4.5 Basis Differences

ASC 323-10

35-13 A difference between the cost of an investment and the amount of underlying equity in net assets of an investee shall be accounted for as if the investee were a consolidated subsidiary. . . .

35-34 The carrying amount of an investment in common stock of an investee that qualifies for the equity method of accounting as described in paragraph 323-10-15-12 may differ from the underlying equity in net assets of the investee. The difference shall affect the determination of the amount of the investor’s share of earnings or losses of an investee as if the investee were a consolidated subsidiary. However, if the investor is unable to relate the difference to specific accounts of the investee, the difference shall be recognized as goodwill and not be amortized in accordance with Topic 350.

The amount an investor pays to acquire an equity method investment is often different from the investor’s proportionate share of the carrying value of the investee’s underlying assets and liabilities. This difference is generally referred to as a “basis difference.” The investor is required to account for this basis difference as if the investee were a consolidated subsidiary in a manner consistent with the provisions of ASC 805; however, the equity method investment should be presented as a single line in an investor’s balance sheet.

ASC 805 requires an entity to apply the acquisition method of accounting. Accordingly, an investor should:

Identify all investee assets and liabilities, including assets and liabilities not recorded in the investee’s balance sheet, such as previously unrecognized identifiable intangible assets.
Determine the acquisition-date fair value of all identifiable assets and liabilities.
Calculate its proportionate share of both (1) the fair value and (2) the carrying value of all identifiable assets and liabilities.
Calculate the basis difference for each identifiable asset and liability as the difference between the investor’s proportionate share of the fair value and the carrying value, if any, of each asset and liability.

The determination of the carrying value of the investee’s equity should be based on the equity attributable to the investee and not its noncontrolling interest holders. If a noncontrolling interest is recorded by the investee in its subsidiaries, this noncontrolling interest amount should be excluded from the calculation of the investee’s equity. If the investor is unable to attribute all the basis difference to specific assets or liabilities of the investee, the residual excess of the cost of the investment over the proportional fair value of the investee’s assets and liabilities (commonly referred to as “equity method goodwill”) is recognized within the equity investment balance. It is important for the investor to appropriately assign the basis difference to the investee’s assets and liabilities instead of simply allocating the basis difference to equity method goodwill. Failure to do so may result in a misstatement of the subsequent measurement of the investor’s share of the investee’s income because equity method goodwill, unlike basis differences assigned to other assets and liabilities, is generally not amortized, as further discussed in Section 5.1.5.2.

However, in accordance with the principles of ASC 805-50, if the investee does not constitute a business, any difference between (1) the amount an investor pays to acquire an equity method investment and (2) the investor’s proportionate share of the carrying value of the investee’s underlying assets and liabilities is allocated to specific assets on the basis of the assets’ relative fair values.

Example 4-8

Investor X purchases a 40 percent interest in Investee Z for $2 million and applies the equity method of accounting. The book value of Z’s net assets is $3.5 million. The table below shows the book values and fair values of Z’s net assets (along with X’s proportionate share) as of the investment acquisition date.

As shown in the table above:

The book values of Z’s current assets and current liabilities approximate their fair values.
Investor X determines that Z has patented technology that was internally developed; therefore, costs associated with developing this technology are expensed as incurred rather than recorded as an intangible asset on Z’s books. The patented technology has a fair value of $300,000.
Investor X determines that the fair value of Z’s fixed assets is $4 million.

See Example 5-12 in Section 5.1.5.2 for a continuation of this example, illustrating subsequent measurement of basis differences.

If a basis difference is related to the investee’s in-process research and development (IPR&D) and the investee is not a business as defined in ASC 805, the investor should immediately expense such a difference if the IPR&D does not have an alternative future use. In a manner consistent with the principles of ASC 805, if the investee meets the definition of a business, the investor should recognize an intangible asset for IPR&D in its calculation of basis differences, regardless of whether the IPR&D has a future alternative use.

Further, intangible assets other than IPR&D are also evaluated for basis differences. If the investee meets the definition of a business, it should evaluate intangible assets in accordance with the principles of ASC 805 (see Section 4.10 of Deloitte’s Roadmap Business Combinations). As aresult, intangible assets would be recognized at fair value. If the investee does not meet the definition of a business, intangible assets are evaluated to determine whether they meet the recognition criteria in FASB Concepts Statement 5 (see Appendix C of Deloitte’s Roadmap Business Combinations). Therefore, more of the intangible assets identified may have basis differences when the investee is not a business.

The example above illustrates the allocation of a positive basis difference; however, a basis difference could also be negative. A negative basis difference may exist because the investor’s proportionate share of the fair value of the investee’s net assets is less than its book value. Section 4.5.1 includes discussion of the limited circumstances in which a negative basis difference may represent a bargain purchase gain.

Example 4-9

Investor X purchases a 30 percent interest in Investee Z for $900,000 and applies the equity method of accounting. The book value of Z’s net assets is $3.5 million. The table below shows the book value and fair value of Z’s net assets (along with X’s proportionate share) as of the investment acquisition date.

