Overview

When an investor has significant influence over an investee, the investor is no longer considered to be a passive investor, and the equity method is an appropriate way to account for the investment. If an investor has the ability to influence significantly the operations and financial policies of an investee, it is appropriate for the investor to reflect that responsibility in the investor's financial statements. The advantages of the equity method are that it:

• Recognizes changes to the underlying economic resources
• More closely meets the objectives of accrual accounting than the cost method
• Best enables investors in corporate joint ventures to reflect their investment in those ventures.

  (ASC 323-10-15-4)

Significant Influence

According to ASC 323-10-15-6, indications of significant influence are:

• Representation on the board of directors
• Participation in policy-making processes
• Material intra-entity transactions
• Interchange of managerial personnel
• Technological dependency
• Extent of ownership in relation to other investors.

Generally, significant influence is presumed to exist when the investor owns between 20 to 50% of the investee's voting shares. However, ASC 323, allows for consideration of circumstances where such influence is present with under 20% ownership, or conversely is absent with holdings of 20% or greater. Over 50% is a strong indicator of control, and full consolidation of the investee's financial statements is mandatory unless the investor lacks control.

Accounting Overview

To the extent that the cost of acquiring the investment exceeds the fair value of the investor's share of the investee's underlying net assets, the excess must be accounted for in a manner analogous to the accounting prescribed for goodwill. Therefore, ASC 350, Intangibles—Goodwill and Other, affects the application of the equity method of accounting because the portion of the purchase cost identified as representing goodwill is not subject to amortization unless the entity is eligible for applies the alternative available under ASU 2014-02. (See the chapter on ASC 350 for more information on this new guidance.)

The equity method involves increasing the original cost of the investment by the investor's pro rata share of the investee's periodic net income, and decreasing it for the investor's share of the investee's periodic net losses and for dividends paid.

Overview

ASC 323-740 provides guidance on a specific tax issue—investments in a Qualified Affordable Housing Project. Created under the Tax Reform Act of 1986, this federal program gives incentives for the utilization of private equity in the development of affordable housing for low-income Americans. The Revenue Reconciliation Act of 1993 retroactively extended and made permanent the affordable housing credit. C corporations eligible for the credits generally purchase an interest in a limited partnership that operates the qualified affordable housing projects. So, the guidance in ASC 323-740 applies to investments in limited partnerships that operate qualified affordable housing projects.

Scope and Scope Exception

ASC 323-740 follows the same scope and scope exceptions as ASC 323-10 and the guidance applies to investments in limited partnerships that operate qualified affordable housing projects.

Introduction and Background

The equity method of accounting has been referred to as “one-line consolidation,” because the net result of applying ASC 323 on reported net income and on net worth should be identical to what would have occurred had full consolidation been applied. However, rather than include its share of each component (e.g., sales, cost of sales, operating expenses, etc.) in its financial statements, the investor only includes its share of the investee's net income as a separate line item in its income. Note that there are exceptions to this one-line rule. The investor's share of investee extraordinary items¹ and prior period adjustments retain their identities in the investor's income and retained earnings statements and are separately reported if material in relation to the investor's income. It should be noted that the final bottom-line impact on the investor's financial statements is identical whether the equity method or full consolidation is employed; only the amount of detail presented within the financial statements differs.

Significant Influence

The equity method is not a substitute for consolidation. It is employed where the investor has significant influence over the operations of the investee but lacks control. In general, significant influence is inferred when the investor owns between 20% and 50% of the investee's voting common stock. Any ownership percentage over 50% presumably gives the investor actual voting control, making full consolidation of financial statements necessary. The 20% threshold stipulated in ASC 323 is presumptive, but not absolute. Circumstances may suggest that significant influence exists even though the investor's level of ownership is less than 20%, or that it is absent despite a level of ownership above 20%. In considering whether significant influence exists, ASC 323-10-15-10 identifies the following factors:

1. Opposition by the investee,
2. Agreements under which the investor surrenders shareholder rights,
3. Majority ownership by a small group of shareholders,
4. Inability to obtain desired information from the investee,
5. Inability to obtain representation on investee board of directors, etc.

Whether sufficient contrary evidence exists to negate the presumption of significant influence is a matter of judgment. Judgment requires a careful evaluation of all pertinent facts and circumstances, over an extended period of time in some cases.

As a practical matter, absence of control by the parent is the only remaining reason to not consolidate a majority-owned investee.

