Private companies hold investments for many reasons: a brokerage account for excess cash, a minority stake in a supplier or customer, a share of a real estate partnership, an interest in a startup or a joint venture with another operator. The accounting depends on the size of the stake, the investor's influence, and whether the investment has a readily determinable fair value. Two topics in the codification do most of the work: ASC 321, Investments: Equity Securities, and ASC 323, Investments: Equity Method and Joint Ventures.
This guide sets out how to choose between them, how each measures the investment, and what auditors test.
Which topic applies
The logic runs in this order.
- Does the investor control the investee? If yes, consolidate under ASC 810.
- Does the investor have the ability to exercise significant influence over operating and financial policies? If yes, and the investment is in common stock or in-substance common stock, the equity method in ASC 323 applies, unless the investor elects the fair value option.
- Otherwise, the investment is accounted for under ASC 321 as an equity security.
Debt securities, investments in funds structured as debt, and certain insurance contracts have separate guidance outside this guide.
ASC 321: equity securities
Since ASU 2016-01, equity securities within ASC 321's scope are measured at fair value with changes in fair value recognized in net income. There is no available-for-sale category for equity securities. This applies to marketable securities held in a brokerage account, mutual fund shares and similar holdings where the investor does not have significant influence.
Securities without readily determinable fair values
Private company shares, interests in closely held businesses and similar investments do not have readily determinable fair values. For these, the investor may elect the measurement alternative:
- measure the investment at cost, less impairment, adjusted for observable price changes in orderly transactions for the identical or a similar investment of the same issuer
- assess qualitatively at each reporting period whether the investment is impaired, considering indicators such as significant deterioration in the investee's earnings, adverse changes in the regulatory or economic environment, or going concern doubt
- if impaired, write the investment down to fair value through net income
- apply the alternative to each identical or similar investment consistently once elected for it
An investor that does not elect the alternative must measure the investment at fair value. The fair value is estimated under ASC 820, which usually means a valuation specialist.
An observable price change is recognized only when the transaction is for an identical or similar security of the same issuer and is orderly. A bridge round with insiders at a discount is not necessarily evidence of an observable price. The analysis of similarity looks at rights and obligations, such as liquidation preference, voting, conversion and dividends.Document the basis for the "similar" judgment.
Presentation and disclosure
Changes in fair value and gains and losses are in net income. Disclosures for measurement alternative investments include the carrying amount, the amount of impairments and downward adjustments, and the amount of upward adjustments, each for the period and cumulatively, plus information about the adjustments. For marketable securities, disclose the fair value hierarchy level under ASC 820, to the extent required for nonpublic entities.
ASC 323: the equity method
Significant influence
Significant influence is the ability to affect the operating and financial policies of the investee even though the investor holds 50 percent or less of the voting stock. The codification presumes it at ownership of 20 percent or more of the voting stock, and presumes the lack of it below 20 percent. Either presumption can be overcome with evidence. Factors include board representation, participation in policy-making, material intercompany transactions, interchange of managerial personnel, technological dependence and the extent of ownership compared with other holders.
For partnerships, LLCs and similar entities that maintain specific ownership accounts, the equity method generally applies at a lower threshold. SEC staff guidance reflected in ASC 323-30-S99-1 treats an interest of more than 3 to 5 percent as more than minor, which calls for the equity method. This matters for real estate funds and private equity partnership interests.
How the equity method works
- The investment is initially recorded at cost, including transaction costs.
- The carrying amount is adjusted each period for the investor's share of the investee's earnings or losses, recognized in income, usually in a single line below operating income or within operating results depending on the nature of the business.
- Distributions received reduce the carrying amount. They are not income.
- A basis difference arises when the purchase price differs from the investor's share of the investee's equity. The difference is allocated to identifiable assets and liabilities, and the portion related to depreciable or amortizable assets is amortized as an adjustment to the share of earnings. The remainder is equity method goodwill, which is not amortized and not separately tested for impairment, but is considered in the overall investment evaluation.
- Intra-entity profits on transactions between the investor and investee are eliminated until realized, to the extent of the investor's ownership.
- Losses are recognized until the investment is reduced to zero. Further losses are generally not recognized unless the investor has guaranteed obligations or is committed to provide financial support. Equity earnings are later recognized only after the unrecognized losses are recovered.
- The investor may record its share of the investee's results on a lag if the investee's financial information is not available in time. ASC 323-10-35-6 requires the lag to be consistent from period to period. Document the lag policy and apply it consistently.
