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.
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?
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.
Should a liquidation scenario always be used when applying the hypothetical liquidation at book value approach?
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.
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?
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.
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?
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.