Recognition and Initial Measurement

Investment in the stock of an investee is recognized as an asset. The investor measures its initial equity method investment at cost.

Determination of cost. When the consideration is in the form of cash, the cost of the acquisition is measured as the amount of cash paid to acquire the investment, including transaction costs associated with the acquisition.²

In some transactions, noncash consideration is surrendered by the investor. This can take the form of

• Noncash assets,
• Liabilities incurred or assumed, or
• Equity interests issued.

The measurement of consideration in these transactions is based on either the cost to the acquirer or the fair value of the assets (or net assets) acquired, whichever is considered more reliably measurable. No gain or loss is recognized by the investor, unless the value of noncash assets surrendered as consideration differs from their carrying amounts in the investor's accounting records.

Contingent consideration arrangements. All business combinations are required to be accounted for using the acquisition method as prescribed in ASC 805. Contingent consideration should, in general, only be included in the initial measurement of an equity method investment if required to be so included by guidance contained in GAAP other than ASC 805.

If an equity method investment agreement involves a contingent consideration arrangement in which the fair value of the investor's share of the investee's net assets exceeds the investor's initial cost (referred to as the “differential”), a liability is to be recognized for the lesser of the

1. Excess of the investor's share of the investee's net assets over the measurement of initial cost (including contingent consideration otherwise recognized), or
2. Maximum amount of contingent consideration not otherwise recognized.

Subsequently, upon the resolution of a contingent liability recorded under this provision (ASC 323-10-30-2B), when the consideration is issued or becomes issuable:

1. An excess of the fair value of the contingent consideration issued or issuable over the amount previously recognized as a liability is to be recognized as an additional cost of the investment.
2. An excess of the amount previously recognized as a liability over the contingent consideration issued or issuable is to be applied to reduce the cost of the investment.

Basis differences. ASC 323 requires that the investor account for any differential between its cost and its proportionate share of the fair value of the investee's net identifiable assets consistent with the accounting for a business combination under the acquisition method prescribed by ASC 805.

In almost all instances, the price paid by an investor to acquire shares of an investee will differ from the corresponding underlying book value (i.e., the investee's net assets per its GAAP-basis financial statements). The differential can be broken down into the following components from the authoritative literature on business combinations:

1. Tangible and intangible assets recognized in the accounting records of the investee at carrying values that are below their fair values.
2. Intangible assets not recognized in the accounting records of the investee because of the longstanding prohibition in GAAP against recognizing internally developed intangibles (with the notable exception of internal-use software). These might include in-process research and development assets, customer lists, and other amortizable or nonamortizable intangibles as discussed in detail in the chapters on ASC 730, Research and Development and ASC 350, Intangibles—Goodwill and Other.
3. Contingent consideration.
4. Goodwill.

This means that premiums or discounts versus underlying book values must be identified, analyzed, and dealt with. It also means that assets or liabilities not recognized by the investee must be identified and assigned, on a memo basis, the appropriate shares of the investor's purchase cost.

In the simplest example of applying this principle, if the investor identifies fixed assets with appreciated fair values, part of the price paid by the investor must be allocated (in a notional sense only—since the entire investment is presented as a single caption in the investor's financial statements, consistent with the “one-line consolidation” characteristic of equity method accounting) to the “step-up” in the values of those assets. Since those assets (other than land) are subject to depreciation, the investor must amortize a part of the investment cost to reduce the proportionate share of investee earnings that it would otherwise recognize in its entirety. This can require a costly and time-consuming effort on the part of the investor, particularly when a range of assets having varying depreciable lives is involved, as is almost always the case.

Under ASC 323, any premium paid by the investor that cannot be identified as being attributable to appreciated recognized tangible and intangible assets or unrecognized internally developed intangible assets of the investee (1 and 2 above) is analogous to goodwill.

Since the ultimate income statement effects of applying the equity method of accounting must generally be the same as full consolidation, an adjustment must be made to account for these differentials.

Subsequent Accounting³

In periods subsequent to the initial acquisition of the investment, the investor recognizes:

• Increases to the carrying value of the investment for the investor's proportionate share of the investee's net income, and
• Decreases in the carrying value of the investment for the investor's proportionate share of the investee's net losses, and by dividends received.

The basic procedure is illustrated below.

