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An investor should generally apply the equity method of accounting for investments in common stock or in-substance common stock of corporations when the investor does not control, but has the ability to exercise significant influence over the operating and financial policies of the investee.
The significant influence determination requires evaluation of the related facts and circumstances for each investment, and should be assessed on an ongoing basis. Therefore, an investor’s initial conclusion regarding significant influence may change. For example, an investee that files for bankruptcy or becomes subject to significant exchange restrictions or other government controls may cast doubt on an investor’s ability to exercise significant influence. This could result in a change in the investor’s conclusion regarding its ability to exercise significant influence.
In addition, the ability to exercise significant influence over an investee is different from the ability to control an investee. Multiple investors may have the ability to exercise significant influence over the operating and financial policies of an investee, even in instances when there is one investor with a controlling financial interest that consolidates the investee.
The voting percentage that is presumed to provide an investor with the required level of influence necessary to apply the equity method of accounting varies depending on the nature of the investee (e.g., corporation, partnership). Figure EM 2-1 summarizes voting percentages by type of investee. These are general guidelines and not bright lines (for example, the difference between a 20% voting interest in common stock and a 19.9% voting interest would not be considered substantive).
Figure EM 2-1
Voting percentages generally presumed to demonstrate significant influence
Investment in:
Investor does not own a controlling financial interest, but owns:
Discussed in:
Common stock
20% or more of the outstanding voting securities
In-substance common stock
20% or more of the outstanding voting securities
General partnership interest in a partnership
Any noncontrolling financial interest
Limited partnership or unincorporated joint venture
3-5% or more of a limited  partnership or other interest
Limited liability company or partnership that does not maintain specific ownership accounts for each investor (similar to a corporation)
20% or more of the outstanding voting securities
Limited liability company or partnership that maintains a specific ownership account for each investor (similar to a limited partnership)
3-5% or more of the outstanding voting securities

2.1.1 Investments in voting common stock or in-substance common stock

The presumption of significant influence is based on ownership of outstanding securities whose holders have current, not potential, voting privileges. An investor would generally disregard potential voting privileges that may become available in the future (e.g., call options or convertible instruments). Also, an investor must consider voting privileges attached to all classes of common stock, preferred stock, and debentures of the investee. For example, some convertible investments may allow investors to vote on an as-converted basis. Others may not permit exercise of voting rights until conversion to common stock. In the second example, those voting rights would not be considered in assessing the presumption of significant influence as they are not currently exercisable. See CG 3.3 for further information regarding consideration of potential voting privileges.
While significant influence is presumed to exist for investments of 20% or more of the investee’s outstanding voting common stock, this can be overcome if there is predominant contrary evidence. These factors are discussed in EM 2.3. Additionally, an investment of less than 20% of the voting common stock of an investee, in combination with other indicators (e.g., board representation), could also provide the investor with the ability to exercise significant influence. See EM 2.2 for further information.
An investor might be relatively passive and still have the ability to exercise significant influence over an investee’s operating and financial policies. That is, an investor does not need to actively exercise and demonstrate such ability. Therefore, it is not appropriate for an investor with an ownership interest of greater than 20% of the outstanding voting securities of an investee to overcome the significant influence presumption solely on the basis that it (1) has not historically exercised influence, and (2) does not intend to influence the investee in the future.

2.1.2 Considerations for limited partnerships and similar entities

Investments in limited partnerships and similar entities (e.g., a limited liability company that maintains a specific ownership account for each investor) should generally be accounted for under the equity method of accounting unless the investment is so minor that the limited partner has virtually no influence over the partnership’s operating and financial policies. In practice, investments exceeding 3 to 5% are viewed as more than minor. This threshold is different than the level applied for an investment in a corporation (see EM 2.1.1).

Excerpt from ASC 323-30-S99-1

The SEC staff’s position on the application of the equity method to investments in limited partnerships is that investments in all limited partnerships should be accounted for pursuant to paragraph 970-323-25-6. That guidance requires the use of the equity method unless the investor’s interest “is so minor that the limited partner may have virtually no influence over partnership operating and financial policies.” The SEC staff understands that practice generally has viewed investments of more than 3 to 5 percent to be more than minor.

The use of the equity method may be applied in situations when an investor has a less than 3% investment in an entity that maintains separate ownership accounts for each investor based on facts and circumstances.
Investments in a limited liability company that does not maintain specific ownership accounts for each investor (see EM 1.3.3) should be assessed under the guidance discussed in EM 2.1.1 for common stock and in-substance common stock.
A general partnership interest should be accounted for under the equity method of accounting unless the investor has a controlling financial interest and is required to consolidate.

