ASC 860 establishes accounting and reporting standards for transfers and servicing of financial assets. Equity method investments are financial assets; therefore, transfers of equity method investments are within the scope of
ASC 860 provided they meet the definition of a transfer, as defined in
ASC 860.
Definition from ASC 860-10-20
Transfer: The conveyance of a noncash financial asset by and to someone other than the issuer of that financial asset.
The implementation guidance in
ASC 845‑10‑55‑2 (related to nonmonetary transactions) also confirms that the exchange of one equity method investment for another equity method investment must be accounted for pursuant to the guidance in
ASC 860.
Accordingly, the sale of investee shares accounted for under the equity method of accounting must meet all of the criteria in
ASC 860‑10‑40‑5 in order to qualify for derecognition and to recognize the associated gain or loss. This guidance is further explained in
TS 3.
Provided the criteria are met, the full gain or loss would be recognized for the difference between the carrying amount of the equity method investment that is surrendered and the consideration received (i.e., the fair value of the equity method investment that is obtained) as described in the equity method guidance in
ASC 323‑10‑35‑35 and the transfers guidance referenced in
TS 4.2.
Example EM 3-3 illustrates the accounting for an exchange of equity method investments under
ASC 860.
EXAMPLE EM 3-3Exchange of one equity method investment for another equity method investment accounted for as a sale pursuant to
ASC 860
Investor A has a 20% investment in Investee, an operating company that manufactures and sells airplanes. The carrying value of Investor’s A interest is $400. Investor accounts for its investment in Investee using the equity method. Assume no basis difference exists between Investor A’s investment balance and its underlying interest in the net assets of Investee (i.e., both are $400).
Acquiror LP, which manufactures and sells speed boats and off‑road vehicles, acquires the 20% interest held by Investor A by providing Investor A with a 4% equity interest in Acquiror LP. The fair value of the 4% interest in Acquiror LP is $2,000.
How should Investor A account for its exchange of a 20% interest in Investee for a 4% interest in Acquiror LP?
Analysis
Investor A should account for this exchange under
ASC 860, and recognize a gain on the sale of its equity interest in Investee once it meets the criteria for derecognition. The gain will be $1,600 (the difference between the $2,000 selling price and the $400 carrying value of the interest sold at the time of sale). Investor A’s cost basis in its investment in Acquiror LP would be $2,000. Prospectively, Investor A would account for its 4% interest in Acquiror LP under the equity method of accounting (see
EM 2.1.2).
In certain circumstances, the exchange of one equity method investment for another equity method investment may in substance be a change in interest transaction (i.e., a change in the percentage ownership of one investment), and not the exchange of one investment for another. This is illustrated in Example EM 3‑4, where the exchange of interests is in substance a dilution event. In such situations, the issuer (investee) is deemed to have effectively issued additional shares to other investors and the change in interest guidance discussed in
EM 5.4.2.2 would be applied.
In practice, judgment must be applied in determining whether an exchange of equity method investments should be accounted for as a sale as illustrated in Example EM 3‑3, or a change in interest transaction, as illustrated in Example EM 3‑4.
EXAMPLE EM 3-4
Exchange of one equity method investment for another equity method investment accounted for as a change in interest transaction
Investors A, B, and C own the following interests in Investee, an operating company that manufactures and sells goods:
Shareholder |
Shares |
Percent ownership |
Carrying value of underlying net assets |
Assume no basis difference exists between Investor A’s investment balance and its underlying interest in the net assets of Investee (i.e., both are $400). Investors A, B, and C created a new company (“Newco”), which had no assets, liabilities, or operations immediately subsequent to formation. Newco issued 15 shares (15% interest) to each of Investors D and E in exchange for $1,500. The proceeds will be used to fund Newco’s operations. At the same time, Investors A, B, and C exchange their equity interests in Investee for equity interests in Newco. Investors A, B, and C receive 28, 21, and 21 shares in Newco, respectively. Immediately after these transactions, the shareholdings of Newco are as follows.
Shareholder |
Shares |
Percent ownership |
Carrying value of underlying net assets, prior to change in interest computation |
Fair value |
Investor A |
28 |
28% |
$400 |
$2,800 |
Investor B |
21 |
21% |
300 |
2,100 |
Investor C |
21 |
21% |
300 |
2,100 |
Investor D |
15 |
15% |
1,500 |
1,500 |
Investor E |
15 |
15% |
1,500 |
1,500 |
Total |
100 |
100% |
$4,000 |
$10,000 |
How should Investor A account for its exchange of a 40% interest in Investee for a 28% interest in Newco?
Analysis
Newco is effectively the same business as that of Investee because Newco has no additional assets, liabilities, or operations, except for the cash paid by Investors D and E to obtain 15% ownership interests in Newco. Therefore, Investor A has an investment in the same underlying business both before and after the transaction; however, its ownership interest has been diluted by virtue of Newco’s issuance of shares to Investors D and E for cash. As such, Investor A should account for this exchange as a change in interest transaction. As further explained in
EM 5.4.2.2, Investor A should recognize a change in interest gain of $720, calculated as the difference between (a) Investor A’s proportionate share of Newco’s new carrying value (28% x $4,000 = $1,120) and (2) the carrying value of Investor A’s ownership interest in the Investee prior to the transaction ($400). This would result in a gain of $720 ($1,120‑$400).
Investor A’s change in interest gain can also be calculated as follows:
Fair value per share |
$100.00 |
a |
Investor A’s carrying value per share |
14.29 |
b |
Excess paid over carrying value per share |
85.71 |
|
Shares issued to Investors D and E by Newco |
x 30 |
|
Total excess paid over carrying value |
2,571 |
|
Investor A’s % ownership in Newco |
x 28% |
|
Investor A’s change in interest gain |
$720 |
|
a – Investors D and E each paid $1,500 in exchange for 15 shares, or $100 per share.
b – Prior to Newco’s issuance of shares to Investors D and E, Investor A held 28 shares of Newco with a carrying value of $400, or $14.29 per share.
|
Investor A’s cost basis in its continuing investment in Newco is $1,120 (28% of $4,000).