Deferred Income Tax Accounting

The equity method is not a recognized accounting method for federal income tax purposes under the U.S. Internal Revenue Code (IRC). For income tax purposes, the investor's share of the investee's net income is not recognized until it is realized through either the investor's receipt of dividends from the investee or through the investor's sale of the investment. Thus, when the investor, under the equity method, recognizes its proportionate share of the net income of the investee as an increase to the carrying value of the investment, a future taxable temporary difference between the carrying value of the equity method investment for financial reporting purposes and the income tax basis of the investment will arise. The temporary difference will give rise to recognition of a deferred income tax liability.

In computing the deferred income tax effects of income recognized by applying the equity method, the investor must make an assumption regarding the means by which the undistributed earnings of the investee will be realized. The earnings can be realized either through later dividend receipts or by disposition of the investment at a gain. The former assumption would result in income taxes at the investor's marginal income tax rate on ordinary income (net of the 80% dividends received deduction permitted by the Internal Revenue Code for intercorporate investments of less than 80% but at least 20%; a lower deduction of 70% applies if ownership is below 20%). The latter option would be treated as a capital gain.

The deferred income tax liability is originally computed with reference to the projected income tax effect of the “temporary difference reversal.” It may be subsequently adjusted for a variety of reasons, including changed income tax rates and altered management expectations (see the chapter on ASC 740 for a complete discussion).

Notwithstanding ASC 740's requirement that deferred income taxes be adjusted for changed expectations at the date of each subsequent statement of financial position, the actual income tax effect of the temporary difference reversal may still differ from the deferred income tax liability provided. This difference may occur because the actual income tax effect is a function of the entity's other current items of income and expense in the year of reversal (while ASC 740 requires the use of a projected effective income tax rate, actual rates may differ). It may also result from a realization of the investee's earnings in a manner other than anticipated (assuming that income tax rates on “ordinary” income differ from those on capital gains).

Note that if the realization through a sale of the investment had been anticipated at the time the 20X1 statement of financial position was prepared, the deferred income tax liability would have been adjusted (possibly to reflect the entire $5,100 amount of the ultimate obligation), with the offset included in 20X1's ordinary income tax expense. The above example explicitly assumes that the sale of the investment was not anticipated prior to 20X2.

Differences in Fiscal Year

If the investor and investee have different fiscal years, ASC 323-10-35-6 permits the investor to use the most recent financial statements available as long as the lag in reporting is consistent from period to period. Analogizing from ASC 810, the lag period is not to exceed three months.

If the investee changes its fiscal year-end to reduce or eliminate the lag period, ASC 810-10-45 stipulates that the change be treated as a voluntary change in accounting principle under ASC 250 (discussed in detail in the chapter on ASC 250). Although ASC 250 requires such changes to be made by retrospective application to all periods presented, it provides an exception if it is not practical to do so.

Goodwill Impairment Testing

Under ASC 350-20-35-58 and 35-59 the goodwill component is not subject to amortization, but rather to impairment testing. There is an exception to this provision for private companies who may elect to amortize goodwill. (Also see the chapter on ASC 350 for more information on the guidance for private companies.)

The impairment testing regime to be applied is not, however, that specified in ASC 350, which only pertains to testing by entities which actually record an asset explicitly as goodwill (i.e., the acquirer in a business combination accounted for under ASC 805). Equity method investors assess impairment of investments in investees by considering whether declines in the fair values of those investments, versus the carrying values of the underlying assets, may be other than temporary in nature as discussed previously in this chapter.

There is a requirement, applicable to the accounting for business combinations, and equity method investments, to identify intangible assets that require recognition separately from goodwill. Accordingly, in analyzing the purchase cost of an equity method investment, an investor needs to identify the portions of the premium paid that relate to identifiable intangibles per ASC 350, as well as to goodwill, with appropriate treatments regarding varying amortizable lives or, in some instances, amortization not being recognized due to the identifiable intangible assets having indefinite lives.

Although infrequently encountered in practice, the amount paid by the investor for its interest in the investee may imply that there had been a discount, analogous to a bargain purchase in the GAAP that relates to business combinations. In the rare instances where this occurs, this would be treated in the same manner as negative goodwill or gain from a bargain purchase. These are discussed in greater detail in the chapter on ASC 805.

In the following examples, the accounting for equity method investments involving both positive goodwill and negative goodwill are presented.

