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There are a number of potential scenarios in which the ownership interest of an investor increases or an investor gains significant influence or control over an investee. These may include an investment that was:
  • previously accounted for by applying ASC 321, and will now qualify for the equity method for the first time (see EM 5.3.1),
  • accounted for using the equity method, that will be adjusted to reflect an increase in interest, and will continue to be accounted for under the equity method (see EM 5.3.2), and
  • previously accounted for under the equity method but which the investor should now consolidate (see EM 5.3.3).

5.3.1 Previously applied ASC 321 and will now apply equity method

An investor holding an investment that is accounted for in accordance with ASC 321 will be required to apply equity method accounting to that investment if it gains significant influence (see EM 2). In addition to obtaining significant influence through its own actions (e.g., purchasing additional common stock), an investor may also gain significant influence as a result of investee transactions, as further explained in EM 5.2.3.
An entity that is required to adopt the equity method of accounting should do so prospectively from the date significant influence is obtained. Under ASC 323-10-35-33, an investor should add the cost of acquiring the additional interest in the investee (if any) to the carrying amount of its previously held interest.

ASC 323-10-35-33

Paragraph 323-10-15-12 explains that an investment in common stock of an investee that was previously accounted for on other than the equity method may become qualified for use of the equity method by an increase in the level of ownership described in paragraph 323-10-15-3 (that is, acquisition of additional voting stock by the investor, acquisition or retirement of voting stock by the investee, or other transactions). If an investment qualifies for use of the equity method (that is, falls within the scope of this Subtopic), the investor shall add the cost of acquiring the additional interest in the investee (if any) to the current basis of the investor’s previously held interest and adopt the equity method of accounting as of the date the investment becomes qualified for equity method accounting. The current basis of the investor’s previously held interest in the investee shall be remeasured in accordance with paragraph 321-10-35-1 or 321-10-35-2, as applicable, immediately before adopting the equity method of accounting. For purposes of applying paragraph 321-10-35-2 to the investor’s previously held interest, if the investor identifies observable price changes in orderly transactions for an identical or a similar investment of the same issuer that results in it applying Topic 323, the entity shall remeasure its previously held interest at fair value immediately before applying Topic 323.

An investor may have accounted for its previously held interest at fair value as further explained in LI 2.3. In such cases, the investor should remeasure its investment at fair value through earnings prior to adding the cost of the additional investment (if any) and accounting for the investment as an equity method investment.
Alternatively, an investor may have accounted for its previously-held interest using the measurement alternative described in ASC 321-10-35-2 (see LI 2.3.3 for an explanation of the measurement alternative). In such cases, prior to transitioning to equity method accounting, an entity should consider whether an orderly transaction exists that would necessitate a remeasurement of its existing ASC 321 investment. Shares purchased by an investor that cause it to account for its investment using the equity method represent an observable transaction if they were identical or similar to the existing investment that was accounted for using the measurement alternative and the shares were purchased in an orderly transaction. See LI 2.3.2.2 for a discussion of whether instruments should be deemed similar and what constitutes an orderly transaction. Only after considering whether remeasurement is warranted should the entity add the cost of the additional investment (if any) and account for the investment as an equity method investment.
ASU 2020-01 clarifies that a forward or option to purchase shares that will be accounted for as an equity method investment should be accounted for under ASC 321. A forward or an option with no intrinsic value at acquisition should be measured at fair value at exercise or settlement even if the measurement alternative is elected based on the guidance in ASC 815-10-35-6. While the scope of ASC 815-10-15-141 and ASC 815-10-15-141A does not include options with intrinsic value at acquisition, we generally believe the guidance should also be applied to options with intrinsic value. See LI 2.3.2.3 for a discussion of options or forwards accounted for under ASC 321.
ASC 323 does not provide specific guidance on how basis differences should be determined and allocated to the equity method investment when the investor had a previous interest that was accounted for in accordance with ASC 321. There are several reasonable and acceptable methods to determine and allocate any basis differences. For example, assume an investor that holds a 15% interest in the investee acquires an additional 10% interest resulting in the investor having significant influence over the investee. The investor may treat the total carrying value of its 25% investment in the investee as the cost of acquiring its 25% equity method investment and determine and allocate basis differences accordingly. Notwithstanding, when the fair value of the acquired assets is greater than the cost basis of the investment, a bargain purchase should not be recognized. See EM 3.3.7 for a discussion of how to treat situations that would result in a bargain purchase gain. See EM 4.3.1 for information on the subsequent accounting of basis differences.

