Equity Method Investments Under ASC 323
Accounting for equity method investments can be complex. Make sure you get it right by using BDO's "Blueprint."
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Overview
Investments in other entities can take many forms. For example, the instrument may be legally structured as an equity interest or debt instrument. The investee’s legal form may be a simple corporation that shares returns pro rata or may have many classes of equity with different rights and privileges. Alternatively, the investee might be structured as a limited partnership (LP) or limited liability company (LLC), which may have specific ownership accounts and preferential returns. The investor might have rights to participate in the investee’s governance and policies (for example, a seat on the investee’s board of directors or veto rights). The investor’s level of influence can range from having limited protective rights to having the ability to unilaterally make decisions that significantly impact the investee’s economic performance. The investor might be explicitly or implicitly committed to funding the investee’s losses. The investment might have been entered with a strategic objective (for example, expanding a presence in a new market or vertically expanding the investor’s supply or distribution chain) or solely for financial gain. Many such investments are potentially subject to the equity method of accounting.
This Blueprint focuses on the accounting for equity method investments, which is codified in Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 323, Investments — Equity Method and Joint Ventures. This Blueprint also includes interpretive guidance, examples, and insights on applying ASC 323.
Scope and Significant Influence
ASC 323 applies to any investment in a corporation’s common stock or in-substance common stock unless a scope exception applies. The equity method also applies to equity investments in partnerships, LPs, LLCs, and other similar legal entities. Accordingly, the equity method may or may not apply to an arrangement referred to in practice as a “joint venture.” Because U.S. GAAP defines the term “joint venture,” a contractual or legal reference to an arrangement being a joint venture does not determine whether the arrangement is in the scope of ASC 323.
ASC 323 has scope exceptions. For example, if an investor controls and consolidates an investee in accordance with ASC 810, the equity method does not apply (see our Blueprint, Control and Consolidation Under ASC 810). Investments in the scope of ASC 815, Derivatives and Hedging, and investments in common stock held by a nonbusiness entity such as an estate, trust, or individual are also outside the scope of ASC 323.
The table below lists the presumptions that apply to different equity investments, unless a scope exception applies.
| Investment | Guidance |
|---|---|
| Equity investment in a corporation’s common stock or in-substance common stock | The investor applies the equity method if it has the ability to exercise significant influence over the investee’s operating and financial policies. The investor is presumed to have significant influence if it holds 20% or more of the investee’s common stock (or in-substance common stock). This presumption stands until overcome by predominant evidence to the contrary. Conversely, an investor that holds less than 20% of a corporation’s voting common stock is presumed not to have the ability to exercise significant influence over the investee’s operating and financial policies unless such ability can be demonstrated. If not, the investment is a financial asset. |
| Equity investment in an LLC that does not have specific ownership accounts (other than the managing member interest) | |
| Equity investment in a corporation’s preferred stock that is not in-substance common stock | The equity method does not apply, regardless of whether the investor otherwise has the ability to exercise significant influence. The investment is a financial asset. |
| Equity investment in an LP (other than the general partner interest), including investments with preferential returns | The investor applies the equity method if it has more than virtually no influence over the investee. The investor is presumed to have more than virtually no influence if it holds an interest of 3% to 5% or more. Other facts and circumstances can also indicate that the investor has more than virtually no influence over the investee. |
| Equity investment in an LLC that has specific ownership accounts (other than the managing member interest), including an investment with preferential returns | |
| General partner or managing member interest | The investor applies the equity method if it does not control and consolidate the investee. |
An investor’s proportion of voting common stock is based on outstanding securities. Determining the proportion held can be complex when the investor holds indirect interests or potential voting rights in the investee. An investor must continuously evaluate all facts and circumstances to determine whether it has the ability to exercise significant influence over an investee. A change in interest of other facts and circumstances can affect an investor’s ability to exercise significant influence over the investee’s operating and financial decisions. See Chapters 1 and 2 for guidance on the scope of the equity method and identifying significant influence.
