Deloitte's Roadmap: Equity Method Investments and Joint Ventures

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.

Further, for an entity to be considered a corporate joint venture, venturers must have joint control of it.

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.

As stated in ASC 272-10-05-3, LLCs may “have characteristics of both corporations and partnerships but are dissimilar from both in certain respects.” EITF Issue 03-16 discussed how LLCs were included in the scope of the guidance and addressed the similarities and differences between LLCs and limited partnerships. When assessing whether the investment in an LLC should be accounted for under the equity method, an investor must first determine whether the LLC is more akin to a corporation or a partnership. In making that determination, the investor should consider whether the LLC maintains specific ownership accounts for each investor. A specific ownership account is one in which an individual investor’s capital transactions (e.g., contributions and distributions) and share of LLC profits and losses are allocated in a manner similar to the way they would be in a partnership capital account structure. The manner in which an LLC is taxed is often an indicator of whether the LLC is structured with separate capital accounts. If the LLC is taxed in a manner similar to a partnership, specific ownership accounts are maintained for each investor. However, if the LLC is taxed in a manner similar to a corporation, equity is often indistinguishable among owners, and an investor’s interest in such entities is similar to a common shareholder’s interest in a corporation.

Investments in partnerships and similar entities (e.g., unincorporated joint ventures or LLCs that maintain specific ownership accounts for each investor) are accounted for under the equity method of accounting in accordance with ASC 970-323-25-6 unless the investor’s interest is “so minor that the limited partner may have virtually no influence over partnership operating and financial policies.” While the guidance in ASC 970-323 is specific to real estate partnerships, ASC 323-30-S99-1 clarifies the SEC’s view that “investments in all limited partnerships should be accounted for pursuant to paragraph 970-323-25-6.” Therefore, we believe that it is appropriate for investors to apply this guidance to all partnerships and similar entities (not only real estate investees).

See Section 3.2.3 for further discussion of the presumed levels of ownership that allow an investor in a partnership or other similar entities to exercise significant influence.

If a partnership is not a variable interest entity (VIE) or if a partnership is a VIE but the general partner (GP) is not the primary beneficiary, the GP should account for its interest in the partnership under the equity method.

However, ASC 323-10 may apply to majority-owned legal entities (1) that are not consolidated because of the exclusions of ASC 810-10-15-10, (2) if the minority shareholder or shareholders have certain approval or veto rights qualifying as substantive participating rights under ASC 810-10-25-1 through 25-14, or (3) if the majority shareholder is determined not to be the primary beneficiary of a VIE under ASC 810-10-25-38 through 25-41. In such instances, the equity method would apply if an investor exercises significant influence over the majority-owned subsidiary. In the rare circumstance that an investor owning a majority of a subsidiary does not exercise significant influence over that subsidiary, the investment would be accounted for under ASC 321 at fair value (unless the measurement alternative is elected).3

Investments in certain securitization entities (whether in the form of an LLC, partnership, trust, or similar entity) that can be contractually settled in such a way that the investor may not recover substantially all of its recorded investment are outside the scope of the equity method of accounting and are instead accounted for as debt securities under ASC 320 (i.e., classified as available-for-sale (AFS) or trading securities) or as a derivative within the scope of ASC 815-10, if applicable.

An investor that meets the definition of a not-for-profit entity (NFP) should apply the guidance in ASC 323-10 to its investments that represent 50 percent or less of the voting stock of a for-profit entity, unless the investor is required or chooses to account for such investments at fair value. If an NFP has an interest in an investee that maintains specific ownership accounts for each investor, the NFP should evaluate the investee in a manner similar to the way it would a partnership (see the discussion in Section 2.2.1). If the investee does not have specific ownership accounts, the NFP should evaluate the investee in a manner similar to the way it would a corporation.

While the above guidance is specific to NFPs, ASC 954-810-15-3 provides similar guidance for investments held by not-for-profit business-oriented health care entities.

ASC 825-10-15-4 allows an investor to elect the fair value option for recognized financial assets. Equity method investments are included in such assets because they represent an ownership interest. If an investor elects the fair value option, its investment must be recorded at fair value at each reporting period, with subsequent changes in fair value reported in earnings. In addition, electing the fair value option requires additional disclosures, which are further discussed in Section 6.3.1.1.

An investor can elect the fair value option on an investment-by-investment basis. The investor is not required to elect the fair value option for identical investments it may have in other investees. However, as stated in ASC 825-10-25-7(b), the election for an equity method investment may be made only if the investor elects the fair value option for all of its eligible interests in the same investee (e.g., equity and debt instruments and guarantees5). In other words, the investor must make the election on a legal-entity-by-legal-entity basis.

