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Investors in a single power plant entity and the entity itself will need to determine the appropriate allocation of income among the investors. Income allocation may be straightforward when all income and distributions (including distributions in liquidation) are determined based on voting interests or a fixed percentage allocated to each equity holder. However, the allocation becomes complex when there are multiple types of investors, multiple classes of shares, or differing allocations of earnings or cash distributions.
When investment agreements related to single power plant entities include different allocations among the investors for profit and loss, distributions of cash from operations, and/or distributions of cash proceeds on liquidation, additional complexities arise. When income and cash allocations vary with the lapse of time or occurrence of a certain event, it may be necessary to use the HLBV method to allocate income. Similarly, entities designed as a “flip structure” (as discussed in UP 9.3 and 9.6.2) will require an alternative allocation methodology.
Allocation using the HLBV method and when there is a “flip structure” follow. The discussions address income allocation from the perspective of an equity method investor; however, the same considerations apply to the entity itself or a consolidating entity (in its calculation of the noncontrolling interest allocation).

9.6.1 Hypothetical liquidation at book value

Authoritative guidance addressing the application of the equity method to complex capital structures is limited. ASC 970-323-35-16 addresses the equity method of accounting for corporate joint ventures, including partnerships, and acknowledges the different allocations that can exist.
In cases where different allocations are used, ASC 970-323 recommends care in determining the method used to allocate profits among the investors. For example, in a structure in which the developer owns all of one class of shares, while one or more tax investors own all of a different class of shares, it would not be appropriate for any of the investors to record income allocations based on their ownership percentage (known as an income statement approach) if the rights of the shares are different. Similarly, if the investors’ ownership percentages or rights to distributions change after a period of time, but rights in liquidation are different, it may not be appropriate to calculate the allocation based on the applicable percentages in the different time periods. The appropriate share of investee equity earnings to be allocated to the investors should be carefully evaluated based on the rights included in all pertinent agreements.

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.

