The equity method under ASC 323 and basis differences

• Identify significant influence using the 20 percent presumption and other indicators
• Allocate the basis difference and amortize it through equity method income
• Eliminate intra-entity profit and apply the loss limitation
• Apply ASU 2016-07 when an investment first qualifies for the equity method

When the equity method applies

An investor applies the equity method under Topic 323 when it can exercise significant influence over the operating and financial policies of an investee but does not control it. 323-10-15-8 presumes significant influence at 20 percent or more of the voting stock and presumes its absence below 20 percent. Either presumption can be overcome. Indicators of influence include board representation, participation in policy decisions, material intra-entity transactions, interchange of managerial personnel and technological dependency. Evidence against influence includes opposition by the investee, an agreement surrendering significant shareholder rights, or a majority owner who runs the company without regard to the investor.

Investments in limited partnerships and LLCs that keep specific ownership accounts usually follow the equity method at much lower stakes, generally above 3 to 5 percent, because limited partners are presumed to have more than minor influence.

An investor may elect the fair value option in Subtopic 825-10 instead.

Initial measurement

The investment is recorded at cost. Cost usually differs from the investor's share of the investee's book net assets. That difference is the basis difference. 323-10-35-13 requires it to be accounted for as if the investee were a consolidated subsidiary:

• Allocate it to identifiable assets and liabilities whose fair values differ from book values, such as property or intangible assets.
• Any remainder is equity method goodwill.

The amounts assigned to depreciable or amortizable assets are depreciated or amortized through equity method income. Equity method goodwill is not amortized and is not tested separately for impairment, unless the investor elected the ASU 2014-02 private company alternative, which then applies to equity method goodwill too. The allocation is a memo calculation: the investment stays a single line on the balance sheet.

Subsequent accounting

Each period the investor:

• adds its share of the investee's net income, adjusted for basis difference amortization
• records its share of the investee's other comprehensive income in its own other comprehensive income
• reduces the investment for dividends received
• eliminates intra-entity profit on assets still held by the buyer, to the extent of its ownership interest (323-10-35-7)

Losses

The investor stops applying the equity method when the investment, plus any advances, is reduced to zero, unless it has guaranteed obligations of the investee or is otherwise committed to provide further financial support (323-10-35-19 and 35-20). If the investee later reports income, the investor resumes only after its share of that income equals its share of the losses not recognized.

Impairment

A loss in value that is other than temporary is recognized (323-10-35-32). Evidence includes an inability to recover the carrying amount or the investee's inability to sustain earnings that would justify the carrying amount. A current fair value below carrying amount alone does not prove the loss is other than temporary, but the investor must evaluate it.

Becoming an equity method investor

ASU 2016-07 removed retroactive adjustment. When an investment first qualifies for the equity method, for example because the investor buys more shares, the investor adds the cost of the new interest to the current basis of the previously held interest and applies the equity method from that date. If the previous interest was an available-for-sale security (a category ASU 2016-01 later removed for equity securities), the unrealized gain or loss in accumulated other comprehensive income is recognized in earnings at that date.

Presentation and audit

The investment is one line on the balance sheet and equity method income is one line in the income statement. Summarized financial information of significant investees is disclosed. The equity method rollforward calculator ties the opening balance, income, amortization, dividends and closing balance. In a group audit, the investee can be a component under AU-C 600, which the auditing lesson covers.

A 30 percent investment with a building step-up and a downstream sale