An investor may have an investment in an equity method investee that holds primarily nonfinancial assets and liabilities. However, when determining whether an equity method investment is eligible for the fair value option, an investor is not required to “look through” the financial statements of the investee to understand whether the assets and liabilities owned by the investee are financial given that the fair value option is available for equity method investments regardless of the nature of the investee’s assets and liabilities. (See Section 12.2.1.1.1 of Deloitte’s Roadmap Fair Value Measurements and Disclosures (Including the Fair Value Option) for further discussion.)

ASC 825-10-25-4 lists election dates (dates when an investor may elect to apply the fair value option to eligible assets or liabilities), and ASC 825-10-25-5 lists events that may create an election date. Under ASC 825-10-25-4, if an investor’s investment in equity securities that was not previously accounted for under the equity method of accounting becomes subject to it, the investor may either apply the equity method or elect the fair value option under ASC 825-10 for the securities. This could occur, for example, (1) upon initial acquisition of an investment; (2) upon acquisition of an additional interest in an investee in which the investor had a preexisting interest; (3) upon an investee’s repurchase of its outstanding equity shares, resulting in an increase in an investor’s ownership percentage in the investee in such a way that the investor obtains significant influence over the investee; (4) if the governing provisions of the investee are modified in such a way that the investor has significant influence over the investee after the modification; or (5) when an investor loses control of but retains significant influence over an investee. (See Section 12.3.2.2.3 of Deloitte’s Roadmap Fair Value Measurements and Disclosures (Including the Fair Value Option) for further discussion.)

Once an investor elects the fair value option, it may not be revoked unless an event creating a new election date occurs.

An investor in a separate entity (including an unincorporated legal entity) that has significant influence generally applies the equity method of accounting. Because the guidance in ASC 323-10 applies only to ownership in the form of common stock (or in-substance common stock), an investor that owns an undivided interest in each asset and is proportionately liable for its share of each liability of an investee should not apply the equity method of accounting to such an investment. However, an investor that holds an interest in an unincorporated legal entity (as opposed to an undivided interest in each asset and liability) in the construction or extractive industries may elect to apply the proportionate consolidation method (if certain criteria are met) and record its proportionate share of the investee’s assets, liabilities, revenues, and expenses in each applicable line item in its financial statements (as opposed to the single line item equity investment presentation). Specifically, to apply proportionate consolidation, the investor must have an undivided interest in each asset and be proportionately liable for its share of each liability of the investee. In addition, in the extractive industry, the investee’s activities must be limited to the extraction of mineral resources (such as oil and gas exploration and production). If its activities include refining, marketing, or transporting extracted mineral resources, the investor should not apply proportionate consolidation.

Proportionate consolidation may be acceptable in the real estate industry even when the investment is an undivided interest in real property as opposed to an investment in an entity if the undivided interest is not subject to joint control and the other conditions in ASC 970-810-45-1 are met. However, as described in ASC 970-323-25-12, most real estate ventures in the form of undivided interests are subject to some form of joint control. In those instances, the equity method of accounting is required.

An investor may proportionately consolidate an investment that qualifies for such treatment even if another party consolidates the investment in accordance with ASC 810-10. Proportionate consolidation requires an investor to apply typical consolidation procedures, which are further discussed in Section 5.1.5.1 and in Chapter 10 of Deloitte’s Consolidation Roadmap. If a public business entity (PBE) investor proportionately consolidates its undivided interest, the proportionately consolidated information must comply with the PBE accounting requirements (see Section 5.1.3.2), including those related to the timing of the adoption of new accounting standards (see Section 5.1.3.4).

Over time, the type and form of investment vehicles have expanded beyond basic voting common stock to include convertible debt, preferred equity securities, options, warrants, interests in unincorporated entities, complex licensing and management arrangements, and a host of other financial instruments. EITF Issue 02-14 (codified in ASC 323-10) noted:

Some of these rights may give an investor the ability to exercise significant influence over the operating and financial policies of an investee without holding an investment in the investee’s voting common stock. When an investment in other than common stock (debt, preferred equity securities, etc.) has all the factors in ASC 323-10-15-13, it is considered to be “in-substance” common stock, and the investor should apply the equity method if it also has significant influence over the investee. If the investment does not have all the factors in ASC 323-10-15-13, it would not be within the scope of ASC 323-10, and the equity method of accounting would be inappropriate even if the holder of the investment has significant influence over the investee.

