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In addition to adjusting for intercompany profits or losses, an investor may need to make other adjustments to its share of earnings or losses of the investee, including for:
  • subsequent accounting for basis differences (see EM 4.3.1),
  • changes in the investee capital accounts, specifically other comprehensive income (see EM 4.3.2),
  • investee prior period adjustments (see EM 4.3.3),
  • differences in accounting principles (see EM 4.3.4),
  • investor shares held by investee (see EM 4.3.5),
  • the receipt of dividends, which are applied as a reduction of the carrying amount of the investment, and
  • stock compensation considerations (see EM 4.3.6 and EM 4.3.7).

As highlighted in ASC 323-10-45-1, an investor’s share of earnings or losses from its investment is shown as a single amount within the investor’s income statement, including the impact of any basis differences or other adjustments. Included in these adjustments, an investor would report its share of the investee’s discontinued operations as part of the single amount in the income statement representing the investor’s share of the investee’s earnings or losses (see EM 4.3.3 for further discussion).

4.3.1 Subsequent accounting for basis differences

As discussed in EM 3.3, the purchase price paid by an investor for an ownership interest in the voting common stock of an investee is presumed to reflect fair value (i.e., the price that would be received to sell an asset in an orderly transaction between market participants). The underlying assets and liabilities of the investee are recorded at historical cost; therefore, there is usually a basis difference between the cost of an investment and the investor’s share of the net assets of the investee as reflected by the investee (historical carrying value).
The basis differences attributed to tangible and separately identifiable intangible assets should be amortized or depreciated as an adjustment to the investor’s share of earnings or losses of the investee.
Excess cost of the equity method investment over the proportional fair value of the assets acquired and liabilities assumed of the investee is recognized as equity method goodwill. Differences that are attributed to equity method goodwill generally would not be amortized. However, a company that adopts the private company goodwill accounting alternative (“goodwill alternative”) approved by the Private Company Council and endorsed by the FASB should account for equity method goodwill in the same manner in which it accounts for goodwill recognized in connection with a business combination. A private company that recognizes equity method goodwill in connection with an equity method investment in an investee and adopts the goodwill alternative should amortize such goodwill on a straight-line basis over 10 years, or less than 10 years if the entity demonstrates that another useful life is more appropriate, in accordance with ASC 323-10-35-13. See BCG 9 for further information regarding the goodwill alternative.
For situations when the investee entity is private and has adopted the goodwill alternative, a public company investor must eliminate the related effects when calculating its proportionate share of the equity in earnings of the investee, as the goodwill alternative is not available to public companies. See further discussion at EM 4.3.4.
If an investee disposes of an asset in which the investor has a related basis difference, the investor should write off the basis difference and adjust the equity in earnings to correctly reflect the investor’s proportionate share of the investee’s reported gain or loss.
If an investee records an impairment charge on its long-lived assets under ASC 360, the investor should review its outside basis in such assets to determine whether any adjustments to its proportionate share of the investee’s recorded impairment loss are necessary. For example, assume an investee recognizes a $100 impairment charge on its long-lived assets under ASC 360. If an investor owns a 40% interest in the voting common stock of the investee and has a $20 basis difference attributed to the long-lived assets at the impairment date (i.e., the investor’s carrying value in the investee’s long-lived assets is higher than the investee’s carrying value), a $60 impairment charge would be included in the investor’s equity in earnings (i.e., its proportionate share of the investee’s reported impairment charge of $40, adjusted to reflect the write-off of the investor’s $20 basis difference attributed to the long-lived assets). See EM 4.8.4 for further information on the impact of impairments recognized by the investee on the investor’s financial statements.

4.3.2 Investee other comprehensive income considerations

As described in ASC 323-10-35-18, if an investee records an increase or decrease in OCI, the investor should record a corresponding proportionate increase or decrease in its equity method investment, along with an adjustment to its OCI account. For example, if the investee records an increase in the fair value of its available-for-sale debt securities within OCI, the investor would record a proportionate increase in its own OCI balance with an offsetting entry to its equity method investment balance. While an investor is able to present OCI from equity method investees with its own OCI, it is also permitted to present components of OCI attributed to an equity method investee separately.