Adjustments to the goodwill portion of the differential are somewhat more complex. ASC 323 requires that the difference between cost and underlying book value be accounted for as if the investee were a consolidated subsidiary. An investor is therefore required to determine the individual components that comprise the differential as illustrated above, and this may result in the identification of part of the differential as goodwill (referred to as “equity method goodwill”). Under GAAP, goodwill associated with a business combination is required to be evaluated annually for impairment. FASB decided, however, that equity method investments would continue to be tested for impairment in accordance with ASC 323 (i.e., the equity method investment as a whole, not the underlying net assets, are to be evaluated for impairment) and that equity method goodwill will not be treated as being separable from the related investment. Accordingly, goodwill is not to be tested for impairment in accordance with the current goodwill and intangible assets standard, ASC 350.

The impact of interperiod income tax allocation in the foregoing example is similar to that demonstrated earlier in the simplified example. Under GAAP goodwill rules, unless goodwill has been reduced for financial reporting purposes due to other-than-temporary impairment of the investment, there will be no book-tax difference and hence no deferred income tax issue to be addressed. The other components of the differential in the foregoing example are all temporary differences, with normal deferred income tax implications.

Investor Share of Investee Losses in Excess of the Carrying Value of the Investment

As demonstrated in the foregoing paragraphs, the carrying value of an investment which is accounted for by the equity method is increased by the investor's share of investee earnings and reduced by its share of investee losses and by dividends received from the investee. Sometimes the losses are so large that the carrying value is reduced to zero, and this raises the question of whether the investment account should be allowed to “go negative,” or whether losses in excess of the investment account should be recognized in some other manner.

In general, an equity method investment would not be permitted to have a negative (i.e., credit) balance, since this would imply that it represented a liability. In the case of normal corporate investments, the investor would enjoy limited liability and would not be held liable to the investee's creditors should, for instance, the investee become insolvent. For this reason, excess losses of the investee would not be reflected in the financial statements of the investor. The practice is to discontinue application of the equity method when the investment account reaches a zero balance, with adequate disclosure being made of the fact that further investee losses are not being reflected in the investor's earnings. If the investee later returns to profitability, the investor ignores its share of earnings until the previously ignored losses have been fully offset; thereafter, normal application of the equity method is resumed.

There are, however, limited circumstances in which further investee losses would be reflected. Often the investor has guaranteed or otherwise committed to indemnify creditors or other investors in the investee entity for losses incurred, or to fund continuing operations of the investee. Having placed itself at risk in the case of the investee's insolvency, continued application of the equity method is deemed to be appropriate, since the net credit balance in the investment account (reportable as a liability entitled “losses in excess of investment made in investee”) would indeed represent an obligation of the investor.

The other situation in which investee losses in excess of the investor's actual investment in common stock of the investee are to be reflected is somewhat more complicated. When the investor has investments consisting of both common stock holdings accounted for under ASC 323, and other investments in or loans to the investee, such as in its preference shares (including mandatorily redeemable preferred stock) or debt obligations of the investee, there will not only be further application of ASC 323, but also possible interaction between the provisions of ASC 323 and those of ASC 310 and/or ASC 320. In addition, there will be the question of the appropriate proportion of the investee's loss to be recognized by the investor—that is, should the investor's share of further investee losses be computed based only on its common stock ownership interest, or would some other measure of economic interest be more relevant?

ASC 323-10-35 addresses the accounting to be applied under the circumstances described in the preceding paragraph. A principal concern was that an anomaly could develop if, for example, the common shareholdings were being accounted for by application of the equity method (including a suspension of the method when the carrying value declined to zero due to investee losses) while investments in the same investee's debt or preferred shares were being carried at fair value per ASC 320 (assuming that the debt was not being carried at amortized cost due to classification as a held-to-maturity investment). A parallel concern invokes the accounting for loans under ASC 310-10-35 when investee debt is being held by the investor.

According to ASC 323-10-35, the adjusted basis of the other investments (preferred stock, debt, etc.) are to be adjusted for the equity method losses, after which the investor is to apply ASC 310-10-35 and ASC 320 to the other investments, as applicable. Those equity method losses are applied to the other investments in reverse order of seniority (that is, the respective priority in liquidation). This sequence is logical because it tracks the risk of investor loss: Common shareholders' interests are the first to be eliminated, followed by those of the preferred shareholders, and so on—with debt having the highest claim to investee assets in the event of liquidation. If the investee later becomes profitable, equity method income subsequently recorded (if, as described earlier, any unrecognized losses have first been exceeded) is applied to the adjusted basis of the other investments in reverse order of the application of the equity method losses (i.e., equity method income is applied to the more senior securities first).