A common way to apply the equity method in these circumstances is referred to as the hypothetical liquidation at book value, or HLBV, method.
The HLBV method is not an accounting principle or an accounting policy election. Rather, it is a mechanical approach to applying the equity method of accounting. Using the HLBV method, the earnings an investor should recognize is calculated based on how an entity would allocate and distribute its cash if it were to sell all of its assets for their carrying amounts and liquidate at a particular point in time (known as a balance sheet approach). Under the HLBV method, an investor would calculate its claim on the investee’s assets at the beginning and end of the reporting period (using the carrying value of the investee’s net assets as reported under U.S. GAAP at those reporting dates) based on the contractual liquidation waterfall (see Question 9-8 for further information on applying a liquidation approach). Current period earnings are recognized by the investor based on the change in its claim on net assets of the investee (excluding any contributions or distributions made during the period).
In practice, liquidation waterfalls are often complex and reporting entities should evaluate all pertinent agreements to determine the proper income allocation. In addition, these agreements are often developed with a focus on income tax regulations; therefore, performing the evaluation with the assistance of tax experts may be helpful.
Question 9-7
Should the hypothetical liquidation at book value approach be used when applying the equity method of accounting to an investment in a single power plant entity?
PwC response
Yes, in most circumstances. We believe this method most accurately depicts an investor’s share in earnings of an investee in complex capital structures. As indicated in ASC 970-323-35-17, specified profit or loss allocation ratios should not be used to record equity earnings if the allocation of cash in operations or in liquidation is on a basis that is different from profit allocation. Said another way, it would not be appropriate to allocate income based on the investors’ ownership percentages when there are profit splits among investors that vary due to events (such as one class achieving a targeted rate of return) or due to the passage of time. In these circumstances, we would expect an HLBV approach to be used to calculate the allocation of earnings among shareholders. The HLBV approach should be used by (1) investors applying the equity method, (2) a reporting entity that is consolidating a single power plant entity and needs to allocate income to the noncontrolling interests, and (3) the entity itself in determining the allocation of income to capital accounts.
Question 9-8
Should a liquidation scenario always be used when applying the hypothetical liquidation at book value approach?
PwC response
Not necessarily. As discussed in UP 9.6.1, the HLBV approach assumes that at the balance sheet date, the investee would liquidate all of its assets and allocate and distribute its cash to the investors based on the waterfall stipulated in the related investment agreements. However, in some cases, the liquidation waterfalls will not reflect the actual distributions expected if the entity continues as a going concern. For example, this would be the case if the allocations in operations are substantially different than those in liquidation. Similarly, a liquidation assumption may not be appropriate if the profit allocation percentages change among the investors based only on the passage of time and certain assets will be recognized in specific periods.
Reporting entities should consider whether the liquidation waterfall appropriately reflects the entity’s economics prior to application of this method. In some situations, it may be necessary to factor in other considerations to appropriately reflect the investor’s actual interest in the assets. If the continuing distributions differ from the liquidation waterfall, the pattern of continuing distributions may be a better representation of the actual interests and should be applied.
Question 9-9
How should a reporting entity account for a difference between its initial capital contribution and its underlying interest in the net assets of the investee?
PwC response
As a result of the contractual liquidation waterfall in the investment agreement, a reporting entity’s interest in the underlying net assets of the investee may be in excess of its initial investment. There is diversity in practice in accounting for such basis differences. Two common methods are (1) recognition of the amount through the equity income pick-up in the first period of applying the HLBV method or (2) capitalizing and amortizing the difference over the life of the underlying investment (which may be based on the term of the investment agreement). We believe both methods are acceptable, provided the accounting policy is consistently applied and disclosed.
Question 9-10
Can a reporting entity apply the guidance on investments in affordable housing partnerships to an equity interest in a single power plant entity that is a partnership?
PwC response
No. Investors in qualified affordable housing projects receive tax benefits in the form of tax deductions from operating losses of the projects as well as tax credits similar to those provided for renewable energy and other power plant projects. Affordable housing tax credits are paid over a 10-year period and are claimed on the tax return of the tax owner of the project. Therefore, it is common for investors seeking the tax benefits to purchase an interest in a limited partnership that operates the qualified affordable housing project(s). ASC 323-740 provides specific guidance on the accounting for such credits, and allows a reporting entity investing in a qualified affordable housing project through a limited partnership to elect to recognize the benefit earned through the investment using an effective yield method—similar to recognition of interest income on a debt investment.
Although the similarities between affordable housing tax benefits and renewable energy tax benefits (e.g., production tax credits and tax depreciation) may result in a similar economic earnings pattern for a tax investor, the ASC 323-740 effective yield model cannot be used in place of the traditional equity method for equity interests in single power plant entities. There are several conditions that need to be met to apply the approach outlined in ASC 323-740-25-1; specifically, the investment should be in an affordable housing project. In addition, the SEC has stated that reporting entities should not analogize to the effective yield method.

Excerpt from ASC 323-740-S99-2

The SEC staff believes that it would be inappropriate to extend the effective yield method of accounting to situations analogous to those described in paragraph 323-740-05-3.

Based on this guidance, the effective yield method of recognizing income pursuant to ASC 323-740 should not be used when accounting for investments in a single power plant entity.

9.6.1.1 Application examples—hypothetical liquidation at book value

ASC 323-10-55 includes a useful illustration of the application of the HLBV approach. This example has been reproduced in Example 9-2. Example 9-3 also illustrates application of the HLBV approach.
EXAMPLE 9-2
Allocating income based on changes in the investor’s claim on investee book value

ASC 323-10-55-49

[Consider] all of the following assumptions:
  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
View table
f. Investee operating income (loss) from 20X1 through 20X3 is as follows:
20X1
($160)
20X2
($200)
20X3
$500
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g. 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
View table

