Chapter 5 — Subsequent Measurement

5.1 Equity Method Earnings and Losses

ASC 323-10

35-4 Under the equity method, an investor shall recognize its share of the earnings or losses of an investee in the periods for which they are reported by the investee in its financial statements rather than in the period in which an investee declares a dividend. An investor shall adjust the carrying amount of an investment for its share of the earnings or losses of the investee after the date of investment and shall report the recognized earnings or losses in income. An investor’s share of the earnings or losses of an investee shall be based on the shares of common stock and in-substance common stock held by that investor. (See paragraphs 323-10-15-13 through 15-19 for guidance on identifying in-substance common stock. Subsequent references in this Section to common stock refer to both common stock and in-substance common stock.)

35-5 The amount of the adjustment of the carrying amount shall be included in the determination of net income by the investor, and such amount shall reflect adjustments similar to those made in preparing consolidated statements including the following adjustments:

Intra-entity profits and losses. Adjustments to eliminate intra-entity profits and losses.
Basis differences. Adjustments to amortize, if appropriate, any difference between investor cost and underlying equity in net assets of the investee at the date of investment.
Investee capital transactions. Adjustments to reflect the investor’s share of changes in the investee’s capital.
Other comprehensive income.

ASC 970-323

35-2 Investors shall record their share of the real estate venture’s losses, determined in conformity with generally accepted accounting principles (GAAP), without regard to unrealized increases in the estimated fair value of the venture’s assets.

After initial measurement of an equity method investment, an investor should record its share of an investee’s earnings or losses in income on the basis of the amount of common stock and in-substance common stock held by the investor. In accordance with ASC 323-10-35-4, the investor should calculate its share of an investee’s earnings and losses by adjusting the investee’s earnings or losses for amounts allocable to NCI. Potential common stock issued by the investee (i.e., securities such as options, warrants, convertible securities, or contingent stock agreements) should not be included in the calculation of the investor’s share of the investee’s earnings or losses unless these securities represent in-substance common stock. See Section 2.5 for further discussion related to the determination of whether an investment is in-substance common stock. The investor’s equity method investment balance is increased by the investor’s share of the investee’s income and decreased by the investor’s share of the investee’s losses in the periods in which the investee reports the earnings and losses rather than in the periods in which the investee declares dividends. In addition, adjustments to the investor’s share of equity method earnings or losses (and corresponding adjustments to the carrying value of the equity method investment) are made for certain items as discussed in detail in Section 5.1.5.

While the guidance above requires an investor to recognize its share of an investee’s earnings or losses, it does not prescribe the order in which adjustments are made to the investor’s share of equity method earnings or losses or the allocation method to be applied. In some cases, the calculation of the investor’s share of the investee’s earnings or losses may be straightforward (e.g., when there is only one share class and the distributions received by the investors are consistent with their percentage ownership in the investee). However, allocation of earnings or losses on the basis of the investor’s ownership percentage may be more difficult to apply in complex structures in which there are multiple share classes and investors have different rights and priorities. See Sections 5.1.2 and 5.1.2.1 for further discussion of when the allocation of the investee’s earnings or losses is disproportionate in relation to the investor’s ownership interest in the investee.

5.1.1 Impact of Preferred Dividends on an Investor’s Share of Earnings (Losses)

ASC 323-10

35-16 If an investee has outstanding cumulative preferred stock, an investor shall compute its share of earnings (losses) after deducting the investee’s preferred dividends, whether or not such dividends are declared.

An investor is required to calculate its share of an equity method investee’s earnings (losses) after deduction of any investee preferred dividends on cumulative preferred stock, regardless of whether the dividends are declared. Conversely, no adjustment is required for preferred dividends on noncumulative preferred stock unless those dividends have been declared.

Example 5-1

Investor A, Investor B, and Investor C each own investments in Investee Z as follows:

On January 1, 20X2, A acquires 45 percent (45,000 of 100,000 shares) of the voting common stock of Z for $90,000. Investor A accounts for its investment by using the equity method because of its ability to exercise significant influence over Z. Investor A will recognize its share of Z’s earnings on a pro-rata basis in accordance with its ownership interest in Z.
On January 1, 20X2, B acquires 10,000 shares of cumulative preferred stock of Z for $50,000, which entitles B to receive an annual dividend of 5 percent (whether or not the dividend is declared).

Investee Z has net income of $25,000 for the year ended December 31, 20X2. Although not declared, the cumulative preferred dividend on B’s investment in preferred stock is $2,500. Assume there are no basis differences, intra-entity profit eliminations, or any other adjustments to net income.

Investor A calculates its share of the earnings of Z to be $10,125 by:

Deducting the cumulative preferred stock dividend from Z’s net income ($25,000 − $2,500 = $22,500) (adjusted net income).
Calculating its pro rata share of adjusted net income (45% × $22,500 = $10,125).

On December 31, 20X2, A’s equity method investment balance would be $100,125 (A’s initial investment of $90,000 plus its share of Z’s adjusted net income of $10,125).

5.1.1.1 Impact of Accretion of Temporary Equity

ASC 480-10-S99-2 provides that:

The initial carrying amount of redeemable preferred stock should be its fair value at date of issue. [For redeemable preferred stock classified in temporary equity] [w]here fair value at date of issue is less than the mandatory redemption amount, the carrying amount shall be increased by periodic accretions.

When calculating its share of an equity method investee’s earnings or losses, the investor should adjust the net income of the equity method investee for this accretion of preferred stock. See Section 9.5 of Deloitte’s Roadmap Distinguishing Liabilities From Equity for additional guidance on the accretion of redeemable preferred stock classified as temporary equity.

5.1.2 Disproportionate Allocation of an Investee’s Earnings or Losses in Relation to an Investor’s Ownership Interest

ASC 970-323

35-16 Venture agreements may designate different allocations among the investors for any of the following:

Profits and losses
Specified costs and expenses
Distributions of cash from operations
Distributions of cash proceeds from liquidation.

35-17 Such agreements may also provide for changes in the allocations at specified times or on the occurrence of specified events. Accounting by the investors for their equity in the venture’s earnings under such agreements requires careful consideration of substance over form and consideration of underlying values as discussed in paragraph 970-323-35-10. To determine the investor’s share of venture net income or loss, such agreements or arrangements shall be analyzed to determine how an increase or decrease in net assets of the venture (determined in conformity with GAAP) will affect cash payments to the investor over the life of the venture and on its liquidation. Specified profit and loss allocation ratios shall not be used to determine an investor’s equity in venture earnings if the allocation of cash distributions and liquidating distributions are determined on some other basis. For example, if a venture agreement between two investors purports to allocate all depreciation expense to one investor and to allocate all other revenues and expenses equally, but further provides that irrespective of such allocations, distributions to the investors will be made simultaneously and divided equally between them, there is no substance to the purported allocation of depreciation expense.

As described in Section 5.1, when applying the equity method of accounting, an investor should typically record its share of an investee’s earnings or losses on the basis of the percentage of the equity interest owned by the investor. However, contractual agreements often specify attributions of an investee’s profits and losses, certain costs and expenses, distributions from operations, or distributions upon liquidation that are different from investors’ relative ownership percentages. For example, developers in the renewable energy sector often use limited partnerships or similar structures for tax purposes. A developer of a renewable energy facility that does not generate sufficient taxable income to offset the tax incentives or investment tax credits (ITCs) generated from its operations may monetize these tax credits by identifying investors that are able to use the tax incentives and credits. These renewable “flip” structures are typically set up as tax pass-through entities to give the investors (i.e., tax equity investors) the ability to use the tax benefits of the partnership. Within these structures, there are typically disproportionate equity distributions until a flip date, at which point the distributions change. In addition, the tax benefits that pass through to the investor are not recognized in the investee’s net income but generally affect the claim that the tax equity investor has on the remaining book value. This is just one example of a structure in which the calculation of an investor’s share of an investee’s earnings or losses may involve more complexity.

Although ASC 970-323 was written for equity method investments in the real estate industry, we believe that it is appropriate to refer to this literature for guidance on developing an appropriate method of allocating a non-real-estate equity method investee’s economic results among investors when a contractual agreement, rather than relative ownership percentages, governs the economic allocation of earnings or losses. ASC 970-323 implies that for the allocation of the investee’s earnings or losses to be substantive from a financial reporting perspective, it must hold true and best represent cash distributions over the life of the entity. Reporting entities should focus on substance over form. The investor should consider the substance of all relevant agreements when determining how an increase or decrease in the investee’s net assets will affect cash payments to the investor over the investee’s life and upon its liquidation.

Connecting the Dots

We believe that the guiding principle for allocating an investee’s earnings or losses to equity method investors is to ascertain whether allocations that would otherwise be made in the current year are at significant risk of being unwound in subsequent periods because a different allocation method will be used for subsequent cash distributions. Hence, it is generally not appropriate to use a single blended rate to recognize an investor’s share of an investee’s earnings and losses when distributions or earnings and losses of the investee will change over the life of the investment on the basis of contractual terms. Rather, in such instances professional judgment must be used, and consideration should be given to the facts and circumstances at hand. Preparers should consider consulting with their independent auditors or their professional accounting advisers.

Examples of such considerations are illustrated in ASC 323-10-35-19 (see Section 5.2), ASC 323-10-55-30 through 55-47, and ASC 323-10-55-48 through 55-57 (see Section 5.2.3.1).

Overall, when selecting the most appropriate method with which to recognize earnings on an equity method investment, an investor should consider the principal objective of the equity method, which ASC 323-10-35-4 states is to recognize the investor’s “share of the earnings or losses of an investee in the periods for which they are reported by the investee.” That is, the investor should appropriately reflect the effect of investee transactions on an investor for a given reporting period.

Therefore, when cash flows, tax attributes, and earnings are contractually allocated to investors in disparate ways over the life of an investee, it would be inappropriate for the investor to forecast expectations of the investee’s performance to determine a weighted-average expected return on the investor’s investment when allocating current-period earnings. That is, we believe that the allocation method should generally be consistent with how the contractual provisions allocate earnings in the current period or how the investor’s rights to the book value change in that current period.

However, we do not think that this means that contractual earnings allocation provisions should be followed blindly. For example, it may be the case that earnings allocation percentages change contractually over the investee’s life while operating and liquidating cash distributions remain constant. In such situations, the substance of the contractual cash distribution provisions may imply relative membership interests in the investee, while earnings are allocated to achieve certain other form-based objectives (e.g., an after-tax return). In summary, when earnings, tax attributes, and cash flows are contractually allocated differently, we think that the substance of those provisions should be carefully considered.

See Section 6.2 of Deloitte’s Roadmap Noncontrolling Interests for further discussion of allocations that are disproportionate to ownership interests.

Example 5-2

Investors A and C have 40 percent and 60 percent equity interests, respectively, in Investee B, a partnership. The investors use the equity method to account for their interests in B. Distributions (including those that would occur if the investee were liquidated) are shared evenly, in accordance with the terms of the partnership agreement.

In this example, A and C would record their proportionate shares of B’s profits and losses on the basis of the allocation method specified in the partnership agreement (i.e., equal distribution), since this allocation reflects the substance of the investment. That is, A and C would not record their equity method earnings on the basis of 40 percent and 60 percent, respectively, of B’s profits and losses.

Example 5-3

Investor Z has an equity method investment in an LLC that owns income-producing real estate properties. For financial reporting purposes, the LLC agreement states that 100 percent of depreciation expense and 50 percent of all other income and expense items are to be allocated to Z. However, the agreement states that 50 percent of all cash distributed by the LLC during its operations and upon liquidation should be allocated to Z.

In this example, there is no basis for the allocation of 100 percent of depreciation expense to Z. Therefore, Z would record its equity method earnings on the basis of 50 percent of the LLC’s total net profits and losses (including depreciation expense).

5.1.2.1 Hypothetical Liquidation at Book Value Method

Although the Codification does not prescribe a specific method for allocating an investee’s earnings or losses to investors, reporting entities will often use the hypothetical liquidation at book value (HLBV) method, which is a balance sheet approach to encapsulating the change in an investor’s claim on an investee’s net assets as reported under U.S. GAAP. Under the HLBV method, changes in the investor’s claim on the investee’s net assets that would result from the period-end hypothetical liquidation of the investee at book value form the basis for allocating the equity method investor’s share of the investee’s earnings or losses. However, in applying the HLBV method, investors should not consider other potential effects of a hypothetical liquidation, such as debt prepayment or lease termination penalties.

The HLBV method arose in response to increasingly complex capital structures, the lack of prescribed implementation guidance on how an equity method investor should determine its share of earnings or losses generated by the equity method investee, and the ensuing diversity in practice. In an attempt to establish in the authoritative literature the appropriate accounting for equity method investments in entities with complex structures, the AICPA issued a proposed Statement of Position (SOP), Accounting for Investors’ Interests in Unconsolidated Real Estate Investments, in November 2000. The proposed SOP, which was not ultimately finalized, was intended for investments of unconsolidated real estate. However, the proposal led to increased use of the HLBV method as an acceptable means to allocate earnings or losses of an equity method investee among its investors when each investor’s right to participate in the earnings or losses of the investee is disproportionate to its ownership interest.

Notwithstanding the HLBV method’s origins (or its absence from the Codification), we believe that given the FASB’s focus on substance over form, the HLBV method will often be an acceptable method for allocating an investee’s earnings or losses. Other methods may also be acceptable depending on the facts and circumstances.

Under the HLBV method, a reporting entity allocates an investee’s earnings or losses to each investor by using the following formula:

The two examples below illustrate the calculation of an investor’s equity method earnings or losses under the HLBV method. In addition, Case B from the example in ASC 323-10-55-54 through 55-57 also illustrates, in substance, the application of the HLBV method (see Section 5.2.3.1).

Example 5-4

Partnership X (or “investee”) was formed to develop and construct a renewable solar energy facility. Partnership X will own the facility and sell electricity at a fixed rate to a local utility under a long-term power purchase agreement. Partnership X is a flow-through entity for tax purposes; therefore, the tax attributes (such as ITCs and accelerated tax depreciation) related to the solar energy facility are allocated to X’s partners in accordance with X’s operating agreement between the partners.

The fair market value of the solar energy facility is $35 million. The tax equity investor and sponsor (collectively, the “investors”) will contribute $15.5 million and $19.5 million, respectively, to X. Assume that both the tax equity investor and the sponsor account for their investments in X under the equity method.1

Partnership X has a complex capital structure that requires an allocation of income, gain, loss, tax deductions, and tax credits before and after a “flip date” to the investors that is not consistent with the investors’ relative ownership percentages. The flip date is defined as the point in time when the tax equity investor receives a target after-tax internal rate of return (IRR) on its investment (in this example, tax equity investor’s target after-tax IRR is 8 percent). The tax equity investor achieves its IRR through cash distributions as well as the allocation of ITCs and other tax benefits.

