon conversion.

3.2.7 Direct and Indirect Interest in an Investee

In determining whether an investor has the ability to exercise significant influence over an investee, an investor should consider all voting interests, which include investments that are both direct and indirect (i.e., those held by the investor’s other investees). In certain instances, an investor that does not have the ability to exercise significant influence through its direct interests may have such ability through a combination of direct and indirect interests.

The examples below illustrate the consideration of direct and indirect interests. Each example assumes that the investor and the investee(s) are corporations.

Example 3-3

Direct Investment in an Investee’s Consolidated Subsidiary

Entity A owns a 30 percent voting interest in Entity B that is accounted for under the equity method of accounting (i.e., A has the ability to exercise significant influence over B) and a 15 percent voting interest in Entity C. Entity B owns an 80 percent voting interest in C that is considered a controlling financial interest, requiring B to consolidate C under ASC 810-10.

Because B controls C, and A has the ability to exercise significant influence over B, A has the ability to exercise significant influence over C, despite the fact that A has only a 15 percent direct voting interest in C. Therefore, A should account for its investment in C under the equity method of accounting.

Example 3-4

Investment of 20 Percent or Greater That Does Not Qualify for Equity Method of Accounting

Assume the same facts as in the example above, except that Entity B owns an 18 percent voting interest in Entity C. In this scenario, Entity A has a 20.4 percent interest in C, which is the sum of its 15 percent direct interest and 5.4 percent indirect interest (30 percent × 18 percent) through B.

As reflected in Table 3-1, an investment in common stock of 20 percent or greater leads to a presumption that an investor has the ability to exercise significant influence and should therefore apply the equity method of accounting. However, in the example above, the ownership percentage alone would not provide A with the ability to exercise significant influence over C since neither A nor B has that ability. Although A has significant influence over B, that does not indicate that it has the ability to significantly influence how B exercises its 18 percent voting interest in C. Entity A should evaluate other indicators of significant influence (see Section 3.3) to determine whether it has significant influence over C. If not, A should not account for its investment in C under the equity method of accounting.

Example 3-5

Investment Held by Commonly Controlled Subsidiaries

Entity A has a controlling financial interest in, and therefore consolidates each of, Entity B, Entity C, and Entity D under ASC 810-10. Entities B, C, and D each own a 10 percent voting interest in Entity E.

Entity A indirectly owns less than a 20 percent voting interest in E (i.e., 6 percent through B, 7 percent through C, and 6 percent through D). However, given that A consolidates B, C, and D, A effectively controls 30 percent of the voting interests in E. Thus, it is presumed that A has the ability to exercise significant influence over E (in the absence of evidence to the contrary).

Entity A’s ability to exercise significant influence over E, however, is not determinative as to how each subsidiary should account for its individual investments in preparing its stand-alone financial statements. Thus, each subsidiary should separately evaluate its individual facts and circumstances in determining whether it has the ability to exercise significant influence over E. Investments held by related parties may be one of the factors to consider in such an evaluation (see Section 3.3).

3.2.7.1 Earnings or Losses of an Investee’s Subsidiary

If an investor accounts for direct interests in both an investee and an investee’s subsidiary under the equity method of accounting, it should ensure that it does not double count the earnings or losses of the investee’s subsidiary. That is, the investor should record only its proportionate share of (1) the earnings or losses of the investee and (2) the earnings or losses of the investee’s subsidiary. When determining its proportionate share of the investee’s earnings or losses, the investor should adjust the investee’s financial information to exclude the earnings or losses of the investee’s subsidiary in which the investor has a direct interest. See additional considerations related to subsequent measurement in this scenario in Section 5.1.7.2.

Footnotes

See ASC 321-10-35-2.

Confidential and Proprietary — for Use Solely by Authorized Personnel

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.