Examples of investments that may have the characteristics of in-substance common stock include convertible stock or warrants (with no barriers to exercise), stock with a nonsubstantive liquidation preference, and participating stock redeemable at the holder’s option. Examples of investments that would generally not be considered in-substance common stock include mandatorily redeemable stock, stock with an embedded non-fair-value put option, stock with a substantive liquidation preference, and nonparticipating, nonconvertible preferred stock.

An investor may also hold an instrument (such as a call or a put option) that gives it the ability to purchase or sell the voting common stock of an investee at some point. In evaluating whether such instruments represent in-substance common stock, an investor must first determine whether the put or call option is a freestanding instrument. If the instrument is not freestanding, the investor should further determine whether the put or call option is an embedded feature within a host arrangement that requires bifurcation and separate accounting. The equity method of accounting does not apply to either a freestanding instrument or bifurcated embedded feature since those instruments are accounted for in accordance with ASC 815 (see Section 2.3). Put and call options, as well as other instruments that are not accounted for under ASC 815 (i.e., the host instrument), may have the characteristics in ASC 323-10-15-13 and therefore represent in-substance common stock.

ASC 323-10 contains examples that illustrate the evaluation of whether an investment is in-substance common stock (see Sections 2.5.1.1 through 2.5.1.3). Each example assumes that the investor is not required to consolidate the investee under ASC 810-10, that it has the ability to exercise significant influence over the operating and financial policies of the investee (see Chapter 3), and that its investment does not meet the definition of a derivative instrument under ASC 815.

It is important to note that EITF Issue 02-14 provided the initial guidance on the evaluation of in-substance common stock. Paragraph 5 of EITF Issue 02-14 states, in part:

We believe that the EITF Issue 02-14 scoping guidance continues to be applicable and, accordingly, the in-substance common stock guidance in ASC 323-10-15-3 through 15-5 should be applied only to investments in corporations. Thus, it would not apply, for example, to investments in partnerships, LLCs, trusts, or other unincorporated entities that maintain specific ownership accounts (see Section 2.2) or to investments within the scope of ASC 815 (see Section 2.3).

An investor must perform its initial evaluation of whether its investment represents in-substance common stock when it determines that it has the ability to exercise significant influence over the operating and financial policies of an investee (see Chapter 3 for further discussion of significant influence). This date may be after the date its initial investment was acquired.

The investor should continually monitor events and circumstances to determine whether its initial conclusion should be reconsidered. This reassessment should be performed only if one of the events in ASC 323-10-15-16 occurs. Although investee losses can significantly change (i.e., reduce or eliminate) the investee’s capital structure, the investor should not reconsider its initial determination solely because of such losses (see Section 5.2 for further discussion).

At the time of the initial determination and of any subsequent reassessment, an investor should perform its evaluation on the basis of all facts and circumstances. Accordingly, the investor would consider its cumulative interest in the investee as opposed to only those interests that were recently acquired. The total fair value of an investment as of the date of a reconsideration event should be used in the reconsideration analysis. As a result of the occurrence of a reconsideration event, and on the basis of the investor’s reassessment at that time, an investment that was previously determined not to be in-substance common stock may become in-substance common stock (or vice versa).

If an investor holds more than a 20 percent interest (directly or indirectly, as discussed in Section 3.2.6) in an investee that has a legal form of a corporation, it is presumed that the investor has the ability to exercise significant influence in the absence of evidence to the contrary (see Section 3.3.1). Similarly, if the same investor holds less than a 20 percent interest in an investee, it may, in combination with other indicators, have the ability to exercise significant influence over that investee (see Section 3.3).

In EITF Topic D-46 (codified in ASC 323-30-S99-1), the SEC acknowledged that, in practice, investments in limited partnerships of more than 3 percent to 5 percent have generally been viewed as “more than minor” and thus are subject to the equity method. Because profits and losses are allocated to individual partner accounts, the partner’s share of earnings is allocated for income tax purposes, and the nature of partnership interests usually gives rise to some degree of influence (stated or unstated), it is presumed that either consolidation or the equity method should be used to account for all partnership interests. This approach de-emphasizes significant influence, instead requiring the equity method of accounting because it enables noncontrolling investors to reflect the underlying nature of their investments.