Under the partnership agreement, income, gain, loss, tax deductions, and tax credits for each tax year will be allocated between the tax equity investor and the sponsor as follows:2

	Pre-Flip	Post-Flip
Tax equity investor	99 percent	5 percent
Sponsor	1 percent	95 percent

Cash distributions for each tax year, which are not designed to approximate GAAP earnings in each period, will be allocated between the tax equity investor and the sponsor as follows:

	Pre-Flip	Post-Flip
Tax equity investor	25 percent	5 percent
Sponsor	75 percent	95 percent

Tax gain (or loss) recognized upon the partnership’s liquidation will be distributed according to the following waterfall:

First, to partners with negative Internal Revenue Code (IRC) Section 704(b)3 capital accounts, the amount needed to bring their capital accounts to zero.
Second, to the partners in accordance with their pre-flip sharing ratios (1 percent to the sponsor and 99 percent to the tax equity investor), until the tax equity investor achieves its target IRR.
Finally, to the partners in accordance with their post-flip tax sharing ratios (95 percent to the sponsor and 5 percent to the tax equity investor), any remaining gain (or loss).

Note that in this example, we assumed a generic set of liquidation provisions in computing HLBV equity method income (loss). In practice, there is tremendous diversity in liquidation provisions from deal to deal since partners develop provisions that more accurately reflect their economic arrangements.

Given X’s complex capital structure, both the tax equity investor and the sponsor have elected a policy of calculating their share of X’s earnings or losses by using the HLBV method. To determine the amount allocated to each investor under the HLBV method, the tax equity investor and sponsor must perform an analysis of the investors’ IRC Section 704(b) capital accounts (as adjusted per the liquidation provisions of the partnership agreement). The mechanics of the HLBV method in this type of flip structure involve a complex combination of U.S. GAAP and tax concepts, typically consisting of the following steps (as of each reporting period end):4

Determine the investee’s period-end U.S. GAAP capital account balance.
Determine the investee’s and each investor’s starting IRC Section 704(b) capital account balance.
Calculate the investee’s IRC Section 704(b) book gain (loss) on hypothetical liquidation (U.S. GAAP capital account from step 1 less starting IRC Section 704(b) capital account balance from step 2).
Allocate the investee’s IRC Section 704(b) book gain (loss) from step 3 in the following order (specifics as determined by the liquidation provisions in the relevant agreement):
1. Allocate the gain to restore negative IRC Section 704(b) capital account balances to zero.
2. Allocate the gain to the tax equity investor until the target IRR is achieved.
3. Allocate the remaining gain (loss) in accordance with the appropriate residual sharing percentages.
Add/subtract the gain (loss) allocated in step 4 to each investor’s IRC Section 704(b) capital account balance determined in step 2.
Determine the change in each investor’s claim on the investee’s book value during the period (adjusted for contributions and distributions).

The attribution of X’s HLBV equity method income (loss) is calculated for the tax equity investor and the sponsor in years 1 through 3 and is shown below. Note that intra-entity profit and loss eliminations and tax impacts have been ignored for simplicity.

Step 1: Determine the investee’s period-end U.S. GAAP capital account balance:

Step 2: Determine the investee’s and each investor’s starting IRC Section 704(b) capital account balance:

Step 3: Calculate the investee’s IRC Section 704(b) book gain (loss) on hypothetical liquidation (U.S. GAAP capital account from step 1 less starting IRC Section 704(b) capital account balance from step 2):

Step 4: Allocate the investee’s IRC Section 704(b) book gain (loss) on liquidation:

Step 4(a): Allocate gain to restore negative capital accounts:

Step 4(b): Allocate gain to tax equity investor until target after-tax return (IRR) is achieved:**

Step 4(c): Allocate remaining gain (loss) in accordance with appropriate residual sharing percentages:

Step 5: Add/subtract the gain (loss) allocated in step 4 to each investor’s starting IRC Section 704(b) capital account balance determined in step 2:

Step 6: Determine the change in each investor’s claim on the investee’s book value during the period (adjusted for contributions and distributions):

Below are the journal entries the tax equity investor and the sponsor would use to record their contributions, equity method earnings or losses, and distributions related to their equity method investments in Partnership X on the basis of the calculation and summary above.

Note that in year 2, as illustrated in the journal entries below, the tax equity investor recognizes a larger loss (and the sponsor a larger gain) than in the other years; this is a result of the ITC’s being realized. See the Connecting the Dots box below this example for a discussion of diversity in practice related to recognizing the change in the tax equity investor’s rights to book value as a result of the ITC’s being realized. The journal entries below do not illustrate the calculation of any basis difference, as discussed in the Connecting the Dots box. Instead, the entries show the recording of the entire change in HLBV through earnings immediately.

Connecting the Dots

We are aware of diversity in practice related to recognizing earnings and losses under the HLBV equity method involving ITCs. The accounting for ITCs under ASC 740 by the tax equity investor can vary depending on whether the investor elects, as an accounting policy, either to (1) recognize the ITC as an immediate reduction to income tax expense (the “flow-through method”) or (2) recognize the ITC on a deferred basis over the life of the underlying asset (the “deferral method”). See Deloitte’s Roadmap Income Taxes for further discussion of these methods of recognizing the ITC in earnings. If the flow-through method is applied, the equity method loss that results from the application of the HLBV method should always be recognized in earnings. However, if the deferral method is applied, diversity exists in accounting for the decrease in the right to book value as a result of the ITC’s impact on the application of the HLBV method.

When applying the deferral method for ITCs, some tax equity investors, as illustrated in Example 5-4, recognize the change in the right to book value in equity method earnings of the tax equity investor in the period in which the ITC is earned (i.e., the period in which the underlying asset is placed in service). However, other tax equity investors believe that it is more appropriate to consider the change in the right to book value as a result of the ITC’s impact on the application of HLBV to be a basis difference that would be amortized in accordance with ASC 323-10-35-13 (see Section 5.1.5.2 for a discussion of basis differences). If a tax equity investor applies the basis difference approach, we recommend consultation with an accounting adviser.

This basis difference approach would not be appropriate for the sponsor if it consolidated the investee in accordance with ASC 810.

Example 5-5

Investee R, a partnership, is capitalized by equity contributions from Investor V and Investor T as follows:

Assets, liabilities, and equity for R as of December 31, 20X4, 20X5, and 20X6, are:

Investee R had net income of $50 during 20X5 and $300 during 20X6.

Assume that V accounts for its investment in R under the equity method. Investee R is a limited life entity that does not make regular distributions to its investors. Upon liquidation of R, its net assets are distributed as follows:

Return of the investors’ capital contributions.
Return of $100 to T.
Remainder to the investors on a pro rata basis.

Given R’s complex capital structure, V has elected a policy of calculating its share of R’s earnings or losses by using the HLBV method. Thus, net income for 20X5 and 20X6 is allocated on the basis of the hypothetical liquidations of net assets as of December 31, 20X4, 20X5, and 20X6, as depicted in the chart below. Note that intra-entity profit and loss eliminations and tax impacts have been ignored for simplicity.

Investor V’s share of R’s earnings during 20X5 is zero, because its claim on the book value has remained unchanged during the year (i.e., T was allocated 100 percent of the net income). Investor V’s share of R’s earnings during 20X6 is $125 (V’s $325 claim on December 31, 20X6, net assets less its $200 claim on December 31, 20X5, net assets).

Connecting the Dots

We believe that while it will often be acceptable for an entity to use the HLBV method to allocate an investee’s earnings or losses, there may be instances in which it would be inappropriate for an entity to use the HLBV method. Because the HLBV method inherently focuses on how an investee’s net assets will be distributed in liquidation, a detailed understanding of the investee’s intention with respect to cash distributions is important. We believe that when provisions governing the attribution of liquidating distributions differ significantly from those governing the attribution of ordinary distributions, it would be inappropriate to rely on the HLBV method to allocate the earnings or losses of a going-concern investee if the investee is expected to make significant ordinary distributions throughout its life.

5.1.2.2 Capital-Allocation-Based Arrangements

Capital-allocation-based arrangements are fee arrangements in which one or more parties receives compensation for managing the capital of one or more investors. These arrangements typically include two payment streams: (1) a management fee (usually a fixed percentage of the net asset value of the assets under management) and (2) an incentive-based fee (i.e., a fee based on the extent to which a fund’s performance exceeds predetermined thresholds). Often, a private-equity or real estate fund manager (who may be the GP and have a small ownership percentage in the fund) will receive incentive-based fees by way of a disproportionate allocation of capital from a fund’s limited partnership interests if certain investment returns are achieved (commonly referred to as “carried interests”). This is an example of a capital-allocation-based arrangement that involves an equity interest (the partnership interests held by the GP).

Before the adoption of ASU 2014-09 (codified as ASC 606), GP investors that did not have a controlling financial interest in the underlying partnership generally accounted for their GP interest, excluding the disproportionate allocation of profits, by using the equity method of accounting as prescribed in ASC 323. With respect to the incentive-based-fee portion of their GP investments, investors usually applied EITF Topic D-96 (codified in ASC 605-20-S99-1), which specifies two acceptable approaches to accounting for the receipt of fees for performance-based fee arrangements such as an incentive-based fee in a capital-allocation-based arrangement:

Method 1 — Because of the possibility that fees earned by exceeding performance targets early in the measurement period may be reversed if performance targets are missed later in the measurement period, no incentive-based-fee income is recorded until the end of the measurement period (which in some cases may be coterminous with the life of the fund under management).
Method 2 — Incentive-based-fee income is recorded on the basis of the amount that would be due under the relevant formula at any point in time as if the contract were terminated at that date.

Notwithstanding the above, before the adoption of ASU 2014-09, some investors may have been treating the incentive-based-fee portion of their GP investments within the scope of ASC 323 on the basis of footnote 1 of EITF Topic D-96 (although not codified in ASC 605-20-S99-1), which states:

The SEC staff understands that in certain entities within the scope of AICPA Statement of Position No. 78-9, Accounting for Investments in Real Estate Ventures, the manager is the general partner in a partnership and receives fees in the form of partnership allocations. If the general partner manager has been accounting for such arrangements on the equity method in accordance with that SOP, the manager may continue to apply that method.

With the issuance of ASU 2014-09, the question has arisen about whether these capital-allocation-based arrangements are within the scope of ASC 606 or whether they would be accounted for under other U.S. GAAP (particularly ASC 323).

We believe that if these capital-allocation-based arrangements are within the scope of ASC 606, the incentive-based-fee portion would represent variable consideration. As illustrated in Example 25 in ASC 606-10-55-221 through 55-225, the application of the variable consideration constraint may result in a delay in recognition of incentive-based fees for entities that previously chose to apply Method 2. In some cases, this delay may be significant. See Deloitte’s Roadmap Revenue Recognition for further discussion of constraining estimates of variable consideration.

Notwithstanding Example 25, ASC 606 does not contain explicit guidance on whether capital-allocation-based arrangements that involve an equity interest are within its scope.

We believe that the accounting for an entity’s capital-allocation-based arrangements will vary in accordance with the nature and substance of the arrangement. Specifically, certain entities may be able to demonstrate that the incentive-based fee is an attribute of an equity interest. In such instances, the entity would be able to make an accounting policy election to account for the incentive-based fee under the provisions of ASC 606 or ASC 323 since the equity interest, inclusive of the incentive fee, would qualify for the scope exception outlined in ASC 606-10-15-2(c)(3). See Section 2.4.2.1.1 for further discussion.

Thus, entities should carefully evaluate the scoping guidance within these topics to determine whether their capital-allocation-based arrangements should be accounted for thereunder, particularly ASC 323.

If an investor determines that the incentive-based-fee portion of its capital-allocation-based arrangements is within the scope of ASC 323 (and thus qualifies for the scope exception to ASC 606 noted above), we believe that the scope exception would be applied only to the incentive-based fee. We believe that the management-fee portion of the capital-allocation-based arrangement, if present, should be accounted for under ASC 606.

Application of the equity method under ASC 323-10-35-4 would permit the investor to recognize its share of earnings or losses, inclusive of the incentive-based fee, in the periods in which they are recognized by the underlying investee. The guidance states, in part, that “[a]n investor’s share of the earnings or losses of an investee shall be based on the shares of common stock and in-substance common stock held by that investor.” However, when an agreement designates allocations among the investors of the investee’s profits and losses, certain costs and expenses, distributions from operations, or distributions upon liquidation that are different from ownership percentages, it may not be appropriate for the investor to record equity method income on the basis of the equity interest owned. Examples of these considerations are illustrated in ASC 323-10-55-30 through 55-47, ASC 323-10-55-48 through 55-57 (see Section 5.2.3.1), and ASC 323-10-35-19 (see Section 5.2). ASC 323-10-55-54 through 55-57 also illustrate, in substance, the application of the HLBV method (see Sections 5.2.3.1 and 5.1.2.1). This guidance is consistent with that in ASC 970-323-35-16 and 35-17 (see Section 5.1.2), under which the equity method is applied to investments in entities that have legal agreements designating the allocation of profits and losses and distributions. Given that capital-allocation-based arrangements often provide for a disproportionate allocation of profits on the basis of the fair value of underlying investments in a fund, the investor should carefully determine the most appropriate method of calculating its share of earnings or losses of the investee after considering all of the arrangement’s facts and circumstances.

ASC 323-10-45-1 states that “[u]nder the equity method, an investment in common stock shall be shown in the balance sheet of an investor as a single amount” and that “an investor’s share of earnings or losses from its investment shall be shown in its income statement as a single amount.” Therefore, if the investor has determined that it is appropriate to account for the incentive-based-fee portion of its capital-allocation-based arrangement under ASC 323, we believe that the investor should present its GP investment in the underlying investee as one unit of account in the same line item in the balance sheet. Regarding income statement presentation, we are aware of the following two potentially acceptable views:

The entire amount of the investor’s share of earnings, including its pro rata allocation of profits as well as allocations under the incentive-based-fee portion of the capital-allocation-based arrangement, represents revenue earned by the investor and should therefore be presented in the revenue total in the income statement. However, since these revenues would be considered outside the scope of ASC 606, the amounts should not be labeled as revenue from contracts with customers in the investor’s financial statements or in the accompanying footnotes and disclosures.
The entire amount of the investor’s share of earnings, including its pro rata allocation of profits as well as allocations under the incentive-based-fee portion of the capital-allocation-based arrangement, should be reflected in a separate line item outside of revenue in the income statement.

5.1.3 Differences Between Investor and Investee Accounting Policies and Principles

An investor and its equity method investee may prepare their financial statements by using different accounting policies and principles. Depending on the circumstances, the investor may be required to make adjustments to the investee’s financial statements when calculating its share of the investee’s earnings or losses.

5.1.3.1 Equity Method Investee Does Not Follow U.S. GAAP

ASC 970-323

35-20 In the real estate industry, the accounts of a venture may reflect accounting practices, such as those used to prepare tax basis data for investors, that vary from GAAP. If the financial statements of the investor are to be prepared in conformity with GAAP, such variances that are material shall be eliminated in applying the equity method.

The term “earnings or losses of an investee” is defined in ASC 323-10-20 as “[n]et income (or net loss) of an investee determined in accordance with U.S. generally accepted accounting principles (GAAP).” Therefore, if an investee is not following U.S. GAAP, an investor that reports under U.S. GAAP must make adjustments to convert the investee’s financial statements into U.S. GAAP so it can apply the equity method and record its share of the investee’s earnings or losses. This situation may arise, for example, when the investee’s financial statements are prepared under IFRS Accounting Standards or some other basis of accounting (i.e., in the real estate industry when the investee’s financial statements were prepared by using tax basis information that differs from U.S. GAAP).