5.3.2 Obtain additional interest and continue to apply equity method

An investor’s proportional ownership in the investee may increase when the:
  • investor buys additional shares from third parties (see EM 5.3.2.1),
  • investee issues new shares and investor buys more than the proportion it previously held making it a “net purchaser” (see EM 5.3.2.2), or
  • investee buys shares as treasury stock and the investor sells less than its proportionate ownership in the investee making it a “net purchaser” (see EM 5.3.2.3).

When an investor acquires an additional interest, either directly or indirectly, there will generally be a difference between (a) the cost of the investor’s incremental share of the investee’s net assets and (b) its interest in the investee’s carrying value of those net assets. Whenever an investor increases its ownership interest in an investee, the investor should identify and recognize any new basis differences.
Any unassigned difference would be designated as equity method goodwill in the equity method memo accounts if the investee is a business. In some cases, the sum of the amounts assigned to assets acquired and liabilities assumed can exceed the cost of the acquired investee interest (excess over cost). In such cases, an investor should not recognize a bargain purchase gain (see EM 3.3.7 for further discussion).
The previously held interests and related equity method memo accounts are not revisited in connection with a step acquisition. Accordingly, the equity method memo account for each asset and liability will reflect the sum of the basis differences for each incremental acquisition associated with the equity method investment.
After the acquisition, the investor will adjust its share of earnings and losses of the investee not only for the impact of basis differences that arose from the initial investment but also those arising from each step (i.e., subsequent investment). See EM 4.3.1 for a discussion of subsequent accounting for basis differences.
Whenever an additional interest is obtained, the investor should first determine whether it has obtained a controlling financial interest, as further discussed in EM 5.3.3.

5.3.2.1 Investor purchases shares from third parties

An investor that applies the equity method of accounting may increase its ownership interest in the investee by purchasing additional shares. Incremental purchases of common stock or in-substance common stock from third parties are recorded at cost. Basis differences should be determined as described in EM 5.3.2.

5.3.2.2 Investee sells additional shares and investor is net purchaser

When the investee sells additional shares of its stock and the investor buys a greater proportion of the shares offered than its pre-sale proportionate ownership, the investor is a “net purchaser” as its post-transaction percentage ownership interest increases. Said differently, the investor has effectively purchased additional shares at a cost that is more or less than the investee book value. The investor would account for the net effect of the purchase in the same manner as if the shares were acquired from a third party, which includes establishing any basis difference in its memo accounts (see EM 3.3.1).
Example EM 5-1 illustrates a scenario in which an investee sells shares and the investor is a net purchaser.
EXAMPLE EM 5-1
Investee sells additional shares and investor is a net purchaser
Investee has 120 shares of common stock outstanding. Investor A, Investor B, and Investor C each own 40 shares or 33% of the Investee. Investee issues 35 additional shares for cash consideration at a price greater than the Investee’s carrying value per share. Investor A and B each purchase 10 shares and Investor C purchases 15 shares. Total outstanding shares after the transaction is 155 shares.
How should Investor C account for the acquisition of 15 shares?
Analysis
Investor C would reflect an increase in the carrying amount of its investment to reflect the cost of the first 10 of its 15 new shares. Investor C would not reflect any incremental basis difference for those shares as Investor A, Investor B, and Investor C each maintained their same ownership interest.
Investor C would record a new incremental basis difference to reflect the 3.2% interest (5 shares /155 shares) it acquired in the Investee through the 5 shares it purchased in excess of the other investors. Investor C should determine the cost of the 5 shares and allocate that cost to its 3.2% incremental interest in the net assets of Investee. The difference between its cost and the carrying value of the investee’s net assets should be reflected as an incremental basis difference.

