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Perspectives

Using the equity method of accounting

On the Radar: Equity method investments and joint ventures

With equity method investments and joint ventures, investors often have questions as to when they should use the equity method of accounting. There are a number of factors to consider, including whether an investor has significant influence over an investee, as well as basis differences. As such, there are questions an investor should ask to make this determination.

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Equity method of accounting: Key questions

An investor must consider the substance of a transaction as well as the form of an investee when determining the appropriate accounting for its ownership interest in the investee. If the investor does not control the investee and is not required to consolidate it, the investor must evaluate whether to use the equity method to account for its interest. This evaluation frequently requires the use of significant judgment. The flowchart below illustrates the relevant questions to be considered in the determination of whether an investment should be accounted for under the equity method of accounting.

When considering the questions in the flowchart, an investor must take into account the specific facts and circumstances of its investment in the investee, including its legal form. The two red circles in the flowchart highlight scenarios in which the equity method of accounting would be applied. Some of the more challenging aspects of applying the equity method of accounting and accounting for joint ventures are discussed next.

On the Radar: Equity Method Investments and Joint Ventures

Evaluating indicators of significant influence

The guidance in ASC 323 on determining whether an investor has significant influence over an investee can be difficult to apply for corporations and limited liability companies that do not have separate capital accounts. For limited partnerships and limited liability companies with separate capital accounts, the equity method of accounting must be used if an investor owns more than 5% of the investee (see ASC 323-30-S99-1) and an evaluation of the indicators of significant influence is not performed. Consequently, there are two models in ASC 323 for applying the equity method (one in ASC 323-10, and one in ASC 323-30), depending on what type of legal entity structure the investee has.

The ability to exercise significant influence is often related to an investor’s ownership interest in the investee on the basis of common stock and in-substance common stock. While there are presumptions in ASC 323 related to whether an investor has the ability to exercise significant influence over an investee, an entity must consider other factors, such as the following, in making this determination.

None of the circumstances listed previously are necessarily determinative with respect to whether the investor is able or unable to exercise significant influence over the investee’s operating and financial policies. Rather, the investor should evaluate all facts and circumstances related to the investment when assessing whether the investor has the ability to exercise significant influence.

Other key indicators

On the horizon

The FASB is engaged in an active project to address the accounting by a joint venture for the initial contribution of nonmonetary and monetary assets to the joint venture. The FASB initiated the project because there is currently no guidance on the recognition and measurement of the contribution of such assets in a joint venture’s stand-alone financial statements. As of the date of this publication, the Board has tentatively decided that a joint venture, upon formation, must recognize and measure the initial contributions of monetary and nonmonetary assets by the venturers at fair value. The FASB has also tentatively decided that a joint venture, upon formation, must measure its net assets (including goodwill) at fair value by using the fair value of the joint venture as a whole. Therefore, a joint venture would measure its total net assets upon formation as the fair value of 100 percent of the joint venture’s equity immediately after formation. On October 27, 2022, the FASB issued a proposed ASU on business formations. Comments on the proposal are due by December 27, 2022. Practitioners should monitor the FASB’s Web site for developments.

Continue your equity method investments and joint ventures learning

For a comprehensive discussion of considerations related to the application of the equity method of accounting and the accounting for joint ventures, see Deloitte’s Roadmap Equity Method Investments and Joint Ventures.

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Andrew Winters
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Deloitte & Touche LLP
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Deloitte & Touche LLP
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