Chapter 4 — Initial Measurement

4.1 Overview

ASC 323-10-30 describes how investments that are accounted for by using the equity method of accounting should initially be measured (see Section 4.2). An equity method investment is presented on the balance sheet as a single amount and is generally reflected at its cost basis upon acquisition. When determining the initial cost of the investment, the entity should include in the cost basis certain transaction costs, certain contingent consideration arrangements (see Section 4.4), and previously held interests in the entity.

An investor is required to account for any differences between the cost of the investment and the underlying equity in the investee’s net assets, referred to as basis differences, as if the investee were a consolidated subsidiary (see Section 4.5).

An investor that had previously accounted for an investment on a basis other than the equity method may subsequently be required to apply the equity method to that investment. For example, an investor holding an investment accounted for at fair value under ASC 321 may obtain the ability to exercise significant influence over such an investee by obtaining or otherwise increasing an ownership interest in the investee’s voting common stock (or in-substance common stock). If the investor is subsequently required to apply the equity method, it should apply the initial measurement principles discussed within this chapter.

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.

4.3 Contribution of Businesses or Assets for an Investment in an Equity Method Investee

An investor may contribute a business or assets in exchange for an equity method investment or an interest in a joint venture. The accounting for the contribution of a business or assets will generally depend on (1) whether the investee (i.e., the counterparty) is considered to be a customer in the transaction, (2) the nature of the asset that was contributed, and (3) in some cases, the legal form of the transaction.

The flowchart below illustrates the relevant questions for the determination of the accounting that should be applied when an investor contributes a business or assets in exchange for a noncontrolling ownership interest in another entity (including a noncontrolling ownership interest in a joint venture or other equity method investment). It is important to note that there are specific accounting considerations associated with the contribution of a business or assets to a joint venture upon formation. See Chapter 8 for details.

If the transfer includes other contractual arrangements that are not assets of the seller to be derecognized (e.g., guarantees), those contracts are separated and accounted for in accordance with other ASC topics or subtopics.

4.3.1 Determining Whether the Counterparty (Equity Method Investee) Is a Customer

A transfer of a nonfinancial asset or an in-substance nonfinancial asset in a contract with a customer is within the scope of ASC 606. For example, if the nonfinancial asset is an output of the entity’s ordinary business activities (e.g., a homebuilder’s sale of real estate), the arrangement would be accounted for under ASC 606. See Section 5.1.5.1 for a discussion of how to apply the intra-entity profit and loss elimination guidance to transactions within the scope of ASC 606. However, if the nonfinancial asset is not an output of the entity’s ordinary business activities (e.g., a financial services company’s sale of its headquarters), ASC 610-20 would apply.

4.3.2 Contribution of a Business or Nonprofit Activity

A transfer of a subsidiary or a group of assets that is a business or a nonprofit activity (as defined in ASC 810-10-20) that is not a conveyance of oil and gas mineral rights or a transfer of a good or service in a contract with a customer within the scope of ASC 606 is within the scope of ASC 810. If the parent ceases to have a controlling financial interest in the subsidiary but still retains an investment that will be accounted for under the equity method in accordance with ASC 323-10, the parent should deconsolidate the subsidiary and recognize a gain or loss in accordance with ASC 810-10-40-5. As of the date the loss of control occurs, the former parent remeasures, at fair value, its retained investment and includes any resulting adjustments as part of the gain or loss recognized on deconsolidation.

When evaluating whether the investee constitutes a business, the investor should determine whether (1) the individual assets and liabilities are concentrated in a single asset or group of assets and (2) inputs, a substantive process, and outputs are maintained at the subsidiary. See Section 2.4 of Deloitte’s Roadmap Business Combinations for more guidance on the definition of a business.

4.3.3 Contribution of Financial Assets

ASC 860-20

25-1 Section 860-20-40 provides derecognition guidance a transferor (seller) applies upon completion of a transfer of financial assets that satisfies paragraph 860-10-40-5’s conditions to be accounted for as a sale. Upon completion of such a transfer, the transferor (seller) shall also recognize any assets obtained or liabilities incurred in the sale, including, but not limited to, any of the following:

Cash
Servicing assets
Servicing liabilities
In a sale of an entire financial asset or a group of entire financial assets, any of the following:
1. The transferor’s beneficial interest in the transferred financial assets
2. Put or call options held or written (for example, guarantee or recourse obligations)
3. Forward commitments (for example, commitments to deliver additional receivables during the revolving periods of some securitizations)
4. Swaps (for example, provisions that convert interest rates from fixed to variable).