Generally accepted accounting principles in some countries other than the United States permit an investor to recognize its share of net income in an equity method investee by using the investee’s basis of accounting, which may be different from that of the investor. For example, a foreign registrant using French GAAP may have an equity method investee that reports under German GAAP. Because a conversion of the investee’s net income into French GAAP is not required under French GAAP, the financial statements of the investor will simply reflect the investor’s share of the investee’s German GAAP net income.

At the 2000 AICPA Conference on Current SEC Developments, the SEC staff indicated that a foreign registrant that is reconciling to U.S. GAAP must convert the net income of its equity method investees into net income prepared under U.S. GAAP and must list the difference as a reconciling item.

5.1.3.2 Investee Has Elected a Private-Company Alternative

ASC 323-10 — Glossary

Public Business Entity

A public business entity is a business entity meeting any one of the criteria below. Neither a not-for-profit entity nor an employee benefit plan is a business entity.

It is required by the U.S. Securities and Exchange Commission (SEC) to file or furnish financial statements, or does file or furnish financial statements (including voluntary filers), with the SEC (including other entities whose financial statements or financial information are required to be or are included in a filing).
It is required by the Securities Exchange Act of 1934 (the Act), as amended, or rules or regulations promulgated under the Act, to file or furnish financial statements with a regulatory agency other than the SEC.
It is required to file or furnish financial statements with a foreign or domestic regulatory agency in preparation for the sale of or for purposes of issuing securities that are not subject to contractual restrictions on transfer.
It has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market.
It has one or more securities that are not subject to contractual restrictions on transfer, and it is required by law, contract, or regulation to prepare U.S. GAAP financial statements (including notes) and make them publicly available on a periodic basis (for example, interim or annual periods). An entity must meet both of these conditions to meet this criterion.

An entity may meet the definition of a public business entity solely because its financial statements or financial information is included in another entity’s filing with the SEC. In that case, the entity is only a public business entity for purposes of financial statements that are filed or furnished with the SEC.

The PCC determines alternatives to existing nongovernmental U.S. GAAP to address the needs of users of private-company financial statements on the basis of criteria mutually agreed upon by the PCC and the FASB. The FASB has issued certain ASUs that contain these PCC alternatives. When an investor accounts for its interest in an investee, the determination of whether PCC alternatives are allowed and whether there is any impact to the investor’s recognition of its share of the investee’s earnings or losses depends on whether the investor and the investee meet the definition of a PBE.

If the investor and the investee are not PBEs — If both the investor and the investee are not PBEs, the investor and the investee may use PCC alternatives. The investor may conform the investee’s accounting policies with its own to unwind a PCC alternative elected by the investee. However, if the investee does not apply a PCC alternative, the investor may not change the investee’s accounting policies to conform with its own.
If the investor is not a PBE but the investee is a PBE — If the investor is not a PBE but the investee is a PBE, the investor may apply PCC alternatives. The investee is prohibited from applying PCC alternatives in its own separate financial statements. Further, the investor is prohibited from conforming the investee’s accounting policies to its accounting policies (i.e., the investor cannot apply the PCC alternatives to the investee’s financial statements when the investor is preparing its own financial statements).
If the investor and the investee are PBEs — If the investor and the investee are PBEs, both the investor and the investee are prohibited from applying PCC alternatives.
If the investor is a PBE but the investee is not a PBE — If the investor is a PBE but the investee is not a PBE, the investor is prohibited from applying PCC alternatives. The investee may elect to apply PCC alternatives in its separate financial statements; however, when applying the equity method of accounting, the investor may need to make adjustments in certain circumstances.

While not authoritative, the guidance in AICPA Technical Q&As Section 7100.08 distinguishes between when the investor meets criterion (a) versus when it meets criteria (b) through (e) of the ASC master glossary definition of a PBE in the determination of whether any adjustments to equity method pickups would be required.

If the investor is a PBE according to criterion (a) of the ASC master glossary definition, the investor is required to reverse the investee’s PCC alternatives when calculating its equity method pickup. The SEC staff has indicated in discussions that PBEs are prohibited from including PCC alternatives in their financial statements on an “indirect” basis when they apply the equity method of accounting. Although the PCC alternatives are considered part of U.S. GAAP, precluding their use by an investor that meets the definition of a PBE (referred to herein as a “PBE investor”) is consistent with requiring investors that apply the equity method to adjust the accounting of an investee that applies other GAAP (e.g., IFRS Accounting Standards) (see Section 5.1.3.1).

If the investor is a PBE according to criteria (b) through (e) of the ASC master glossary definition, the investor is not required to reverse the investee’s PCC alternatives when calculating its equity method pickup. However, the investor may elect to do so in certain circumstances (e.g., if it plans to go public).

Example 5-6

Company P holds an interest in Company Q and accounts for it by applying the equity method. Because P is an SEC registrant, it is a PBE for financial reporting purposes according to criterion (a) of the ASC master glossary definition. Company Q is a private company that has elected to amortize goodwill in accordance with ASC 350-20-15-4 in its own financial statements. In addition, P is not required to include Q’s separate financial statements in its own SEC filings (in accordance with Regulation S-X, Rule 3-09).5 Therefore, for P’s SEC filing purposes, Q does not explicitly meet criterion (a) of the definition of a PBE because Q is not one of the “other entities whose financial statements or financial information are required to be or are included in a filing.” Company P’s accounting under the equity method cannot reflect Q’s election to amortize goodwill. Although Q may be eligible to amortize goodwill when it prepares its stand-alone financial statements, Q’s accounting must be changed to that of a PBE when P applies the equity method to account for its interest in Q. Thus, P would reverse the amortization recorded by Q (and the related tax effects, if any) and evaluate whether the adjusted carrying value of goodwill on Q’s books, without the election to amortize goodwill, would be deemed impaired if Q performed the impairment analysis required of a PBE (i.e., an annual test performed at the reporting-unit level).

See Section 5.1.3.4 for details regarding application of the definition of a PBE to an equity method investee and a discussion of the extent to which PBE effective dates of new accounting standards apply when a PBE investor accounts for its interest in an investee that may or may not be a PBE.

5.1.3.3 Investee Applies Different Accounting Policies Under U.S. GAAP

While a PBE investor cannot apply the equity method to account for its interest in an investee until it adjusts the investee’s financial statements to eliminate any elected private-company accounting alternatives (as discussed in the previous section), there is no need to align the investee’s accounting policies with those of the investor as long as the investee’s policies can be applied by a PBE. That is, in accordance with the ASC master glossary definition of the term “earnings or losses of an investee,” as long as the investee’s accounting policies are acceptable under U.S. GAAP, the investee’s financial statements should not be adjusted to conform to the accounting policies of the investor.

For instance, if an equity method investee accounts for its inventory under the last-in, first-out method while the investor uses the first-in, first-out method (or vice versa), the investor should not adjust the investee’s financial statements to conform to the investor’s inventory policy. However, it is important for the investor to understand the impact of these differing accounting policies when calculating equity method earnings and, specifically, whether any intra-entity profit or loss eliminations are required. For example, assume that an investor and its equity method investee enter into a sales contract and the investor determines that the contract is a derivative while the investee elects the normal purchases and normal sales derivative scope exception. This difference in accounting policy leads the investor to account for the contract at fair value, with changes in fair value reported in earnings, while the investee accounts for the same contract on an accrual basis. In this case, the investor will have to eliminate unrealized intra-entity profits or losses recognized on the contract. See Section 5.1.5.1 for details on intra-entity profit or loss eliminations.

5.1.3.4 Investee Adopts a New Accounting Standard on a Different Date

New accounting standards often establish divergent adoption requirements (e.g., different effective dates) for PBEs and non-PBEs. The determination of whether an investor registrant must adjust an equity method investee’s adoption of a new standard to make it conform to the manner of adoption required of PBEs depends on whether the equity method investee is considered a PBE. For example, an equity method investee whose financial statements are included in a registrant’s filing under Regulation S-X, Rule 3-09, because the equity method investee is significant to the registrant is considered a PBE under U.S. GAAP.

In his remarks before the 2016 AICPA Conference on Current SEC and PCAOB Developments, Jonathan Wiggins, associate chief accountant in the OCA, stated, in part:

Whether an entity is a public business entity can have a significant impact on financial reporting, particularly since certain FASB guidance, including the new revenue, leases, and financial instruments standards, have different effective dates for public business entities. You should ensure that all entities that meet the definition of a public business entity adopt such guidance using the effective dates for public business entities for purposes of the financial statements or financial information included in a filing with the SEC.

OCA has received related questions regarding the accounting for equity method investees that do not otherwise meet the FASB’s definition of a public business entity. [Footnotes omitted]

When a PBE investor accounts for its interest in an investee, the determination of whether the PBE effective dates of new accounting standards apply to (1) the investee’s financial statements or financial information filed with or furnished to the SEC and (2) the PBE investor’s recognition of its share of the investee’s earnings or losses depends on whether the investee (1) is a PBE itself, (2) is a PBE because of its relationship with the PBE investor, or (3) is not a PBE.

If the investee is a PBE itself — If the investee is a PBE itself (i.e., it meets the definition of a PBE regardless of its relationship with the PBE investor), the investor’s equity method of accounting should be based on the financial statements that the investee prepared by applying the specific PBE transition dates and provisions, if any, of the new accounting standard being adopted. In addition, the investee’s financial statements or financial information filed or furnished by the PBE investor must reflect the investee’s adoption of the new accounting standard and its compliance with the specific PBE transition dates and provisions, if any.
If the investee is a PBE because of its relationship with the PBE investor — In some instances, an investee meets the definition of a PBE according to the ASC master glossary “solely because its financial statements or financial information is included in another entity’s filing with the SEC.” For example, an SEC filer may include financial statements or financial information of investees that otherwise would not meet the definition of a PBE (referred to herein as “specified PBEs”) in its own filings with the SEC under the following Regulation S-X rules:6
- Rule 3-05, “Financial Statements of Businesses Acquired or to Be Acquired.”
- Rule 3-09, “Separate Financial Statements of Subsidiaries Not Consolidated and 50 Percent or Less Owned Persons.”
- Rule 3-10(g), “Recently Acquired Subsidiary Issuers or Subsidiary Guarantors.”
- Rule 3-14, “Special Instructions for Real Estate Operations to Be Acquired.”
- Rule 4-08(g), “Summarized Financial Information of Subsidiaries Not Consolidated and 50 Percent or Less Owned Persons.”
- Rule 10-01(b)(1), “Interim Financial Statements.”
If the investee is not a PBE — Mr. Wiggins indicated that in the determination of the applicable effective dates of accounting standards, he believes that when an SEC registrant uses the equity method to account for its investment in an entity that is not a PBE, amounts recognized by the registrant would not be considered financial information included in a filing with the SEC under the FASB’s definition of a PBE. Thus, the non-PBE equity method investee would not be required to use PBE effective dates solely to determine the registrant’s application of the equity method of accounting.

See Section 6.4.2.1 for details regarding form and content considerations.

Note that if an investee early adopts a new accounting standard while the investor adopts that standard on the required adoption date, the investor is not required to eliminate the effects of the investee's early adoption in its financial statements since both the investor and investee have complied with the adoption dates for that standard. However, care must be taken in the elimination of intercompany transactions to avoid the recognition of profit or loss that results from the investee’s adoption of a new accounting standard before adoption by the investor.

5.1.3.4.1 Application of PBE Adoption Dates to Equity Method Investees With Different Fiscal Year-Ends

Determining the adoption date for a new accounting standard when a PBE investor and its equity method investee that meets the definition of a PBE have different fiscal year-end dates can be complex. Mr. Wiggins noted that when an equity method investee meets the definition of a PBE, the registrant’s equity method accounting would be expected “to be based on the [investee’s] financial statements prepared using the public business entity effective dates.” Therefore, we believe that when the investee has a different fiscal year-end than the investor, it would be appropriate for the investee to use the adoption date based on the investee’s fiscal year-end, which may be later than the investor’s adoption date.

Example 5-7

Investor K is a PBE that holds an equity method investment in Investee M. Although M is a private company, it meets the definition of a PBE because its financial statements are included in K’s SEC filing under Regulation S-X, Rule 3-09, given that M is significant to K. Investor K has a December 31 fiscal year-end, whereas M has a June 30 fiscal year-end.

Note that M is permitted to use the non-PBE effective dates in accordance with the relief provided by the SEC, as described in ASU 2020-02, which we understand has been extended to include deferral of the effective dates in ASU 2020-05. However, to illustrate the use of different fiscal year-ends and not the SEC relief, this example assumes that both K and M are applying the PBE effective dates.

In its filing of financial statements for the year ending December 31 with the SEC, K would include M’s financial statements for the year ending June 30. Because there is a greater-than-three-month lag between K’s and M’s fiscal year-end dates, the equity method earnings (losses) reported in K’s financial statements are adjusted in such a way that K is recording its equity method earnings (losses) in M for the 12 months ending December 31. See Section 5.1.4 for details related to accounting for an investor’s share of earnings on a time lag.

ASC 606 and ASC 842 are effective for PBEs for annual periods beginning after December 15, 2017, and December 15, 2018, respectively (i.e., calendar periods beginning on January 1, 2018, and January 1, 2019, respectively), and interim periods therein. Since M meets the definition of a specified PBE, it may choose to adopt these standards by using the PBE effective date.

Investee M would not be precluded from adopting ASC 606 and ASC 842 by using its own PBE effective date (i.e., July 1, 2018, and July 1, 2019, respectively). In the year of adoption, this would result in the reflection in K’s equity method earnings (losses) in M of six months of M’s accounting before the adoption of ASC 606 and ASC 842 and six months of M’s accounting after the adoption of ASC 606 and ASC 842. If M were required to use the PBE adoption date of K (i.e., January 1, 2019), this would effectively cause M to adopt ASC 606 and ASC 842 as of July 1, 2017, and July 1, 2018, respectively, which is, respectively, one year before its own PBE effective date and more than two years before the non-PBE effective date.

5.1.3.5 Investee Applies Specialized Industry Accounting

ASC 323-10

25-7 For the purposes of applying the equity method of accounting to an investee subject to guidance in an industry-specific Topic, an entity shall retain the industry-specific guidance applied by that investee.

ASC 810-10

25-15 For the purposes of consolidating a subsidiary subject to guidance in an industry-specific Topic, an entity shall retain the industry-specific guidance applied by that subsidiary.

Under ASC 323-10-25-7, if an equity method investee applies industry-specific guidance, the investor should retain the application of the industry-specific guidance when preparing its financial statements. For example, specialized industry accounting allows investment companies to carry their investments at fair value, with changes in the fair value of the investments recorded in the statement of operations. Since ASC 323-10 essentially requires a one-line consolidation, an investor that holds investments that qualify for specialized industry accounting for investment companies (in accordance with ASC 946) should follow that guidance regardless of whether the investment is accounted for under the equity method or is consolidated. Therefore, the investor should record in its statement of operations its share of the earnings or losses, realized and unrealized, as reported by its equity method investees that qualify for specialized industry accounting for investment companies.