Because the SEC staff refers to a range of “3 to 5 percent” in EITF Topic D-46, investments of more than 3 percent to 5 percent have generally been viewed as “more than minor.” Thus, any investment of more than 5 percent is subject to the equity method, and any investment from 3 percent to 5 percent should be accounted for under the equity method unless the presumption of significant influence is overcome. However, an investment of less than 3 percent is typically considered “minor” and therefore may be accounted for at fair value in accordance with ASC 321 (unless the measurement alternative is elected)1 or under the equity method in accordance with ASC 970-323-25-6.

In a speech at the 2019 AICPA Conference on Current SEC and PCAOB Developments, then OCA Professional Accounting Fellow Erin Bennett provided the SEC’s perspectives on assessing whether an investor’s interest is “more than minor” in an LLC structure with separate capital accounts or whether it is so minor that the investor may have virtually no influence over the LLC’s operating and financial policies.

Ms. Bennett noted that when evaluating whether an entity’s interest is more than minor, the SEC staff assesses LLC structures with separate capital accounts in the same manner as partnerships under ASC 323-30-35-3. She described a consultation in which the registrant held a 25 percent interest in the member units of an LLC with separate capital accounts. The registrant argued that the “virtually no influence” threshold did not apply to its investment since this threshold was (1) intended for real estate companies with “less complicated fact patterns” and (2) not appropriate for an investment whose nature and intent were “passive.” Accordingly, the registrant believed that it would be more appropriate to evaluate the indicators of significant influence. Ms. Bennett provided the following insights into the staff’s position and ultimate objection to the registrant’s view:

Note that while the guidance in EITF Topic D-46 is intended for public entities, in practice, it is generally applied to investments held by nonpublic entities.

An investor may hold certain rights that allow it to acquire additional voting interests in an investee. For example, an investor may have a call option to purchase additional equity in an investee that is not a partnership, or a limited partner may have the contractual right to purchase partnership interests held by other partners. Potential voting rights may also exist through other types of securities that are convertible into voting interests (e.g., convertible securities).

In the determination of whether significant influence exists, ASC 323-10-15-9 applies only to “[a]n investor’s voting stock interest” and not to potential voting interests, such as stock options, convertible debt, or derivatives thereof. However, ASC 323-10-15-13 lists several characteristics that might indicate that an investment (other than an investment in common stock) is in-substance common stock (see Section 2.5). Therefore, when determining whether the use of the equity method is appropriate, an investor should consider investments in common stock and investments that are in-substance common stock, which may include, but not be limited to, the following:

• As stated in Section 3.2, if an investor holds both common stock and other investments (including in-substance common stock), it should consider the rights afforded by all such instruments in evaluating whether, in combination, they provide it with the ability to exercise significant influence over an investee. To be considered in the assessment, such voting rights must be currently exercisable.
• An investor with an investment that qualifies as in-substance common stock may be able to exercise its voting rights on an as-if-converted basis or may be precluded from exercising voting rights until the in-substance common stock is converted into common stock. In the latter instance, despite the investment’s qualifying as in-substance common stock, such voting rights would not be considered in the assessment of significant influence because they are not currently exercisable (i.e., the voting rights are contingent upon conversion).

The examples below illustrate the consideration of direct and indirect interests. Each example assumes that the investor and the investee(s) are corporations.

ASC 323-10-15-10 lists several indicators (not all-inclusive) that may suggest that the significant influence presumption is overcome when an investor holds 20 percent or more of the outstanding voting common stock of an investee. In addition, the following conditions may indicate that an investor lacks the ability to exercise significant influence:

• The chairperson of the investee owns a large, but not necessarily controlling, block of the investee’s outstanding stock; the combination of the chairperson’s substantial shareholding and his or her position with the investee may preclude the investor from being able to influence the investee.
• Adverse political and economic conditions exist in foreign countries (especially restrictions on the repatriation of dividends) in which the investee is located.
• The investor has less than 20 percent ownership of the investee with an option to acquire additional ownership that would increase the investor’s stake to 20 percent or more, but there is no substantive plan or agreement to do so in the near future.
• The investee is to settle its litigation, particularly when that litigation involves bankruptcy, by issuing shares to the settling parties, and it is probable that the new shares, when issued, will reduce the investor’s ownership percentage to less than 20 percent.
• The investee actively and publicly resists the exercise of influence by the investor.

None of the circumstances above are necessarily conclusive that the investor is unable to exercise significant influence over the investee’s operating and financial policies. The investor should evaluate all facts and circumstances related to the investment when determining whether the presumption of significant influence over the investee is overcome.

In addition, the fact that an investor has not exercised significant influence in the past or does not intend to exercise it in the future does not indicate that the general presumption of significant influence is overcome. See Section 3.3 for additional details on the 2020 speech that addresses significant influence.