Initial Measurement
The initial measurement of an equity method investment has two steps.
Step 1: Determine the investment’s cost
ASC 323 requires an investor to initially measure an equity method investment at cost and present the investment on the balance sheet as a single line item. The investor determines the cost in accordance with the cost accumulation model for asset acquisitions in ASC 805-50, Business Combinations — Related Issues. The cost basis of an equity method investment includes transaction costs directly related to the investment’s acquisition, contingent consideration in specific circumstances, and commitments and guarantees the investor provided on the investee’s behalf. The cost of an equity method investment also includes any other consideration paid. When the investor obtains the equity method investment in exchange for consideration other than cash, the investment’s initial measurement often is in the scope of other U.S. GAAP and recognized at fair value.
Step 2: Identify basis differences and allocate the cost of the investment in the memo accounts as if the investee were a subsidiary
The cost of an equity method investment typically differs from the investor’s share of the investee’s identifiable assets and liabilities (referred to as “net assets”). In Step 2, an investor must allocate this basis difference to the investee’s identifiable net assets in separate accounts, referred to as “memo accounts,” as if the investee were a consolidated subsidiary. If the investee meets the definition of business in ASC 805, Business Combinations, an investor accounts for any unallocated basis difference as equity method goodwill.
Other factors to consider when accounting for the basis difference include:
- The deferred tax consequences of basis differences related to identifiable net assets
- The investee’s accumulated other comprehensive income (OCI)
- Any in-process research and development
- Noncontrolling interests (NCI) in the investee’s subsidiaries.
See Chapter 3 for more guidance on the initial measurement of an equity method investment.
Subsequent Measurement
Under the equity method, an investor recognizes its share of the investee’s income (loss) when recognized by the investee in its financial statements (rather than when an investee declares a dividend) and increases (or decreases) the investment. An investor’s share of the investee’s income generally is based on the investor’s share of the investee’s common stock. However, determining an investor’s share of an investee’s income can be challenging when returns, distributions, or dividends are not shared pro rata. It can also be challenging to determine an investor’s share of the investee’s income when the investee is accounted for on a lag or has different fiscal year-end, accounting policies, or functional currency.
An investor adjusts its share of the investee’s income to:
- Eliminate intra-entity profit
- Amortize basis differences
- Recognize the investor's share of changes in the investee's capital
- Report the investor's share of the investee’s OCI.
An investor generally recognizes equity method losses only up to the carrying amount of its investment. However, an investor continues recognizing losses to reduce its investment (and any other interests in the investee) below zero if it has guaranteed the investee’s obligations; has provided, or is otherwise committed to provide, more financial support; or if the investee will imminently return to profitability. Otherwise, an investor accumulates any unrecognized equity method losses in its memo accounts. If the investee later recognizes income, the investor resumes recognizing equity method income only after its share of the investee’s income equals the share of losses not recognized while the equity method was suspended.
An investor impairs its equity method investment when it has an other than temporary loss in value, and it remeasures the investment to fair value.
See Chapter 4 for more guidance on the subsequent measurement of an equity method investment and measuring the investor’s equity method income.
Changes in Ownership
An investor’s ownership interest in an investee may increase or decrease and with that, the investor’s level of influence over the investee may increase or decrease. Sometimes, such changes occur because of the investor’s actions (like buying or selling the investee’s voting common stock). At other times, those changes occur without any actions by the investor (for example, because the investee issues or repurchases shares). Chapter 5 addresses changes in an investor’s ownership in an investee when the investor has an equity investment in the investee before the transaction.
Presentation and Disclosure
The table below summarizes presentation requirements for an equity method investment in ASC 323.
| Presentation Requirements | |
|---|---|
| Balance Sheet |
|
| Income Statement |
|
| Cash Flow Statement |
|
See Chapter 6 for more guidance on the presentation and disclosure requirements in ASC 323.