Equity Method Investments for the CPA FAR Exam
Master the equity method of accounting under ASC 323 for the CPA FAR exam. Covers significant influence, journal entries, basis differences, and impairment.
Overview of the Equity Method Under ASC 323
The equity method is used to account for investments in entities over which the investor has significant influence but not control. Under ASC 323, an investment of 20% to 50% of the voting stock of an investee generally creates a presumption of significant influence, requiring the use of the equity method. However, this is a rebuttable presumption; facts and circumstances may indicate significant influence exists below 20% or does not exist above 20%.
Indicators of Significant Influence
Beyond the 20% ownership threshold, indicators of significant influence include:
- Representation on the board of directors of the investee
- Participation in the policy-making process of the investee
- Material intercompany transactions
- Interchange of managerial personnel
- Technological dependency
Conversely, significant influence may not exist despite holding 20% or more if the investee opposes the investor's attempts to influence, the investor is unable to obtain adequate financial information from the investee, or other concentrated ownership groups operate without regard to the investor.
Initial Recording
The investment is initially recorded at cost, which includes the purchase price and any directly attributable transaction costs. The investor then identifies any difference between the cost of the investment and the investor's proportionate share of the investee's underlying net assets (the book value). This difference, often called the basis difference, is allocated to specific identifiable assets and liabilities (based on their fair values) and to goodwill (for any residual amount).
Subsequent Measurement
Investor's Share of Investee Income
The investor recognizes its proportionate share of the investee's net income (or loss) as income, increasing (or decreasing) the carrying amount of the investment. The journal entry is: Debit Investment in Investee, Credit Equity in Earnings of Investee (for income); or the reverse for a loss.
Dividends Received
Dividends received from the investee reduce the carrying amount of the investment. They are not recognized as income because the investor already recognized its share of the investee's earnings. The journal entry is: Debit Cash, Credit Investment in Investee.
Amortization of Basis Differences
Basis differences allocated to finite-life assets (such as property, plant, and equipment or identifiable intangible assets) are amortized over the remaining useful lives of those assets. This amortization reduces the investor's equity income. Basis differences allocated to goodwill are not amortized but are subject to impairment testing.
For example, if an investor paid $2,000,000 for a 25% interest in an investee with net assets of $6,000,000, the basis difference is $500,000 ($2,000,000 minus 25% of $6,000,000). If $300,000 of the excess is attributable to equipment with a remaining life of 10 years, the investor amortizes $30,000 per year, reducing its equity income.
Intercompany Transactions
Unrealized profits from intercompany transactions between the investor and investee must be eliminated to the extent of the investor's ownership percentage. This applies to both upstream transactions (investee sells to investor) and downstream transactions (investor sells to investee). For upstream transactions, the investor eliminates its proportionate share of the unrealized profit. For downstream transactions, the investor eliminates 100% of the unrealized profit (since the investor generated the profit).
Impairment
An equity method investment must be evaluated for impairment when events or circumstances indicate the carrying amount may not be recoverable. Unlike goodwill impairment, which has specific testing rules, equity method investment impairment is assessed qualitatively: if the decline in value is other than temporary, the investment is written down to fair value, and the loss is recognized in net income. Factors considered include the duration and extent of the decline, the financial condition of the investee, and the intent and ability to hold the investment.
Changes in Ownership Level
If an investor's ownership drops below 20% (or significant influence is otherwise lost), the investor discontinues the equity method and accounts for the investment at fair value under ASC 321. The carrying amount at the date of change becomes the new cost basis. If ownership increases to the point where consolidation is required (generally above 50%), the investor must consolidate and apply the acquisition method.
Financial Statement Presentation
The investment is reported as a single line item on the balance sheet (Investment in Investee). Equity in earnings of the investee is reported as a single line item on the income statement, typically below operating income. The investor does not combine the investee's revenues, expenses, assets, or liabilities with its own.
Exam Preparation Tips
- Know the 20%-50% presumption for significant influence and the factors that can rebut it.
- Dividends from an equity method investee reduce the investment balance; they are not income.
- Be able to calculate and amortize basis differences between cost and the proportionate share of book value.
- Practice eliminating unrealized intercompany profits for both upstream and downstream transactions.
- Understand the one-line consolidation concept: the investment and equity income are each a single line item.
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