11.2 Equity Investments and Equity Method
Key Takeaways
- Under ASC 321, equity investments with readily determinable fair values are measured at fair value through net income (FVTNI), eliminating the historical Available-for-Sale equity classification.
- The Measurement Alternative allows equity investments without readily determinable fair values to be recorded at cost less impairment, adjusted for observable price changes in orderly transactions of the same or similar securities.
- The equity method (ASC 323) is required when an investor exercises significant influence over the investee, typically presumed at 20% to 50% voting common stock ownership.
- Dividends received under the equity method represent a return of capital and reduce the carrying value of the investment, rather than being recognized as dividend income.
- The excess of an equity investment's cost over the book value of the net assets acquired must be allocated to identifiable assets (and amortized accordingly) and embedded goodwill (which is not amortized).
11.2 Equity Investments and Equity Method
Equity Securities (ASC 321 & ASU 2016-01)
Under ASC 321, investments in equity securities (excluding those accounted for under the equity method or consolidation) are measured at fair value through net income (FVTNI). This represents a major shift introduced by ASU 2016-01, which eliminated the old "Available-for-Sale" classification for equity securities.
Standard Measurement
- Fair Value Measurement: Equity securities with readily determinable fair values are adjusted to fair value at each reporting date. Unrealized holding gains and losses are recognized directly in earnings (net income).
- Dividend Income: Dividends are recognized as dividend income in earnings when the investor's right to receive payment is established (typically the ex-dividend date), provided it does not represent a return of capital.
Journal Entries:
- To record purchase:
Dr. Investment in Equity Securities $XX,XXX Cr. Cash $XX,XXX - To record year-end adjustment to fair value (gain):
Dr. Investment in Equity Securities $X,XXX Cr. Unrealized Gain on Equity (Net Income) $X,XXX
Measurement Alternative
For equity investments that do not have a readily determinable fair value (and do not qualify for the equity method), the entity may elect the Measurement Alternative:
- The investment is carried at cost, less any impairment, plus or minus changes resulting from observable price changes in orderly transactions for the same or a similar security of the same issuer.
- If an observable price change occurs, the investment must be remeasured to fair value as of the date of the transaction, and the gain/loss is recognized in earnings.
- Impairment under this alternative is assessed qualitatively. If impairment is indicated, the investment is written down to its fair value, with the loss recognized in earnings.
The Equity Method (ASC 323)
The equity method is used when an investor exercises significant influence over the operating and financial policies of an investee.
Determining Significant Influence
Significant influence is generally presumed to exist if the investor holds, directly or indirectly, 20% to 50% of the voting stock of the investee. However, this is a rebuttable presumption.
- Significant Influence Exists (<20% ownership): Can be demonstrated by representation on the board of directors, participation in policy-making processes, material intercompany transactions, interchange of managerial personnel, or technological dependency.
- Significant Influence Absent (>20% ownership): Can be demonstrated if the investee files a lawsuit against the investor, the investor signs a standstill agreement, a small group of shareholders controls the investee without consulting the investor, or the investor tries and fails to obtain representation on the board of directors.
Equity Method Accounting Mechanics
The equity method acts as a "one-line consolidation" on the balance sheet.
| Event | Impact on Investment Account | Impact on Income Statement | Journal Entry |
|---|---|---|---|
| Initial Acquisition | Increase (at cost) | None | Dr. Investment / Cr. Cash |
| Investee Net Income | Increase (Investor's Share) | Increase (Investment Income) | Dr. Investment / Cr. Investment Income |
| Investee Net Loss | Decrease (Investor's Share) | Decrease (Investment Loss) | Dr. Investment Loss / Cr. Investment |
| Investee Cash Dividend | Decrease (Investor's Share) | None (Return of Capital) | Dr. Cash / Cr. Investment |
| Amortization of Excess Fair Value | Decrease | Decrease (Investment Income) | Dr. Investment Income / Cr. Investment |
Adjustments for Excess Acquisition Cost
When an investor purchases an equity method investment, the purchase price (cost) often exceeds the book value of the investee's underlying net assets. This difference must be analyzed and allocated to:
- Book Value of Net Assets: The investor's share of the investee's recorded net assets.
