Expand
Resize
Add to favorites
The subsequent accounting for an equity method investment generally follows the consolidation model. An investor increases the carrying amount of the investment to reflect its contributions and its share of the investee’s earnings, and reduces it to reflect its share of investee’s losses, investee distributions, and other-than-temporary impairments.

4.1.1 Share of earnings of the investee

When the initial equity method investment is recorded at cost, the investor recognizes its proportionate share of the reported earnings or losses of the investee through net income and as an adjustment to the investment balance. This proportionate share is subject to adjustments, such as for the elimination of intra-entity (intercompany) gains or losses or amortization of basis differences.
The investor’s share of investee earnings or losses is generally based on shares of common stock or in-substance common stock held by the investor. However, there may also be other investments that participate in earnings. For example, an investor may need to record earnings on an investment in investee’s preferred stock. Refer to EM 4.5.2 for further discussion.
Determining the investor’s share of the earnings or losses of the investee may be straightforward when all income and distributions (including distributions in liquidation) are determined based on interests held or a fixed percentage allocated to each equity holder. The allocation becomes more complex when the investee has multiple classes of equity outstanding or the allocation of earnings or cash distributions to investors is not commensurate with ownership interests.
If an investee has multiple classes of common stock outstanding, analysis is required to determine if a single class is subordinate or if all classes possess substantially identical subordination characteristics when determining the investor’s share of the investee’s earnings or losses.

4.1.2 Preferred stock impact on share of earnings of the investee

An investor would not adjust its share of the investee’s earnings or losses for any non-cumulative preferred dividends unless those dividends were declared, but would adjust to deduct the investee’s cumulative preferred dividends, regardless of whether those dividends have been declared. However, some preferred dividends are only cumulative when earned, so preferred shareholders would not have a future claim for dividends if sufficient income has not been generated. In that case, the investee income (loss) is only adjusted to the extent preferred dividends are earned.
Accretion of redeemable preferred stock classified in temporary equity is required when the stock is redeemable at a fixed or determinable date, or at any time at the holder’s option. The equity method investor should adjust its share of earnings (or losses) of the investee for this accretion.

4.1.3 Non-pro rata profit allocations

Investment agreements may include allocations among investors for the investee’s earnings, taxable profit and loss, distributions of cash from operations, and/or distributions of cash proceeds on liquidation that differ from the investor’s ownership interest. These agreements can impact the investor’s recognition of its share of the investee earnings for accounting purposes. All relevant agreements among the investors should be evaluated to determine the rights of each investor. To be considered substantive, the profit allocation should be consistent over time (i.e., not able to be unwound based on subsequent events).
ASC 970, Real Estate, contains guidance on the allocation of investee earnings for investments in real estate ventures. In practice, this guidance is also considered when determining an investor’s share of an investee’s earnings for investments in non-real estate ventures.

Excerpt from ASC 970-323-35-17

Such agreements may also provide for changes in the allocations at specified times or on the occurrence of specified events. Accounting by the investors for their equity in the venture’s earnings under such agreements requires careful consideration of substance over form and consideration of underlying values as discussed in paragraph 970-323-35-10. To determine the investor’s share of venture net income or loss, such agreements or arrangements shall be analyzed to determine how an increase or decrease in net assets of the venture (determined in conformity with GAAP) will affect cash payments to the investor over the life of the venture and on its liquidation. Specified profit and loss allocation ratios shall not be used to determine an investor’s equity in venture earnings if the allocation of cash distributions and liquidating distributions are determined on some other basis.

ASC 970-323-35-17 concludes that the contractual non-pro rata profit allocation should be followed for accounting purposes only when the allocation of cash distributions over the life of the investee and upon its liquidation are determined on the same basis.
One example of a specified profit allocation is when one investor that may be able to monetize tax benefits generated by the investee entity is allocated all tax credit benefits, while the other investors receive all other operating income and losses. Alternatively, an investor may have preference over other investors for the first set amount of income earned by the investee entity, after which there is a pro-rata allocation among all investors.
One way to apply the equity method in these circumstances is referred to as the hypothetical liquidation at book value method, which is discussed in ASC 323-10-35-27 to ASC 323-10-35-28 and ASC 323-10-55-48 to ASC 323-10-55-57 and the following section.

