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3.2 Initial measurement of equity method investment
Publication date: 28 Feb 2023
us Equity method of accounting guide
When an investor acquires an equity method investment for a fixed amount of cash, the cost of the investment is straightforward and reflects the cash transferred to the seller in return for the equity method investment, as described in ASC 323-10-30-2. Often, however, a transaction includes transaction costs, contingent consideration, or other items that warrant further consideration to determine the cost of the investment, as described in the following subsections.
When cash is used to acquire an equity method investment, the investor should recognize the equity method investment at the point at which it acquires both (1) the common stock (or in substance common stock), as discussed in EM 1.2 and (2) the ability to exercise significant influence, as discussed in EM 2.
When noncash consideration is used to acquire an equity method investment, the investor should evaluate what it transferred to the seller, or contributed to the investee, in return for its interest in order to determine the point at which the equity method investment should be recognized, as further described in EM 3.2.4.
3.2.1 Transaction costs to obtain an equity method investment
The initial measurement of an equity method investment should include the cost of the investment itself and all direct transaction costs incurred by the investor in order to acquire the investment.
Direct transaction costs are generally out‑of‑pocket costs directly associated with the acquisition of an investment and paid to third parties. Examples of direct transaction costs include appraisal fees (e.g., fees paid to third party valuation specialist to assist management in determining whether to invest in an investee and to determine its fair value), legal and consulting fees (e.g., fees paid to external legal counsel to draft and review investment agreements in order to consummate the transaction), and finder’s fees (e.g., fees paid to a broker to identify and facilitate the acquisition of an interest in the investee). All costs that are not directly associated with the acquisition of an investment, including all internal costs, should be expensed as incurred. Costs associated with financing the acquisition, such as debt or equity issuance costs, would not be considered direct costs and would be accounted for in accordance with other applicable guidance. See FG 1.2.2 and FG 7.4.2.
Costs incurred by the investor on behalf of the investee may not be part of the cost of the investment. See EM 4.3.7 for a discussion of stock compensation costs that should be viewed as those of the investee.
The treatment of transaction costs incurred in connection with the acquisition of an equity method investment is different than the treatment of such costs incurred in connection with the acquisition of a business, which are required to be expensed as incurred pursuant to ASC 805. See BCG 2 for further information regarding business combinations.
3.2.2 Contingent consideration
In some situations, an investor and the seller of an equity interest may be unable to agree on the value of the investee, and therefore tie a portion of the consideration to future events or conditions. Contingent consideration represents an obligation of the investor to transfer additional cash, noncash assets, or equity interests to the selling shareholders if future events occur or conditions are met.
If contingent consideration is recognized by the investor, it will increase the carrying amount of the equity method investment, and result in the recognition of an obligation.
Contingent consideration should only be recognized when:
a) recognition is required by specific authoritative guidance other than ASC 805, or
b) the fair value of the investor’s share of the investee’s net assets exceeds the investor’s initial cost.
The contingent consideration guidance for an equity method investment is described in ASC 323 and the following subsections, and is different from the contingent consideration guidance for business combinations (see BCG 2).
If an equity method investment agreement involves a contingent consideration arrangement in which the fair value of the investor’s share of the investee’s net assets exceeds the investor’s initial cost, a liability shall be recognized.
Contingent consideration shall only be included in the initial measurement of an equity method investment if it is required to be recognized by specific authoritative guidance other than Topic 805.
A liability recognized under paragraph 323-10-25-2A shall be measured initially at an amount equal to the lesser of the following:
(a) The maximum amount of contingent consideration not otherwise recognized
(b) The excess of the investor’s share of the investee’s net assets over the initial cost measurement (including contingent consideration otherwise recognized).
3.2.2.1 Contingent consideration recognized under other guidance
If contingent consideration is required to be recognized by specific authoritative guidance other than ASC 805 (e.g., ASC 480, Distinguishing Liabilities from Equity, ASC 450, Contingencies, ASC 610‑20, Gains and Losses from the Derecognition of Nonfinancial Assets, or ASC 815, Derivatives and hedging), it should be recognized in accordance with that guidance and recorded as part of the cost of the equity method investment.
