Investors can make an investment in another entity with any amount. If they exercise significant influence and hold substantial shareholding (at least 20%), they will account for the investment with the equity method of accounting.
The initial investment, subsequent measurement adjusted for income/loss, and finally the disposal will also be recorded under the equity accounting method.
ASC 323 Investments and ASC 810 Consolidation provide guidelines on recording the equity investments.
Let us discuss what is the equity method of accounting and how it is used to record the investment.
What is the Equity Method of Accounting?
The equity method of accounting refers to the accounting treatment of ownership stakes of an entity in another entity through common stocks or capital investment.
ASC 323 Investments – Equity Method and Joint Venture provides guidelines on the application of equity accounting.
An entity may have several motives to invest in another entity. Some of these include:
- An entity wants a profitable investment and earn lucrative profits.
- Two or more entities enter into a partnership or joint venture.
- The investee is a subsidiary of the investor and the parent company divested part of its shareholding.
- Two or more companies enter into a partnership or joint venture for a specific project, research development, market expansion, or any other motive.
The entity must hold significant influence over the operating and financial decisions of the investee. The definition of significant influence varies by the size and nature of the investee. However, it is usually described in terms of percentage in stocks.
The percentage ownership remains the criteria to determine the investor’s stakes in the assets, liabilities, and eventually profit/loss of the investee. As the investor does not fully own the investee, the investor’s stakes will be partially calculated.
Investments through stocks or capital investment are considered for the application of equity accounting. For instance, investments for partnerships, joint ventures, or partial ownership in limited liability companies.
The investor would record such investment as an asset on its balance sheet. The valuation of the investment is evaluated as on the reporting date like any other investment valuation on the balance sheet.
Applying the Equity Method of Accounting
Generally, the equity method of accounting is applicable for any significant ownership stake of an entity in another that enables the investor to influence (not control) operating and financial decisions.
As per the ASC 323, equity investment options include:
- Common Shares
- Capital Investment
- Undivided Interest
- In-Substance Common Stocks
Similarly, ASC 323 excludes some specific investments from the application of equity accounting. These investments include:
- Investments held by non-business entities
- Controlling financial interests
- Debt securities accounted for under ASC 860 Transfer and Services
- Qualified housing investments
Let us now discuss how to determine significant influence as per ASC 323 guidelines.
Determining the Significant Influence for Equity Method of Accounting
The main point of equity accounting application is to determine significant influence. If the entity holds significant control, it will be accounted for under ASC 810 consolidation.
If an entity holds more than 50% ownership stocks in an investee, it is accounted for as a subsidiary. The accounting method applicable in such events falls under ASC 810 consolidation.
Generally, if an investor holds around 20% of the stocks on the investee it is accounted for under the equity method of accounting. However, the decision will depend on professional judgment. The definition of significant influence can change depending on the size and nature of a business.
Although we can define a threshold of 20% ownership stakes as a significant influence, there are other indicators to make the judgment as well. The FASB recognizes the fact that determining the 20% shareholding will vary by the entity structure, arrangement, and size of the investee.
ASC 323 – 10-15-6 provides some indicators to help investors make decisions on the equity method of accounting application.
- A representation in the Board of Directors (BOD)
- Active participation in the decision-making process
- Interchange of managerial personnel between the investor and the investee
- Material intra-entity transaction between the investor and the investee
- Technological dependency
- The extent of ownership by an investor as compared to the relationship of concentration of other ownership holdings by the investor
If an investor holds more than 20% stocks and less than 50%, it also needs to exhibit significant influence over the investee as well. Importantly, the guidelines distinguish between the significant influence and significant control over the investee.
Similarly, when an investor holds less than 20% stock in an investee entity, the demonstration of significant influence may not be sufficient. However, there are no set rules to determine that an investment of less than 20% does not result in a “significant influence”.
In a nutshell, the determination of significant influence will depend on the percentage shareholding as well as the investor’s ability to affect the decision-making of the investee. Generally, we can categorize a 20-50% shareholding for the equity method of accounting application.
