4.2 Initial Measurement

ASC 323-10

30-2 Except as provided in the following sentence, an investor shall measure an investment in the common stock of an investee (including a joint venture) initially at cost in accordance with the guidance in Section 805-50-30. An investor shall initially measure, at fair value, the following:

A retained investment in the common stock of an investee (including a joint venture) in a deconsolidation transaction in accordance with paragraphs 810-10-40-3A through 40-5
An investment in the common stock of an investee (including a joint venture) recognized upon the derecognition of a distinct nonfinancial asset or distinct in substance nonfinancial asset in accordance with Subtopic 610-20.

ASC 805-50

30-1 Paragraph 805-50-25-1 discusses exchange transactions that trigger the initial recognition of assets acquired and liabilities assumed. Assets are recognized based on their cost to the acquiring entity, which generally includes the transaction costs of the asset acquisition, and no gain or loss is recognized unless the fair value of noncash assets given as consideration differs from the assets’ carrying amounts on the acquiring entity’s books. For transactions involving nonmonetary consideration within the scope of Topic 845, an acquirer must first determine if any of the conditions in paragraph 845-10-30-3 apply. If the consideration given is nonfinancial assets or in substance nonfinancial assets within the scope of Subtopic 610-20 on gains and losses from the derecognition of nonfinancial assets, the assets acquired shall be treated as noncash consideration and any gain or loss shall be recognized in accordance with Subtopic 610-20.

30-2 Asset acquisitions in which the consideration given is cash are measured by the amount of cash paid, which generally includes the transaction costs of the asset acquisition. However, if the consideration given is not in the form of cash (that is, in the form of noncash assets, liabilities incurred, or equity interests issued) and no other generally accepted accounting principles (GAAP) apply (for example, Topic 845 on nonmonetary transactions or Subtopic 610-20), measurement is based on either the cost which shall be measured based on the fair value of the consideration given or the fair value of the assets (or net assets) acquired, whichever is more clearly evident and, thus, more reliably measurable. For transactions involving nonmonetary consideration within the scope of Topic 845, an acquirer must first determine if any of the conditions in paragraph 845-10-30-3 apply. If the consideration given is nonfinancial assets or in substance nonfinancial assets within the scope of Subtopic 610-20, the assets acquired shall be treated as noncash consideration and any gain or loss shall be recognized in accordance with Subtopic 610-20.

Partial sales are sales or transfers of a nonfinancial asset (or an in-substance nonfinancial asset) to another entity in exchange for a noncontrolling ownership interest in that entity. The guidance in ASC 610-20 (which consists of guidance in ASU 2014-09, as amended by ASU 2017-05) conforms the derecognition guidance on nonfinancial assets with the model for transactions in the revenue standard (ASC 606, as amended).

Before adopting ASC 606, entities accounted for partial sales principally under the transaction-specific guidance in ASC 360-20 on real estate sales, the industry-specific guidance in ASC 970-323, and (sometimes) ASC 845-10-30. ASU 2014-09 (as amended by ASU 2017-05) simplifies the accounting treatment for partial sales (i.e., entities will use the same guidance to account for similar transactions) by (1) amending the guidance in ASC 970-323 to align it with the requirements in ASC 606 and ASC 610-20, (2) significantly limiting the scope of ASC 360-20 to be applicable only for sale-leaseback transactions, and (3) eliminating the guidance in the Exchanges of a Nonfinancial Asset for a Noncontrolling Ownership Interest subsections of ASC 845-10. Subsequently, ASU 2016-02 (codified in ASC 842) superseded ASC 360-20 as the source of guidance for accounting for sale-leaseback transactions. As a result of these changes, any transfer of a nonfinancial asset (or an in-substance nonfinancial asset) in exchange for a noncontrolling ownership interest in another entity (including a noncontrolling ownership interest in a joint venture or other equity method investment) should be accounted for in accordance with ASC 610-20 as long as none of the scope exceptions in ASC 610-20-15-4 apply.

Investors must initially measure investments accounted for under the equity method of accounting by using a cost accumulation model. With the exception of certain transactions (see Sections 4.3.2, 4.3.4, and 4.3.5), cost includes the amount paid (i.e., cash or other consideration paid)1 and the direct transaction costs incurred to acquire the investment.

Direct transaction costs include incremental “out-of-pocket” costs paid to third parties directly associated with the investment’s acquisition. Such costs may include appraisal fees, fees paid to external consultants for legal and accounting services, and finder’s fees paid to brokers. All other costs, including internal costs (regardless of whether they are incremental and directly related to the acquisition) should be expensed as incurred. In addition, debt or equity issuance costs incurred by the investor to acquire the investment should not be included as a cost of the investment and should be accounted for in accordance with other debt and equity issuance–related accounting guidance.

Example 4-1

An investor purchases a 30 percent interest in an investee for $800,000 in cash and will account for its investment under the equity method. The investor incurred the following costs to acquire the investment:

Internal legal costs for preparation of the investment acquisition agreement	$ 2,000
Broker fee for identifying the acquisition opportunity	10,000
Fee paid to external valuation specialist to determine the fair value of the investment	10,000
Employee travel costs directly related to the acquisition	1,000

The investment acquisition agreement was reviewed by external legal counsel, to whom the investor pays a monthly retainer fee of $5,000.

Because the broker fee and external valuation specialist fee are costs paid to third parties that are directly associated with the investment’s acquisition, the investor would include such amounts in the cost of its investment and would record its initial investment at $820,000. Although the internal legal costs ($2,000) and employee travel costs ($1,000) are incremental to the investment’s acquisition, the investor would expense them since they are not paid to third parties (i.e., they are internal costs). Although the investment acquisition agreement was reviewed by external legal counsel, the monthly retainer fee ($5,000) would have been incurred regardless of whether the investment was acquired and, accordingly, should be expensed as incurred.