2.1.3 Direct and indirect investments

When determining significant influence, investors must consider both direct and indirect investments (i.e., those that may be held by its other investees) in an investee.
Example EM 2-1, Example EM 2-2, Example EM 2-3, Example EM 2-4, Example EM 2-5, and Example EM 2-6 illustrate the consideration of direct and indirect investments held by an investor.
EXAMPLE EM 2-1
Investment in each tier qualifies for equity method accounting
Company A owns a 20% voting common stock interest in Company B. Company B owns a 20% voting common stock interest in Company C. Therefore, Company A indirectly owns 4% of Company C. No contrary evidence exists to overcome the presumption that Company A has significant influence over Company B and that Company B has significant influence over Company C. All investors and investees are corporate entities.
How should Company A and Company B account for their investments?
Analysis
Company B should account for its investment in Company C pursuant to the equity method of accounting. Company A should account for its investment in Company B pursuant to the equity method of accounting. Company B would record its proportionate share of the earnings or losses of Company C in its financial statements before Company A records its proportionate share of the earnings or losses of Company B in its financial statements.
EXAMPLE EM 2-2
Investment qualifies for equity method accounting through ownership by commonly controlled investors
Company A owns an 80% voting common stock interest in Company B and a 70% voting common stock interest in Company C. Company B and Company C each own a 10% voting interest in Company D. Company A’s investments in Company B and Company C represent controlling financial interests. Therefore, Company A consolidates Company B and Company C. All investors and investees are corporate entities.
How should Company A account for its interest in Company D?
Analysis
Company A’s economic interest in Company D is 15%: an 8% interest through its controlling financial interest in Company B (80% * 10%) and a 7% interest through its controlling financial interest in Company C (70% * 10%). However, because Company A controls both Company B and Company C, Company A would not limit its indirect investment in Company D due to the partial ownership. Instead, it would be considered to have a 20% voting interest in Company D (10% through its control of Company B and 10% through its control of Company C).
Therefore, Company A’s indirect ownership interest in Company D, absent evidence to the contrary, is presumed to provide it with the ability to exercise significant influence over Company D. Therefore, if the presumption is not overcome, Company A should account for its investment in Company D under the equity method of accounting.
In their standalone financial statements, Company B and Company C would separately evaluate whether they have the ability to exercise significant influence over Company D. Given their parent (Company A) controls 20% of Company D’s voting stock, Company B and C would generally conclude in their separate financial statements that they have significant influence over Company D.
EXAMPLE EM 2-3
Equity method accounting despite majority interest through direct and indirect interests
Company A owns a 40% voting common stock interest in each of Company B and Company C. Company B also owns a 30% voting common stock interest in Company C. The remaining interests in Company B and Company C are widely held by other investors and there are no other agreements that affect the voting or management structures of Company B and Company C. All investors and investees are corporate entities. Company C is not a VIE.
How should Company A account for its direct and indirect interests in Company C?
Analysis
As there are no other agreements that affect the voting or management structures of Company B and Company C, Company A’s interest in Company B is not sufficient to direct the actions of Company B’s management. This includes how Company B should vote its 30% interest in Company C. Therefore, despite its 52% economic interest in Company C (40% direct interest, plus its 12% indirect interest through Company B (40% * 30%)), Company A would not consolidate Company C in its financial statements. Instead, Company A would account for its investment in Company C under the equity method of accounting.
EXAMPLE EM 2-4
Investment in investee and direct investment in investee’s consolidated subsidiary
Company A owns a 25% voting common stock interest in Company B, which is accounted for under the equity method of accounting. Company A also owns a 15% voting common stock interest in Company C. Company B owns an 80% voting common stock interest in Company C, which provides Company B with a controlling financial interest; therefore, Company B consolidates Company C. All investors and investees are corporate entities.
How should Company A account for its direct interest in Company C?
Analysis
Company A has the ability to exercise significant influence over Company B. Company B has control over Company C; therefore, through its ability to exercise significant influence over Company B, Company A also has the ability to exercise significant influence over Company C, despite only having a 15% direct interest. As such, Company A should account for its direct investment in Company C under the equity method of accounting.
EXAMPLE EM 2-5
Equity method accounting through direct and indirect interests
Company A owns 50% of the voting common stock of Company B and applies the equity method of accounting since it has significant influence over Company B. Company B owns 22% of the voting common stock of Company C and applies the equity method of accounting since it has significant influence over Company C. Company A owns (directly) 7% of the voting common stock of Company C. All investors and investees are corporate entities.
How should Company A account for its direct investment in Company C?
Analysis
Company A’s economic interest in Company C is 18% (7% direct interest plus its 11% indirect interest (50% * 22%)). Given that Company A has the ability to exercise significant influence over the operating and financial policies of Company B (including Company B’s investment in Company C), Company A would apply the equity method of accounting to its 7% direct investment in Company C.
EXAMPLE EM 2-6
Investment may not qualify for equity method of accounting despite an economic interest of 20%
Company A owns a 40% voting common stock interest in Company B, which is accounted for under the equity method of accounting. Company A also owns a 16% voting common stock interest in Company C. Company B owns a 10% voting common stock interest in Company C. Individually, Company A and Company B are not able to exercise significant influence over the operating and financial policies of Company C. All investors and investees are corporate entities.
How should Company A account for its direct and indirect interests in Company C?
Analysis
Company A’s economic interest in Company C is 20% (16% direct interest, plus its 4% indirect interest (40% * 10%)). As neither Company A nor Company B have the ability to exercise significant influence over the operating and financial policies of Company C individually, Company A’s 20% economic interest in Company C is not, in and of itself, sufficient to indicate that it has the ability to exercise significant influence over Company C. Absent other factors that indicate that Company A has the ability to exercise significant influence over Company C (e.g., Company A having representation on Company C’s board), the equity method of accounting would not be appropriate for Company A’s investment in Company C.
1Equity method accounting for interests in limited partnerships is generally appropriate unless the interest is so minor that the investor has virtually no influence (less than 3%). See EM 2.1.2.
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