See Examples 1, 2, and 5 (paragraphs 860-20-55-43 through 55-59) for illustration of this guidance.

30-1 The transferor shall initially measure at fair value any asset obtained (or liability incurred) and recognized under paragraph 860-20-25-1.

In accordance with ASC 860, a transferor “shall initially measure at fair value any asset obtained (or liability incurred) and recognized under paragraph 860-20-25-1.” A transfer of a financial asset for an equity method investment may be within the scope of ASC 860 (see Section 5.7 for additional discussion). For example, when an equity method investment is exchanged for another equity method investment, generally the investor should first consider whether derecognition of the equity method investment being transferred in the exchange is appropriate in accordance with ASC 860, which addresses the transfer of financial assets. This is consistent with guidance in ASC 845-10-55-2, which states that the exchange of an equity method investment for another equity method investment should be accounted for under ASC 860.

However, ASC 860 is intended to apply to exchanges of equity method investments in unrelated investees, in which the substance of the transaction is an exchange of one investment for a “new” investment in an unrelated investee (as discussed in the example below). Therefore, when determining the appropriate accounting for the exchange transaction, the investor should evaluate both the form and substance of the transaction. In certain circumstances, the substance of the exchange transaction may be analogous to a partial dilution of the investor’s investment in exchange for another equity method investment, which would result in partial gain recognition in accordance with ASC 323-10-40-1 (see the discussion of change in level of ownership or degree of influence in Section 5.6) rather than full gain recognition under ASC 860. The two examples below illustrate situations in which full gain recognition under ASC 860 and partial gain recognition in accordance with ASC 323-10-40-1, respectively, may be appropriate.

Example 4-3

Entity A has a 35 percent interest in Entity B that it appropriately accounts for by using the equity method. Entity C has a 40 percent interest in Entity D that it appropriately accounts for by using the equity method. Entities B and D are in similar industries and perform the same functions. Basis differences, intra-entity profit and loss eliminations, and tax impacts have been ignored for simplicity.

Entity A is contemplating a transaction in which it will transfer a 30 percent interest in B to C in exchange for a 30 percent interest in D. Therefore, after the transaction, A will own 30 percent of D, and C will own 30 percent of B. Both A and C will have the ability to exercise significant influence over their respective investments upon completion of the exchange.

Even though B and D are in similar industries, the substance of this transaction is that A is exchanging its equity method investment for a “new” equity method investment. Therefore, A should account for this transaction in accordance with ASC 860. As long as all the conditions for derecognition under ASC 860 are met, A would recognize the full gain (or loss) equal to the difference between the selling price (fair value of a 30 percent interest in D) and the carrying value of the interest sold at the time of the sale (i.e., book value of a 30 percent interest in B).

Example 4-4

Entity A has a 40 percent interest in Entity K. Entity B and Entity C each have a 30 percent interest in K. Entities A, B, and C appropriately account for their investments in K under the equity method. The book value of the interests of A, B, and C in K are $800,000, $600,000, and $600,000, respectively, and there are no basis differences between their investment balances and underlying interests in K’s net assets. Further, intra-entity profit and loss eliminations and tax impacts have been ignored for simplicity.

Entities A, B, and C entered into a transaction with Entity E to merge K and E into a new entity, Newco. As part of the transaction, A, B, C, and the E shareholders will each contribute their interests in K and E, respectively, to Newco.

After the transaction, Newco’s ownership structure will be as follows (assume that K was the acquirer of E, and therefore, Newco recognized E’s net assets at fair value):

Therefore, upon the transaction’s execution, A’s ownership interest in K effectively decreases from 40 percent to 25 percent. That is, A effectively exchanges 15 percent of its ownership interest in K for a 25 percent interest in E.

Because of the significance of A’s retained interest in K through its investment in Newco, we believe that the transaction’s substance is analogous to a partial dilution of A’s investment in K in exchange for a partial ownership interest in E. The economic outcome is the equivalent of K’s acquiring E’s business in exchange for its own equity, thereby diluting A’s, B’s, and C’s previously held ownership interest in K.

On the basis of the substance of the transaction, A should account for the transaction as a partial sale of its investment in K and should recognize a gain of $600,000, calculated as follows:

Entity A’s cost basis of its investment in Newco is $1.4 million, which is calculated as the $500,000 book value of A’s 25 percent interest in K that was retained ($800,000 × 25% ÷ 40%) plus the $900,000 fair value of A’s 25 percent interest in E that was acquired ($3,600,000 × 25%). Therefore, A would record the following journal entries:

Conversely, if the transaction’s substance was a transfer of a financial asset for another financial asset within the scope of ASC 860 (and derecognition was appropriate), a full gain on the sale of A’s equity interest in K of $1.2 million would be recognized, calculated as the difference between the selling price (i.e., fair value of A’s interest in Newco of $2 million) and the book value of A’s interest in K that was sold ($800,000).