4.1.4 Hypothetical liquidation at book value method

There is no prescriptive guidance for determining an investor’s share of investee earnings for investments in complex structures. The hypothetical liquidation at book value (HLBV) method, referred to as a balance sheet approach, calculates the share of investee earning or losses based on the change in the investor’s claim on the net assets of the investee (i.e., how an entity would allocate and distribute its cash if it were liquidated as of the balance sheet date based on its articles of incorporation, bylaws, or other governing documents).
Under the HLBV method, an investor would calculate its share of current period investee earnings as illustrated in Figure EM 4-1.
Figure EM 4-1
HLBV method to determine current period investee earnings
The AICPA detailed the HLBV method in a proposed Statement of Position, Accounting for Investors’ Interests in Unconsolidated Real Estate Investments. While it was never finalized, the proposed guidance is used by investors to determine equity method earnings when a non-pro rata profit allocation is in place. However, investors should assess if the use of the HLBV method is appropriate and consistent with the economic substance of the profit allocation. In practice, contractual distribution of cash upon liquidation (i.e., liquidation waterfalls) are often complex and reporting entities should carefully evaluate all relevant agreements.
ASC 323-10-55-49 begins an example that illustrates the approach to determining the amount of equity method earnings based on the change in the investor’s claim on the investee’s book value. While not specifically referred to as HLBV, the example illustrates similar concepts.

Excerpt from ASC 323-10-55-49

  1. Investee was formed on January 1, 20X0.
  2. Five investors each made investments in and loans to Investee on that date and there have not been any changes in those investment levels (that is, no new money, reacquisition of interests by Investee, principal payments by Investee, or dividends) during the period from January 1, 20X0 through December 31, 20X3.
  3. Investor A owns 40 percent of the outstanding common stock of Investee; the common stock investment has been reduced to zero at the beginning of 20X1 because of previous losses.
  4. Investor A also has invested $100 in preferred stock of Investee (50 percent of the outstanding preferred stock of Investee) and has extended $100 in loans to Investee (which represents 60 percent of all loans extended to Investee).
  5. Investor A is not obligated to provide any additional funding to Investee. As of the beginning of 20X1, the adjusted basis of Investor’s total combined investment in Investee is $200, as follows:
    Common stock
    $—
    Preferred stock
    $100
    Loan
    $100
  6. Investee operating income (loss) from 20X1 through 20X3 is as follows:
    20X1
    ($160)
    20X2
    ($200)
    20X3
    $500
  7. Investee’s balance sheet is as follows:
1/1/X1
12/31/X1
12/31/X2
12/31/X3
Assets
$ 367
$ 207
$ 7
$ 507
Loan
167
167
167
167
Preferred stock
200
200
200
200
Common stock
300
300
300
300
Accumulated deficit
(300)
(460)
(660)
(160)
$ 367
$ 207
$ 7
$ 507

ASC 323-10-55-54

Under this approach, Investor A would recognize equity method losses based on the change in the investor’s claim on the investee’s book value.

ASC 323-10-55-55

With respect to 20X1, if Investee hypothetically liquidated its assets and liabilities at book value at December 31, 20X1, it would have $207 available to distribute. Investor A would receive $120 (Investor A’s 60% share of a priority claim from the loan [$100] and a priority distribution of its preferred stock investment of $20 [which is 50% of the $40 remaining to distribute after the creditors are paid]). Investor A’s claim on Investee’s book value at January 1, 20X1, was $200 (60% × $167 = $100 and 50% × $200 = $100). Therefore, during 20X1, Investor A’s claim on Investee’s book value decreased by $80 and that is the amount Investor A would recognize in 20X1 as its share of Investee’s losses. Investor A would record the following journal entry.

Equity method loss
$80
Preferred stock investment
$80

ASC 323-10-55-56

With respect to 20X2, if Investee hypothetically liquidated its assets and liabilities at book value at December 31, 20X2, it would have $7 available to distribute. Investor A would receive $4 (Investor A’s 60% share of a priority claim from the loan). Investor A’s claim on Investee’s book value at December 31, 20X1, was $120 (see the preceding paragraph). Therefore, during 20X2, Investor A’s claim on Investee’s book value decreased by $116 and that is the amount Investor A would recognize in 20X2 as its share of Investee’s losses. Investor A would record the following journal entry.

Equity method loss
$116
Preferred stock investment
$20
Loan
$96

ASC 323-10-55-57

With respect to 20X3, if Investee hypothetically liquidated its assets and liabilities at book value at December 31, 20X3, it would have $507 available to distribute. Investor A would receive $256 (Investor A’s 60% share of a priority claim from the loan [$100], Investor A’s 50% share of a priority distribution from its preferred stock investment [$100], and 40% of the remaining cash available to distribute [$140 × 40% = $56]). Investor A’s claim on Investee’s book value at December 31, 20X2, was $4 (see above). Therefore, during 20X3, Investor A’s claim on Investee’s book value increased by $252 and that is the amount Investor A would recognize in 20X3 as its share of Investee’s earnings. Investor A would record the following journal entry.

Loan
$96
Preferred stock
100
Investment in investee
56
Equity method income
$252

Expand

Welcome to Viewpoint, the new platform that replaces Inform. Once you have viewed this piece of content, to ensure you can access the content most relevant to you, please confirm your territory.

Your session has expired

Please use the button below to sign in again.
If this problem persists please contact support.

signin option menu option suggested option contentmouse option displaycontent option contentpage option relatedlink option prevandafter option trending option searchicon option search option feedback option end slide