If the contingent consideration is a derivative within the scope of ASC 815, it would be initially recorded at fair value, which would be included in the carrying amount of the equity method investment. The derivative would, however, represent a separate unit of account from the equity method investment. Accordingly, subsequent changes in the fair value of the derivative should be recorded in the income statement and not as an increase or decrease to the carrying amount of the equity method investment. See DH 2 for the characteristics of a derivative instrument.
Example EM 3‑1 illustrates the accounting for contingent consideration that meets the definition of a derivative.
EXAMPLE EM 3‑1
Contingent consideration recognized pursuant to ASC 815
Contingent consideration recognized pursuant to ASC 815
Investor acquired a 20% interest in the voting common stock of Investee for cash consideration of $100 and a contingent consideration arrangement meeting the definition of a derivative with a fair value of $10. Investor’s interest in Investee provides it with the ability to exercise significant influence over the operating and financial policies of Investee. Therefore, Investor accounts for its investment in Investee pursuant to the equity method of accounting.
At what amount should Investor’s investment in the common stock of Investee be measured on the date of acquisition?
Analysis
The contingent consideration arrangement is required to be recognized pursuant to ASC 815. Therefore, the initial cost of Investor’s investment should be measured at $110 ($100 (cash consideration) plus $10 (fair value of derivative)). Subsequent changes in the fair value of the contingent consideration would be accounted for pursuant to ASC 815 and would not affect the carrying value of the equity method investment.
3.2.2.2 Contingent consideration recognized based on fair value
In some situations, the fair value of the investor’s share of the investee’s net assets is greater than its initial cost, which would include the consideration initially transferred and any contingent consideration recognized under other guidance. In these cases, ASC 323‑10‑30‑2B requires that the investor recognize a liability equal to the lesser of the following
- The maximum amount of contingent consideration not otherwise recognized, and
- The excess of the investor’s share of the investee’s net assets over the initial cost measurement (including contingent consideration otherwise recognized).
While not explicit in the guidance, we believe that “excess of the investor’s share of the investee’s net assets” should be understood as the excess of the investor’s share in the fair value of the investee’s net assets. In determining the fair value of the investee’s net assets, the investor should include only the identifiable net assets and should not consider the fair value of the overall investment, which might include implied goodwill.
If contingent consideration is recognized based on this guidance, upon resolution of the contingency, the carrying amount of the investment should be adjusted to reflect the ultimate settlement amount. Accordingly, if the consideration paid exceeds the liability initially recorded, that amount should be recognized as an additional cost of the investment. Alternatively, if the consideration paid is less than the liability initially recorded, the difference should reduce the cost of the investment.
If a contingency is resolved relating to a liability recognized in accordance with the guidance in paragraph 323‑10‑25‑2A and the consideration is issued or becomes issuable, any excess of the fair value of the contingent consideration issued or issuable over the amount that was recognized as a liability shall be recognized as an additional cost of the investment. If the amount initially recognized as a liability exceeds the fair value of the consideration issued or issuable, that excess shall reduce the cost of the investment.
Example EM 3‑2 illustrates the recognition of contingent consideration when the fair value of the investor’s share of the investee’s net assets exceeds the investor’s initial cost.
EXAMPLE EM 3‑2
Contingent consideration when the fair value of the Investor’s share of the Investee’s net assets exceeds the investor’s initial cost
Contingent consideration when the fair value of the Investor’s share of the Investee’s net assets exceeds the investor’s initial cost
On January 1, 20X0, Investor acquired a 20% interest in the voting common stock of Investee for cash consideration of $100. On the date of acquisition, the fair value of Investor’s share of the Investee’s net assets was $120. Investor is required to pay additional consideration of $25 to Investee if certain performance targets are met. Contingent consideration was not required to be recorded upon acquisition pursuant to other specific authoritative guidance (e.g., ASC 450).
At what amount should Investor’s investment in the common stock of Investee be measured on the date of acquisition?
Analysis
The investor should record a liability for the contingent consideration equal to the lesser of (1) the maximum amount of contingent consideration not otherwise recognized, which is $25 and (2) the excess of the fair value of Investor’s share of the Investee’s net assets over the cost of Investor’s investment of $20 ($120 – $100).