- Fair Value of Identifiable Net Assets: Excess of fair value over book value of assets like inventory, equipment, patents, and buildings.
- Goodwill: The remaining unallocated portion of the purchase price.
The investor must amortize or write off the excess allocated to depreciable/amortizable assets over their remaining useful lives. This adjustment reduces both the investment account and the investment income recognized by the investor:
- Undervalued Inventory: Written off to cost of goods sold in the period the inventory is sold by the investee (typically Year 1).
- Undervalued Equipment: Depreciated over the remaining useful life of the equipment.
- Undervalued Patents: Amortized over the patent's remaining useful life.
- Goodwill: Embedded goodwill is not amortized and is not tested separately for impairment.
Journal Entry for Amortization of Undervalued Equipment:
Dr. Investment Income (Earnings) $X,XXX
Cr. Investment in Investee $X,XXX
Comprehensive Example of Equity Method
On January 1, Year 1, Alpha Corp purchases 30% of Beta Corp's voting stock for $300,000. On this date, Beta's net assets had a book value of $800,000. The fair value of Beta's equipment (10-year remaining useful life, straight-line) was $100,000 higher than its book value. The remaining difference is attributed to goodwill. During Year 1, Beta reported net income of $80,000 and paid cash dividends of $20,000.
1. Purchase Analysis
- Total purchase price: $300,000
- Book value acquired (30% of $800,000): $240,000
- Total excess cost: $300,000 - $240,000 = $60,000
- Allocation of excess:
- Equipment excess (30% of $100,000): $30,000
- Remaining excess (Goodwill): $60,000 - $30,000 = $30,000
2. Year 1 Journal Entries
- Initial Acquisition:
Dr. Investment in Beta Corp $300,000 Cr. Cash $300,000 - Share of Net Income (30% * $80,000 = $24,000):
Dr. Investment in Beta Corp $24,000 Cr. Investment Income $24,000 - Share of Dividends (30% * $20,000 = $6,000):
Dr. Cash $6,000 Cr. Investment in Beta Corp $6,000 - Amortization of Equipment Excess ($30,000 / 10 years = $3,000):
Dr. Investment Income $3,000 Cr. Investment in Beta Corp $3,000
3. Year-End Investment Balance
- Balance = $300,000 (initial) + $24,000 (income) - $6,000 (dividends) - $3,000 (amortization) = $315,000.
- Alpha Corp's ending balance sheet shows "Investment in Beta Corp" at $315,000, and its income statement shows "Investment Income" of $21,000 ($24,000 - $3,000).
Step Acquisitions and Transitions
If an investment increases from a non-significant influence level to a significant influence level (e.g., buying an additional 15% to increase holdings from 10% to 25%), the equity method is applied prospectively. Under ASU 2016-01, the previously held equity investment is remeasured to its fair value on the date significant influence is obtained. The gain or loss on remeasurement is recognized in earnings. The equity method is then applied going forward, using the fair value of the combined interest as the new cost basis. Prior periods are not retroactively restated.
An investor uses the equity method to account for its 30% investment in an investee. During the current year, the investee reports net income of $200,000 and pays total cash dividends of $50,000. How should the investor account for the receipt of its share of the cash dividend?
On January 1, Year 1, Parent Co. acquired 40% of the voting common stock of Subsidiary Co. for $400,000, which equaled the book value of the net assets acquired. However, on the acquisition date, Subsidiary Co. owned a patent with a fair value that exceeded its book value by $50,000. The patent has a remaining useful life of 5 years. During Year 1, Subsidiary Co. reported net income of $100,000. What is the balance in Parent Co.'s investment account at December 31, Year 1?
Under US GAAP, when an investor increases its ownership in an investee such that the investment transitions from the fair value method (no significant influence) to the equity method (significant influence), how is the transition accounted for?