ASC 323-10-35-18

An investor shall record its proportionate share of the investee’s equity adjustments for other comprehensive income (unrealized gains and losses on available-for-sale securities; foreign currency items; and gains and losses, prior service costs or credits, and transition assets or obligations associated with pension and other postretirement benefits to the extent not yet recognized as components of net periodic benefit cost) as increases or decreases to the investment account with corresponding adjustments in equity. See paragraph 323-10-35-37 for related guidance to be applied upon discontinuation of the equity method.

An investor should generally not record investee losses in excess of its investment and any additional advances whether through net income or OCI, unless the investor has guaranteed the investee’s obligations or has committed to provide further financial support to the investee. See EM 4.5.
Accounting for cumulative OCI upon the sale of an interest in investee
An investor that sells a portion of its interest in the investee may recognize a gain or loss on the sale of those shares. In determining this gain or loss, the basis of the investment would include the investor’s cumulative OCI relating to the portion of the investment to be sold. The investor would record a corresponding reclassification adjustment for the credit or debit balance in OCI (i.e., the investor would reclassify the amounts in OCI to earnings under ASC 220, Comprehensive Income). See EM 5 for further information on sales of investee shares.
Accounting for cumulative translation adjustment relating to an equity method investment
An equity method investment in a foreign operation may be a standalone foreign entity or it may be part of a larger foreign entity. If the investor sells its entire ownership interest in an equity method investment that is part of a larger foreign entity (i.e., the disposition of the equity method investment did not involve the entire foreign entity), it should not recognize the cumulative translation adjustment account balance in net income unless the sale is a substantially complete liquidation of that foreign entity. A partial sale of an equity method investment that is a standalone foreign entity for which the retained interest will also be accounted for using the equity method requires a pro rata portion of the cumulative translation adjustment to be recognized in measuring the gain or loss on sale as prescribed by ASC 830-30-40-2. See FX 8 for more information.

4.3.3 Investee prior period adjustments

Issues can arise when an error or other adjustment reported by the investee relates to a period prior to when the investor made its investment. The portion of the investor’s share of the investee prior period adjustment that pre-dates the investment would be treated as an adjustment to the investor’s basis difference, which would need to be assigned based on the investee’s revised balance sheet amounts as of the investment date. Depending upon the underlying reasons for the adjustment to the investee’s financial statements, the investor may need to consider whether its investment is impaired.
If the investee reports a discontinued operation, the investor should consider whether this represents a strategic shift that has (or will have) a major effect on its own operations and financial results and, therefore, also requires discontinued operation presentation by the investor. It is rare that the criteria for discontinued operations would be met at the investor level and therefore an investor would generally not report discontinued operations in its income statement for its share of the discontinued operations of an equity method investee. See FSP 27 for further information on the presentation of discontinued operations. If the investor does not report discontinued operations, it would report its share of the investee’s discontinued operations as part of the single amount in the income statement representing the investor’s share of the investee’s earnings or losses.

