Accounting, Reporting, and Compliance Hub (ARCH)

Summary

Under a recent proposal from the FASB, investors would apply a single threshold of significant influence to determine whether the equity method of accounting applies to investments in common stock, in-substance common stock, limited partnerships, and limited liability companies (LLCs). That is, the significant influence threshold would replace the more-than-minor influence threshold currently applied to investments in limited partnerships and similar entities.

The proposed Accounting Standards Update (“Proposed ASU”), Investments — Equity Method and Joint Ventures (Topic 323): Equity Method of Accounting — Targeted Improvements, would also clarify the application of the equity method, for example, with respect to complex earnings allocation structures, and would add illustrative examples.

Key Takeaways

• Investors would need to reassess their investments in limited partnerships and similar entities on adoption, since the more-than-minor influence threshold (commonly viewed in practice as more than 3% to 5%) for applying the equity method to such investees would be replaced by the significant influence threshold.
• Investments that are no longer accounted for under the equity method due to the higher threshold would be within the scope of Accounting Standards Codification (ASC) 321, Investments — Equity Securities. Investors would then need to decide whether to elect the measurement alternative under that guidance for eligible investments.
• The Proposed ASU would move some guidance on allocating profits and losses when an investee has a complex allocation structure (for example, a distribution waterfall) from ASC 970-323, Real Estate — General, Investments — Equity Method and Joint Ventures, into ASC 323. It would also add examples illustrating one method of allocating profits and losses.
• Investments eligible for proportionate consolidation or the proportional amortization method (PAM) are expected to remain eligible for that accounting.
• Comments are due by January 11, 2027.

Why is the FASB Proposing Changes to U.S. GAAP?

The Proposed ASU comes in response to feedback from the 2025 FASB Invitation to Comment, Agenda Consultation, wherein stakeholders identified two challenging areas:

• The different scopes for applying the equity method to investments in corporations and to investments in partnerships
• The lack of authoritative guidance for allocating earnings and losses in complex allocation structures

Who Would this Change Affect?

The Proposed ASU would primarily affect investors with investments in limited partnerships and similar entities. Such investors would need to perform a robust qualitative analysis to determine whether to apply the equity method to their investments. It would also potentially affect other investors with investments currently accounted for under the equity method, particularly if the investees have complex earnings allocation structures, as well as parents that consolidate non-wholly owned subsidiaries that have complex allocation structures.

What Would Change?

The Proposed ASU would make changes focused on two aspects of ASC 323: its scope, and the allocation of earnings and losses when the investee has a complex allocation structure.

Issue A: Scope of ASC 323

Under current U.S. GAAP, the requirement to apply the equity method differs based on the investee’s legal form:

• Investments in the common stock (or in-substance common stock) of corporations, corporate joint ventures, and limited liability companies (LLCs) that do not have specific ownership accounts are accounted for under the equity method when the investor has the ability to exercise significant influence over the investee’s operating and financial policies. Significant influence is presumed to exist when the investor holds 20% or more of the investee’s voting stock (and does not control the investee), but that presumption may be overcome. Significant influence is presumed to not exist when the investor holds less than 20% of the investee’s voting stock, but that presumption also may be overcome.
• Investments in limited partnerships, unincorporated joint ventures, and LLCs that have specific ownership accounts (“limited partnerships and similar entities”) are accounted for under the equity method unless the investor’s interest is so minor that the limited partner has virtually no influence over the investee (commonly viewed in practice as less than a 3% to 5% interest).

Stakeholders said that these different thresholds lead to inconsistent outcomes that are confusing, unintuitive, and difficult to explain.

The Proposed ASU would remove the separate threshold for limited partnership and similar entities and would eliminate the presumption that significant influence does not exist when the investor holds less than 20% of the investee’s voting stock. Instead, investors would evaluate whether they have significant influence over such investees, using the definition and indicators of significant influence in ASC 323 (for example, representation on the investee’s board of directors), which are not changing. See Chapter 2 of BDO’s Blueprint, Equity Method Investments Under ASC 323, for more guidance on determining whether an investor has the ability to exercise significant influence over an investee.

The elimination of the more-than-minor influence threshold for limited partnerships and similar entities will not automatically cause a change in the accounting for such investments. Investors must still evaluate whether they have significant influence over the investee. The Proposed ASU would:

• Remove the presumption that an entity does not have significant influence when it holds less than 20% of an investee.
• Expand references to the board of directors in ASC 323 to include functionally equivalent governing bodies in partnership structures.
• Specify that a noncontrolling general partner, or functional equivalent (such as a managing member in an LLC), has significant influence over the investee.

Investments currently eligible for proportionate consolidation or the PAM are expected to remain eligible for those methods under the Proposed ASU. For more guidance on which investments are eligible for the PAM, see BDO’s Bulletin, Investments in Tax Credit Structures and the Proportional Amortization Method.

Issue B: Complex Earnings Allocation Structures

Under the equity method, an investor recognizes its share of the investee’s income or losses each reporting period, which generally is based on the investor’s proportionate share of the investee’s equity, assuming the equity investors share in the income and losses on a pro rata basis. However, investees often issue classes or types of equity with differing economic rights that are not necessarily shared on a pro rata basis. For example, an investee’s contractual agreements (such as the limited partnership or LLC agreement) might have varying formulas for allocating income, specified costs and expenses, distributions of cash from operations, and distributions upon liquidation. 

Currently, ASC 323 does not address how to allocate an investor’s share of the investee’s earnings or losses when the economics are other than pro rata. However, there is industry-specific guidance in ASC 970-323 that discusses how to allocate earnings and losses for entities with complex earnings allocation structures. The Proposed ASU would move that guidance, along with other guidance in ASC 970-323 that is not industry-specific, to ASC 323. It would also add illustrative examples to ASC 323 showing one method of allocating earnings in those structures. In addition, the Proposed ASU would require parents of non-wholly owned subsidiaries to consider the guidance on complex allocation structures in ASC 323 when allocating income to a noncontrolling interest (NCI).

When Would the Changes Be Effective?

The following table summarizes the proposed transition.

Link to Proposed ASU.

The proposed ASU is not authoritative and may change before a final ASU is issued. Investors must continue to apply existing U.S. GAAP while monitoring the FASB’s standard-setting activities. Stakeholders may submit comments to the FASB through January 11, 2027, here.