5.1.4 Accounting for an Investor’s Share of Earnings on a Time Lag

ASC 323-10

35-6 If financial statements of an investee are not sufficiently timely for an investor to apply the equity method currently, the investor ordinarily shall record its share of the earnings or losses of an investee from the most recent available financial statements. A lag in reporting shall be consistent from period to period.

In some situations, an equity method investee’s fiscal-year-end date will not be the same as an investor’s. In addition, an equity method investee may have the same fiscal-year-end date as the investor, but the financial statements of the equity method investee may not be made available to the investor in a sufficiently timely manner. The investor should consider all facts and circumstances when assessing the appropriateness of reporting its share of the equity method investee’s financial results on a time lag. For instance, investors may receive periodic financial information from investees in the form of capital statements, performance reports, statements of net asset value, or statements of unit value. Such financial information is most likely derived from investee accounting records that are substantively the same as financial statements. Accordingly, investors should carefully evaluate their conclusions concerning what constitutes an investee’s “most recent available financial statements.”

It is generally acceptable for an investor to apply the equity method accounting by using an equity method investee’s financial statements with a different reporting date as long as the reporting dates of the investor and investee are no greater than three months apart. Since equity method accounting generally results in single-line consolidation, ASC 810-10-45-12 provides the following analogous guidance:

It ordinarily is feasible for the subsidiary to prepare, for consolidation purposes, financial statements for a period that corresponds with or closely approaches the fiscal period of the parent. However, if the difference is not more than about three months, it usually is acceptable to use, for consolidation purposes, the subsidiary’s financial statements for its fiscal period; if this is done, recognition should be given by disclosure or otherwise to the effect of intervening events that materially affect the financial position or results of operations.

When the investor reports its share of the results of its equity method investee on a time lag, the investee’s results should be for the same length of time as the investor’s results. For example, in the investor’s 12-month financial statements, the investee’s results also would be for the full 12 months, although the results will be for a different 12 months than the investor’s stand-alone results. It would not be appropriate to include the investee’s results for a period that is greater or less than 12 months. The investor’s evaluation of whether to report its share of the equity method investee’s financial results on a time lag should be performed for each investment separately. For instance, the investor may use a reporting time lag for certain equity method investees but not for others. The decision to use a reporting time lag for an equity method investee should be applied consistently for that investee in each reporting period.

The investor should evaluate material events occurring during the time lag (i.e., the period between the investee’s most recent available financial statements and the investor’s balance sheet date) to determine whether the effects of such events should be disclosed or recorded in the investor’s financial statements. By analogy to ASC 810-10-45-12, “recognition should be given by disclosure or otherwise to the effect of intervening events that materially affect the [investor’s] financial position or results of operations” (emphasis added).

An investor may elect a policy of either disclosing all material intervening events or both disclosing and recognizing them. Either policy is acceptable and should be consistently applied to all material intervening events that meet the recognition requirements of U.S. GAAP. When the investor chooses to recognize material intervening events, either in accordance with its elected policy or because the events are so significant that disclosure alone would not be sufficient, it should take care to reflect only the impact of such events. Further, the investor should track recognized material intervening events for the time lag to ensure that those events are not recognized again in subsequent periods. It would generally not be appropriate to present the investor’s share of more than 12 months of operations for the investee in the investor’s financial statements (in addition to the effects of the recognized event or another change in the investor’s accounting for the investee). See Section 11.1.3 of Deloitte’s Consolidation Roadmap for further discussion of when recognition or disclosure or both are appropriate for material intervening events. This guidance applies to material (or significant) intervening events that would affect the investee’s financial results rather than transactions or events of the investor. For instance, if the investor sold its interest in the investee during the reporting lag, the sale is a transaction of the investor. Therefore, in such circumstances, the disposal of the investee should be recognized in the period in which the disposition occurs, regardless of whether a reporting lag exists. It would be inappropriate to defer recognition of the transaction at the investor level because the transaction falls into a different interim or annual period for the investee. Further, if an investor disposes of its interest in an equity method investee that reports its financial results on a lag, the investor only recognizes its share of the investee’s profit (loss) for the period up to the most recently available financial statements of the investee. Any resulting gain or loss on the disposal of the investee should be recognized by the investor in the period in which the sale occurred (i.e., not on a lag).

Also, an investor’s other-than-temporary impairment (OTTI) testing of its equity method investments should be performed as of the investor’s balance sheet date, in accordance with ASC 323-10-35-32. The investor should evaluate all impairment indicators that occur during the time lag. See Section 5.5 for additional guidance on evaluating equity method investments for OTTIs, including examples of impairment indicators.

The example below illustrates the adoption of a new accounting standard when an investor records its share of earnings of its equity method investee on a time lag.

Example 5-8

Investor Q is a public company that has adopted ASC 606 as of January 1, 2018, by using the modified retrospective approach. Investor Q records its share of earnings of its equity method investee, G, on a one-quarter lag. Specifically, for the first quarter of 2018, Q will record its share of G’s earnings for the period from October 1, 2017, through December 31, 2017. Because of this time lag, the impact from G’s adoption of ASC 606 would not be included in Q’s results until April 1, 2018. In this situation, we believe that Q should report its share of the impact from G’s adoption of ASC 606 as an adjustment to equity on April 1, 2018. Although Q’s ASC 606 adoption date is January 1, 2018, Q records its share of G’s earnings on a one-quarter lag. Therefore, it is appropriate that Q’s share of G’s cumulative equity adjustment because of ASC 606 adoption should also be reported on a lag (on April 1, 2018). We believe that since Q recognizes its share of G’s first quarter earnings in the second quarter, Q should also recognize the cumulative equity adjustment resulting from G’s adoption of ASC 606 on the first day of the second quarter (April 1, 2018).

In addition, ASC 810-10-45-13 requires investors to record the elimination of a reporting time lag “as a change in accounting principle in accordance with the provisions of Topic 250.” ASC 250-10-45-2 indicates that an entity may change an accounting principle only if the change is considered preferable, stating, in part:

A reporting entity shall change an accounting principle only if either of the following apply:

The change is required by a newly issued Codification update.
The entity can justify the use of an allowable alternative accounting principle on the basis that it is preferable. [Emphasis added]

While the criterion in ASC 250-10-45-2(b) above refers to preferable methods of applying accounting principles in situations with multiple allowable alternatives, investors should view the application and discontinuance of the reporting time lag as a matter of acceptability rather than preference. That is, the method an investor uses to apply a reporting time lag and its discontinuance or modification of this method are matters of fact and necessity rather than elections among multiple acceptable alternatives. Generally, under ASC 250, voluntary changes in accounting principles must be presented retrospectively.

Even if an investor’s use of a reporting time lag for its equity method investee was appropriate in previous periods, the investor must discontinue the use of such time lag once the equity method investee can produce reliable and timely financial statements by using the same reporting date as the investor.

Note that if an investor that historically did not use a reporting time lag for its equity method investee subsequently determines that results should be reported on a time lag, that change would be considered a change in accounting policy subject to the requirements in ASC 250. In practice, it is often difficult to justify an investor’s use of a reporting time lag for its equity method investee when it has historically not used a time lag. Similarly, it is difficult to justify lengthening the period of a time lag, and such a change is expected to be rare. In the evaluation of a new or extended time lag period, the inability to obtain timely financial information from the equity method investee is generally not sufficient to justify the change. Further, such inability to obtain timely information may indicate that the investor lacks significant influence over the equity method investee.

5.1.5 Adjustments to Equity Method Earnings and Losses

As noted in ASC 323-10-35-5 (see Section 5.1), to determine its share of an investee’s earnings or losses in income, an investor should adjust its share of equity method earnings or losses (and make corresponding adjustments to the carrying value of the equity method investment) for the following:

Intra-entity profits and losses (see the next section).
Amortization or accretion of basis differences (see Section 5.1.5.2).
Investee capital transactions (see Section 5.1.5.3).
Other comprehensive income (OCI) (see Section 5.1.5.4).

5.1.5.1 Intra-Entity Profits and Losses

ASC 323-10

35-7 Intra-entity profits and losses shall be eliminated until realized by the investor or investee as if the investee were consolidated. Specifically, intra-entity profits or losses on assets still remaining with an investor or investee shall be eliminated, giving effect to any income taxes on the intra-entity transactions, except for any of the following:

A transaction with an investee (including a joint venture investee) that is accounted for as a deconsolidation of a subsidiary or a derecognition of a group of assets in accordance with paragraphs 810-10-40-3A through 40-5.
A transaction with an investee (including a joint venture investee) that is accounted for as a change in ownership transaction in accordance with paragraphs 810-10-45-21A through 45-24.
A transaction with an investee (including a joint venture investee) that is accounted for as the derecognition of an asset in accordance with Subtopic 610-20 on gains and losses from the derecognition of nonfinancial assets.

35-8 Because the equity method is a one-line consolidation, the details reported in the investor’s financial statements under the equity method will not be the same as would be reported in consolidated financial statements under Subtopic 810-10. All intra-entity transactions are eliminated in consolidation under that Subtopic, but under the equity method, intra-entity profits or losses are normally eliminated only on assets still remaining on the books of an investor or an investee.

35-9 Paragraph 810-10-45-18 provides for complete elimination of intra-entity income or losses in consolidation and states that the elimination of intra-entity income or loss may be allocated between the parent and the noncontrolling interests. Whether all or a proportionate part of the intra-entity income or loss shall be eliminated under the equity method depends largely on the relationship between the investor and investee.

35-10 If an investor controls an investee through majority voting interest and enters into a transaction with an investee that is not at arm’s length, none of the intra-entity profit or loss from the transaction shall be recognized in income by the investor until it has been realized through transactions with third parties. The same treatment applies also for an investee established with the cooperation of an investor (including an investee established for the financing and operation or leasing of property sold to the investee by the investor) if control is exercised through guarantees of indebtedness, extension of credit and other special arrangements by the investor for the benefit of the investee, or because of ownership by the investor of warrants, convertible securities, and so forth issued by the investee.

35-11 In other circumstances, it would be appropriate for the investor to eliminate intra-entity profit in relation to the investor’s common stock interest in the investee. In these circumstances, the percentage of intra-entity profit to be eliminated would be the same regardless of whether the transaction is downstream (that is, a sale by the investor to the investee) or upstream (that is, a sale by the investee to the investor).

35-12 Example 3 (see paragraph 323-10-55-27) illustrates the application of this guidance.

ASC 970-323

30-7 An investor shall not record as income its equity in the venture’s profit from a sale of real estate to that investor; the investor’s share of such profit shall be recorded as a reduction in the carrying amount of the purchased real estate and recognized as income on a pro rata basis as the real estate is depreciated or when it is sold to a third party. Similarly, if a venture performs services for an investor and the cost of those services is capitalized by the investor, the investor’s share of the venture’s profit in the transaction shall be recorded as a reduction in the carrying amount of the capitalized cost.

35-14 Intra-entity profit shall be eliminated by the investor in relation to the investor’s noncontrolling interest in the investee, unless one of the exceptions in paragraph 323-10-35-7 applies. An investor that controls the investee and enters into a transaction with the investee shall eliminate all of the interentity profit on assets remaining within the group. (See Subsection 323-30-35 for accounting guidance concerning partnership ownership interest.)

35-15 A sale of property in which the seller holds or acquires a noncontrolling interest in the buyer shall be evaluated in accordance with the guidance in paragraphs 360-10-40-3A through 40-3B. No profit shall be recognized if the seller controls the buyer.

As discussed in Section 10.2.1 of Deloitte’s Consolidation Roadmap, ASC 810-10-45-1 and ASC 810-10-45-18 require intercompany balances and transactions to be eliminated in their entirety. The amount of profit or loss eliminated would not be affected by the existence of a noncontrolling interest (e.g., intra-entity open accounts balances, security holdings, sales and purchases, interest, or dividends). Since consolidated financial statements are based on the assumption that they represent the financial position and operating results of a single economic entity, the consolidated statements would not include any gain or loss transactions between the entities in the consolidated group.

Although ASC 810 provides for complete elimination of intercompany profits or losses in consolidation, it also states that the elimination of intercompany profit or loss may be allocated proportionately between the parent and noncontrolling interests.

Because the equity method is a one-line consolidation, an investor should eliminate its intra-entity profits or losses resulting from transactions with equity method investees until the investor or the investee realizes the profits or losses through transactions with independent third parties.

When performing the analysis about whether an intra-entity sale should be recognized, an investor must determine whether there are any unstated rights or privileges present in the transaction and whether the transaction includes, in whole or in part, a capital contribution or distribution that should be accounted for separately. If recognition of the sale is deemed appropriate, the investor would recognize gross revenue, costs, and profits (or losses) on the transaction, all of which would flow through those respective financial statement line items, as well as its proportionate share of expense recorded by the investee through the application of equity method accounting, which would flow through the same financial statement line item as equity method earnings (losses).

In applying the equity method, the investor will first need to determine whether intra-entity assets remain on the books of either the investor or the investee (e.g., inventory). If assets do remain on the books of either the investor in an upstream transaction (i.e., a sale by the investee to the investor) or the investee in a downstream transaction (i.e., a sale by the investor to the investee), the determination of whether all or only the investor’s proportionate share of the intra-entity profit or loss is eliminated depends on (1) an evaluation of the nature of the relationship between the investor and the investee (i.e., generally, whether the investor controls the investee through a majority voting interest or other means as described in ASC 323-10-35-10) and (2) whether the intra-entity transaction is conducted at arm’s length in the normal course of business. If an investor controls the investee through a majority voting interest and the intra-entity transaction is not conducted at arm’s-length terms, all of the intra-entity profit or loss is required to be eliminated by the investor. However, situations in which an investor would have control over an investee through a majority voting interest would be rare because an investor with a controlling financial interest in a legal entity must consolidate the legal entity under ASC 810.

In ASU 2017-05, the FASB noted that it had ”placed more emphasis on eliminating differences between the derecognition of assets and the derecognition of businesses or nonprofit activities.” Therefore, it decided to amend ASC 323-10-35-7 “to require that no gain or loss should be eliminated when an entity transfers an asset subject to Subtopic 610-20.” The accounting for intra-entity transactions is summarized in the following table:

An investor is required to assess an Intra-entity transaction in which assets remain on the books to determine whether the transaction is at arm’s length. Factors to consider when assessing whether an intra-entity transaction is at arm’s length include, but are not limited to, the following:

Does the sales price approximate the fair value of the assets transferred, and will payment of the sales price be collected?
Does the transaction have economic substance?
Does the seller have an obligation to support the asset sold, even after the transaction is completed?

Intra-entity profit or loss elimination is required even if the elimination exceeds the carrying amount of the investor’s equity method investment and therefore results in a negative equity method investment balance. In such instances, it may be acceptable to credit the investor’s inventory or fixed asset balances as appropriate.

Note that an investor also recognizes the tax effects of the intra-entity transactions, including any deferred taxes, regardless of whether profit or loss is eliminated. (See Sections 4.5.2 and 12.3 of Deloitte’s Roadmap Income Taxes for additional guidance on the tax considerations for equity method investees.) The examples below illustrate the elimination of intra-entity profit or loss in both upstream and downstream transactions that are within the scope of both ASC 606 and ASC 610-20. To reflect the intra-entity profit eliminations, an investor should consider which presentation is most meaningful in the circumstances in accordance with ASC 323-10-55-28. We believe that there should be consistent application of an accounting policy for similar facts and circumstances (i.e., it would not be appropriate to apply different alternatives for the same or similar transactions or circumstances).