4.3.4 Differences in accounting principles

An investor and investee may apply different accounting principles in the preparation of their financial statements.
Investee applies US GAAP
ASC 323-10-20 defines earnings or losses of an investee as income or loss determined in accordance with US GAAP. The investee is ultimately responsible for the selection of its accounting policies. The investee may apply different accounting policies than the investor provided they are acceptable alternatives under US GAAP. For example, an investee could apply the FIFO method of inventory costing while the investor applies the LIFO method. As the investee’s method is permissible under US GAAP, the investor does not need to adjust the investee’s financial statements before recording its proportionate share of the investee’s earnings.
However, care must be taken in the elimination of intra-entity profits and losses to avoid the recognition of profit or loss that results solely from differences in accounting policies. For example, an investor and investee may be counterparties in a long-term natural gas supply contract in which the investor accounts for the contract as a derivative instrument pursuant to ASC 815, Derivatives and Hedging (i.e., on a mark-to-market basis, with changes in fair value being reported in earnings) and the investee elects the normal-purchase, normal-sale scope exception, which results in the investee accounting for the contract on an accrual basis. The investor may have to eliminate unrealized intra-entity profits and losses recognized on such a contract. See EM 4.2 for discussion on the elimination of intercompany profits on transactions between an investor and an investee.
Investee does not apply US GAAP
An investor reporting under US GAAP is required to record its share of earnings or losses and other changes in net assets of the investee using investee financial statements that are prepared under US GAAP. The investor should arrange for the investee to prepare financial statements in accordance with US GAAP or obtain the information necessary to adjust the investee’s financial statements to a US GAAP basis when the investee’s financial statements have been prepared in accordance with other acceptable alternatives (e.g., IFRS, other GAAP, or accounting principles prescribed by a regulatory agency). In cases when an investee’s policies under other GAAP (e.g., IFRS) are not acceptable alternatives under US GAAP, the investor should conform the investee’s financial information using policies consistent with its own policies.
Investee applies industry-specific accounting principles
If an investee uses industry-specific accounting principles when preparing its own financial statements, the investor is required to retain the industry-specific accounting principles in its application of the equity method as described in ASC 323-10-25-7.

ASC 323-10-25-7

For the purposes of applying the equity method of accounting to an investee subject to guidance in an industry-specific Topic, an entity shall retain the industry-specific guidance applied by that investee.

This requirement is consistent with the consolidation guidance that similarly requires industry-specific accounting applied by a subsidiary be retained in its parent’s financial statements.
Investee applies private company accounting alternatives
A public company investor may have an equity method investment in a private company investee that has elected an accounting alternative (“PCC alternative”) approved by the PCC and endorsed by the FASB, such as the goodwill accounting alternative discussed in EM 4.3.1. A public company investor should eliminate the effects of its private company investee’s application of such PCC alternatives as PCC alternatives are not available to public companies.
Accounting standards separately adopted by investee
It is common for new accounting standards to allow either early adoption or a delayed mandatory adoption date for private companies. If the investee adopts an accounting standard before the investor, the investor is not required to eliminate the effects of the adoption by the investee in its (the investor’s) financial statements. Similarly, if an investor adopts a new accounting standard before the investee entity, the investee is not required to also adopt the new accounting standard solely for purposes of the investor’s equity method accounting. However, care must be taken in the elimination of intercompany transactions to avoid the recognition of profit or loss that results from a difference in the investor or investee adopting a new accounting standard before the other entity.

4.3.5 Reciprocal interests

A reciprocal relationship exists when the investor and investee each hold an equity method investment through interests in the other’s stock. Two methods are commonly applied in practice for an investor to account for shares held by the investee (the reciprocal shareholding):
  • The treasury stock method
  • The simultaneous equation method

While the treasury stock method is more common in practice, the simultaneous equation method is also an acceptable alternative, though significantly more complex in application. The investor should apply its selected method consistently for all reciprocal interests.
Treasury stock method
The treasury stock method considers the investor’s stock held by the investee to be investor treasury stock. Accordingly, the investor’s share of the investee’s net income is recorded excluding the investee’s equity method earnings from the investee’s investment in the investor. The investor should not include shares held by the investee as treasury stock on the investor’s balance sheet.
Simultaneous equation method
The simultaneous equation method is based on a concept for reciprocal interests between a parent entity and its consolidated subsidiary that are viewed as a single economic unit. The combined earnings of the equity method investor “parent” and the equity method investee “subsidiary” needs to reflect the amount that accrues to the “noncontrolling” interests in the equity method investee (i.e., the other investors in the investee entity), given those investors indirectly own a portion of the investor’s equity. That is, the amount that accrues to the investee’s other investors (other than the equity method investor) in the combined economic unit is comprised of the following amounts:
  • The other investors’ interest in the equity method investee’s earnings from its own separate operations. This excludes any earnings the investee has from its investment in the equity method investor
  • The other investors’ interest in:
    • the investor’s earnings from its separate operations, and
    • the investor’s share of the equity investee’s earnings from the equity investee’s separate operations (excluding earnings the investee may have from its investment in the investor entity).