REITs, which can be formed as trusts, associations, or corporations, should consider the guidance in ASC 974-323-25-1 in addition to the ownership interest and other factors of significant influence (see Section 3.3) when evaluating whether they have the ability to exercise significant influence over the operating and financial policies of the service corporation, as discussed above.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.

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.

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.

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:

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.

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:

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.

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:

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.

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.

A guarantee that is not contemplated or required by the formation documents may be issued after the equity method investee’s formation. In such a situation, if the investor does not receive any consideration from the equity method investee or the other investors for issuing the guarantee, the investor should recognize a guarantee liability initially at fair value in accordance with ASC 460-10-25-3 and 25-4 and ASC 460-10-30-2. When the investor initially recognizes a guarantee liability related to a guarantee issued after the investee’s formation, the investor should use judgment to allocate the initial fair value of the guarantee between its interest in the equity method investee and that of other investors. The investor should do the following:

• Expense the portion of the debit entry related to noncontributing investors.
• Record the portion of the debit entry related to the investor’s interest in the equity method investee as an increase in its investment in the equity method investee and amortize that portion over the life of the guarantee.

If a controlling financial interest holder deconsolidates a subsidiary in accordance with ASC 810-10-40-3A through 40-5 and retains an equity method investment, the investor measures the equity method investment at its fair value in accordance with ASC 323-10-30-2. If the investor issues a guarantee of the investee’s third-party debt in conjunction with the deconsolidation, we believe that the initial fair value of the guarantee liability would be accounted for as part of the gain or loss upon deconsolidation rather than capitalized as part of the investor’s basis in the equity method investment.

If the investor’s share of the investee’s cumulative losses exceeds the investor’s equity investment and loan balances, it would not be appropriate for the investor to avoid recording equity losses associated with the guarantee of the investee’s loans because the liquidation value of the collateral it holds exceeds the amount of the guarantee. In other words, the investor should not consider the liquidation value of collateral to offset the guarantee. However, it may be appropriate for the investor to consider the liquidation value of collateral when recognizing investee losses if all the following conditions are met:

• The operations related to the assets that serve as collateral do not represent a large percentage of the investee’s operations, and removal of the assets would not preclude the investee’s continued operations.
• The investor has the ability and intent to take possession of the collateral if it is required to honor the guarantee. That is, the investor has the ability to obtain clear title to the collateral, notwithstanding any potential claims that other third parties may have.
• The investor could use the equipment in its own operations or has sufficient experience with and access to a market for assets that serve as collateral so that it can sell and realize the collateral’s value.

If the collateral is essential to the investee’s operations, the first condition would not be met. We expect that it would be rare for all these conditions to be met.

If the investee extinguishes or settles the loan guaranteed by the investor, the investor should stop recognizing excess losses from the time of extinguishment or settlement of the loan and reverse its related liability with an adjustment to the equity method gains or losses from the investee. The investor should consider disclosing the adjustment.

When an investor does not have a requirement or commitment to advance additional funds to an investee and losses have reduced its common stock equity method investment balance to zero, the investor should continue to record its share of equity method losses to the extent the investor has other investments (e.g., preferred stock, loans to the investee, other securities) in the equity method investee. The SEC staff has held that all investments and advances, other than receivables, are presumed to fund the investee’s operating losses.

Equity method losses should be applied in order of seniority of the investor’s other investments, starting with the most subordinated investment to the extent that such investment has a positive adjusted basis.

We believe that the guidance in ASC 323-10-35-25 is meant to reflect the calculation of the adjusted basis of an investment but does not address the order with which to apply the measurement guidance.

Generally, an investor applies the following steps to its other investments when it has incurred equity method losses during a reporting period: (1) it adjusts its other investments for equity method losses to the extent that the other investments’ adjusted basis is positive and (2) adjusts the other investments further by applying other U.S. GAAP to them (e.g., ASC 310-10, ASC 320-10, ASC 321-10, and so forth). That is, for example, the investor would apply the guidance in ASC 323 first and then apply the guidance in ASC 321, which would result in the other equity investments’ being recorded at fair value in accordance with ASC 321.

Once the adjusted basis of an investor’s other investments reaches zero, the investor should stop recording equity method losses as an adjustment to those investments. If there are no other investments with a positive adjusted basis, the investor should continue to track the unreported equity method losses for subsequent periods. When an investee returns to profitability, the investor should wait until profits recover unreported equity method losses before adjusting other investments.