In applying ASC 323, the cost basis of the other investments is taken to mean the original cost of those investments adjusted for the effects of

• Other than temporary write-downs,
• Unrealized holding gains and losses on ASC 320 securities classified as trading, and
• Amortization of any discount or premium on debt securities or loans.

The adjusted basis is defined as the cost basis, as adjusted for the ASC 310-10-35 valuation allowance account for an investee loan and for the cumulative equity method losses applied to the other investments.

The interaction of ASC 323 and ASC 310-10-35 and ASC 320 could mean, for example, that investee losses are recognized via a reduction in carrying value of preferred shares, which might then be immediately upwardly adjusted to recognize fair value as of the date of the statement of financial position in accordance with ASC 320. In a situation such as this, the equity method downward adjustment would be a loss recognized currently in net income, while the upward revaluation to fair value would typically be credited to other comprehensive income, and thus excluded from current period net income (unless defined as being held for trading purposes, which would be unusual).

ASC 323-10-35 addresses only the situation where the investor had the same percentage interests in common stock and all the other equity or debt securities of the investee. However, a further complication can arise when the investor's share in the common stock of the investee is not mirrored in its investment in the other debt or equity securities of the investee that it also holds. While this possibility is discussed in ASC 323, GAAP is not definitive regarding the mechanism by which the investor's share of further losses should be recognized in such situations. What is clear, however, is that merely applying the investor's percentage interest in the investee's common stock to the period's loss would not be appropriate in these cases.

In the absence of definitive guidance, two approaches are justifiable. The first is to eliminate the carrying value of first, the common stock and then, the other securities of the investee (including loans made to the investee), in reverse order of seniority, as set forth under ASC 323-10-35. The percentage of the investee's loss to be absorbed against each class of investment other than common stock would be governed by the proportion of that investment held by the investor—and emphatically not by its common stock ownership percentage. The logic is that, if the investor entity were to be harmed by the investee's further losses (once the common stock investment were reduced to zero carrying value), the harm would derive from being forced to take a reduced settlement in a liquidation of the investee, at which point the percentage ownership in separate classes of stock or in holdings of classes of debt would determine the amount of the investor's losses.

The second acceptable approach also takes into account the investor's varying percentage interests in the different equity and debt holdings. However, rather than being driven by the investee's reported loss for the period, the investor's loss recognition is determined by the period-to-period change in its claim on the net assets of the investee, as measured by book value. This approach implicitly assumes that fair values upon a hypothetical liquidation of the investee would equal book values—an assumption which is obviously unlikely to be borne out in any actual liquidation scenario. Nonetheless, given the enormous difficulty of applying this measurement technique to the continuously varying fair values of the investee's assets and liabilities, this was deemed to be a necessary compromise.

Thus, both methods of computing the excess investee losses to be recognized by an investor having more than just a common stock interest in the investee depend on the varying levels of those other investment vehicles. These two alternative, acceptable approaches are described and illustrated below.

Accounting for Subsequent Investments in an Investee After Suspension of Equity Method Loss Recognition

Recognition of investee losses by the investor is suspended when the investment account is reduced to zero, subject to the further reduction in the carrying value of any other investments (preferred stock, debt, etc.) in that investee, as circumstances warrant. In some cases, after the recognition of investee losses is suspended, the investor will make a further investment in the investee, and the question arises whether recognition of some or all of the previously unrecognized investee losses should immediately be given recognition, up to the amount of the additional investment.

ASC 323-10-S99 addresses the situation where the increased investment in the equity method investee triggered a need to consolidate (i.e., the 50% ownership threshold was exceeded), and cites the Securities and Exchange Commission (SEC)'s position against further loss recognition. ASC 323-10-35-29 deals with the situation where the increased investment did not cause control to be assumed, but rather where equity method accounting was specified both before and after the further investment is made (e.g., the investor owned 30% of the investee's common stock previously, and then increased the interest to 35%) has been dealt with.