As shown in the table above:

The book values of Z’s current assets and current liabilities approximate their fair values.
Investor X determines that Z has identified a significant decrease in the market price for its long-lived assets; however, because the investee tests its fixed assets for impairment under ASC 360, which is a two-step impairment model, no impairment charge is recorded given that the fixed assets are determined to be recoverable under the step 1 undiscounted cash flow evaluation. Although no impairment charge is recorded at the investee level, there is a decrease in fair value of the fixed assets, which results in a negative basis difference because the cost of the investment is lower than X’s share of Z’s net assets.
Entity X should record its investment in Z at its cost of $900,000. The $150,000 negative basis difference between the cost of X’s investment ($900,000) and its proportionate share of the book value of Z’s net assets ($1,050,000) is entirely attributable to Z’s fixed assets.

Basis differences should be tracked in the investor’s “memo” account(s) (i.e., a subsidiary ledger to the equity method investment) given that such differences will affect subsequent measurement of the investor’s share of investee income. See Section 5.1.5.2 for details regarding the subsequent measurement of basis differences.

If an investee’s financial statements are not prepared in accordance with U.S. GAAP, an investor must conform such financial statements to U.S. GAAP before determining whether there are any basis differences. Future investee financial statements should similarly be adjusted to reflect the identified differences with U.S. GAAP.

Under the Private Company Council (PCC) accounting alternative for intangible assets codified in ASC 805-20-15-1A through 15-4 and ASC 805-20-25-29 through 25-33, a private company or NFP may make an accounting policy election to not recognize the following intangible assets separately from equity method goodwill:

Customer-related intangible assets unless they are capable of being sold or licensed independently from other assets of a business.
Noncompetition agreements.

An investor’s election to apply this PCC alternative can affect how equity method basis differences are measured. Specifically, if an investor identifies an intangible asset related to one of the two excluded types of intangible assets listed above, it would not be required to separately recognize and track basis differences related to that asset. Instead, any equity method basis differences that otherwise would have been identified in connection with the intangible asset would be reflected as part of equity method goodwill. Note that if this PCC alternative for intangible assets is elected, the investor must also elect the PCC alternative to amortize goodwill. See Section 8.2.1 of Deloitte’s Roadmap Business Combinations for additional interpretive guidance on this PCC alternative.

4.5.1 Bargain Purchase

In certain circumstances, an investor’s share of an investee’s net assets is higher than the consideration paid and the investor is unable to attribute all the negative basis difference to specific assets or liabilities. Such a scenario is often referred to as a “bargain purchase” and may indicate a potential economic gain to the investor. ASC 323-10 does not address a bargain purchase; nor does it address when (if ever) a bargain purchase gain would be appropriate upon initial measurement of an equity method investment. During the deliberations of EITF Issue 08-6, the Task Force discussed the appropriate accounting for identified bargain purchases but failed to reach a consensus. Therefore, diversity in practice may exist regarding the accounting for bargain purchases. We believe that a bargain purchase related to an equity method investment should be rare because it would be unusual for another investor to sell (or an investee to issue) an equity interest at a price that is below its fair (market) value.

In all instances, an investor should first allocate any negative basis difference in a manner consistent with Example 4-9. This requires the investor to perform a full purchase price allocation and measure the investee’s assets and liabilities at fair value, including those not recorded by the investee. If, after performing this allocation, the investor determines that there is a remaining economic gain (i.e., the cost paid is less than the fair value of the investment), the investor may be able to support recognizing a bargain purchase gain. That is, we believe that although a bargain purchase should be rare, it would be acceptable for an investor to recognize a gain in a circumstance in which the investor has the requisite information to perform a purchase price allocation in a manner consistent with the measurement principles in ASC 805. ASC 323-10-35-13 requires the investor to account for the “difference between the cost of an [equity method] investment and the amount of underlying equity in net assets of an investee . . . as if the investee were a consolidated subsidiary,” which would support recognition of the gain in earnings on the investment date. However, before recognizing the gain, the investor should (1) ensure that all underlying assets acquired and liabilities assumed as part of the equity investment were correctly identified and recognized (in accordance with the guidance in ASC 805) and (2) understand the reasons that led to the bargain purchase gain (i.e., why the seller sold the investment below the fair value of the investee’s underlying assets and liabilities). Bargain purchases may occur, for example, because of underpayments for the investment acquired (e.g., in a forced liquidation or distress sale or because of the lack of a competitive bidding process).

If the information necessary to perform a purchase price allocation under ASC 805 for the incremental equity interests is not readily available, it is appropriate for an investor to recognize a pro rata reduction (on a relative fair value basis) to the amounts allocated to an investee’s underlying assets. This treatment is consistent with the cost accumulation model for asset acquisitions prescribed in ASC 805-50-30, which precludes gains or losses upon recognition when consideration is paid in cash.