4.3.6 Stock compensation awarded by investee to its employees

Stock-based compensation awarded by an investee to its own employees results in recognition of compensation cost in net income in the investee’s financial statements over the related vesting period. The investor would therefore recognize its proportionate share of the compensation expense as part of its equity method earnings.
When the stock-based compensation is equity classified, the investee records expense with an offsetting entry to additional paid-in-capital, the net effect of which does not change the investee’s reported equity. The investor would record its proportionate share of the investee’s stock-based compensation expense, but there’s a question as to how the investor should account for its share of the investee’s “credit” entry to additional paid-in-capital.
Generally, an investor accounts for change in interest transactions only when common shares have been issued by the investee. Therefore, during the vesting period, the investor would generally track its share of the investee’s credit to additional paid-in-capital in its equity method memo accounts as a reconciling item. Alternatively, the investor could record the adjustment in its own equity with a corresponding increase in the investment account similar to how an investee’s changes in OCI are treated by an investor (see EM 4.3.2 for further information).
However, we do not believe the investor should record its share of the investee’s increase in additional paid-in-capital as part of its share of earnings of the investee as it would effectively result in the investor not recording its share of the investee’s compensation expense.
The exercise of an option or vesting of restricted shares decreases the investor’s percentage ownership in the investee. Therefore, the investor should account for a change in interest as an indirect sale of a portion of its interest in the investee. Regardless of how the investor accounts for the investee’s increase in additional paid-in-capital, the investor should adjust its investment for a change in its share of the investee’s net assets upon exercise of the option or for the vesting of restricted shares. See EM 5 for further information on accounting for change in interest transactions.

4.3.7 Stock compensation awarded by investor to investee employees

Stock-based compensation that is awarded by an investor to employees of its equity method investee can have an impact on both the reported investment and the investor’s share of the earnings or loss of the equity method investment.
An investor may sponsor a stock-based compensation plan for its investee’s employees. If the other investors do not provide proportionate funding or the investor does not receive any consideration, such as an increase in its relative ownership percentage of the investee for the awards, the investor should expense the entire cost associated with the award when the investee recognizes the related expense in its books, not just its proportionate share based on ownership interest in the investee. This assumes that the awards were not agreed to and accounted for as part of the investor’s acquisition of an interest in the investee.
The investee will recognize the costs of the stock-based compensation incurred by the investor on its behalf with a related capital contribution.
Investors that do not participate in sponsoring the stock-based compensation plan for investee employees are also impacted. Such investors would recognize their respective share of the expense recorded by the investee as part of the share of earnings or losses of the investee. In addition, as the investee would have recorded an increase in its capital, the other non-contributing investors would also record their share of the investee’s increase in net assets as part of their share of earnings or losses, with a corresponding increase in their equity method investment. The accounting is described in ASC 323-10-25-3 through ASC 323-10-25-5. See SC 7.1.8 for further information.

ASC 323-10-25-3

Paragraphs 323-10-25-4 through 25-6 provide guidance on accounting for share-based payment awards granted by an investor to employees or nonemployees of an equity method investee that provide goods or services to the investee that are used or consumed in the investee’s operations when no proportionate funding by the other investors occurs and the investor does not receive any increase in the investor's relative ownership percentage of the investee. That guidance assumes that the investor's grant of share-based payment awards to employees or nonemployees of the equity method investee was not agreed to in connection with the investor's acquisition of an interest in the investee. That guidance applies to share-based payment awards granted to employees or nonemployees of an investee by an investor based on that investor's stock (that is, stock of the investor or other equity instruments indexed to, and potentially settled in, stock of the investor).

ASC 323-10-25-4

In the circumstances described in paragraph 323-10-25-3, a contributing investor shall expense the cost of share-based compensation granted to employees and nonemployees of an equity method investee as incurred (that is, in the same period the costs are recognized by the investee) to the extent that the investor’s claim on the investee’s book value has not been increased.