When an investee begins to report equity method income, the income should first be applied to the adjusted basis of the investor’s other investments starting with the most senior investment (the reverse order of the application of losses described above). Therefore, the investor would not recognize any equity method income unless or until the amount of the subsequent equity method income exceeds the cumulative unreported equity method losses.

 

Changing Lanes

Clarifying the Interaction Between ASC 321 and ASC 323

In May 2019, the FASB added a project9 to the EITF’s technical agenda on clarifying the interaction between ASC 321 and ASC 323. The project included an issue related to “[r]ecognizing investee losses when an investor has other equity investments in the investee.” As stated in Issue Summary 1 of EITF Issue 19-A, at its June 13, 2019, meeting, the EITF discussed the order in which an investor should apply the guidance when (1) “an investor has additional investments in the equity method investee that do not qualify for the equity method of accounting,” (2) “the investee’s equity method losses have resulted in a zero carrying amount for the investor’s equity method investment,” (3) the investor is applying the measurement alternative in ASC 321, and (4) within an accounting period, there is an observable transaction that will result in an adjustment (i.e., increase) to the carrying value of the investment under ASC 321. Issue Summary 1 of EITF Issue 19-A provides the following example:

On January 1, 20X1, an investor acquires 20 percent of Company A’s common stock and 10 percent of its preferred stock for $10,000,000 and $5,000,000, respectively. The investor’s investment in the common stock is accounted for in accordance with the equity method of accounting, and the investment in the preferred stock is accounted for as an equity security under the measurement alternative under Topic 321. In each of the quarters between January 1, 20X1 and December 31, 20X3, Company A reports net losses. Because the investor records its share of Company A’s losses, the cost basis in both investments is reduced to zero. As of December 31, 20X3, the investor has accumulated approximately $50,000,000 of unrecognized equity method losses in a memo account.

On March 31, 20X4, Company A completes a new round of equity financing involving new investors. The investor determines that the new round of equity financing constitutes an orderly transaction with an observable price that requires the investor to remeasure its investment in the preferred stock to its fair value of $60,000,000. Additionally, the investor’s share of the investee’s equity losses for the period ended March 31, 20X4 is $10,000,000.

Normally, an entity would apply the measurement guidance in ASC 321 after applying adjustments recognized under ASC 323. However, under the measurement alternative in ASC 321, the entity would adjust the equity security to fair value for an observable transaction that occurred during the period and may not be at the end of the reporting period. Because this observable transaction may not be at the end of the period, it calls into question the normal sequencing the entity would follow of applying the measurement guidance in ASC 321 after recognizing equity method losses for the period under ASC 323.

The EITF was able to reach consensus with respect to other issues contemplated as part of EITF Issue 19-A, which led to the FASB’s issuance of ASU 2020-01. However, the Task Force was unable to reach a consensus on the order in which Codification topics would be applied related to the recognition of investee losses when an investor has other equity investments in the investee.

We believe that in the absence of authoritative guidance addressing the issue, either of the following approaches described in Issue Summary 1 of EITF Issue 19-A would be acceptable.

• Approach 1 — “Accumulated equity method losses that have not been allocated to an investor’s investments in the investee (that is, accumulated investee losses in the memo account) should offset any unrealized gains resulting from remeasurement of the investment due to an observable transaction in accordance with Topic 321.” That is, the investor would apply the guidance in ASC 321 first and then apply the guidance in ASC 323.
  Application of this guidance to the example above would result in a preferred stock carrying amount of $0. “The investor would apply the guidance in Topic 321 and remeasure the preferred stock to its fair value of $60,000,000. The investor would then apply the guidance in Topic 323 and adjust the basis of the preferred stock for cumulative investee losses of $60,000,000.”
• Approach 2 — “Recognition of unrealized gains related to an orderly transaction in accordance with the measurement alternative in Topic 321 should be applied after the allocation of any equity method losses. As such, the carrying amount of the equity investment should reflect the most recent observable price, without offsetting any accumulated equity method losses.” That is, the investor would apply the guidance in ASC 323 first and then apply the guidance in ASC 321.
  Application of this guidance to the example above would result in a preferred stock carrying amount of $60,000,000. “The investor would apply the guidance in Topic 323 and record the additional $10,000,000 of investee losses in the memo account. The investor would then apply the guidance in Topic 321 to remeasure the preferred stock to its fair value of $60,000,000.”

An entity should use one entity-wide method that is disclosed in the footnotes to the financial statements. Preparers should monitor developments in this area and consider consulting with their independent auditors or their professional accounting advisers as needed.