ASC 323-10-35-29 holds that recognition of some or all of the previously unrecognized (“suspended”) losses is conditioned on whether the new investment represents funding of prior investee losses. To the extent that it does, the previously unrecognized share of prior losses will be given recognition (i.e., reported in the investor's current period net income). Making this determination requires the use of judgment and is fact-specific, but some of the considerations would be as follows:

• Whether the additional investment is acquired from a third party or directly from the investee, since it is unlikely that funding of prior losses occurs unless funds are infused into the investee;
• The fair value of the consideration received in relation to the value of the consideration paid for the additional investment, with an indicated excess of consideration paid over that received being suggestive of a funding of prior losses;
• Whether the additional investment results in an increase in ownership percentage of the investee, with investments being made without a corresponding increase in ownership or other interests (or, alternatively, a pro rata equity investment made by all existing investors) being indicative of the funding of prior losses; and
• The seniority of the additional investment relative to existing equity of the investee, with investment in subordinate instruments being suggestive of the funding of prior losses.

When additional investments are made in an investee that has experienced losses, the corollary issue of whether the investor has committed to further investments may arise. If such is the case, then yet-unrecognized (suspended) investee losses may also need to be recognized in investor net income currently—in effect, as a loss contingency that is deemed probable of occurrence.

Intercompany Transactions Between Investor and Investee

Transactions between the investor and the investee may require that the investor make certain adjustments when it records its share of the investee earnings. According to the realization concept, profits can be recognized by an entity only when realized through a sale to outside (unrelated) parties in arm's-length transactions (sales and purchases) between the investor and investee. Similar problems, however, can arise when sales of fixed assets between the parties occur. In all cases, there is no need for any adjustment when the transfers are made at book value (i.e., without either party recognizing a profit or loss in its separate accounting records).

In preparing consolidated financial statements, all intercompany (parent-subsidiary) transactions are eliminated. However, when the equity method is used to account for investments, only the profit component of intercompany (investor-investee) transactions is eliminated. This is because the equity method does not result in the combining of all income statement accounts (such as sales and cost of sales), and therefore will not cause the financial statements to contain redundancies. In contrast, consolidated statements would include redundancies if the gross amounts of all intercompany transactions were not eliminated.

Another distinction between the consolidation and equity method situations pertains to the percentage of intercompany profit to be eliminated. In the case of consolidated statements, the entire intercompany profit is eliminated, regardless of the percentage ownership of the subsidiary. However, only the investor's pro rata share of intercompany profit is to be eliminated in equity accounting, whether the transaction giving rise to the profit is “downstream” (a sale to the investee) or “upstream” (a sale to the investor). An exception is made when the transaction is not “arm's-length” or if the investee company was created by or for the benefit of the investor. In these cases, 100% profit elimination would be required, unless realized through a sale to a third party before year-end.

Eliminating entries for intercompany profits in fixed assets are similar to those in the examples above. However, intercompany profit is realized only as the assets are depreciated by the purchasing entity. In other words, if an investor buys or sells fixed assets from or to an investee at a price above book value, the gain would only be realized piecemeal over the asset's remaining depreciable life. Accordingly, in the year of sale the pro rata share (based on the investor's percentage ownership interest in the investee, regardless of whether the sale is upstream or downstream) of the unrealized portion of the intercompany profit would have to be eliminated. In each subsequent year during the asset's life, the pro rata share of the gain realized in the period would be added to income from the investee.

In the above example, the income tax currently paid by Investor Co. (34% × $25,000 taxable gain on the transaction) is recorded as a deferred income tax benefit in 20X1 since current income taxes will not be due on the book gain recognized in the years 20X2 through 20X6. Under provisions of ASC 740, deferred income tax assets are recorded to reflect the income tax effects of all future deductible temporary differences. Unless Investor Co. could demonstrate that future taxable amounts arising from existing future taxable temporary differences exist (or, alternatively, that a net operating loss [NOL] carryback could have been elected), this deferred income tax asset will be offset by an equivalent valuation allowance in Investor Co.'s statement of financial position at year-end 20X1. Thus, the deferred income tax asset might not be recognizable, net of the valuation allowance, for financial reporting purposes unless other future taxable temporary differences not specified in the example generate future taxable income to offset the net deductible effect of the deferred gain.

NOTE: The deferred income tax impact of an item of income for book purposes in excess of tax is the same as a deduction for income tax purposes in excess of book.

Investee Income Items Separately Reportable by the Investor

In the examples thus far, the investor has reported its share of investee income, and the adjustments to this income, as a single item described as equity in investee income. However, when the investee has extraordinary items⁴ and/or prior period adjustments that are material, the investor is to report its share of these items separately on its statements of income and retained earnings.

