New Accounting Standards Update: Simplifying the Transition to the Equity Method
The Financial Accounting Standards Board (FASB) continued its efforts to simplify accounting requirements while maintaining or improving information for financial statement users. To this end, it recently issued ASU 2016-07, Investments – Equity Method and Joint Ventures: Simplifying the Transition to the Equity Method of Accounting. Before diving into the substance of this new ASU, it’s important to identify the transactions and arrangements impacted by equity method treatment, namely, corporate joint ventures.
Types of Investments Applicable to the Equity Method
Investments in common stock or in-substance common stock, including common stock investments of corporate joint ventures, all apply for possible presentation under the equity method. A corporate joint venture is a limited group of investors investing in a new entity whose pursuits mutually benefit the members, usually by complementing existing services, sharing risk to enter new markets, or expanding product offerings. Typically, investors in joint ventures actively manage the entity, and the ownership interests rarely change.
Investments in partnerships, unincorporated joint ventures, and limited liability companies should also be assessed as to whether they could possibly qualify for equity method accounting.
Does Your Investment Qualify for the Equity Method?
The prevailing rule for using the equity method of accounting is focused on ownership interests of 20%-50%. This percentage range assumes that significant influence comes with that level of ownership. The percentage criterion is intended to provide a level or degree of uniformity in assessing whether an investment qualifies for equity method accounting.
However, situations could exist within your organization in which an investment of less than 20% does support exercising significant influence or an investment of greater than 20% does not.
The equity method of accounting is synonymous with joint ventures because owners in those ventures usually have “significant influence,” despite not having a controlling interest (which would require consolidation).
The ability to exercise significant influence could be displayed through:
- Representation on the investee’s board of directors.
- Involvement in the investee’s policy-making process.
- Material intercompany transactions.
- Technological dependency on the investor.
- Managerial personnel interchange between investor and investee.
However, like most things, there are exceptions to the rule, and an investor’s ability to significantly influence an investee can depend on a variety of factors that should be properly evaluated. When facing a potential joint venture arrangement, consult a CPA professional or review the guidance, since disclosures can get complex for equity method investments.
Presentation Under Equity Method Accounting
With initial investments that require the equity method of accounting, generally investors record the original equity transfer as an investment on the balance sheet, then adjust that investment based on its proportional share of earnings or losses of the joint venture. Complexity comes into play when the existing investment subsequently qualifies for the equity method of accounting because of an increase in ownership percentage or an increased degree of influence.
Old guidance currently requires retroactively adjusting the retained earnings on a step-by-step basis as if the investment had always qualified for the equity method of accounting. This often can be a costly and time-consuming calculation with little benefit to financial statement users. The new ASU 2016-07 specifically focuses on transactions in which ownership interests in joint ventures rise to the level of significant influence, where previously that interest did not create significant influence.
For example, Entity A had a 10% interest in Joint Venture Z. On June 30, Entity A made an equity transfer to increase its ownership percentage in Joint Venture Z to 25%. At this point, the equity method of accounting would be applicable.
In more limited cases, an investor may hold an equity interest as available for sale. There are potential changes in the ownership structure or level of influence that would qualify the investment for the equity method. In those cases, ASU 2016-07 would be effective, thereby requiring any unrealized gains and losses historically recorded in other comprehensive income to be recognized in earnings in the period the equity method is effective.
What Can You Do Now?
To eliminate the current retroactive reporting requirements and simplify the transition to the equity method, entities can adopt ASU 2016-07 early, now. With early adoption, any subsequent ownership increase would be added to the existing investment balance, and the equity method accounting would begin prospectively from the date the investment became qualified for equity method accounting. If the guidance is not adopted early, it will go into effect for all entities for fiscal years beginning after December 15, 2016.