Impairment
An equity method investment is evaluated for impairment when the decline in value is determined to be other than temporary. Indicators include a sustained fall in the investee's value, a series of operating losses, a going concern doubt and inability to recover the carrying amount. If impaired, the investment is written down to fair value. Impairment is not reversed.
The fair value option
An investor may elect the fair value option in ASC 825 for an equity method investment. The election is made at initial recognition or on a qualifying event, applies to the whole investment and is irrevocable, and changes in fair value go through net income.
Changes between methods
When a stake increases and the investor gains significant influence, the equity method is applied prospectively from that date, and the cost of the additional interest is added to the carrying amount of the existing investment. When influence is lost, the equity method stops and the retained interest moves to ASC 321. Earnings and losses already recognized stay in the carrying amount, with no retroactive adjustment, and the carrying amount at that date becomes the cost basis under ASC 321 (ASC 323-10-35-36). Document the date influence changed and why.
What auditors test
Investments may be small in count but carry high-risk items: valuation, the choice of method and the completeness of share of earnings.
Existence, rights and completeness
- Confirm marketable securities directly with the custodian or broker under AU-C 505. Agree to the statement, and consider whether a service organization report applies. See SOC 1 reports and AU-C 402 for custodians.
- For private investments, obtain the investment agreement, subscription documents, capital account statements and shareholder register.
- Inquire about all related entities and agreements to identify investments not on the schedule.
Accounting method
- Evaluate management's conclusion on control, significant influence and the applicable model, including ownership percentage, board seats, agreements and the nature of the instrument.
- For measurement alternative investments, evaluate the election, the consistent application and any observable price changes.
Valuation
- For marketable securities, agree to quoted prices at the balance sheet date.
- For investments at fair value without quoted prices, evaluate the method, inputs and the work of any specialist under AU-C 620 and the estimate requirements in AU-C 540.
- For equity method investments, obtain the investee's financial statements, which may be audited. Recompute the share of earnings, basis difference amortization, elimination of intra-entity profit and dividends. Where the investee's financial statements are unaudited or the lag is unusual, consider additional procedures. Where the investee's audited financial statements are used as evidence, read them and the auditor's report, consider differences in reporting periods and accounting frameworks, and obtain evidence for differences between the carrying amount and the investor's share of the investee's net assets.
- Evaluate impairment indicators and the support for management's conclusion.
Presentation and disclosure
- Test classification (current vs noncurrent), the income statement location and the disclosures, including summarized financial information of significant equity method investees where required, and the fair value disclosures. Use the GAAP disclosure checklist.
- Consider related parties under AU-C 550 when the investee is owned by management or affiliates.
Document the work under AU-C 230.
Issues to look for
- Wrong model. A 25 percent interest with board representation carried at cost.
- No evidence for the measurement alternative. Cost carried for years without impairment or observable price review.
- Share of earnings booked on unaudited or stale information without a lag policy.
- Basis difference ignored.
- Distributions recorded as income.
- Losses recognized below zero.
- Investment held through a partnership and reported at the partnership's carrying amount without looking through to the method.
FAQ
How are equity securities measured under ASC 321?
At fair value, with changes recognized in net income. For securities without a readily determinable fair value, an entity may elect the measurement alternative: cost, less impairment, adjusted for observable price changes in orderly transactions for the identical or a similar investment of the same issuer.
What is significant influence?
The ability to affect the operating and financial policies of the investee. Ownership of 20 percent or more of the voting stock generally presumes it, but other evidence can rebut the presumption in either direction.
Does the 20 percent test apply to LLCs and partnerships?
Often a lower threshold applies. For entities that maintain specific ownership accounts, SEC staff guidance in ASC 323-30-S99-1 treats an interest of more than 3 to 5 percent as more than minor, which supports the equity method.
Are dividends from an equity method investee income?
No. They reduce the carrying amount of the investment. Income is the investor's share of the investee's earnings.
What happens when an equity method investment reaches zero?
The investor generally stops recognizing losses unless it has guaranteed the investee's obligations or committed to provide further support. Later earnings are recognized only after they exceed the unrecognized losses.
CORAA prepares ready-to-review audit files for US CPA firms; see /us.
Sources
- FASB ASC 321-10 (Investments, Equity Securities): fair value measurement, measurement alternative, disclosures; FASB ASU 2016-01
- FASB ASC 323-10 (Equity Method): significant influence (323-10-15), lag in reporting (323-10-35-6), losses, impairment, discontinuing the method (323-10-35-36); ASU 2016-07
- FASB ASC 323-30-S99-1 (SEC staff guidance on partnerships and LLCs); ASC 825-10 (fair value option); ASC 820; ASC 810
- AICPA, AU-C Sections 505, 540, 550, 620 and 230
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