ASU 2019-04

In April 2019, the FASB issued ASU 2019-04, which, among other things, provided Codification improvements to ASU 2016-01, ASU 2016-13, and ASU 2017-12. Upon adoption of ASU 2019-04, an investor must first adjust its other investments for equity method losses and then may have to adjust them further on the basis of the application of other U.S. GAAP (e.g., ASC 310-10, ASC 320-10, ASC 321-10, ASC 326-20, and ASC 326-30) to those investments.

In addition to ASU 2019-04, ASU 2016-13 amends the guidance in U.S. GAAP on impairment of financial instruments.

ASU 2016-13 adds to U.S. GAAP an impairment model (known as the current expected credit loss [CECL] model) that is based on expected losses rather than incurred losses. Under the new guidance, an entity recognizes as an allowance its estimate of expected credit losses, which the FASB believes will result in more timely recognition of such losses. This ASU is also intended to reduce the complexity of U.S. GAAP by decreasing the number of credit impairment models that entities use to account for debt instruments.

In situations in which equity method losses have reduced an investor’s equity method investment balance to zero and the investor makes an additional contribution to an equity method investee for no additional ownership interest, the investor must first determine whether this additional investment provides it with a controlling financial interest in the investee. See Section 5.6 for further discussion related to accounting for changes in the level of ownership or degree of influence over an investee.

If the additional contribution does not result in a change from significant influence to control, the investor must determine whether the additional investment in the investee represents the funding of prior losses. ASC 323-10-35-29 discusses factors to consider in the determination of whether additional investments in an investee represent funding of prior losses when the investor has suspended equity method loss recognition in accordance with ASC 323-10-35-20 and ASC 323-10-35-23 through 35-26. This determination involves significant judgment, and the investor should consider all relevant facts and circumstances.

The factors in ASC 323-10-35-29 suggest that if the additional investment is determined, in substance, to be a funding of prior losses, the investor should recognize any prior suspended losses up to the amount of this investment. The investor should also evaluate whether the additional investment results in a commitment to provide financial support to the equity method investee. If the additional investment is not considered to be a funding of prior losses, the investor should account for the additional investment by using the equity method, including recording its share of equity method losses incurred after the additional investment is made. However, the investor would not recognize any prior suspended losses related to its initial investment.

If an investee reimburses a contributing investor for share-based payment awards, the investee generally accrues a dividend to the contributing investor for the amount of the reimbursement in the same periods as the capital contribution from the contributing investor. The recognition of a dividend is generally appropriate given that the issuance of the awards resulted in a capital contribution from the contributing investor. See Section 5.3.2 for a more detailed discussion of the accounting by the investee related to the awards.

If an investee reimburses a contributing investor for share-based payment awards, the noncontributing investor or investors generally recognize a loss equal to the amount by which their interest in the investee’s net book value has decreased (i.e., their percentage share of the distributed capital recognized by the investee) as a result of the reimbursement to the contributing investor. The recognition of a loss by the noncontributing investor is typically appropriate given that its interest in the investee’s net book value has decreased as a result of the reimbursement provided to the investor issuing the awards.

Under U.S. GAAP, there is no explicit guidance on the accounting for an arrangement in which the investee reimburses the contributing investor; therefore, other views may be acceptable for the accounting by the contributing investor, the investee, and the noncontributing investor.

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.

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.

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:

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.

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).

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:

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.

If the investee and investor are not under common control, the investor should consider whether the investee is:

• A business as defined in ASC 805-10 (see Deloitte’s Roadmap Business Combinations). In such case, the investor should remeasure its equity interest to fair value as of the acquisition date and recognize any gain or loss from the remeasurement of the previously held equity method investment in earnings. Also, the investor should reclassify the AOCI balance related to the investee and include it in the computation of gain or loss.
• A VIE as defined in ASC 810-10 that is not a business. In such case, the VIE should consider the recognition and measurement guidance in ASC 810-10-30-3 and 30-4 (see Appendix C of Deloitte’s Roadmap Consolidation — Identifying a Controlling Financial Interest). The primary beneficiary of the VIE should not recognize goodwill and should measure and recognize the assets and liabilities of the VIE in accordance with ASC 805-20-25 and ASC 805-20-30. Also, no gain or loss should be recognized on assets and liabilities that were transferred to the VIE on, after, or shortly before the date the investor became the primary beneficiary of the VIE. The gain or loss should be measured as the difference between (1) the sum of the fair value of the consideration paid, the fair value of any noncontrolling interests, and the reported amount of any previously held interests and (2) the net amount of the VIE’s identifiable assets and liabilities recognized and measured in accordance with ASC 805.