4.3.4 Contribution of Nonfinancial Assets or In-Substance Nonfinancial Assets That Do Not Constitute a Business or Nonprofit Activity

ASC 610-20

32-2 When an entity meets the criteria to derecognize a distinct nonfinancial asset or a distinct in substance nonfinancial asset, it shall recognize a gain or loss for the difference between the amount of consideration measured and allocated to that distinct asset in accordance with paragraphs 610-20-32-3 through 32-6 and the carrying amount of the distinct asset. The amount of consideration promised in a contract that is included in the calculation of a gain or loss includes both the transaction price and the carrying amount of liabilities assumed or relieved by a counterparty.

32-4 If an entity transfers control of a distinct nonfinancial asset or distinct in substance nonfinancial asset in exchange for a noncontrolling interest, the entity shall consider the noncontrolling interest received from the counterparty as noncash consideration and shall measure it in accordance with the guidance in paragraphs 606-10-32-21 through 32-24. Similarly, if a parent transfers control of a distinct nonfinancial asset or in substance nonfinancial asset by transferring ownership interests in a consolidated subsidiary but retains a noncontrolling interest in its former subsidiary, the entity shall consider the noncontrolling interest retained as noncash consideration and shall measure it in accordance with the guidance in paragraphs 606-10-32-21 through 32-24. (See Case A of Example 2 in paragraphs 610-20-55-11 through 55-14.)

In the event a transfer is not with a customer, as defined in ASC 606, and not a transfer of a business or nonprofit activity, the transferor should consider whether the transfer is within the scope of ASC 610-20, which applies to the transfer of nonfinancial assets and in-substance nonfinancial assets. The ASC master glossary defines a nonfinancial asset as “[a]n asset that is not a financial asset. Nonfinancial assets include land, buildings, use of facilities or utilities, materials and supplies, intangible assets, or services.” ASC 610-20-05-2 states, in part, that “[t]he term transfer in this Subtopic is used broadly and includes sales and situations in which a parent transfers ownership interests (or variable interests) in a consolidated subsidiary or other changes in facts and circumstances that result in the derecognition of nonfinancial assets or in substance nonfinancial assets that do not constitute a business.”

Sales or transfers of nonfinancial assets (or in-substance nonfinancial assets) to another entity in exchange for a noncontrolling interest in that entity are referred to as partial sales (e.g., a seller transfers a building [or an asset] to a buyer but either retains an interest in the building [or the asset] or has an interest in the buyer). These types of transactions should generally be accounted for in accordance with ASC 610-20 when the transaction results in the derecognition of the transferred assets and does not meet any of the scope exceptions in ASC 610-20-15-4. See Deloitte’s Roadmap Revenue Recognition for additional discussion of the scope exceptions.

In accordance with ASC 610-20, the transferor should account for any noncontrolling ownership interest received as noncash consideration, which should be measured at fair value in a manner consistent with the guidance on noncash consideration in ASC 606. Specifically, ASC 606-10-32-21 and 32-22 require the entity to first measure the estimated fair value of the noncash consideration received and then consider the stand-alone selling price of the goods or services promised to the customer only when the entity is unable to reasonably estimate the fair value of the noncash consideration received.

ASC 610-20 applies to gains and losses upon derecognition of nonfinancial assets and in-substance nonfinancial assets. However, there could be transfers of nonfinancial assets or in-substance nonfinancial assets with a noncustomer that are not directly within the scope of ASC 610-20 because the entity does not meet the derecognition criteria. For example, an entity that transfers a license of intellectual property (IP) should not account for the transaction under ASC 610-20 because the entity is not derecognizing the IP. In other words, the entity is not transferring the actual asset but is instead licensing the rights to the IP. Because there is no clear guidance on how to account for the transfer of a license of IP that is not part of the entity’s ordinary activities, we believe that the entity would apply the licensing guidance in ASC 606 by analogy when evaluating the recognition and measurement of consideration received in exchange for transferring the rights to the IP.

See Deloitte’s Roadmap Revenue Recognition for further information regarding the application of ASC 610-20 and considerations related to derecognition and gain or loss measurement.

Example 4-5

Entities A, B, and C form Company D. Company D does not constitute a business and is not a customer of A. In exchange for 33.3 percent of D’s common stock, A contributes land that has a carrying value of $1 million but a fair value of $4 million. Entities B and C contribute nonfinancial assets of the same fair value to D.