5.3.2.3 Investee purchases shares and investor is net purchaser

When an investee buys treasury stock and the investor does not sell shares, the investor is a “net purchaser” as its ownership interest in the investee increases. This transaction is effectively an indirect acquisition by the investor and is similar to when an investor acquires shares of the investee directly from other investors. Accordingly, the investor will need to identify any basis differences created as a result of its ownership percentage increase.
One way to determine the basis difference is to consider the investee purchase of treasury stock and the increase in the investor’s ownership percentage as two transactions. Any cash proceeds received from the investee would reduce the investor’s investment balance. Subsequently, the investor will be deemed to have indirectly acquired an additional interest and should determine the applicable basis differences using that incremental cost.
Example EM 5-2 illustrates a scenario when an investee purchases its own shares at a price greater than their carrying amount, and the investor reflects a change in basis resulting from the decrease in the investee’s carrying amount.
EXAMPLE EM 5-2
Investee purchases shares and investor is a net purchaser
Investor owns 40 common shares in Investee representing a 40% ownership interest (a total of 100 shares are outstanding). The carrying value of the investment on Investor’s books is $10 per share, which is also Investee’s book value per share (i.e., no basis differences exist). Investee subsequently purchases 25 shares from third parties at $12 per share in a treasury stock transaction. The price exceeds Investee’s book value per share of $10.
As a result of this transaction, Investor’s ownership interest in Investee has increased from 40% to 53.3% (40 shares/75 shares). Investor, as a result of not selling any of its ownership interest has, in substance, purchased an additional interest in Investee. Investor does not obtain control of Investee.
How should Investor record the transaction?
Analysis
Investee’s initial net assets of $1,000 were reduced by the $300 paid by Investee to purchase 25 shares from third parties at $12 per share. Accordingly, the Investor’s proportionate interest in the Investee’s net assets is now $373 (53.3% × $700). As Investor’s carrying amount of $400 is unchanged, Investor will need to identify basis differences of $27, which represents the amount by which its carrying amount exceeds the Investee's carrying amount.
This could also be determined by calculating the excess decrease in Investee’s carrying amount attributable to the repurchase of the shares from third parties of $50 ($2 per share ($12 - $10) * 25 shares) multiplied by Investor’s proportionate interest of 53.3%, which results in a difference of $27. The $27 basis difference should be allocated to the newly acquired 13.3% interest in the net assets of the Investee.
Investee would reflect a treasury stock transaction in its stand-alone financials.

5.3.3 Previously applied equity method and will now consolidate

An investor should no longer apply the equity method of accounting to an investee entity if it gains a controlling financial interest over the investee. An investor could gain control of an investee entity as a result of:
  • a direct or indirect change in its level of ownership interest,
  • a change to a contractual arrangement or to the investee’s governing documents, or
  • the expiration of a contractual relationship or the resolution of a contingency.
The determination of whether consolidation is required in accordance with the variable interest entity (VIE) model is something that can change over the life of an investment. Even if the investee was not initially determined to be a VIE, an investor is required upon the occurrence of certain events to reassess whether or not an entity is, in fact, a VIE, as discussed in CG 4.8. Alternatively, if the investee was previously determined to be a VIE, but the investor was determined not to be the primary beneficiary, the investor is required to perform the primary beneficiary analysis each subsequent reporting date, as discussed in CG 5.9.
When a reporting entity obtains control of a legal entity, the method of consolidation will vary depending on whether the entity is a VIE, or meets the definition of a business, as described in CG 6.1. See BCG 5.4 for information on the acquisition method when an investor gains control of a financial interest that is deemed a business combination.
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