The Who and How of the Equity Accounting Method

THE WHO

The proposed SOP is broader than both SOP 78-9 and APB Opinion no. 18, The Equity Method of Accounting for Investments in Common Stock. Under the proposal, holders of the following investments should apply the equity method of accounting:

A corporate joint venture meeting the requirements of Opinion no. 18.

Voting common stock if the investor is able to exercise significant influence.

Nonvoting common stock or nonredeemable preferred stock if the investor is able to exercise significant influence and the stock does not meet the definition in FASB Statement no. 115, Accounting for Certain Investments in Debt and Equity Securities, of an equity security having a readily determinable fair value.

An ownership interest in a noncorporate investee if the investor is able to exercise significant influence.

An ownership interest in an investee organized in a “specific ownership account” structure if the investor is not able to exercise significant influence and the ownership interest does not meet the Statement no. 115 definition of an equity security with a readily determinable fair value.

A specific ownership account structure is one in which each owner (partner, member) has a specific ownership account to which the owner’s share of profits and losses, contributions and distributions accrue directly. For purposes of the proposed SOP, this includes general partnerships, limited partnerships, limited liability partnerships (LLPs) and limited liability companies (LLCs) but does not cover S corporations or real estate investment trusts.

THE HOW

The proposed SOP takes a balance sheet approach that differs from the conventional income statement approach whereby an investor applies its “percentage ownership interest” to the investee’s GAAP net income to determine the investor’s share of earnings or losses. If the investee’s capital structure gives different rights and priorities to its owners, the income statement approach has been difficult to apply in practice. The approach in the proposed SOP is called the hypothetical liquidation at book value (HLBV) method. It takes into account all forms of financial interest an investor has with respect to an investee, including common stock, preferred stock, partnership interests, debt securities, loans, advances, notes receivable and other obligations.

Under HLBV, an investor determines its share of the investee’s earnings or losses for a period by answering this question: How much better (or worse) off is the investor at the end of the period than it was at the beginning, taking into consideration only those transactions and other events the investee recognizes under GAAP?

To answer that question, the investor calculates—at each balance sheet date—the amount it would receive (or be obligated to pay) if the investee had liquidated all of its assets at recorded GAAP amounts and distributed the resulting cash to its creditors and investors in accordance with their respective priorities, including amounts distributed to investors to satisfy any loans, receivables or preferred securities they hold. The amount the investor receives (or is obligated to pay) is called the investor’s claim on the investee’s book value. The difference between this amount at the end of the period and the investor’s claim at the beginning of the period represents the investor’s share of the investee’s earnings or losses for the period. The difference excludes the effects of any capital contributions or investments the investor had made during the period and any distributions it had received during the period.

THE EQUITY METHOD UNDER HLBV

The proposed SOP also includes additional guidance on how to apply equity method accounting under HLBV. It provides 25 numerical examples to illustrate the proposed guidance for accounting for negative investments; basis differences; additional investments; other comprehensive income and similar items; interaction with FASB Statement no. 114, Accounting by a Creditor for Impairment of a Loan, and Statement no. 115; investor sale of an investee; transactions between investor and investee; and presentation and disclosures.

EFFECTIVE DATE

The proposed SOP would be effective for fiscal years beginning after December 15, 2001, with earlier application encouraged. An entity would recognize any changes caused by adopting the SOP’s provisions as a cumulative effect in the adoption period. The comment deadline for the ED is April 15, 2001; see the box above for more information.

MARC SIMON, CPA, is a technical manager in the AICPA accounting standards division in New York City. His e-mail address is msimon@aicpa.org . Mr. Simon is an employee of the American Institute of CPAs and his views, as reflected in this article, do not necessarily reflect the views of the AICPA. Official positions are determined through certain specific committee procedures, due process and deliberation.