The investor should also disclose its accounting policy for the aforementioned eliminations.

In addition, investors and equity method investees that engage in downstream or upstream transactions should consider the related-party disclosure requirements as discussed in Section 6.3.2. Once the intra-entity profit or loss is realized by the investor or investee through transactions with independent third parties (and therefore no intra-entity asset remains), no elimination is required.

ASC 323-10

55-27 The following Cases illustrate how eliminations of intra-entity profits might be made in accordance with paragraph 323-10-35-7. Both Cases assume that an investor owns 30 percent of the common stock of an investee, the investment is accounted for under the equity method, the income tax rate to both the investor and the investee is 40 percent, the inventory is a good that is an output of the entity’s ordinary activities, and the contract is with a customer that is within the scope of Topic 606 on revenue from contracts with customers:

Investor sells inventory downstream to investee (Case A)
Investee sells inventory upstream to investor (Case B).

Case A: Investor Sells Inventory Downstream to Investee

55-28 Assume an investor sells inventory items to the investee (downstream). At the investee’s balance sheet date, the investee holds inventory for which the investor has recorded a gross profit of $100,000. The investor’s net income would be reduced $18,000 to reflect a $30,000 reduction in gross profit and a $12,000 reduction in income tax expense. The elimination of intra-entity profit might be reflected in the investor’s balance sheet in various ways. The income statement and balance sheet presentations will depend on what is the most meaningful in the circumstances.

Case B: Investee Sells Inventory Upstream to Investor

55-29 Assume an investee sells inventory items to the investor (upstream). At the investor’s balance sheet date, the investor holds inventory for which the investee has recorded a gross profit of $100,000. In computing the investor’s equity pickup, $60,000 ($100,000 less 40 percent of income tax) would be deducted from the investee’s net income and $18,000 (the investor’s share of the intra-entity gross profit after income tax) would thereby be eliminated from the investor’s equity income. Usually, the investor’s investment account would also reflect the $18,000 intra-entity profit elimination, but the elimination might also be reflected in various other ways; for example, the investor’s inventory might be reduced $18,000.

Example 5-9

Assets Remain on the Books but Will Be Sold Through to a Third Party

Downstream Transaction

Investor A holds a 40 percent ownership interest in Investee C and accounts for its investment in C under the equity method. Earnings in C are allocated pro rata on the basis of the ownership interests in C. Investee C purchases 10 units of inventory from A in an arm’s-length transaction for $1,000 per unit, which is accounted for in accordance with ASC 606. Investor A’s cost associated with each unit of inventory is $600, thus generating an intra-entity profit of $400 for each unit of inventory sold. As of C’s balance sheet date, 5 units of inventory were sold to independent third parties and 5 units remain in C’s ending inventory. Investor A should eliminate $800 of intra-entity profit: (5 units remaining in C’s inventory × $400 profit for each unit of inventory) × A’s 40% ownership interest in C.

To reflect this intra-entity profit elimination, A should consider which presentation is most meaningful in the circumstances in accordance with ASC 323-10-55-28. Potential acceptable alternatives for recording the intra-entity profit elimination for this downstream transaction include the following; however, there could be additional alternatives (such alternatives ignore the effect of income taxes):

If the transaction between A and C was not considered to be at arm’s length, 100 percent of A’s $2,000 profit on the 5 units remaining in C’s ending inventory (5 units remaining in ending inventory × $400 profit on each unit) would be eliminated.

Upstream Transaction

The above example represents a downstream transaction; however, if this were an upstream transaction in which C was selling the units of inventory to A, the intra-entity elimination by A could be reflected differently than what is shown depending on the alternative selected by A. Potential acceptable alternatives for recording the intra-entity profit elimination if this were an upstream transaction include the following; however, there could be additional alternatives (such alternatives ignore the effect of income taxes):

Example 5-10

Assets Remain on the Books That Will Not Be Sold to a Third Party

Assume the same facts as in the example above, except the investee does not intend to sell the inventory, which has a useful life of five years.

Downstream Transaction

See the example above for initial intra-entity profit elimination alternatives.

Subsequently, the investor would recognize the deferred intra-entity profit of $800 over the five-year useful life of the asset, which effectively adjusts the investor’s share of the depreciation expense recorded by the investee.

Upstream Transaction

See the example above for initial intra-entity profit elimination alternatives.

Subsequently, the investor recognizes the deferred intra-entity profit of $800 over the five-year useful life of the asset.

Example 5-11

Sale of an Asset Within the Scope of ASC 610-20

Downstream Transaction

Investor B holds a 35 percent ownership interest in Investee W and accounts for its investment under the equity method. Investor B sells equipment (that is not an output of its ordinary activities) to W in an arm’s-length transaction for $10,000. Investor B’s cost associated with the equipment is $9,000, resulting in an intra-entity profit of $1,000. Investee W does not intend to sell the equipment, which has a useful life of five years.

On the transaction’s closing date, B concludes that the transaction is the sale of a nonfinancial asset within the scope of ASC 610-20 and determines that W has control of the nonfinancial asset under ASC 606. Therefore, B determines that it should derecognize the equipment under ASC 610-20 and recognize a gain of $1,000 ($10,000 − $9,000) (i.e., no portion of the profit or loss should be eliminated).

Upstream Transaction

Assume the same facts as above, except that the transaction is upstream, wherein W sells the equipment to B (B is not a customer as defined in ASC 606). Intra-entity profit elimination should be recorded in a manner consistent with an upstream sale of assets that (1) are within the scope of ASC 606 and (2) will not be sold to a third party. Thus, B should consider which presentation is most meaningful in the circumstances in accordance with ASC 323-10-55-28. Investor B should disclose its accounting policy for such eliminations.

5.1.5.2 Amortization or Accretion of 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. Paragraph 350-20-35-58 requires that the portion of that difference that is recognized as goodwill not be amortized. However, if an entity within the scope of paragraph 350-20-15-4 elects the accounting alternative for amortizing goodwill in Subtopic 350-20, the portion of that difference that is recognized as goodwill shall be amortized on a straight-line basis over 10 years, or less than 10 years if the entity demonstrates that another useful life is more appropriate. Paragraph 350-20-35-59 explains that equity method goodwill shall not be reviewed for impairment in accordance with paragraph 350-20-35-58. However, equity method investments shall continue to be reviewed for impairment in accordance with paragraph 323-10-35-32.

35-14 See paragraph 323-10-35-34 for related guidance when an investment becomes subject to the equity method.

ASC 323-10-35-13 requires an 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.” The investor therefore determines any differences between the cost of an equity method investment and its share of the fair values of the investee’s individual assets and liabilities by using the acquisition method of accounting in accordance with ASC 805. Such differences are commonly known as “basis differences” and result from the investor’s requirement to allocate the cost of the equity method investment to the investee’s individual assets and liabilities. Any excess of the cost of an equity method investment over the proportional fair value of the investee’s assets and liabilities (commonly referred to as “equity method goodwill”) is recognized in the equity investment balance. See Section 4.5 for details regarding the initial measurement of basis differences.

ASC 323-10-35-5 specifies that after initial measurement, adjustments to the investor’s share of investee earnings or losses (and corresponding adjustments to the carrying value of the equity method investment) are made for amortization or accretion of basis differences (aside from equity method goodwill, which is not amortized unless the PCC alternative is elected — see ASC 323-10-35-13 and Section 5.1.3.2). Note that an investor should make these adjustments to its share of the investee’s earnings or losses regardless of the allocation method the investor used to determine its share of investee’s earnings or losses.

If an investee subsequently disposes of an asset that initially gave rise to an equity method basis difference recognized by the investor, that basis difference should be written off at the time of sale and the investor should adjust the equity in earnings to correctly reflect the investor’s proportionate share of the investee’s reported gain or loss. Note that the guidance in ASC 323-10-35-13 does not provide specific insights into the determination of the period over which basis differences should be amortized or accreted. Generally, basis differences are amortized or accreted over the life of the underlying assets and liabilities to which the basis differences are attributable. For instance, if a positive basis difference exists because the investor’s proportionate share of the fair value of the investee’s net assets exceeds its book value and the positive basis difference is solely attributable to fixed assets of the equity method investee with an estimated remaining useful life of 25 years, the positive basis difference would be amortized over the 25-year life of those specific fixed assets. The amortization of the positive basis difference would result in increased depreciation expense recognized by the investor related to the fixed assets of the investee to reflect the investor’s basis in the investee, thus reducing the investor’s equity method earnings in each period. Similarly, if a negative basis difference exists because the investor’s proportionate share of the fair value of the investee’s net assets is less than its book value and the negative basis difference is solely attributable to fixed assets of the equity method investee with an estimated remaining useful life of 25 years, the negative basis difference would be accreted over the 25-year life of those specific fixed assets. The accretion of the negative basis difference would result in decreased depreciation expense recognized by the investor related to the fixed assets of the investee to reflect the investor’s basis in the investee, thus increasing the investor’s equity method earnings in each period. See Section 4.5.1 for further discussion of the limited circumstances in which initial negative basis differences are recorded as bargain purchase gains upon initial measurement of an equity method investment.

Example 5-12

Investor X purchases a 40 percent interest in Investee Z for $2 million, applies the equity method of accounting, and will recognize earnings in Z pro rata on the basis of its ownership interest. 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 value of Z’s current assets and current liabilities approximate their fair value.
Investor X determined that Z has patented technology that was internally developed; therefore, costs associated with developing this technology were expensed as incurred rather than recorded as an intangible asset on Z’s books. The patented technology has a fair value of $300,000 and a remaining useful life of 30 years as of the investment acquisition date.
Investor X determined that the fair value of Z’s fixed assets is $4 million with a remaining useful life of 20 years as of the investment acquisition date.

Assume that for the year after the investment acquisition date, Z’s net income is $1 million. Below is a calculation of X’s equity method earnings for the period. Assume that allocations of profit and loss as well as distributions are made in accordance with investor ownership percentages. Further, taxes and intra-entity profit eliminations are ignored for simplicity.

As shown above, the basis differences attributable to Z’s fixed assets and intangible assets are amortized over their estimated remaining useful lives, creating adjustments to X’s proportionate share of Z’s earnings for the period. As discussed, the $80,000 related to equity method goodwill is not amortized; however, it should be assessed along with the entire equity method investment for impairment in accordance with ASC 323-10-35-32 and 35-32A. See Section 5.5 for further guidance on impairment testing.

5.1.5.3 Investee Capital Transactions

ASC 323-10

35-15 A transaction of an investee of a capital nature that affects the investor’s share of stockholders’ equity of the investee shall be accounted for on a step-by-step basis.

35-15A For guidance on a share issuance by an investee, see paragraph 323-10-40-1.

Adjustments to an investor’s share of equity method earnings or losses (and corresponding adjustments to the carrying value of the equity method investment) may be necessary for certain investee capital transactions, including share issuances, share repurchases, and transactions with noncontrolling interest holders, since all of these transactions may affect the investor’s share of the equity method investee’s net assets.

5.1.5.3.1 Treasury Share Repurchases

An investee may repurchase its own shares in a treasury stock transaction. This transaction may affect an investor’s claim to the investee’s net assets.

If the investor participates in the treasury stock transaction (i.e., shares are repurchased from the investor) and it causes a decrease in the investor’s claim to the investee’s net assets, the investor would need to assess whether the decrease results in a loss of significant influence and account for the decrease accordingly (see Sections 5.6.4 and 5.6.5). If the investor does not participate in the treasury stock transaction (i.e., shares are repurchased from other investors only), there will be an increase in the investor’s claim to the investee’s net assets; however, there will also be a decrease to the investee’s net assets in the amount of consideration paid to repurchase the shares. If there is an increase to the investor’s ownership interest with significant influence retained (that is, the investor continues to account for its investment under the equity method), the investor would account for the increase in its claim to the investee’s net assets on a step-by-step basis in a manner similar to that in the accounting described in Section 5.6.3. Although the investor has not directly paid consideration for its increase in ownership interest, it has indirectly acquired an additional ownership interest for consideration equal to the investor’s proportionate share of the consideration paid by the investee for the repurchase. This transaction would not result in a change to the investor’s equity method investment balance, but it would result in a change to the investor’s basis differences that are tracked in memo accounts, as illustrated in the example below.

If a treasury stock transaction results in a change to an investor’s ownership interest with significant influence retained, the investor should adjust its share of equity method investee earnings and losses as of the date of the treasury stock transaction to reflect (1) the change in ownership and (2) the impact of any additional basis differences.

Example 5-13

Investor X holds a 40 percent interest in Investee Z, applies the equity method of accounting, and will recognize earnings in Z pro rata on the basis of its ownership interest. Investee Z repurchases 10 percent of its outstanding voting common shares from third parties for $500,000, which increases X’s ownership interest in Z to 44 percent. Assume that X does not obtain a controlling financial interest in Z. The book value of Z’s net assets at the time of the repurchase is $4.5 million. Although X has not directly paid consideration for its 4 percent increase in ownership interest, it has indirectly acquired an additional ownership interest for consideration of $200,000, which is equal to its 40 percent proportionate share of the $500,000 of consideration paid by Z for the repurchase. The table below shows the book values and fair values of Z’s net assets at the time of the repurchase (along with a calculation of X’s incremental 4 percent share) as of the share repurchase date. Taxes and intra-entity profit eliminations are ignored for simplicity.

As shown in the table above:

The book values of Z’s current assets and current liabilities approximate their fair values at the time of repurchase.
Investor X determined that Z has patented technology that was internally developed; therefore, costs associated with developing this technology were expensed as incurred rather than recorded as an intangible asset on Z’s books. The patented technology has a fair value of $100,000 at the time of repurchase.

On the basis of the calculations in the above table, the $20,000 difference between the cost of X’s investment ($200,000) and its proportionate share of the book value of Z’s net assets ($180,000) is attributable to Z’s fixed assets ($16,000) and Z’s patented technology ($4,000). The basis differences are presented as part of X’s overall investment in Z and subsequently tracked in memo accounts. That is, X would not present the $4,000 separately as an “intangible asset” on its balance sheet.

This transaction would not result in a change to X’s equity method investment balance, but it would result in a change to X’s basis differences that are tracked in memo accounts, as illustrated in the table above. On a prospective basis, X would adjust its share of equity method investee earnings and losses to reflect (1) the 4 percent increase in ownership and (2) the impact of the additional basis differences.