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
View table

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
View table

EXAMPLE 9-3
Application of hypothetical liquidation at book value
On January 1, 20X3, SunFlower Power Company (SFP) is capitalized with $5 million of equity: $1 million contributed by M&H Holding Company and $4 million contributed by Desert Sun Tax Company (DST). In addition, at the time of initial capitalization, SFP had borrowed $7 million from a third party, which it invested in plant along with $4 million of the additional capitalization. Under the terms of the shareholder agreement, operating cash flows are distributed to the parties based on their initial equity contributions (if and when distributed). However, DST has a preference of $6 million in liquidation, after which the remaining capital will be allocated pro-rata based on the initial equity contribution of 20%/80%. Assume that the profit and loss allocation ratio does not change and that there are no book/tax differences related to the assets; therefore, SFP performs its calculations assuming the entity would liquidate as of the balance sheet date.
The following table includes SFP’s balance sheet information at January 1, 20X3 and December 31, 20X3. The balance sheet is based on net revenue of $3 million less depreciation of $1 million, resulting in net income of $2 million. Assume there are no dividend distributions.
1/1/X3
12/31/X3
Cash
$ 1,000
$ 4,000
Plant
11,000
10,000
Debt
(7,000)
(7,000)
Equity
(5,000)
(7,000)
View table
DST has determined that it should apply the equity method of accounting for its investment in SFP. How should it record its investment in SFP?
Analysis
Under an income statement approach, DST would calculate and record income based on 80% of SFP’s $2 million of income, which would result in equity income of $1.6 million. However, the income statement approach would ignore DST’s priority in liquidation.
Under the HLBV method, DST would determine its claim on SFP’s net assets as follows:
January 1, 20X3
In liquidation, SFP would have $5 million available for equity holders after repayment of liabilities. DST would receive all of the $5 million available for distribution due to its priority distribution in liquidation of $6 million.
December 31, 20X3
Based on distributable cash flows (equity balance) of $7 million, in liquidation, DST would receive $6.8 million ($6 million plus 80% of the remaining equity). The change in DST’s claim on net assets is $1.8 million ($6.8 million claim at December 31, 20X3 less $5 million at January 1, 20X3). Therefore, DST should recognize $1.8 million in equity method income for 20X3.

9.6.2 Flip structures and inverted leases

Government authorities have encouraged the development of renewable energy facilities through the issuance of tax credits and government grants in exchange for the generation of clean energy. Often, investors enter into these ventures solely to earn these credits or grants and either have no equity in the power plant entity or surrender their equity at the time the incentives are earned in full. Flip structures and inverted leases are two common tax equity structures.
A tax investor may make an initial investment in the entity to finance the construction. This may take the form of equity or a loan. In exchange for this contribution, the investor will receive the rights to the tax credits or government grants generated by the production of renewable energy. Refer to UP 9.3 for more details on these types of structures. For discussion of the accounting for government grants, see UP 16.
EXAMPLE 9-4
Inverted lease structure
Tax investor A provides $40 million cash in the form of an up-front lease payment to the developers/owners of a solar generation facility for purposes of financing the construction of the facility. Through the leased facility, the investor will enter into a power purchase agreement with an off-taker and will be entitled to all tax credits and any revenue generated through the power purchase agreement for a period of five years. The investor is not purchasing the underlying property, but rather is receiving financial assets: (1) an investment tax credit (ITC) (fair value of $30 million) and (2) a financing receivable (fair value of $10 million). The tax basis of the underlying assets is $60 million. The assets remain on the owners’ books. The method for determining the resulting deferred tax asset to be recognized is based on the nature of the underlying assets acquired.
In accordance with ASC 740-10-25-51, for purchases of financial assets that are not business combinations, the assets received should be recorded at their fair value. The tax effect of asset purchases that are not business combinations in which the amount paid differs from the tax basis of the asset should not result in immediate income statement recognition.
Assume a 35% tax rate.
How should Tax Investor A and the investor recognize the transaction?
Analysis
Tax investor accounting:
On day one, the investor would record the cash outlay and the respective assets purchased (the ITC and the financing receivable). A deferred tax asset would be recorded for the book/tax basis difference of the underlying assets ($60 million tax basis less $40 million book basis times 35%). The excess of the fair value of the financial assets and the deferred tax asset recorded over the cash purchase price would be recorded as a deferred credit. Tax investor A would record the following journal entry.
Financing receivable
$ 10
ITC
30
DTA
7
Cash
$ 40
Deferred credit
7
View table
Recognition of the ITC in income would follow the guidance in UP 16. The financing receivable would be paid back through the revenue generated by the power purchase agreement.
Accounting for a flip structure, as discussed in UP 9.3, would be similar, except that instead of leasing the assets, the tax investor must be the owner of the assets to receive the tax credits. Once the tax credits have been exhausted, the investor will exit the project and ownership will revert to the developer.
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