Obtaining Significant Influence Subsequent to Initial Investment

An investor that holds an investment accounted for using the cost method may subsequently qualify to use the equity method of accounting. This can occur, for example, if the investor acquires additional voting shares or if the investor's voting percentage increases as a result of repurchase of voting stock by the investee.

Accounting for a Partial Sale or Additional Purchase of an Equity Method Investment

This section covers the accounting issues that arise when the investor sells some or all of its equity in the investee, or acquires additional equity in the investee.

The process of discontinuing the use of the equity method and adopting ASC 320, as necessitated by a reduction in ownership below the significant influence threshold level, does not require retroactive application. However, the opposite situation having the 20% ownership level equaled or exceeded again (or for the first time) is more complex. ASC 323 stipulates that this change in accounting principle (i.e., to the equity method) requires that the investment account, results of operations (all periods being presented, current and prior), and retained earnings of the investor company be retroactively adjusted.

Investor Accounting for Investee Capital Transactions

According to ASC 323, investee transactions of a capital nature that affect the investor's share of the investee's stockholders' equity are accounted for as if the investee were a consolidated subsidiary. These transactions principally include situations where the investee purchases treasury stock from, or sells unissued shares or reissues treasury shares it holds to outside shareholders. (If the investor participates in these transactions on a pro rata basis, its percentage ownership will not change and no special accounting will be necessary.) Similar results are obtained when holders of outstanding options or convertible securities acquire investee common shares.

When the investee engages in one of the above capital transactions, the investor's ownership percentage is changed. This gives rise to a gain or loss, depending on whether the price paid (for treasury shares acquired) or received (for shares issued) is greater or lesser than the per share carrying value of the investor's interest in the investee. However, since no gain or loss can be recognized on capital transactions, these purchases or sales will affect additional paid-in capital and/or retained earnings directly, without being reflected in the investor's income statement. This method is consistent with the treatment that would be accorded to a consolidated subsidiary's capital transaction. An exception is that, under certain circumstances, the SEC will permit income recognition based on the concept that the investor is essentially selling part of its investment.

Investor's Proportionate Share of Other Comprehensive Income Items

ASC 323-10-35-37 holds that an investor's proportionate share of an investee's equity adjustments for other comprehensive income items (e.g., fair value adjustments to available-for-sale investments) is to be offset against the carrying value of the investment in the investee entity at the time significant influence is lost. To the extent that the offset results in a carrying value of the investment that is less then zero, an investor will (1) reduce the carrying value of the investment to zero; and (2) record the remaining balance in income.

Exchanges of Equity Method Investments

According to ASC 845, an exchange of an equity method investment for another such investment is to be accounted for at book value, without gain or loss recognition (other than what may be necessary to record impairment, of course).

Change in Level of Ownership or Degree of Influence

An equity method investor is to account for an issuance of shares by the investee as if the investor had sold a proportionate share of its investment. Any gain or loss to the investor that results from the investee's share issuance is to be recognized in net income.

Significant Influence in the Absence of Ownership of Voting Common Stock

ASC 323 was written to apply to investments in voting common stock of an investee, and authoritative guidance has been lacking regarding the accounting for investments in other investment vehicles, such as options and warrants, and complex licensing and/or management agreements, where significant influence might also be present. These nontraditional modes of investment, providing the investor with significant influence, have become more common over the years, and thus the need for guidance became acute. ASC 323-10-15-13 addresses the accounting for these alternative investments.

ASC 323-10-15-13 states that a reporting entity that has the ability to exercise significant influence over the operating and financial policies of an investee is to apply the equity method only when it has an investment(s) in common stock and/or an investment that is in-substance common stock. In-substance common stock is an investment in an entity that has risk and reward characteristics that are substantially similar to the investee's common stock. Whether or not significant influence is wielded is a fact question, and suggested criteria are not provided in the ASC.

Management is to consider certain characteristics when determining whether an investment in an entity is substantially similar to an investment in that entity's common stock. These are conjunctive constraints: thus, if the entity determines that any one of the following characteristics indicates that an investment in an entity is not substantially similar to an investment in that entity's common stock, the investment is not in-substance common stock.