5.1.5.3.2 Shares Issued to Employees of an Investee

If an investee issues additional shares as a result of employees’ exercise of options, an investor should determine the corresponding impact on its ownership interest in the investee. When the investee issues stock compensation awards to its employees, it recognizes stock compensation expense as the awards vest in accordance with ASC 718 with a corresponding increase to additional paid-in capital (APIC) (as long as the awards are classified as equity). During the vesting period, the investor would recognize its share of the stock compensation expense through its equity method pickup; however, there is no guidance regarding the investor’s accounting for the investee’s increase in APIC. Two acceptable methods that are applied in practice are as follows:

During the vesting period, the investor reflects the change in its share of the investee’s equity as an adjustment to the investor’s equity method investment with a corresponding adjustment to the investor’s own equity. When these adjustments are coupled with the investor’s recognition of its share of the investee’s stock compensation expense through equity earnings (losses), there is ultimately no net impact on the equity method investment account balance. Instead, the resulting net impact is to equity method earnings (losses) and the investor’s own equity.
During the vesting period, the investor does not make any adjustments to its equity method investment balance but instead tracks its share of the increase in the investee’s APIC as a reconciling item in memo accounts.

We do not believe that the investor should record its share of the investee’s increase in APIC in equity earnings (losses) given that this would essentially negate the impact of recording the investor’s share of the investee’s stock compensation during the vesting period.

Regardless of the method applied during the vesting period, the investor is required to adjust for the change in its share of the investee’s net assets once the options are exercised (shares are issued to the employees in exchange for consideration equal to the exercise price of the options). See Sections 5.6.4 and 5.6.5 for details on accounting for decreases in an investor’s level of ownership or degree of influence.

5.1.5.3.3 Investee Acquisitions and Dispositions of Noncontrolling Interests

An equity method investee may consolidate certain less than wholly owned subsidiaries and present noncontrolling interests in its financial statements. The investee may transact with noncontrolling interest holders, either acquiring or disposing of noncontrolling interests while retaining a controlling financial interest in the subsidiary. As noted in ASC 810-10-45-23, a parent’s acquisition or disposition of any noncontrolling interest should be accounted for as an equity transaction, with any difference between price paid and the carrying amount of the noncontrolling interest reflected directly in equity and not in net income as a gain or loss. Investee-level transactions with noncontrolling interest holders do not directly involve the investor; however, these transactions would affect the investor’s claim to the investee’s net assets because of the change in the investee’s equity.

If the equity method investee acquires a noncontrolling interest while retaining a controlling financial interest in the subsidiary and thereby causes an increase in the equity method investor’s claim to the investee’s net assets, we believe that the investor should account for the increase on a step-by-step basis, as illustrated in Section 5.1.5.3.1.

If the equity method investee’s subsidiary sells existing shares or issues additional shares to another party while retaining a controlling financial interest in the subsidiary (i.e., creates or increases outstanding noncontrolling interests), the equity method investor should consider the substance of the transaction. We believe that in these circumstances, there are potentially two accounting outcomes:

If, in substance, the transaction is structured so that the investor essentially sold a portion of its interest in the equity method investee, we believe that it is appropriate to apply ASC 323-10-35-35 and ASC 323-10-40-1, whereby the investor records a gain or loss in equity method earnings (losses). See Section 5.6.4 for details on accounting for decreases in an investor’s level of ownership when significant influence is retained.
We also understand that others believe that the issuance of noncontrolling interests at the investee level while the investee retains a controlling financial interest in the subsidiary generally represents an equity transaction not only for the investee but also for the investor in accordance with ASC 810-10-45-23. Under this accounting outcome, the transaction would be accounted for as a change in the investor’s share of the investee’s equity as an adjustment to the investor’s equity method investment with a corresponding adjustment to the investor’s own equity.

We believe that either accounting outcome could potentially be acceptable; however, the investor should carefully analyze the transaction and apply the view that best aligns with the substance of the disposal transaction.

For details related to accounting for equity issuances by an investee, see Section 5.6.

5.1.5.4 Other Comprehensive Income

ASC 323-10

35-18 An investor shall record its proportionate share of the investee’s equity adjustments for other comprehensive income (unrealized gains and losses on available-for-sale securities; foreign currency items; and gains and losses, prior service costs or credits, and transition assets or obligations associated with pension and other postretirement benefits to the extent not yet recognized as components of net periodic benefit cost) as increases or decreases to the investment account with corresponding adjustments in equity. See paragraph 323-10-35-37 for related guidance to be applied upon discontinuation of the equity method.

An investor should record its proportionate share of an equity method investee’s OCI (which may include foreign currency translation adjustments, actuarial gains or losses, and gains and losses on AFS debt securities, among other items) as an increase or decrease to its equity method investment account for the investee, with a corresponding debit or credit to OCI, which will ultimately be reflected within AOCI in the equity section of the financial statements. See Section 6.2.3 for further discussion of acceptable presentation alternatives related to an investor’s share of an equity method investee’s OCI. See Section 5.6.5.1 for further discussion of the impact to OCI when there is a decrease in the level of ownership or degree of influence of an equity method investment. Also, see Section 4.5.3 for further discussion of basis differences related to assets and liabilities measured at fair value and recorded in the investee’s AOCI.

Example 5-14

On December 31, 20X5, Investor G acquires a 25 percent interest in Investee T for $500. Investor G accounts for its investment in T under the equity method and will recognize earnings in T pro rata on the basis of its ownership interest. For the year ended December 31, 20X6, T has net income of $1,000 and records a $100 gain in OCI related to foreign currency translation adjustments. Assuming no basis differences or intra-entity profit or loss eliminations, G should record the following entries for the year ended December 31, 20X6:

5.1.6 Dividends Received From an Investee

ASC 323-10

35-17 Dividends received from an investee shall reduce the carrying amount of the investment.

As discussed in Section 5.1, an investor’s equity method investment balance is increased by its share of an investee’s income and decreased by its share of the investee’s losses in the periods in which the investee reports the income and losses rather than in the periods in which the investee declares dividends. Therefore, when dividends or distributions are received from the equity method investee, the investor should record a reduction to its equity method investment balance rather than recording income. See Section 6.2.4 for details related to cash flow classification of dividends and distributions from equity method investees.

To determine whether cash distributions by an equity method investee that exceed an investor’s carrying amount should be recorded as income or as a liability, the investor should evaluate whether the following two criteria are met: (1) the distributions are not refundable by agreement, law, or convention7 and (2) the investor is not liable (and may not become liable) for the obligations of the investee or otherwise committed or expected to provide financial support to the investee. If these two criteria are met, the investor should record the excess cash distributions as income. Otherwise, the investor should record the excess cash distributions as a liability. If the investor suspends equity method loss recognition8 and has recorded the cash distributions as income or a liability, the investor should record future equity method earnings reported by the investee only after its share of the investee’s cumulative earnings during the suspended period exceeds the investor’s income or liability recognized for the excess cash distributions.

The guidance above is supported by the AICPA Issues Paper “Accounting by Investors for Distributions Received in Excess of Their Investment in a Joint Venture” (an addendum to the AICPA Issues Paper “Joint Venture Accounting”), issued on October 8, 1979, which states the following in its advisory conclusion:

A noncontrolling investor in a real estate venture should account for cash distributions received in excess of its investment in a venture as income when (a) the distributions are not refundable by agreement or by law and (b) the investor is not liable for the obligations of the venture and is not otherwise committed to provide financial support to the venture.

ASC 970-323-35-3 through 35-10 provide further details about an investor’s accounting for its share of losses that are greater than its investment (see Section 5.2). This literature also defines general partnership interests as having unlimited liability; therefore, these interests would meet criterion (2) as described above.

Example 5-15

Investor A and Investor B form Investee C by investing $1 million each in exchange for a 50 percent ownership interest. Investors A and B both use the equity method to account for their investment in C and will recognize earnings in C pro rata on the basis of their ownership interests. Investee C subsequently incurs a U.S. GAAP loss of $2.4 million. As a result, A’s and B’s investment balances are exceeded by $200,000 each, but because the losses are owing to noncash depreciation expense, C has available cash and distributes $100,000 to both A and B.

The $100,000 distribution made to A is not refundable by agreement, law, or convention, and A is not liable (and may not become liable) for the obligations of C or otherwise committed or expected to provide financial support to C. Therefore, A should reduce its investment in C to zero and record the $100,000 received as income. Investor A would initially record the following journal entry:

If C subsequently becomes profitable, A cannot increase its basis in its investment in C until C’s cumulative earnings during the suspended period exceed the $100,000 excess distribution. For example, if C subsequently reported earnings of $1.5 million, A would record $450,000 of equity method earnings, which represents A’s portion of C’s subsequent earnings (50% × $1.5 million = $750,000), net of A’s previously unrecognized losses ($200,000), less income previously recognized by A for the cash distribution ($100,000). The following journal entry would be recorded:

Example 5-16

Investor A and Investor B form Investee C by investing $1 million each for a 50 percent ownership interest. Investee C is not a VIE under ASC 810-10. Investors A and B both use the equity method to account for their investment in C and will recognize earnings in C pro rata on the basis of their ownership interests. Investee C subsequently incurs a U.S. GAAP loss of $2.4 million. As a result, A’s and B’s investment balances are exceeded by $200,000 each, but because the losses are owing to noncash depreciation expense, C has available cash and distributes $100,000 to both A and B.

The $100,000 distribution made to B is not refundable by agreement, law, or convention, and B is not liable (and may not become liable) for C’s obligations. However, B has a history of providing financial support to C. Therefore, B should reduce its investment in C to zero and should record a liability (negative investment balance) of $300,000, representing its initial investment of $1 million less (1) its share of equity in losses of $1.2 million and (2) the cash distributions it received of $100,000. Investor B would initially record the following journal entry:

Investor B would continue to recognize earnings or losses of C under the equity method. However, B would reduce the liability (e.g., negative investment balance) to zero before recording an asset for its share of earnings in C. For example, if C subsequently reported earnings of $1.5 million, B would record $750,000 of equity method earnings, which represents B’s portion of C’s subsequent earnings (50% × $1.5 million). Investor B would record the following journal entry:

Example 5-17

Four investors form Partnership Z, a limited partnership. The table below summarizes the amounts contributed by, and ownership interests of, each investor.

Partnership Z is not a VIE under ASC 810-10. Partnership Z acquires an operating real estate project for $180 million, using a nonrecourse mortgage loan to finance the additional $80 million purchase price. Partnership Z subsequently incurs U.S. GAAP losses of $100 million. Therefore, each investor’s investment balance is reduced to zero, but because the losses are owing to noncash depreciation expense, Z has available cash and distributes it to the investors.

As the GP, A is not required to consolidate Z since Z is not a VIE (see Deloitte’s Consolidation Roadmap). Accordingly, A uses the equity method to account for its investment in Z. In these circumstances, A should continue to recognize any future losses of Z and its receipt of the cash distribution by recording a liability (e.g., negative investment balance). For a GP, the existence of nonrecourse debt is not justification for discontinuing the recording of losses or for recognizing a gain for the cash distribution. Because of its general partnership interest, A is legally obligated to provide additional financial support to Z. If A recognizes losses only to the extent of its investment in Z, it would effectively be recognizing a gain on a debt extinguishment that has not occurred, which is prohibited in accordance with ASC 405-20-40-1. Company A would subsequently reduce any liability (negative investment balance) to zero before recording an asset for its share of earnings in Z.

Note that A’s journal entries would be similar to those in the previous example.

Company A should also determine whether it is required to absorb any future losses by Z that are otherwise allocable to the other partners. This decision would depend on whether any other partners, by agreement, convention, or otherwise, are required to provide additional support to Z and, if so, whether they have the financial wherewithal to do so.

In accordance with ASC 323-30-S99-1 and ASC 323-30-35-3, B, C, and D also use the equity method to account for their investments in Z. Generally, B, C, and D, as limited partners, would not have unlimited liability or a legal or other commitment to further support the partnership. Therefore, B, C, and D should reduce their respective investments to zero and record distributions that exceed their investments as income. If Z subsequently becomes profitable, B, C, and D cannot increase their basis in their investment in Z until Z’s cumulative earnings during the suspended period exceed the excess distribution amount. However, B, C, and D should carefully review contractual arrangements, review past funding practices, and consider other relevant facts and circumstances before reaching this conclusion.

Note that B, C, and D would record journal entries similar to those in Example 5-15.

5.1.7 Interests Held by an Investee

5.1.7.1 Reciprocal Interests

When an investor holds an equity method investment in an investee and the investee concurrently holds an equity method investment in the investor, such investments are known as reciprocal interests. The investor should present reciprocal interests as a reduction of both its investment in the equity method investee and its equity in the investee’s earnings. In practice, there are two methods of calculating the investee’s earnings: the treasury stock method and the simultaneous equations method. Application of the treasury stock method tends to be more common since, as illustrated in Section 6.6 of Deloitte’s Roadmap Noncontrolling Interests, the simultaneous equations method can be very complex. However, we believe that either method is acceptable as long as an investor applies its selected method consistently to all reciprocal interests. Under the treasury stock method, the equity method investor considers its shares held by the equity method investee to be treasury stock. Therefore, the investor records its share of the investee’s net income exclusive of the equity method earnings from the investee’s equity method investment in the investor. Below is an example illustrating the treasury stock method.

Example 5-18

Entity A owns a 30 percent interest in Entity B, and B owns a 20 percent interest in A. Entities A and B have 10,000 shares and 5,000 shares, respectively, of common stock issued and outstanding, and each entity paid $100 per share for its ownership interests. Entities A and B both use the equity method to account for their investment in the other party and will recognize earnings in each other pro rata on the basis of their respective ownership interests.

Entity A’s basis in its investment in B, B’s basis in A, and A’s corresponding reciprocal interest in A are calculated as follows:

Entity A’s basis in B = $100/share × (30% × 5,000 shares) = $150,000.
Entity B’s basis in A = $100/share × (20% × 10,000 shares) = $200,000.
Entity A’s reciprocal interest in A = 30% × $200,000 = $60,000.

The reduction in A’s investment should be offset by a decrease in retained earnings, and as with treasury stock, the offset to the reduction may be presented as a separate line item in A’s equity section.

Entity A’s Journal Entries

Initial investment in B:

Entity B’s investment in A and B’s reciprocal interest in B would be calculated and accounted for similarly:

B’s basis in A = $100/share × (20% × 10,000 shares) = $200,000.
A’s basis in B = $100/share × (30% × 5,000 shares) = $150,000.
B’s reciprocal interest in B = 20% × $150,000 = $30,000.

Entity B’s Journal Entries

Initial investment in A:

If earnings of A, exclusive of any equity in B, total $100,000 (“direct earnings of A”) and earnings of B, exclusive of any equity in A, total $50,000 (“direct earnings of B”), net income and earnings per share (EPS) for A and B, respectively, are calculated as follows:

Net income and EPS of A:

Although A owns 30 percent of B, A’s investment in B is reduced for its ownership interest in itself through B’s reciprocal 20 percent ownership interest in A’s stock.

Net income and EPS of B:

Although B owns 20 percent of A, B’s investment in A is reduced for its ownership interest in itself through A’s reciprocal 30 percent ownership interest in B’s stock.

5.1.7.2 Earnings or Losses of an Investee’s Subsidiary

As described in Section 3.2.7.1, when an investor accounts for direct interests in both an investee and an investee’s subsidiary under the equity method of accounting, the investor should adjust the investee’s financial information to exclude the earnings or losses of the investee’s subsidiary in which the investor has a direct interest to determine its proportionate share of the investee’s earnings or losses.