If the investee and investor are under common control, the investor does not remeasure its previously held interests in the investee. Instead, it should measure the newly acquired assets and liabilities at the common control parent’s historical carrying amounts regardless of whether pushdown accounting was previously applied. The investor should recognize any difference between the consideration paid and the net assets recognized in equity.

If the investee is neither a business nor a VIE, the investor should account for the transaction in which it obtains control as an asset acquisition and consider the guidance in Appendix C of Deloitte’s Roadmap Business Combinations. There are two alternatives available to an investor for determining the cost of assets acquired. Under the first alternative, the investor includes both the carrying value of its preexisting ownership interests and the cost of additional ownership interest as part of the total cost of the assets acquired, which follows the cost accumulation model. Under the second alternative, the investor may analogize to the guidance for business combination in ASC 805-30-30-1 and include the fair value of any previously held interests (after recognizing a gain or loss for the difference between the interest’s fair value and its carrying value), consideration paid, and transaction costs incurred as the total cost of the assets acquired.

When an investor obtains an additional interest that provides it with significant influence, it must apply the equity method of accounting. This is the case regardless of whether the transaction that leads to significant influence is undertaken by the investor (e.g., a purchase of additional shares) or the investee (e.g., a change in the structure of the board of directors that provides the investor with increased relative influence).

For investments in equity securities that do not require consolidation or application of the equity method, an investor will recognize them at fair value (unless the measurement alternative is elected).12

The guidance requires the equity method to be applied prospectively from the date an investor obtains significant influence. When an investment qualifies for the equity method (as a result of an increase in the level of ownership interest or degree of influence), the cost of acquiring the additional interest in an investee would be added to the current basis of the investor’s previously held interest, and the equity method would be applied subsequently from the date on which the investor obtains the ability to exercise significant influence over the investee.

An entity that applies the measurement alternative in ASC 321 should consider observable transactions that require it to remeasure its equity investment in accordance with that guidance before it applies ASC 323. Therefore, immediately before applying the equity method of accounting, an investor would remeasure its original investment on the basis of the valuation implied by the additional investment in accordance with ASC 321-10-35-1 or 35-2, as applicable. In other instances, qualification for the equity method of accounting can occur without an observable price change (e.g., an increase in the level of influence without an acquisition of an additional interest). If the transaction is not an observable transaction, the investor should add the cost of the new investment to the carrying amount of its existing interest, which would become the initial measurement of the equity method investment in the investee. Under either scenario, the investor must analyze any remaining basis differences after applying the equity method, if applicable.

If the investor’s claim to the investee’s carrying value is more than the total cost basis after the addition of the cost of acquiring the additional interest, a negative basis difference will exist. Because the investor records the investments at fair value under ASC 321 before applying the equity method if there is an observable price change, this would generally be limited to instances in which the investor elects the measurement alternative and qualifies for the equity method without an observable price change. In these cases, the guidance in ASC 323 is unclear on how the investor should account for the negative basis difference related to the original investment. We do not believe that it would be acceptable to recognize the negative basis difference immediately in earnings. That is, we do not believe that this circumstance (i.e., an increase in value since the original investment) is akin to a bargain purchase gain as discussed in Section 4.5.1. Rather, the investor should account for the negative basis difference in a manner similar to the amortization or accretion of any other negative basis difference (see Section 5.1.5.2). In some situations, it may be appropriate to defer the recognition of negative basis differences until the investment’s disposal.

Since equity method investments other than in-substance nonfinancial assets are considered to be financial assets, an investor should first consider the requirements of ASC 860 (see Section 3.1 of Deloitte’s Roadmap Transfers and Servicing of Financial Assets) to determine whether the transfer of financial assets should be considered as a sale before derecognizing the partial investment and recognizing a gain or loss.

An investor’s ownership of or influence over an investee may decline as a result of its own action or the investee’s actions. For example, direct sales of interests by the investor will result in a decline in ownership or influence.13 Similarly, sales of additional shares by the investee will dilute the investor’s influence and ownership if the investor does not purchase additional shares equal to its proportionate ownership interest immediately preceding the additional sale. In either case, a gain or loss should be recognized on the basis of the deemed selling price. When calculating the gain or loss, the investor would include basis differences, if any, which would proportionately reduce its equity method basis differences to reflect the sale or dilution and proportionate reduction in ownership.