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The equity method of accounting does not apply for certain investments as detailed in ASC 323.

ASC 323-10-15-4

The guidance in this Topic does not apply to any of the following:
  1. An investment accounted for in accordance with Subtopic 815-10
  2. An investment in common stock held by a nonbusiness entity, such as an estate, trust, or individual
  3. An investment in common stock within the scope of Topic 810
  4. Except as discussed in paragraph 946-323-45-2, an investment held by an investment company within the scope of Topic 946.

ASC 323-30-15-4

This Subtopic does not provide guidance for investments in limited liability companies that are required to be accounted for as debt securities pursuant to paragraph 860-20-35-2.

Certain investments scoped out of the equity method guidance are discussed in the following sections. Additionally, equity method is not applied when the fair value option is elected or when the proportionate consolidation method is used.

1.4.1 Investments in common stock held by a nonbusiness entity

Nonbusiness entities, such as an estate, trust, or an individual, are not required to account for their investments in common stock under the equity method of accounting even if they are able to exercise significant influence over the financial and operating policies of the investee. A nonbusiness entity is not precluded from the use of the equity method if it has significant influence. Rather, this exemption recognizes the diverse nature of nonbusiness entities and that the use of the measurement alternative or fair value to recognize these investments may better present the financial position and changes in financial position of such entities. Nonbusiness entities should consider applying the equity method of accounting to investments held for long-term operating purposes. However, nonbusiness entities generally would not use the equity method of accounting to account for portfolio investments.
Real estate investment trusts (REITs) are considered to have business activities, typically by earning income through real estate loans and investments, and therefore do not qualify for the nonbusiness entity exception. As a result, investments held by REITs should be analyzed to determine if the equity method of accounting should be applied.

1.4.2 Investments in common stock within the scope of ASC 810

An investment in common stock that represents a controlling financial interest should be consolidated pursuant to ASC 810, Consolidation. It would not be appropriate for a reporting entity preparing consolidated financial statements to account for an investment in common stock that represents a controlling financial interest under the equity method of accounting. See CG 2 and CG 3 for further information on the accounting for investments that represent a controlling financial interest under the VIE and VOE consolidation models, respectively.

1.4.3 Investment in common stock held by an investment company

An investment held by an investment company, as defined in ASC 946, is required to be accounted for at fair value, except as described below. Therefore, use of the equity method of accounting by an investment company is not appropriate, regardless of whether or not the investment company has the ability to exercise significant influence over the investee.
The one exception to this general principle is when an investment company has an investment in an operating entity that provides services to the investment company, such as investment advisory or transfer agent services. The purpose of this type of investment is to provide services to the investment company and not to realize a gain on the sale of the investment. These types of investments should be accounted for under the equity method of accounting (not at fair value), provided that the investment otherwise qualifies for use of the equity method.

1.4.4 Investments in LLCs accounted for as debt securities

An investor may have significant influence over the operating and financial policies of an investee, but if the investment does not qualify as common stock or in-substance common stock, the application of the equity method would not be appropriate. Per ASC 860-20, investments in limited liability companies that can be contractually prepaid or settled in a way that the investor would not recover substantially all of its recorded investment are accounted for as debt securities under ASC 320. These types of securities are outside the scope of the equity method.

1.4.5 Equity investments for which the fair value option is elected

ASC 825 permits reporting entities to choose to elect the fair value option at specified election dates and measure eligible items at fair value.

Excerpt from ASC 825-10-15-4

All entities may elect the fair value option for any of the following eligible items:
  1. A recognized financial asset and financial liability…

Equity method investments are financial assets and are generally eligible for the fair value option under ASC 825-10. However, if the investor’s interest includes a significant compensatory element (e.g., a performance incentive interest embedded as part of a general partner’s equity interest) and no bifurcation of the compensatory element is required, the investor is precluded from electing the fair value option for its equity investment. For example, if an equity investment included a substantive obligation for the investor to provide services to the investee, the election of the fair value option would not be appropriate as it could result in the acceleration of revenue that should be earned when future services are provided to the investee.
An investor electing to adopt the fair value option for any of its equity method investments is required to present those equity method investments at fair value at each reporting period, with changes in fair value reported in the income statement. In addition, certain disclosures are required in the investor’s financial statements when it has elected the fair value option for an investment that otherwise would be accounted for under the equity method of accounting. See FSP 20.6.3.2 for these disclosure requirements.
An investor can generally elect the fair value option for a single eligible investment without needing to elect the fair value option for identical types of investments in other entities. That is, an instrument-by-instrument election is permitted. However, when an investor elects the fair value option for a specific investment, it must apply the fair value option to all of its eligible interests in the same entity (e.g., all tranches of equity, debt investments, guarantees).
The fair value option can be elected when an investment becomes subject to the equity method of accounting for the first time. For example, an investment may become subject to the equity method of accounting for the first time when an investor obtains significant influence by acquiring an additional investment in an investee or when an investor loses control of an investee, but retains an interest that provides it with the ability to exercise significant influence.
The election of the fair value option is irrevocable, unless an event creating a new election date occurs. Therefore, absent a qualifying event, a reporting entity that elects to adopt the fair value option to account for an equity method investment is precluded from subsequently applying the equity method of accounting to that investment. An investor that elects the fair value option and subsequently loses the ability to exercise significant influence would be required to continue to account for its retained interest on a fair value basis (i.e., the retained investment would not be eligible to be accounted for pursuant to other GAAP, such as the measurement alternative under ASC 321). See FV 5.4.2 for further information on qualifying election dates.

1.4.6 The proportionate consolidation method

Proportionate consolidation is appropriate only in limited circumstances and in certain industries. There is a longstanding practice in the construction and extractive industries of investors displaying investments in separate unincorporated legal entities (versus an investment in an incorporated entity or an undivided interest in the separate assets and liabilities) accounted for using the equity method of accounting on a proportionate gross basis, such that the investor’s financial statements reflect the investor’s pro rata share of each of the venture’s assets, liabilities, revenues, and expenses (rather than the one-line treatment) consistent with the guidance in ASC 810-10-45-14. See CG 6.4 for further details.
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