Example 5-19

Direct Investment in an Investee’s Consolidated Subsidiary

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

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

Entity B’s consolidated financial statements for the year ended 20X6 and A’s proportionate share of earnings (both the correct and incorrect application) are as follows (for simplicity, taxes, intra-entity transactions, and basis differences are ignored):

The incorrect computation double counts A’s proportionate share of the earnings in C since 100 percent of C’s earnings are included in net income (i.e., net income has not been adjusted to exclude the net income attributable to the noncontrolling interest, 15 percent of which is attributable to A).

5.1.7.3 Earnings or Losses of a Consolidated Subsidiary’s Investee

As described in Section 3.2.7, an investor that does not have the ability to exercise significant influence through its direct interests in an investee may have such ability through a combination of direct and indirect interests. When an investor accounts for indirect interests in an investee under the equity method of accounting, the investor should calculate its proportionate share of the equity method investee’s earnings or losses on the basis of (1) the investor’s ownership interest in the intermediary and (2) the intermediary’s ownership in the equity method investee.

Example 5-20

Entity A is a calendar-year-end entity that has a controlling financial interest in Entities B, C, and D. Therefore, under ASC 810-10, A consolidates B, C, and D, which each own a 10 percent voting interest in Entity E.

Entity A indirectly owns less than a 20 percent voting interest in E (i.e., 6 percent through B, 7 percent through C, and 6 percent through D). However, because A consolidates B, C, and D, A effectively controls 30 percent of the voting interests in E. Hence, A has the ability to exercise significant influence over E.

Assume that A, B, and C do not individually have the ability to exercise significant influence over E.

For the year ended December 31, 20X3, E has net income of $1 million. Entity A records the following journal entry to record its share of E’s earnings:

5.1.8 Contingent Consideration

ASC 323-10

35-14A If a contingency is resolved relating to a liability recognized in accordance with the guidance in paragraph 323-10-25-2A and the consideration is issued or becomes issuable, any excess of the fair value of the contingent consideration issued or issuable over the amount that was recognized as a liability shall be recognized as an additional cost of the investment. If the amount initially recognized as a liability exceeds the fair value of the consideration issued or issuable, that excess shall reduce the cost of the investment.

As discussed in Section 4.4, if the acquisition of an equity method investment involves contingent consideration, the contingent consideration is included as part of the initial cost of the equity method investment only if it meets the definition of a derivative instrument under ASC 815 or is required to be recognized by other U.S. GAAP aside from ASC 805. If the contingent consideration arrangement meets the definition of a derivative instrument, the fair value of the derivative is included in the initial cost of the equity method investment. Subsequently, changes to the fair value of the derivative are recorded in the income statement separate from the accounting for the equity method investment. Further, payments under the contingent consideration arrangement represent the settlement of the derivative instrument and therefore should not increase the cost of the equity method investment.

If the contingent consideration arrangement does not meet the definition of a derivative under ASC 815 and is not otherwise required to be recognized by other U.S. GAAP aside from ASC 805, no amounts related to the contingent consideration arrangement should be included as part of the cost of the equity method investment until the contingent consideration payments are made.

If a liability is initially recognized for a contingent consideration arrangement because an investor’s proportionate share of an investee’s net assets is greater than the investor’s initial cost in accordance with ASC 323-10-25-2A, any difference between the ultimate settlement of the contingent consideration and the initial liability recorded should be recognized as an increase or decrease to the cost of the equity method investment.

Example 5-21

Investor Q acquires an equity method investment for $1,250. Investor Q is obligated to pay an additional $100 if certain earnings targets of the investee are reached. Investor Q’s proportionate share of the investee’s net assets is $1,300, which exceeds Q’s initial cost of $1,250. In accordance with ASC 323-10-30-2B, on the date of acquisition, a liability of $50 is recorded (with a corresponding increase to the initial cost of the equity method investment) since this amount is less than the $100 maximum amount of contingent consideration not recognized. If the contingency is resolved after the initial measurement of the equity method investment and a $75 payment related to the contingent consideration arrangement is required, Q would record an increase to its equity method investment of $25. Alternatively, if the contingency is subsequently resolved and only a $20 payment related to the contingent consideration arrangement is required, Q would record a decrease to its equity method investment of $30. The impact to basis differences, if any, should be considered.

Footnotes

Note, however, that the sponsor will frequently consolidate the partnership and account for the tax equity investor’s interest as a noncontrolling interest in its consolidated financial statements. Nonetheless, the sponsor may attribute income and loss to itself and the noncontrolling interest in a manner consistent with the HLBV method by using the mechanics described herein. See Example 6-1 in Section 6.2.1 in Deloitte’s Roadmap Noncontrolling Interests.

The partnership operating agreement may call for certain allocations, such as 99:1, in the pre-flip period. However, the tax equity investor and the sponsor must still perform a detailed analysis of the partners’ 704(b) capital accounts and tax basis since the operation of the partnership tax rules/limitations can often result in allocations that do not necessarily match the stated allocation percentages in the operating agreement.

IRC Section 704(b) discusses special allocations of partnership items.

This example represents a simple HLBV waterfall calculation. Depending on the complexity of the liquidation waterfall in the operating agreement, as well as the discrete items in the entity’s financial statements, additional steps may be necessary.

See Section 6.4 for details.

This list of Regulation S-X rules is not exclusive, and any rule that requires an investee’s financial statements or financial information to be included in another entity’s filing with the SEC would cause the investee to be a “specified PBE.”

When the investor is not under a legal obligation to refund its distributions or provide financial support to the investee, it must consider specific facts and circumstances, including the relationship among the investors. For instance, if the investor has a history of refunding distributions provided by the investee or otherwise providing financial support to the investee, the investor may be expected, by convention, to refund its distributions and provide financial support in the future.

In situations in which the investor’s share of equity method losses equals or exceeds its equity method investment balance plus any advances, equity method loss recognition should generally be discontinued (that is, the investor should stop reflecting the equity method investee’s losses in its financial statements) unless the investor has provided, or committed to provide, the investee additional financial support or the investor has guaranteed the investee’s obligations. See Section 5.2 for details.

5.4 Costs Incurred on Behalf of an Investee

5.4.1 Accounting for Costs Incurred on Behalf of an Investee in the Financial Statements of the Investor

The guidance in ASC 323-10-25-3 through 25-5, which was initially introduced by EITF Issue 00-12 (see Section 5.3), examines situations in which an additional investment made by an investor is not determined to be a funding of prior losses and considers the manner in which (i.e., capitalization or expense), and period(s) over which, the investor should account for any costs incurred on behalf of an investee. The following are two different views proposed by the EITF regarding how an investor should recognize the many types of expenditures it might incur on behalf of an investee:

View A — The investor should record the expenditures as expenses “to the extent that the investor’s claim on the investee’s book value has not been increased.” If the investor’s claim on the investee’s book value has been increased (e.g., when the cost incurred by the investor is capitalized by the investee), the investor should recognize the portion of the expenditures represented by the increase as an additional investment in the investee.
View B — The investor should recognize the expenditures as an increase in its investment in the investee. The investor would then recognize its share of the earnings or losses of the investee, inclusive of the costs incurred, on the basis of its ownership percentage in the investee. The remainder of the cost incurred (the percentage of the cost that benefits the other investors) results in an originated-basis difference between the investor’s investment balance and its underlying equity in net assets of the investee. This difference should be accounted for in a manner similar to that described in ASC 323-10-35-34, whereby the difference is attributed to specific individual assets or liabilities of the investee, and any residual excess of the cost of the investment over the proportional fair value of the investee’s assets and liabilities is treated as equity method goodwill. When attributing the basis difference to the investee’s underlying net assets, the investor should consider the relevant facts and circumstances, including the nature of the expenditures. See Sections 4.5 and 5.1.5.2, respectively, for initial measurement of and subsequent accounting for basis differences.

After the EITF considered these two alternatives, the scope of the discussion and consensus in EITF Issue 00-12 (as codified in ASC 323-10-25-3 through 25-5) was narrowed to focus only on the costs of investor stock-based compensation granted by the investor to employees of the equity method investee, and not on contributions in other forms. When investor stock-based compensation costs are incurred, the consensus of ASC 323-10-25-3 through 25-5 would be followed. That is, the contributing investor would expense the cost of investor stock-based compensation granted to employees of an equity method investee as incurred (i.e., as the contribution is recognized by the investee) to the extent that the investor’s claim on the investee’s book value has not increased (see Section 5.3).

However, for costs that do not represent investor stock-based compensation costs incurred by the contributing investor on behalf of the equity method investee for no additional ownership interest, and when no proportionate funding is provided by the other equity holders, we believe that View B would generally be appropriate, after consideration of the provisions of ASC 323-10-35-29 (see Section 5.2.4). Although the investor’s contribution may not result in an additional ownership interest for that investor, the contribution would presumably be made to enhance the investor’s investment or would result in the investee’s avoidance of costs, benefiting the investor indirectly.

Example 5-25

Investor W holds an investment in Investee M, which owns the mineral rights to an exploratory mining project. Investee M is in the development stage with no revenue or forms of debt financing and has no other assets or activities other than those related to the mining project. Investor W accounts for its investment in M under the equity method. Investor W elects to fund 100 percent of M’s exploration costs incurred for the calendar year. These exploration payments are expected to cover all of M’s exploration program costs and allow M to complete its exploration phase. The exploration payments do not represent a funding of prior losses.

Although W will not receive an additional ownership in M when it funds the exploration costs, these contributions enhance W’s investment because M does not have to bear the economic burden that it would have otherwise incurred if W had not made these contributions. Given M’s capital structure, W will provide all of M’s operating financing during this exploration phase of the mining project. The viability of M, as an entity in the development stage with no revenue or forms of debt financing, depends wholly on W’s equity commitment, and thus the contributions will enhance the value of W’s investment. Therefore, in these circumstances, it is appropriate for W to recognize the exploration payments as an increase to the carrying value of its investment in M in accordance with View B. The costs attributable to the noncontributing investor(s) result in an originated-basis difference between W’s investment balance and its underlying equity in M’s net assets. This basis difference would be attributable to the underlying investee’s mineral rights property asset and would be amortized over the life of that asset.

5.4.2 Accounting for Costs Incurred on Behalf of an Investee in the Financial Statements of the Investee

When costs are incurred by an investor related to an equity method investment, the investor should use judgment to determine whether the costs are incurred on behalf of the investee and therefore should be reflected in the investee’s financial statements. SAB Topic 1.B states, in part, that “[i]n general, the staff believes that the historical income statements of a registrant should reflect all of its costs of doing business. Therefore, in specific situations, the staff has required the subsidiary to revise its financial statements to include certain expenses incurred by the parent on its behalf.” In addition, SAB Topic 5.T discusses the concept of reflecting costs incurred by a shareholder on behalf of a company in the company’s financial statements. SAB Topic 5.T states, in part, that a transaction in which “a principal stockholder pays an expense for the company, unless the stockholder’s action is caused by a relationship or obligation completely unrelated to his position as a stockholder or such action clearly does not benefit the company” should be reflected as an expense in the company’s financial statements, with a corresponding credit to APIC. We believe that the guidance in SAB Topics 1.B (by analogy) and 5.T applies to equity method investees. Therefore, we believe that costs incurred by an investor on behalf of an investee should be recorded in the financial statements of the investee as an expense (or capitalized if permitted under other U.S. GAAP), with a corresponding credit to APIC.

In addition, even though the guidance in SAB Topics 1.B and 5.T applies to public companies, we believe that private companies should also apply this guidance when evaluating the recognition of costs incurred by an investor on behalf of an investee.

5.5 Decrease in Investment Value and Impairment

ASC 323-10

35-31 A series of operating losses of an investee or other factors may indicate that a decrease in value of the investment has occurred that is other than temporary and that shall be recognized even though the decrease in value is in excess of what would otherwise be recognized by application of the equity method.

35-32 A loss in value of an investment that is other than a temporary decline shall be recognized. Evidence of a loss in value might include, but would not necessarily be limited to, absence of an ability to recover the carrying amount of the investment or inability of the investee to sustain an earnings capacity that would justify the carrying amount of the investment. A current fair value of an investment that is less than its carrying amount may indicate a loss in value of the investment. However, a decline in the quoted market price below the carrying amount or the existence of operating losses is not necessarily indicative of a loss in value that is other than temporary. All are factors that shall be evaluated.

35-32A An equity method investor shall not separately test an investee’s underlying asset(s) for impairment. However, an equity investor shall recognize its share of any impairment charge recorded by an investee in accordance with the guidance in paragraphs 323-10-35-13 and 323-10-45-1 and consider the effect, if any, of the impairment on the investor’s basis difference in the assets giving rise to the investee’s impairment charge.

ASC 970-323

35-12 A loss in value of an investment other than a temporary decline shall be recognized. Such a loss in value may be indicated, for example, by a decision by other investors to cease providing support or reduce their financial commitment to the venture.

35-13 If a transaction with a real estate venture confirms that there has been a loss in the value of the asset sold that is other than temporary and that has not been recognized previously, the loss shall be recognized on the books of the transferor.

An investor must determine whether its equity method investment is impaired when certain indications are present even if an investee has not recognized impairments of its assets. In addition, an equity method investment may be impaired in an amount greater than impairments recognized by the investee. Although a current fair value below the recorded investment is an indicator of impairment, the investor should recognize an impairment only if the loss in value is deemed to be an OTTI.10 If an impairment of an equity method investment is determined to be other than temporary, the investor must record an impairment charge sufficient to reduce the investment’s carrying value to its fair value, which results in a new cost basis. This new cost basis cannot subsequently be written up to a higher value as a result of increases in fair value. The investor should apply the equity method of accounting to the new cost basis in its investment by recording its share of subsequent income or loss of the investee in a manner consistent with the accounting method used before the OTTI (see Section 5.1).

The investor should not test the investee’s underlying assets for impairment; rather, the investor should test the equity method investment for impairment as its own unit of account. Also, ASC 323-10-35-32A requires the investor to “recognize its share of any impairment charge recorded by an investee in accordance with the guidance in paragraphs 323-10-35-13 and 323-10-45-1 and consider the effect, if any, of the impairment on the investor’s basis difference in the assets giving rise to the investee’s impairment charge.” However, the investor must nonetheless ensure that the amounts recognized comply with U.S. GAAP. Therefore, the investor should consider if impairment indicators exist at the investee level that were not recognized but should have been in accordance with U.S. GAAP.

5.5.1 Identifying Impairments

ASC 323-10-35-31 and 35-32 provide certain factors that may be indicative of an impairment, including:

“A series of operating losses of an investee.”
The “absence of an ability to recover the carrying amount of the investment.”
The “inability of the investee to sustain an earnings capacity.”
“A current fair value of an investment that is less than its carrying amount.”

In addition to these factors, the SEC issued SAB Topic 5.M, which provided three indicators of OTTI on investments in AFS equity securities. As a result of the issuance (and the adoption) of ASU 2016-01, SAB Topic 5.M was removed from the Codification. Although that guidance specifically related to AFS equity securities, we believe that the indicators of an OTTI contained therein continue to be helpful when an investor is evaluating whether an OTTI of any equity method investment exists. The indicators in SAB Topic 5.M were as follows:

The length of the time and the extent to which the market value has been less than cost;
The financial condition and near-term prospects of the issuer, including any specific events which may influence the operations of the issuer such as changes in technology that may impair the earnings potential of the investment or the discontinuance of a segment of the business that may affect the future earnings potential; or
The intent and ability of the holder to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in market value.