Accounting for the Equity Method
An investor entity will record the investment as an asset on the balance sheet. It is recorded at the cost value initially. The investor then adjusts for the subsequent changes, remeasurement of value, and partial or full disposal accordingly.
Initial Measurement of Equity Interest
Under the equity accounting method, the investor will record the investment at cost. The cost will include the consideration for ownership stocks and the transactions costs.
The initial recognition will be recorded as per ASC 805-50-30 business combinations. The investor would include transaction value, transaction costs, any legal fees, or commission in the total initial cost of the transaction.
In some cases, an investor would pay non-cash items as transaction consideration. These non-cash items include:
- Non-cash assets – tangible or intangible
- Equity interest issues (shares)
- Liability incurred or assumed for the investee
In almost all cases, the fair value of the shareholding and the book values will be different. The ASC 323 requires an investor to recognize, measure, and record the difference between the book value and the fair value of the consideration being made.
Subsequent Measurement of Equity Interest
The investor will record income/loss from the investment according to the percentage shareholding. The investor’s income statement will reflect the effects of profit or loss in the same proportion of shareholding when the investee declares financial results.
The investor must recognize their share of income/loss subsequently adjusted for the earnings declared by the investee. The investor must also adjust for dividends, distributions, and impairments.
An investee may announce a dividend or distribution for their shareholders. A dividend declaration will mean the investor’s fair value of the shareholding decreases on the balance sheet.
Conversely, if the investor makes an additional capital investment, it will increase the shareholding of the investor. Eventually, the fair value of the investment will also increase on the balance sheet.
Disposal of Equity Interest
As per ASC 323 guidelines, when an investor disposes of an equity investment in proportion or full, it will be recorded as a sale. If the investor sells a portion of the investment, it will reduce the equity investment also.
The investor will record the gain or loss on the sale of equity investment by comparing the consideration received and the fair value of the investment.
Disposal of equity investment may lead to the reduction of shareholding significantly so that it no longer qualifies for equity accounting. In such scenarios, the fair value of the equity investment will be recorded as the carrying value of the investment asset going forward.
Suppose a company ABC enters into a partnership agreement with XYZ. It purchases 25% of the stocks of XYZ for a market fair value of $ 1 million.
After careful considerations, ABC decides to apply the equity method of accounting to represent its 25% shares in XYZ.
The initial investment will be recorded with the following journal entry:
|Equity Investment in XYZ||$ 1 million|
|Cash||$ 1 million|
Suppose XYZ declares a loss of $ 500,000 for the current financial year. The subsequent measurement by ABC company will be:
|Loss from Non-Consolidated Entities||$ 125,000|
|Equity Investment in XYZ||$ 125,000|
Suppose in the following year; the company XYZ makes a profit of $ 300,000. It retains $ 200,000 and distributes $ 100,000 as dividend.
ABC will record the adjustments in 25% proportion of ownership as below:
|Equity Investment in XYZ||$ 75,000|
|Income from Non-consolidated Entities||$ 75,000|
|Cash Received (Dividend)||$ 25,000|
|Equity in XYZ||$ 25,000|
Suppose ABC Company decides to dispose-off its investment in XYZ fully. Another company W purchases the 25% shareholding in XYZ for a fair market value of $ 500,000.
ABC Company will recognize the net gain/loss from the divestment as:
|Initial Investment||$ 1,000,000|
|Loss for Year 1||($ 500,000)|
|Income for Year 2||$ 75,000|
|Dividends Received||($ 25,000)|
|Cumulative Balance||$ 450,000|
|Fair Market value of 25% shareholding||$ 500,000|
|Net Gain/Loss||$ 50,000|
ABC will record the journal entry for the disposal of equity investment in XYZ as:
|Cash Proceeds||$ 500,000|
|Gain from the Sale of Investment||$ 50,000|
|Equity Investment in XYZ||$ 450,000|