Further, we believe that it is always acceptable, as an accounting policy, to not recognize bargain purchase gains for equity method investments and instead to allocate the negative basis difference to the investee’s underlying assets, as described above.

4.5.2 Tax Effects of Basis Differences

Basis differences may give rise to deferred tax effects (i.e., tax-related basis differences). There are two categories of tax-related basis differences:

An “inside” basis difference, which is a temporary difference between the carrying amount, for financial reporting purposes, of individual assets and liabilities and their tax bases that will give rise to a tax deduction or taxable income when the related asset is recovered or liability is settled and reflected in the investee’s financial statements.
An “outside” basis difference, which is a difference between the carrying amount of an equity method investment and the tax basis of such an investment in the financial statements.

To accurately account for its equity method investment, an investor should consider any inside and outside basis differences in its investment. See Deloitte’s Roadmap Income Taxes for additional guidance on inside and outside basis differences.

Tax-related basis differences are another component of the single equity method line item in an investor’s financial statements. In addition, to accurately measure the tax basis differences (i.e., tax assets and liabilities), the investor should apply ASC 740 to analyze the investee’s uncertain tax positions.

Example 4-10

Assume the same facts as in Example 4-8. In addition, the effective tax rate of Investor X and Investee Z is 21 percent. Investee Z did not record any deferred tax assets (DTAs) or deferred tax liabilities (DTLs) in its own financial statements. Further, there are no basis differences between the carrying amount of X’s equity method investment in Z for financial statement and tax purposes (i.e., no outside basis differences).

On the basis of the calculations in Example 4-8, the $600,000 difference between the cost of X’s investment ($2 million) and its proportionate share of the book value of Z’s net assets ($1.4 million) is attributable to Z’s fixed assets ($400,000), Z’s patented technology ($120,000), and equity method goodwill ($80,000). Therefore, X recognizes a DTL in its memo accounts as follows:

Since equity method goodwill is treated as if it were goodwill acquired in a business combination, there is no DTL associated with this basis difference.

Because the total amount of the basis difference between the cost of X’s investment ($2 million) and its proportionate share of the book value of Z’s net assets ($1.4 million) has not changed, the DTL recognized in the memo accounts increases the basis difference attributable to equity method goodwill in an amount equal to the DTL, as shown in the table below.

If an investee with a DTA concludes that it is not more likely than not that the net operating losses will be realized, it will recognize a valuation reserve for such DTAs. In such an instance, the investor may be prepared, given its expectation that a net DTA has value greater than the amount recorded by the investee, to pay a premium to acquire an interest in that investee. If such a premium is paid, the investor is not allowed to assign any of the premium paid to the investee’s DTAs in the memo accounts because (1) the investor’s investment does not provide the investee with a new ability to recover the DTAs for which a valuation allowance was previously recognized and (2) there has also been no change in control at the investee level as a result of the investor’s investment.

See Deloitte’s Roadmap Income Taxes for additional guidance on tax considerations related to equity method investments.

4.5.3 Accumulated Other Comprehensive Income

Changes in value for certain investee assets or liabilities (e.g., derivative financial instruments, AFS securities, and pension or postemployment benefits) may be recorded in the investee’s accumulated other comprehensive income (AOCI) in accordance with other U.S. GAAP.

On the date the investor qualifies for application of the equity method of accounting, it should identify and measure all the investee’s identifiable assets and liabilities at fair value. Accordingly, the investor would not recognize its proportionate share of the investee’s AOCI because such amounts would already be contemplated in the fair value measurement of the respective assets or liabilities identified. However, this will result in additional basis differences that should be tracked in the memo accounts to ensure that subsequent changes in the investee’s AOCI are not recognized by the investor when the amounts are reclassified to earnings by the investee. The example below illustrates this guidance.

Example 4-11

Investor A purchases a 25 percent interest in Investee B and applies the equity method of accounting. Investee B holds an AFS security that was purchased for $1,000 and has a fair value of $1,100 on the date A purchases its interest in B. Therefore, B has recorded $100 in unrealized gains in AOCI. One year later, B sells its AFS security for $1,100.

Initial Measurement

On the date A purchases its 25 percent investment in B, A should calculate its proportionate share of the AFS security’s fair value ($1,100 × 25% = $275) and its proportionate share of the AFS security’s book value ($1,000 × 25% = $250). Investor A should not recognize its proportionate share of the $100 of unrealized gains in B’s AOCI balance; however, A should present the $25 basis difference ($275 − $250) as part of its overall investment in B and subsequently track this difference in memo accounts.

Subsequent Measurement

Although B will recognize a realized gain of $100 upon the sale of its AFS security, A should not record its proportionate share of B’s realized gain. Instead, because A’s basis in B’s AFS security already reflects the AFS security’s appreciation (i.e., recognized as part of the initial measurement), A should reduce its equity in earnings of B by $25 ($100 × 25%).

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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.