SEC Accounting and Auditing Enforcement Release Nos. 309, 316, 370, and 422 provide additional factors to evaluate in the determination of an OTTI, including the following:

The condition and trend of the economic cycle.
The issuer’s financial performance and projections.
Trends in the general market.
The issuer’s capital strength.
The issuer’s dividend payment record.
Whether other adverse conditions at the investee level are further indicators of an other-than-temporary diminution in value, including:
- Known liquidity crisis.
- Bankruptcy proceedings.
- Going-concern commentary in the auditor’s report on the investee’s most recent financial statements.

Any impairment analysis will require a careful consideration of all the facts and circumstances, with no individual factor being determinative. Note, however, that when an equity method investment has a readily determinable value, it is more difficult to overcome the indication of impairment (e.g., by performing an internal discounted cash flow analysis that contradicts the market value).

An investor is required to test certain long-lived assets for recoverability by using undiscounted cash flows as a first step in determining whether an impairment loss should be recognized under ASC 360-10; however, equity method investments are outside the scope of ASC 360-10. At the 2002 AICPA Conference on Current SEC Developments, the SEC staff indicated that it would object to the use of an undiscounted cash flow analysis under ASC 360-10 for the determination of whether an equity method investment is impaired. In addition, at the March 17–18, 2004, EITF meeting, during deliberations of EITF Issue 03-1, the SEC observer stated that registrants “should continue to rigorously assess equity method investments for impairment” and that the “SEC staff will continue to object to inappropriate impairment analyses for such investments, for example a Statement 144 [codified in ASC 360] undiscounted cash flow approach.” Thus, it would not be appropriate to conclude that an impairment of an equity method investment does not exist simply because the investment’s undiscounted cash flows exceed its carrying amount. An investor should consider all factors, as well as the severity and duration of the equity method investment’s decline in value, when determining whether an impairment is other than temporary. However, if the equity method investment’s undiscounted cash flows are less than its carrying amount, this is a strong indicator of an impairment.

The table below outlines factors that may indicate that an equity method investment’s decline in value is an OTTI as well as those that may indicate that it is not an OTTI.

Indicator	OTTI	Not an OTTI
Length of time that the fair value is below the investor’s carrying value	Prolonged period	Short period, generally measured in months rather than in years
Current expected performance relative to expected performance when the investor initially invested in the investee	Current expected performance is significantly worse than anticipated when the investor initially invested in the investee	Current expected performance is consistent with the level anticipated when the investor initially invested in the investee
Performance relative to peers	The investee is performing significantly worse than peer companies	The investee is performing in a manner that is commensurate with peer companies
Industry performance relative to economy	The investee’s industry is declining and significantly lags the performance of the economy as a whole	The investee’s industry is performing in a manner that is consistent with the general economy as a whole
Credit rating	The investee’s credit rating has been downgraded	No significant change in the investee’s credit rating has occurred
Regulatory action	Adverse regulatory action is expected to substantially reduce the investee’s product demand or profitability	No significant adverse regulatory actions against the investee have occurred
Loss of principal customers or suppliers	The investee has lost significant customers or suppliers with no immediate prospects for replacement	The investee has maintained significant customers and suppliers or has identified replacements for those expected to be lost
Discounted cash flows	The investee’s discounted cash flows are below the investor’s carrying amount	The investee’s discounted cash flows are greater than the investor’s carrying amount
Undiscounted cash flows	The investee’s undiscounted cash flows are below the investor’s carrying amount	The evaluation of the investee’s undiscounted cash flows would not be determinative of whether an OTTI exists

5.5.2 Measuring Impairment

ASC 323 requires an investor to measure impairment (if it is determined to be other than temporary) by comparing the carrying value of the investment with its fair value. The investor is prohibited from testing an equity method investee’s underlying assets for impairment; instead, the investor must test the total equity method investment for impairment, including any goodwill recognized on the date of initial investment (i.e., equity method goodwill recognized is not separately tested for impairment in accordance with ASC 350 but included as part of the total equity method investment subject to impairment testing under ASC 323).

If an investor uses a cash flow analysis to determine the fair value of an equity method investment, it must discount the cash flows to arrive at a measure of the investment’s fair value. A discounted cash flow analysis is similar to the present value techniques described in ASC 820-10-55-5(c) and (d) and incorporates the time value of money and risk premiums that market participants would take into account when pricing the asset. The time value of money generally cannot be incorporated into an estimate of future cash flows but must be incorporated into the discount rate used to measure fair value under the discounted cash flow method. Certain risk factors are also usually included in the discount rate. However, it is inappropriate for an investor to use an undiscounted cash flow approach since such a valuation method would not take into account the considerations described above and would not result in a correct measurement of the “loss in value” of an equity method investment.

Depending on the facts and circumstances, there may be other acceptable ways to determine the fair value of an equity method investment for impairment, such as the market approach or other income approach methods described in ASC 820 (e.g., a discount rate adjustment technique or probability-weighted techniques). However, if the investment has a readily determinable fair value, it would be inappropriate for the investor to modify the amount of impairment measured by using the readily determinable fair value by substituting another valuation technique (e.g., discounted cash flows).

5.5.2.1 Consideration of Basis Differences After Recognizing an Impairment

As discussed in Section 5.5, equity method investments are tested for impairment as a single unit of account (i.e., the investment rather than individual assets or basis differences). However, the recognition of an impairment charge will often affect existing basis differences or give rise to new ones. For example, if an investor has a positive basis difference allocated to various assets and equity method goodwill greater than an impairment, the impairment will be likely to reduce the existing positive basis differences and affect their subsequent amortization. ASC 323 does not provide guidance on how the impact of an impairment charge should be allocated to basis differences. Therefore, an investor should select an accounting policy to allocate impairment charges to basis differences and apply it consistently. As illustrated in the example below, it would be appropriate to allocate on the basis of the fair value at the time of impairment. While there may be other acceptable allocation methods, we believe that the allocation method applied should be reasonable on the basis of the facts and circumstances and the nature of the impairment.

Example 5-26

As of December 31, 20X1, Investor X has a 40 percent interest in Investee Z with a carrying value of $2.376 million, which consists of the following:

Share of underlying net assets: $1.8 million.
Basis differences: $576,000.
- Fixed assets: $380,000.
- Intangible assets: $116,000.
- Goodwill: $80,000.

Investor X concludes that the fair value of its investment in Z is $1.84 million, and the decline in value is other than temporary. Investor X would record a $536,000 impairment charge and allocate it on the basis of the fair value of Z’s underlying assets as follows:

After comparing the new basis differences with the carrying value immediately before the impairment, X would allocate the impairment to the existing basis differences as follows:

Conversely, if an investor does not have any positive basis differences or the impairment exceeds the existing basis differences, the recognition of an impairment charge will result in the creation of a negative basis difference. The write-down may affect the amortization of basis differences. Subsequent increases in the investment’s value as a result of increases in fair value not related to the amortizable basis differences would not be recognized until realized (i.e., disposal of the investment). See Section 5.5 for details related to recording an OTTI.

Example 5-27

Assume the same facts as in the example above, except the following:

As of December 31, 20X1, Investor X concludes that the fair value of its investment in Investee Z is $1.76 million, and the decline in value is other than temporary. Investor X would record a $616,000 impairment charge and allocate it on the basis of the fair value of Z’s underlying assets as follows:

After comparing the new basis differences with the carrying value immediately before the impairment, X would allocate the impairment to the existing basis differences as follows:

Because the basis difference attributable to fixed assets was $380,000 immediately before the recognition of the impairment, the recognition created a $40,000 negative basis difference. This difference will be amortized over the remaining useful life of the underlying fixed assets.

5.5.2.2 Consideration of Cumulative Translation Adjustment in an Impairment Analysis

An equity method investment may generate cumulative translation adjustment (CTA) balances given that the investee may be a foreign operation or hold interests in foreign operations. ASC 830 provides specific guidance regarding how CTA balances should be assessed during an impairment review. ASC 830-30-45-13 states, in part, that “[a]n entity that has committed to a plan that will cause the cumulative translation adjustment for an equity method investment or a consolidated investment in a foreign entity to be reclassified to earnings shall include the cumulative translation adjustment as part of the carrying amount of the investment when evaluating that investment for impairment.” However, ASC 830-30-45-14 states, in part, that “no basis exists to include the cumulative translation adjustment in an impairment assessment if that assessment does not contemplate a planned sale or liquidation that will cause reclassification of some amount of the cumulative translation adjustment.” Therefore, a CTA balance should be considered in an impairment analysis only when the investment’s recoverability is predicated on a plan to dispose of the investment.

Example 5-28

Investor A determines that there are indicators of impairment for Investee B. Investor A’s investment in B has a carrying value of $60 million and a CTA debit balance of $10 million. Investor A has no plan to sell its investment in B or any other transaction that would cause reclassification of the CTA. Therefore, A would consider only the carrying value of $60 million when testing its investment in B for impairment.

Example 5-29

Assume the same facts as in the example above, except that Investor A plans to sell its investment in Investee B within one year. Investor A would consider the carrying value of $60 million and the CTA debit balance of $10 million (i.e., the total carrying value of $70 million must be compared with the fair value) when testing its investment in B for impairment.

5.5.2.3 Consideration of Nonrecourse Debt

The existence of nonrecourse debt or other similar financing structures does not affect the amount of impairment recognized. If an investor considered nonrecourse financing in determining an impairment charge of an equity method investment, the investor would, in substance, be accounting for the effects of a debt extinguishment before the threshold in ASC 405-20-40-1 was reached.

Example 5-30

Investor A and Investor B each contribute $6 million of cash in Investee C (a real estate project), which is financed, in part, by $10 million of nonrecourse financing. Assume that C has break-even operations after the original contribution. If A’s and B’s investment in C is determined to be other-than-temporarily impaired to such a degree that its value is reduced from $12 million to $8 million, A and B must write their investment down beyond the $10 million nonrecourse financing amount to $4 million each. The existence of nonrecourse debt is not justification for limiting the impairment charge. If A and B were to write their investment down to only $5 million each, they effectively would be recognizing a $2 million gain on a debt extinguishment that has not yet occurred, which is prohibited by ASC 405-20-40-1.

5.5.3 Impairment of Investee Goodwill

ASC 350-20-35-48 requires a goodwill impairment loss recognized at a subsidiary level to be recognized in the consolidated financial statements only if the goodwill of the reporting unit in which the subsidiary resides is also impaired. However, whether an impairment is ultimately recognized in the consolidated financial statements of the subsidiary’s parent does not affect whether an impairment is recognized by an equity method investor. Thus, if an equity method investee recognizes a goodwill impairment charge in its separate financial statements, the investor should recognize its share of the impairment in its financial statements in the same manner in which it recognizes other earnings of the investee.

5.5.4 Events During a Lag Period — Impact on Impairment Evaluation

Investors are permitted in certain instances to record their share of earnings or losses in an investee on a lag (as long as the intervening period is no more than three months); see Section 5.1.4. However, an investor should consider testing an equity method investment for impairment up until its balance sheet date because the guidance on reporting on the lag is limited to the “earnings or losses” of the investee and does not address reporting an impairment on a lag. Generally, the investor should evaluate its equity method investments as of its balance sheet date to determine whether an OTTI exists. If an OTTI exists on the balance sheet date, the measurement of the impairment should be determined as of the balance sheet date and not as of the reporting date for the lag. For example, if an investor reports its share of an investee’s earnings and losses on a three-month reporting lag, and the investor determines as of its quarter ended June 30 that its investment in the investee has an OTTI, the investor should measure an impairment using the fair value of its investment as of June 30, not the fair value of its investment as of March 31.

If significant events occur during the period between the financial statements used to record an equity method investment and the balance sheet date, questions may be raised about whether an OTTI exists. The investor should apply the guidance in ASC 810-10-45-12 to account for transactions or events in the intervening period. It states, in part:

[R]ecognition should be given by disclosure or otherwise to the effect of intervening events that materially affect the financial position or results of operations.

Thus, investors should carefully evaluate whether material intervening events are disclosed in the notes to the financial statements or recognized in the statements themselves as an adjustment to the investment. The following events in the intervening period may require further considerations in the context of impairment evaluation:

Loss or bankruptcy of a significant customer or supplier.
Adverse credit event (e.g., downgraded rating, default on lending agreements).
Impairment of investee assets (e.g., property destroyed by fire and no insurance proceeds expected).

Additional factors may also require further consideration.

An investor may hold investments that qualify for specialized industry accounting under ASC 946. Under this guidance, investments are measured at fair value, and changes in fair value are recognized in current-period earnings. An investor holding equity method investments in entities applying accounting under ASC 946 would record its equity method earnings and losses on the basis of amounts reported by an investee, including the investor’s proportionate share of the change in fair value of the investee’s assets.

Typically, changes in the fair value of the investee’s assets arising from events occurring after the date of the investee’s most recent available financial statements should not be considered an OTTI of the investor’s equity method investment. An OTTI is the difference between the equity method investment’s carrying value and its fair value. In the absence of a reporting time lag, a difference would not exist as of the investor’s balance sheet date for the effects of fair value changes because the investee’s accounting under ASC 946 (i.e., fair value) is retained in the investor’s application of the equity method of accounting. That is, there is no impairment charge, since carrying value and fair value would be the same.

However, if the investee and the investor have different reporting dates, the fair value reported in the investee’s most recent available financial statements may not be indicative of the fair value as of the investor’s balance sheet date. Therefore, the investor would need to evaluate the OTTI indicators to determine whether an impairment should be recognized.

Footnotes

OTTI classification does not mean that the impairment is permanent.

5.7 Real Estate Investments

5.7.1 Sale of an Investment in a Real Estate Venture

ASC 970-323

40-1 A sale of an investment in a consolidated real estate venture (including the sale of stock in a corporate real estate venture) shall be evaluated under the guidelines set forth in paragraphs 360-10-40-3A through 40-3B. The sale of a noncontrolling investment in a real estate venture that is being accounted for in accordance with Topic 320 on investments — debt securities; Topic 321 on investments — equity securities; Topic 323 on investments — equity method and joint ventures; or Topic 325 on investments — other, shall be accounted for in accordance with the guidance in Topic 860 on transfers and servicing.

The sale of an investment in real estate, including an investment accounted for under the equity method, is not treated as a sale of the underlying real estate. In a transfer of only an equity method investment in which the investee holds nonfinancial assets, the seller will account for the transfer under ASC 860.

However, in certain unique circumstances, if a transfer to a counterparty (that does not meet the definition of a customer in ASC 606) in a contract represents a group of assets that (1) doesn’t constitute a business and (2) includes both an equity method investment and a nonfinancial asset whose fair value is equal to substantially all of the fair value of the assets transferred, the equity method investment would be considered part of the entire nonfinancial asset transaction under ASC 610-20 (see ASC 610-20-15-5). Also see Deloitte’s Roadmap Revenue Recognition for further information regarding the application of ASC 610-20.