ASC 323-10-25-5

In the circumstances described in paragraph 323-10-25-3, other equity method investors in an investee (that is, noncontributing investors) shall recognize income equal to the amount that their interest in the investee’s net book value has increased (that is, their percentage share of the contributed capital recognized by the investee) as a result of the disproportionate funding of the compensation costs. Further, those other equity method investors shall recognize their percentage share of earnings or losses in the investee (inclusive of any expense recognized by the investee for the stock-based compensation funded on its behalf).

ASC 323-10-55-19 through ASC 323-10-55-26 includes a comprehensive example that demonstrates an investor’s accounting for stock-based compensation awarded to employees of an equity method investee by the investor.

ASC 323-10-55-19

This Example illustrates the guidance in paragraphs 323-10-25-3 and 323-10-30-3 for share-based compensation by an investor granted to employees of an equity method investee. This Example is equally applicable to share-based awards granted by an investor to nonemployees that provide goods or services to an equity method investee that are used or consumed in the investee’s operations.

ASC 323-10-55-20

Entity A owns a 40 percent interest in Entity B and accounts for its investment under the equity method. On January 1, 20X1, Entity A grants 10,000 stock options (in the stock of Entity A) to employees of Entity B. The stock options cliff-vest in three years. If an employee of Entity B fails to vest in a stock option, the option is returned to Entity A (that is, Entity B does not retain the underlying stock). The owners of the remaining 60 percent interest in Entity B have not shared in the funding of the stock options granted to employees of Entity B on any basis and Entity A was not obligated to grant the stock options under any preexisting agreement with Entity B or the other investors. Entity B will capitalize the stock-based compensation costs recognized over the first year of the three-year vesting period as part of the cost of an internally constructed fixed asset (the internally constructed fixed asset will be completed on December 31, 20X1).

ASC 323-10-55-21

Before granting the stock options, Entity A’s investment balance is $800,000, and the book value of Entity B’s net assets equals $2,000,000. Entity B will not begin depreciating the internally constructed fixed asset until it is complete and ready for its intended use and, therefore, no related depreciation expense (or compensation expense relating to the stock options) will be recognized between January 1, 20X1, and December 31, 20X1. For the years ending December 31, 20X2, and December 31, 20X3, Entity B will recognize depreciation expense (on the internally constructed fixed asset) and compensation expense (for the cost of the stock options relating to Years 2 and 3 of the vesting period). After recognizing those expenses, Entity B has net income of $200,000 for the fiscal years ending December 31, 20X1, December 31, 20X2, and December 31, 20X3.

ASC 323-10-55-22

Entity C also owns a 40 percent interest in Entity B. On January 1, 20X1, before granting the stock options, Entity C’s investment balance is $800,000.

ASC 323-10-55-23

Assume that the fair value of the stock options granted by Entity A to employees of Entity B is $120,000 on January 1, 20X1. Under Topic 718, the fair value of share-based compensation should be measured at the grant date. This Example assumes that the stock options issued are classified as equity and ignores the effect of forfeitures.

ASC 323-10-55-24

Entity A would make the following journal entries. View image

(a)Entity A recognizes as an expense the portion of the costs incurred that benefits the other investors (in this Example, 60 percent of the cost or $24,000 in 20X1, $36,000 in 20X2, and $12,000 in 20X3) and recognizes the remaining cost (40 percent) as an increase to the investment in Entity B. As Entity B has recognized the cost associated with the stock-based compensation incurred on its behalf, the portion of the cost recognized by Entity A as an increase to its investment in Entity B (40 percent) is expensed in the appropriate period when Entity A recognizes its share of the earnings of Entity B.
(b)It may be appropriate to classify the debit (expense) within the same income statement caption as equity in earnings of Entity B.
(c)This amount represents Entity C’s 40 percent interest in the additional paid-in capital recognized by Entity B related to the cost incurred by the third party investor. It may be appropriate to classify the credit (income) within the same income statement caption as equity in earnings of Entity B.

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