Accounting For Investments In Equity Securities

Heads Up -Choose Very Carefully

Under U.S. GAAP, there are three methods of accounting for a company’s investment in equity securities:

• Fair value method
• Equity method
• Consolidation

The method of accounting depends on the level of control or influence the acquiring company has over the investee’s operating and financial policies AND whether the securities acquired have readily determinable fair values. However, remember that the method used is not elective or optional but is a matter of GAAP.

We will discuss consolidations, but this article will focus on the fair value and equity methods.

When the Method is Appropriate

Fair Value Method. The fair value method (FVM) is utilized when the acquiring company does not control or have significant influence over the acquired company AND the acquired company’s securities have readily determinable fair values. For example, you generally will use the FVM when the company invests in the equity of a publicly traded company.

• If the securities do not have readily determinable fair values but would otherwise be accounted for under the FVM, the alternative method to fair value is appropriate (described below.)

Equity Method. The equity method is utilized when the acquiring company exercises significant influence over the investee but does not control the entity.

Consolidation. Consolidation is utilized when the parent company controls the subsidiary. Consolidated financial statements must be prepared.

Fair Value Method

FVM is appropriate when the investor does not control or cannot exercise significant influence over the investee company, and the securities have a readily determinable fair value.

An investor with an ownership of 20% or less is presumed unable to exert significant influence. But 20% is not a bright line. Based on facts and circumstances, an investor with ownership of 20% or less may be able to exert significant influence. In that case, the FVM is not appropriate.

The FVM applies to investments in equity securities (ASC Topic 321) and investments in joint ventures (ASC Topic 323.)

Under the FVM:

• The original investment is recorded at the acquisition cost plus the cost of any direct transaction fees.
• Receipt of investment income, such as dividends, is recorded as income and, therefore, does not impact the investment’s carrying amount.
• The investee’s income and expenses do not affect the carrying amount of the investing company’s investment in the investee.
• However, the investment should be marked to market at the end of each reporting period with the offset to the income statement’s unrealized gain or unrealized loss accounts.

Alternative to Fair Value Method

When the investing company does not have control or significant influence over the investee, AND the securities don’t have a readily determinable fair value, an “alternative to the fair value method” may be used.

The investing company may elect to record those securities at cost, less impairment.

The election to measure securities using this alternative method is made for each investment separately. Therefore, it is not a “summary of significant accounting policy” disclosure.

HEADS UP: The traditional cost method was replaced under ASU 2016-01 with the FVM. However, the “alternative to the fair value method” can be elected if the investment does not have a readily determinable fair value. It is similar to the traditional cost method. In practice, the “alternative to the fair value method” is often called the cost method.

Equity Method

It is appropriate to use the equity method when the investor exercises significant influence over the operating and financial policies of the investee.

• Significant influence is presumed when the investor owns 20% to 50% of the investee’s common stock or other securities that grant voting rights.
• However, 20% to 50% is not a bright-line rule. The presumption of significant influence can be overcome by contrary evidence, such as:
• The investing company cannot obtain the necessary financial information from the investee company to apply the equity method.
• The investing company and the investee have an agreement in which the investing company surrenders essential rights as a stockholder.
• A small group of stockholders collectively own and operate the investee without regard to the investor’s views.
• The investor cannot obtain representation on the investee’s board.
• As described above, if the investor cannot obtain sufficient information from the investee to apply the equity method, then the investor does not have sufficient influence. Therefore, the equity method cannot be used. The FVM must be applied instead (or the alternative to the FVM discussed above.)
• On the flip side, an investor with less than 20% ownership may be able to exert significant influence. That investor should use the equity method instead of the fair value method to account for that particular investment.

Under the Equity Method:

• The original investment is recorded at the acquisition cost. Any direct transaction fees are added to the investment cost.
• The total acquisition cost may or may not equal the fair value of the underlying assets and liabilities acquired.
• HEADS UP: If the acquisition cost is greater than the carrying amounts of the net assets acquired, then the acquisition cost should be allocated to the assets and liabilities of the investee based on their fair values.
• HEADS UP: The excess of the acquisition cost over the total fair value of the net assets acquired is called equity method goodwill. This equity method goodwill is not reported separately as goodwill on the acquiring company’s balance sheet.
• Equity method goodwill is not reviewed for impairment.
• However, the investment accounted for under the equity method is reviewed for impairment.
• HEADS UP: If a private company has elected the accounting alternative for goodwill, its equity method goodwill must be amortized.
• The acquiring company will adjust the investment account for its share of the investee’s net income or net loss and present it on the statement of income as a single line item.
• Any dividends paid by the investee reduce the investment account.
• Net losses of the acquired company may reduce the investment account to zero. Equity method accounting should be discontinued at that point.
• HEADS UP: The purchase price allocated to depreciable assets is depreciated in accordance with the investee’s depreciation policies. Note that this is the investee’s depreciation policy, not the depreciation policies of the investing company. The entry will reduce the investment account.
• HEADS UP: If the investee disposes of an asset to which specific excess amounts have been allocated, the unamortized excess is removed from the investment account and adjusted to income via the equity in the net income of the investee account.
• HEADS UP: Under the equity method, unrealized intercompany profits are eliminated, much like done with consolidated financial statements, except, under the equity method:
• When the investee initiates the transaction, only the actual ownership percentage of the intercompany gains and losses are eliminated.
• However, when the investor initiates the transaction, the entire intercompany gain or loss is eliminated through equity.
• HEADS UP: If the investor cannot obtain information from the investee company to determine such things as the investee’s depreciation method, etc., then this is an indication that the investor company does not have sufficient influence that is required to use the equity method. As discussed above, the FVM or the alternative to the FVM must be used instead.
• HEADS UP: A variation of the equity method is available for investment in a construction joint venture in which the investor construction company can exercise significant influence but does not own more than 50%. The method is called proportional consolidation. Its use is limited to specific types of construction joint ventures. See our April 18, 2022, blog for a discussion.

Consolidation

It is a presumption that consolidated financial statements are more meaningful than separate financial statements. However, remember that the equity method is not a substitute for consolidated financial statements, and there are notable differences between the two methods.

For example, unlike the equity method, consolidated financial statements record the original investment at the acquisition cost but do not include direct transaction fees, such as finder’s and accounting fees. They are expensed as incurred.

• If there is a noncontrolling interest, regardless of ownership interest percentage, the total amounts of the subsidiary’s assets and liabilities are presented on the parent’s financial statements.
• The noncontrolling interest is reported as one line on the consolidated financial statements (one line on the balance sheet as a component of consolidated stockholders’ equity and one line on the statement of income, generally presented as a deduction in arriving at net income attributed to the controlling interest.)