As such, Investor should initially record its investment in the common stock of Investee at $120 and would recognize a liability of $20. When the contingency is resolved, the difference between the contingent consideration liability recorded at the acquisition date (i.e., $20) and the consideration paid should be recorded as an increase or decrease to the carrying amount of the equity method investment.
3.2.3 Guarantee issued by investor on behalf of equity method investee
An investor may issue a guarantee to a third party on behalf of an equity method investee. In such situations, the investor should consider the guidance in ASC 460, Guarantees, and if applicable record a liability to reflect its obligation.
Although a parent’s guarantee of its subsidiary’s debt is not subject to ASC 460, as noted in ASC 460‑10‑25‑1(g), an investor’s guarantee of the debt of an equity method investee is subject to that guidance as the equity method investee is not a subsidiary.
At the inception of a guarantee, a guarantor shall recognize in its statement of financial position a liability for that guarantee. This Subsection does not prescribe a specific account for the guarantor’s offsetting entry when it recognizes a liability at the inception of a guarantee. That offsetting entry depends on the circumstances in which the guarantee was issued. See paragraph 460-10-55-23 for implementation guidance.
Excerpt from ASC 460-10-55-23
Although paragraph 460-10-25-4 does not prescribe a specific account, the following illustrate a guarantor’s offsetting entries when it recognizes the liability at the inception of the guarantee:
…
a. If the guarantee were issued in conjunction with the formation of a partially owned business or a venture accounted for under the equity method, the recognition of the liability for the guarantee would result in an increase to the carrying amount of the investment.
If an investor issued a guarantee in connection with the formation of the equity method investment, or provided the guarantee as part of consideration transferred to the investee in return for the shares, the guarantee should be viewed as part of the total consideration provided in return for the investment. Accordingly, the recognized guarantee would be reflected as an increase to the carrying value of the investment.
After the initial recognition of the guarantee, all subsequent accounting for the guarantee would be in accordance with ASC 460, and therefore would not impact the carrying amount of the equity method investment.
If a guarantee is issued by the investor after the formation of the equity method investment, see EM 4.5.
3.2.4 Noncash assets used to acquire an equity method investment
Investors may transfer noncash assets in exchange for an equity interest in an investee. The counterparty may be another investor that is selling its interest in the investee, or may be the investee itself issuing interests to the investor. For situations in which an investor had a prior interest in the investee, see EM 5.
When noncash assets are used to acquire an equity method investment, the equity method investment is recognized when the noncash assets are derecognized, which is generally once control has been transferred. Noncash assets can be either financial assets or nonfinancial assets and the determination of when control has transferred depends on the type of noncash assets transferred. When nonfinancial assets are transferred, the guidance discussed in PPE 6.2 and illustrated in Figure PPE 6‑1 should be followed. When financial assets are transferred, the guidance in ASC 860 (discussed in TS 3) should be followed. If those financial assets are equity method investments, see EM 3.2.4.1.
3.2.4.1 Exchange of an equity method investments
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 3-3
Exchange of one equity method investment for another equity method investment accounted for as a sale pursuant to ASC 860
Exchange 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
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 |
Investor A |
40 |
40% |
$400 |
Investor B |
30 |
30% |
300 |
Investor C |
30 |
30% |
300 |
Total |
100 |
100% |
$1,000 |
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).
3.2.5 Purchase agreements for equity method investments
An investor may enter into a purchase agreement to acquire an investment that will be accounted for using the equity method when the transaction closes. These arrangements are effectively forward or option contracts and are subject to ASC 321 if they do not meet the definition of a derivative under ASC 815.
When a purchase agreement is in the scope of ASC 321, an investor should account for changes in its fair value prior to closing through earnings, unless the contract qualifies for the measurement alternative and it is elected. If the measurement alternative is elected, the change in the fair value of the contract would be reflected in earnings upon closing. In addition, the guidance requires remeasurement of the contract to fair value if the entity observes transactions in the underlying shares or they are impaired.
When the equity method investment is acquired, any amount associated with the purchase agreement that was recognized on the balance sheet in accordance with ASC 321 should be considered part of the cost of the equity method investment and included in its carrying amount.
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