Upon making its contribution, A derecognizes the carrying value of the land ($1 million) and records the fair value of its investment ($4 million) in D’s common stock, recognizing a gain on contribution of $3 million ($4 million fair value less $1 million carrying value).

4.3.5 Contribution of Real Estate or Intangibles

ASC 970-323

30-3 An investor that contributes real estate to the capital of a real estate venture generally should record its investment in the venture at fair value when the real estate is derecognized, regardless of whether the other investors contribute cash, property, or services. The transaction shall be accounted for in accordance with the guidance in paragraphs 360-10-40-3A through 40-3C. Some transactions are sales of an ownership interest that result in an entity being an investor in a real estate venture. An example of such a transaction includes one in which investor A contributes real estate with a fair value of $2,000 to a venture and investor B contributes cash in the amount of $1,000. The real estate is not considered a business or nonprofit activity and, therefore, is within the scope of Subtopic 610-20 on gains and losses from the derecognition of nonfinancial assets. Investor A immediately withdraws the cash contributed by investor B and, following such contributions and withdrawals, each investor has a 50 percent interest in the venture (the only asset of which is the real estate). Assuming investor A does not have a controlling financial interest in the venture, investor A applies the guidance in paragraphs 610-20-25-5 and 610-20-25-7. When investor A meets the criteria to derecognize the property, investor A measures its retained ownership interest at fair value consistent with the guidance in paragraph 610-20-32-4 and includes that amount in the consideration used in calculating the gain or loss on derecognition of the property.

Contribution of Services or Intangibles

30-6 The contribution of real property or an intangible to a partnership or joint venture shall be accounted for in accordance with Subtopic 610-20. The contribution of services or real estate syndication activities in which the syndicators receive or retain partnership interests are accounted for in accordance with the guidance in Topic 606 on revenue from contracts with customers.

The Codification excerpts above were updated by ASU 2014-09 (as amended by ASU 2017-05), which provides guidance on the recognition and measurement of transfers of nonfinancial assets and is codified in ASC 610-20. ASU 2017-05 amended the guidance in ASC 970-323 to align it with the requirements in ASC 606 and ASC 610-20. Accordingly, the guidance outlined in Section 4.3.4 is consistent with the guidance on contributions of real estate and intangibles under ASC 970-323.

Under the guidance in ASC 970-323-30-6 above, the contribution of services or real estate syndication activities in which the syndicators receive or retain partnership interests will be accounted for in accordance with ASC 606. See Deloitte’s Roadmap Revenue Recognition for further information regarding the application of ASC 606 and ASC 610-20.

4.3.6 Transactions Addressed by Other Guidance

The deconsolidation and derecognition guidance in ASC 810-10-40-5 applies to the contribution of an interest in a subsidiary that is not a nonprofit activity or a business unless the substance of the transaction is addressed by other U.S. GAAP, which would include, but not be limited to, the following:

Revenue transactions (ASC 606). See Section 4.3.1.
Exchanges of nonmonetary assets (ASC 845).
Transfers of financial assets (ASC 860). See Section 4.3.3.
Conveyances of mineral rights and related transactions (ASC 932).
Gains and losses from the derecognition of nonfinancial assets (ASC 610-20). See Section 4.3.4.

In essence, an investor should not ignore other U.S. GAAP that would otherwise have been applicable simply because, for example, the investor transferred an equity interest in a subsidiary to effect the transaction.

The application of the derecognition guidance in ASC 810-10 is discussed in further detail in Appendix F of Deloitte’s Consolidation Roadmap.

Footnotes

4.4 Contingent Consideration

ASC 323-10

25-2A If an equity method investment agreement involves a contingent consideration arrangement in which the fair value of the investor’s share of the investee’s net assets exceeds the investor’s initial cost, a liability shall be recognized.

30-2A Contingent consideration shall only be included in the initial measurement of an equity method investment if it is required to be recognized by specific authoritative guidance other than Topic 805.

30-2B A liability recognized under paragraph 323-10-25-2A shall be measured initially at an amount equal to the lesser of the following:

The maximum amount of contingent consideration not otherwise recognized
The excess of the investor’s share of the investee’s net assets over the initial cost measurement (including contingent consideration otherwise recognized).