An investor should differentiate between the incremental costs incurred to acquire the investment and the incremental costs incurred on behalf of the investee. See Section 5.4 for a discussion of the accounting for costs incurred on behalf of an investee.

4.2.1 Commitments and Guarantees

ASC 460-10

25-4 At the inception of a guarantee, a guarantor shall recognize in its statement of financial position a liability for that guarantee. This Subsection does not prescribe a specific account for the guarantor’s offsetting entry when it recognizes a liability at the inception of a guarantee. That offsetting entry depends on the circumstances in which the guarantee was issued. See paragraph 460-10-55-23 for implementation guidance.

55-23 Although paragraph 460-10-25-4 does not prescribe a specific account, the following illustrate a guarantor’s offsetting entries when it recognizes the liability at the inception of the guarantee: . . .

c. If the guarantee were issued in conjunction with the formation of a partially owned business or a venture accounted for under the equity method, the recognition of the liability for the guarantee would result in an increase to the carrying amount of the investment. . . .

When accounting for its equity method investment, an investor should also consider any commitments to make future contributions to the investee and guarantees issued to a third party on behalf of the equity method investee. However, commitments to make future contributions are usually not included in the initial measurement of the investment unless required by other authoritative accounting literature.

If an investor issues a guarantee to a third party (e.g., a bank) on behalf of an investee or to the investee itself, it should consider the guidance in ASC 460, which requires a liability (credit) be recognized in an amount equal to the fair value of the guarantee.

For example, an investor’s proportionate guarantee of a line of credit (LOC) held by its equity method investee may be recorded as a guarantee in accordance with ASC 460. Specifically, ASC 460-10-15-4(a)–(d) list the types of guarantee contracts that are within the scope of ASC 460. ASC 460-10-15-4(b) states that such contracts include those that “contingently require a guarantor to make payments (as described in [ASC 460-10-15-5]) to a guaranteed party based on another entity’s failure to perform under an obligating agreement (performance guarantees).”

Guarantees of an equity method investee’s debt generally do not meet any of the scope exceptions from the initial recognition and measurement provisions of ASC 460. Most notably, the scope exception in ASC 460-10-25-1(g) for guarantees made by a parent on a subsidiary’s debt to a third party is not applicable since an investor would not be considered the parent of its equity method investee.

In addition, situations can arise in which the investee must obtain the investor’s approval before drawing on the LOC. In these instances, the guidance in ASC 460 is not applicable until the investor grants its approval. At that point, the investor cannot avoid its obligation under the guarantee and must recognize a guarantee under ASC 460. This conclusion is analogous to paragraph A9 of the Basis for Conclusions of FASB Interpretation 45 (codified in ASC 460), which notes that loan commitments are outside the scope of this guidance partly because those instruments typically contain material adverse change clauses or similar provisions that enable the issuing institution (the guarantor) to avoid making payments. By analogy, if the investor can avoid its stand-ready obligation to perform, no obligation has been incurred under ASC 460. However, if the investee does not need to obtain approval from the investor to draw on the LOC, the investor cannot avoid its obligation to pay at the time it enters into the guarantee of repayment under the LOC.

If a guarantee is issued by the investor in conjunction with the equity method investee’s formation or issued after formation as required by the formation documents, we generally believe that, in the absence of substantive evidence to the contrary, the value of the guarantee would be included in the initial measurement of the equity method investment (i.e., the debit entry would be recorded to the equity method investment account rather than to expense) given that it is more likely that the guarantee was issued to balance the investor’s investment in the investee. However, if there is substantive evidence that suggests that the investor issued the guarantee as a means to protect its investment while protecting other investors, rather than to balance its investment in the investee, the investor should use judgment to allocate the initial fair value of the guarantee between its interest in the equity method investee (debit recorded to equity method investment) and that of other investors (debit recorded to expense). After initial recognition of the guarantee, the investor should separately account for it by using the guidance in ASC 460. See Section 5.2.1 for further discussion of the accounting for guarantees that are issued after the equity method investee’s formation.

For example, in certain situations, an entity deconsolidates a subsidiary, retains an equity method investment, and records the equity method investment at fair value in accordance with ASC 323-10-30-2. We believe that if a guarantee is issued to the equity method investee by the deconsolidating investor in conjunction with the sale of the subsidiary, the value of the guarantee would be included in the gain or loss on deconsolidation (a debit for the expense of the guarantee recorded as a part of the gain or loss) rather than capitalized into the basis of the equity method investment. The guarantee is still recognized at fair value (i.e., a credit is recognized for the guarantee liability).

Example 4-2

Entity A, an SEC registrant, acquires 30 percent of the voting stock of Investee B upon B’s formation in exchange for a combination of $600 in cash and the issuance of a guarantee for B’s indebtedness to an unrelated third party. The guarantee, which is within the scope of ASC 460, obligates A to make payments to the third party if B is unable to make debt payments. The fair value of the guarantee is $200. Entity A has the ability to exercise significant influence over B and accounts for its investment under the equity method.

Entity A should record its equity method investment in B initially at $800, which represents the $600 paid in cash and the $200 fair value of the guarantee at inception. After B’s formation, A should account for the guarantee in accordance with ASC 460, separately from its equity method investment.

Footnotes

If an equity method investment is obtained as part of a business combination in accordance with ASC 805, the investor should recognize such an investment at fair value on the date of acquisition under ASC 820.

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