On the Radar
On the Radar
An investor must consider the substance of a transaction as well as the form of an
investee when determining the appropriate accounting for its ownership interest in
the investee. If the investor does not control the investee and is not required to
consolidate it, the investor must evaluate whether to use the equity method to
account for its interest. This evaluation frequently requires the use of significant
judgment.
The flowchart below illustrates the relevant questions to be considered in the
determination of whether an investment should be accounted for under the equity
method of accounting.
When considering the questions above, an investor must take into
account the specific facts and circumstances of its investment in the investee,
including its legal form. The two red circles in the decision tree highlight
scenarios in which the equity method of accounting would be applied. Some of the
more challenging aspects of applying the equity method of accounting and accounting
for joint ventures are discussed below.
Evaluating Indicators of Significant Influence
The guidance in ASC 323 on determining whether an investor has
significant influence over an investee can be difficult to apply for
corporations and limited liability companies that do not have separate capital
accounts. For limited partnerships and limited liability companies with separate
capital accounts, the equity method of accounting must be used if an investor
owns more than 5 percent of the investee (see ASC 323-30-S99-1) and an
evaluation of the indicators of significant influence is not performed.
Consequently, there are two models in ASC 323 for applying the equity method
(one in ASC 323-10, and one in ASC 323-30), depending on what type of legal
entity structure the investee has.
The ability to exercise significant influence is often related to an investor’s
ownership interest in the investee on the basis of common stock and in-substance
common stock.1 While there are presumptions in ASC 323 related to whether an investor has
the ability to exercise significant influence over an investee,2 an entity must consider other factors, such as those listed below, in
making this determination.
None of the circumstances above are necessarily determinative
with respect to whether the investor is able or unable to exercise significant
influence over the investee’s operating and financial policies. Rather, the
investor should evaluate all facts and circumstances related to the investment
when assessing whether the investor has the ability to exercise significant
influence.
Basis Differences
An investor presents an equity method investment on the balance sheet as a single
amount. However, the investor must identify and account for basis differences.
An equity method basis difference is the difference between the cost of an
equity method investment and the investor’s proportionate share of the carrying
value of the investee’s underlying assets and liabilities. The investor must
account for this basis difference as if the investee were a consolidated
subsidiary. To identify basis differences, the investor must perform a
hypothetical purchase price allocation on the investee as of the date of the
investor’s investment. Once basis differences are identified, the investor
tracks them in “memo” accounts and amortizes and accretes them into equity
method earnings and losses, depending on the nature of the respective basis
difference.
Equity Method Earnings and Losses
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 the investor owns. 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 an investor’s relative ownership
percentages. An investor may find it particularly challenging to account for
arrangements in which its earnings and losses are not attributed on the basis of
the percentage of equity interest the investor owns.
SEC Registrant Considerations Related to Equity Method Investments
If an equity method investee is considered significant to a
registrant, the registrant may be required to provide the investee’s separate
financial statements or summarized financial information in the financial
statement footnotes (or both). The amount of information a registrant must
present depends on the level of significance, which is determined on the basis
of the results of various tests outlined in SEC Regulation S-X. See Deloitte’s
Roadmap SEC Reporting
Considerations for Equity Method Investees for more
information.
Joint Ventures
Generally, a venturer accounts for its investment in a joint venture the same way
it would account for any other equity method investment. However, it is
necessary to assess whether a legal entity is in fact a joint venture because
this determination may affect the financial statements of the joint venture upon
the venture’s initial formation and thereafter. The specific characteristics of
the entity must be evaluated.
The ASC master glossary defines a
corporate joint venture as follows:
A corporation owned and operated
by a small group of entities (the joint venturers)
as a separate and specific business or project for
the mutual benefit of the members of the group. A
government may also be a member of the group. The
purpose of a corporate joint venture frequently is
to share risks and rewards in developing a new
market, product or technology; to combine
complementary technological knowledge; or to pool
resources in developing production or other
facilities. A corporate joint venture also usually
provides an arrangement under which each joint
venturer may participate, directly or indirectly,
in the overall management of the joint venture.
Joint venturers thus have an interest or
relationship other than as passive investors. An
entity that is a subsidiary of one of the joint
venturers is not a corporate joint venture. The
ownership of a corporate joint venture seldom
changes, and its stock is usually not traded
publicly. A noncontrolling interest held by public
ownership, however, does not preclude a
corporation from being a corporate joint
venture.
Further, for an entity to be considered a corporate joint
venture, venturers must have joint control of it.
All of the following criteria
must be met for a venturer to conclude that an entity is a corporate joint
venture under U.S. GAAP:
Recent Updates
In March 2023, the FASB issued ASU 2023-02, which expands the
use of the proportional amortization method to tax equity investments beyond
low-income housing tax credit investments provided that the investments meet
certain revised criteria in ASC 323-740-25-1. The ASU is intended to improve the
accounting and disclosures for investments in tax credit structures. Although
the accounting under the proportional amortization method differs from that for
equity method investments, the proportional amortization method serves as an
alternative accounting treatment for investments in structures that would
otherwise be evaluated for accounting under the equity method.
For additional details about tax credit structures, see
Appendixes C and D.
In August 2023, the FASB issued ASU 2023-05 to address the
accounting by a joint venture for the initial contribution of nonmonetary and
monetary assets to the venture. Adoption of the ASU will be required for joint
ventures with a formation date on or after January 1, 2025, with early adoption
permitted. The FASB issued the ASU because of the absence of guidance on the
recognition and measurement of the contribution of nonmonetary and monetary
assets in a joint venture’s stand-alone financial statements. While the ASU does
not change the definition of a joint venture, a new basis of accounting is
established upon the venture’s formation. The ASU requires a joint venture, upon
formation, to (1) recognize and measure the initial contributions of monetary
and nonmonetary assets by the venturers at fair value and (2) measure its net
assets (including goodwill) at fair value by using the fair value of the joint
venture as a whole. Therefore, upon adoption of ASU 2023-05, a joint venture
will measure its total net assets upon formation as the fair value of 100
percent of the joint venture’s equity immediately after formation.
For additional details about the accounting for joint ventures,
see Chapter 9.