1. Subordination. It must be determined whether the investment has subordination characteristics substantially similar to the investee's common stock. If there are substantive liquidation preferences, the instrument would not be deemed substantially similar to common stock. On the other hand, certain liquidation preferences are not substantive (e.g., when the stated liquidation preference that is not significant in relation to the purchase price of the investment), and would be discounted in this analysis.
2. Risks and rewards of ownership. A reporting entity must determine whether the investment has risks and rewards of ownership that are substantially similar to an investment in the investee's common stock. If an investment is not expected to participate in the earnings (and losses) and capital appreciation (and depreciation) in a manner that is substantially similar to common stock, this condition would not be met. Participating and convertible preferred stocks would likely meet this criterion, however.
3. Obligation to transfer value. An investment is not substantially similar to common stock if the investee is expected to transfer substantive value to the investor and the common shareholders do not participate in a similar manner. For example, if the investment has a substantive redemption provision (for example, a mandatory redemption provision or a non-fair-value put option) that is not available to common shareholders, the investment is not substantially similar to common stock.

In some instances it may be difficult to assess whether the foregoing characteristics are present or absent. ASC 323-10-15-13 suggests that, in such circumstances, management of the reporting entity (the investor) is also to analyze whether the future changes in the fair value of the investment are expected to be highly correlated with the changes in the fair value of the investee's common stock. If the changes in the fair value of the investment are not expected to be highly correlated with the changes in the fair value of the common stock, then the investment is not in-substance common stock.

According to ASC 323-10-15-13, the determination of whether an investment vehicle is in-substance common stock must be made upon acquisition, if the entity has the ability to exercise significant influence. The assessment is to be revisited if one or more of these occur:

1. The contractual terms of the investment are changed resulting in a change to any of its characteristics described above.
2. There is a significant change in the capital structure of the investee, including the investee's receipt of additional subordinated financing.
3. The reporting entity obtains an additional interest in an investment in which the investor has an existing interest. As a result, the method of accounting for the cumulative interest is based on the characteristics of the investment at the date at which the entity obtains the additional interest (that is, the characteristics that the entity evaluated in order to make its investment decision), and will result in the reporting entity applying one method of accounting to the cumulative interest in an investment of the same issuance.

The mere fact that the investee is suffering losses is not a basis for reconsideration of whether the investment is in-substance common stock.

Upon implementation of ASC 323-10-15-13, for investments in which the entity has the ability to exercise significant influence over the operating and financial policies of the investee, the reporting entity is to make an initial determination about whether existing investments are in-substance common stock. The initial determination is to be based on circumstances that existed on the date of adoption, rather than on the date that the investment was made.

General Partnerships

There is a rebuttable presumption that a general partner that has a majority voting interest is in control of the partnership. If voting rights are indeterminate under the provisions of the partnership agreement or applicable law, the general partner with a majority of the financial interests in the partnership's profits or losses would be presumed to have control. If this presumption is not overcome, the general partner with voting control or the majority financial interest would consolidate the partnership in its financial statements and the other noncontrolling general partners would use the equity method. (ASC 323, ASC 970-323)

Limited Liability Companies

A limited liability company may maintain a specific ownership account for each investor—similar to a partnership capital account structure. In that case, the investment in the limited liability company is viewed as similar to an investment in a limited partnership for purposes of determining whether a noncontrolling investment in a limited liability company is accounted for using the cost method or the equity method.

Effective Yield Method

The effective yield is the internal rate of return on the investment, based on the cost of the investment and the guaranteed tax credits allocated to the investor, excluding any expected residual value of the investment. (ASC 323-740-35-2) Investors may use the effective yield method if the following conditions are met:

• The investor is a limited partner, for both legal and tax purposes, with liability limited to its capital investment.
• A creditworthy entity guarantees the availability of the tax credits allocable to the investor.
• Based solely on the cash flows from the guaranteed tax credits, the investor's projected yield is positive.

The decision to use the effective yield method is an accounting policy decision.

Recognition. The investor should recognize a liability for:

• Delayed equity contributions that are unconditional and legally binding.
• Equity contributions that are contingent upon a future event.

An investor should not recognize credits before their inclusion in the investor's tax return.

Subsequent measurement. Investors recognize tax credits as they are allocated and amortize the initial cost of the investment to provide a constant effective yield over the period that tax credits are allocated to the investor. Investors include in earnings any cash received from operations of the limited partnership or sale of the property.

The tax credit allocated, net of the amortization of the investment in the limited partnership, is recognized in the income statement as a component of income taxes attributable to continuing operations. (ASC 323-740-45-2)