A contingent consideration arrangement should be recognized as a liability and included in the cost of an equity method investment in only two circumstances:

Authoritative literature other than ASC 805 (e.g., ASC 480, ASC 450, or ASC 815) requires the arrangement to be recognized. For example, if the contingent consideration meets the definition of a derivative under ASC 815, it would be initially recognized at fair value and included in the basis of the equity method investment. Subsequent changes in fair value of the derivative would not be included in the cost of the equity investment, as further discussed in Section 5.1.8.
The fair value of an investor’s share of an investee’s net assets exceeds the initial cost of the investment. In such an instance, a liability should be recognized in a manner consistent with ASC 323-10-30-2B (which is consistent with the requirement to recognize an asset acquisition at its cost or the fair value of the asset received, whichever is more reliably measurable). In accordance with ASC 323-10-30-2B, on the date of acquisition, the investor should recognize a liability (with a corresponding increase in the cost of the equity method investment) at the lesser of (1) “[t]he maximum amount of contingent consideration not otherwise recognized” or (2) “[t]he excess of the investor’s share of the investee’s net assets over the initial cost measurement.” The share of the investee’s net assets should be calculated on the basis of fair value and should exclude any calculated equity method goodwill (see Section 4.5).

Example 4-6

Entity A acquires a 25 percent interest in the voting stock of Investee X for cash consideration of $200. The arrangement also includes contingent consideration that meets the definition of a derivative and has a fair value of $20. Entity A has the ability to exercise significant influence over X and accounts for its investment under the equity method of accounting. Because the contingent consideration arrangement meets the definition of a derivative, A must recognize it in accordance with ASC 815 and would record a total initial cost of its investment of $220 ($200 cash consideration plus the $20 fair value of the derivative).

Example 4-7

Entity A acquires an equity method investment for $1,250. Entity A is obligated to pay an additional $100 in the future if certain earnings targets of the investee are reached. Entity A’s proportionate share of the investee’s net assets is $1,300, which exceeds A’s initial cost of $1,250. In accordance with ASC 323-10-30-2B, on the date of acquisition, A records a liability of $50, which is the lesser of (1) the maximum contingent consideration not already recognized ($100) or (2) the excess of A’s share of the investee’s net assets ($1,300) over the initial cost measurement ($1,250), with a corresponding increase in the cost of the equity method investment.

ASC 323-10-30-2B(b) does not provide specific guidance about whether the investee’s net assets are based on book value or fair value. The guidance in ASC 323-10-25-2A and ASC 323-10-30-2A and 30-2B was codified from EITF Issue 08-6, which states, in part:

5. Contingent consideration should only be included in the initial measurement of the equity method investment if it is required to be recognized by specific authoritative guidance other than Statement 141(R).

6. However, if an equity method investment agreement involves a contingent consideration arrangement in which the fair value of the investor’s share of the investee’s net assets exceeds the investor’s initial cost, an amount equal to the lesser of the following shall be recognized as a liability:

The maximum amount of contingent consideration not otherwise recognized
The excess of the investor’s share of the investee’s net assets over the initial cost measurement (including contingent consideration otherwise recognized).

In the Codification, which is organized by topics, paragraph 6 from EITF Issue 08-6 is broken out into two separate paragraphs under ASC 323-10: one within the Recognition section (ASC 323-10-25-2A), and the other within the Initial Measurement section (ASC 323-10-30-2B). This separation makes it unclear whether the reference to fair value in ASC 323-10-25-2A also applies in ASC 323-10-30-2B, which has no such reference. Since paragraph 6 of EITF Issue 08-6 does refer to fair value and the Codification was not intended to change existing U.S. GAAP, we believe that investors should apply ASC 323-10-30-2B by using the fair value of the investee’s net assets even though the fair value reference is absent.

Another question that may arise is whether equity method goodwill (see Section 4.5.1) should be included in the calculation of the investee’s net assets if the liability has to be recognized in accordance with ASC 323-10-25-2A. ASC 323-10-30-2B specifies that the liability should be recognized at the lesser of (1) “[t]he maximum amount of contingent consideration not otherwise recognized” or (2) “[t]he excess of the investor’s share of the investee’s net assets over the initial cost measurement (including contingent consideration otherwise recognized).” If equity method goodwill is included in the calculation of the investee’s net assets, the amount calculated in (1) will always equal the amount calculated in (2), thereby rendering the distinction of recognition at the “lesser of” amount irrelevant. Inclusion of equity method goodwill in the calculation of the investee’s net assets would be circular and would ignore the guidance’s intent to include the distinction of recognizing the liability at the “lesser of” amount. In addition, equity method goodwill for the investment is associated more with an investor rather than with an investee as part of its net assets. Therefore, we believe that equity method goodwill should not be included in the calculation of the investee’s net assets when an entity is evaluating ASC 323-10-30-2B.

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%).