Technical accounting memo

Background and Facts

Investor, Inc. (“Investor”) recently purchased 15% of the outstanding common stock of ABC Corp, a nonpublic company, for $3 million. Along with this purchase, Investor was also given the ability to appoint five new members (out of ten total members) to ABC Corp's Board of Directors. Additionally, Investor will be leading a restructuring (such as a refinance) of ABC Corp's current outstanding debt, as a condition of its equity investment.

Issues

Issue 1: Should Investor account for its investment under the cost method, or under the equity method?

Issue 1: Background

Investor has evaluated the appropriate accounting treatment for its investment in 15% of ABC Corp's stock. Because this is a noncontrolling (less than 50%) ownership interest, two alternatives were considered: 1) Account for the investment under the "cost method", or 2) Account for the investment under the "equity method".

Issue 1: Research and Analysis

Use of the cost method is addressed in ASC 325-20-05-2 and 05-3 ("Investments - Other, Cost Method Investments"), as follows:

05-2. Investments are sometimes held in stock of entities other than subsidiaries, namely corporate joint ventures and other noncontrolled entities. These investments are accounted for by one of three methods—the cost method (addressed in this Subtopic), the fair value method (addressed in Topic 320), and the equity method (addressed in Topic 323).

05-3. While practice varies to some extent, the cost method is generally followed for most investments in noncontrolled corporations, in some corporate joint ventures, and to a lesser extent in unconsolidated subsidiaries, particularly foreign.

The guidance above indicates that the cost method can be used to account for investments in "noncontrolled corporations." It is true that Investor does not control ABC Corp. However, this topic (ASC 325-20) does not offer additional interpretive guidance for determining which transactions are within the scope of the cost method. (Note that the scope guidance for cost method investments is minimal, and is not on point, and implementation guidance is not available for this topic). Therefore, it is appropriate to consider what guidance is available regarding use of the equity method.

ASC 323-10-15-3 (Investments - Equity Method, Scope) identifies investments that fall within the scope of this topic, as follows:

15-3 The guidance in the Investments—Equity Method and Joint Ventures Topic applies to investments in common stock or in-substance common stock... that give the investor the ability to exercise significant influence (see paragraph 323-10-15-6) over operating and financial policies of an investee even though the investor holds 50% or less of the common stock or in-substance common stock...

Therefore, par. 15-3 states that common stock giving the investor the ability to exercise significant influence should be accounted for under the equity method. Additional scope guidance available in par. 15-6 and 15-8 states the following for determining whether "significant influence" is present:

15-6 Ability to exercise significant influence over operating and financial policies of an investee may be indicated in several ways, including the following:

a. Representation on the board of directors

b. Participation in policy-making processes

c. Material intra-entity transactions

d. Interchange of managerial personnel

e. Technological dependency

f. Extent of ownership by an investor in relation to the concentration of other shareholdings (but substantial or majority ownership of the voting stock of an investee by another investor does not necessarily preclude the ability to exercise significant influence by the investor).

15-8 ...an investment of less than 20 percent of the voting stock of an investee shall lead to a presumption that an investor does not have the ability to exercise significant influence unless such ability can be demonstrated...

In this case, Investor purchased 15% of ABC Corp's stock. Therefore, par. 8 indicates that there is a presumption that Investor does not have significant influence. However, this presumption can be overcome if other indicators of significant influence are present, such as those listed in par. 6. Along with Investor's purchase of the stock, Investor was given the ability to appoint five of ten total members to ABC Corp's Board. Investor will also be leading a restructuring of ABC Corp's current debt load. As such, indicators (a) and (b) of par. 6 are present, indicating that Investor does have the ability to exercise significant influence and therefore the investment should be accounted for under the equity method.

Issue 2: How should Investor initially record its investment?

Issue 2: Research and Analysis Note: In this example, Issue 2 follows from Issue 1 so no additional background is necessary.

Recognition guidance within ASC 323-10 states the following regarding how investors should initially record an equity method investment:

25-2 An investor shall recognize an investment in the stock of an investee as an asset.

Accordingly, Investor shall record the cost of its investment in an asset account, Investment in ABC Corp.

ASC 323-10 provides the following initial measurement guidance for equity method investments:

30-2 …[A]n investor shall measure an investment in the common stock of an investee (including a joint venture) initially at cost in accordance with the guidance in Section 805-50-30.

ASC 805-50, referenced in the preceding guidance, states the following regarding investments made in exchange for a cash payment:

30-2 Asset acquisitions in which the consideration given is cash are measured by the amount of cash paid, which generally includes the transaction costs of the asset acquisition.

Based on the preceding guidance, Investor shall record its Investment asset “at cost”. When cash is paid to acquire an investment, ASC 805-50 states that cost is generally measured by the amount of cash paid. Investor shall therefore initially record its investment at $3 million, plus any applicable transaction costs.

Conclusion

Investor has evaluated whether its purchase of 15% of ABC Corp’s common stock should be accounted for under the cost or equity method. Although there is a presumption that the cost method is more appropriate for purchases of less than 20% of an investee’s stock, this presumption can be overcome if an investor has significant influence. In this case, significant influence is evidenced by Investor’s ability to appoint five of ten total members to ABC Corp's Board and its role in restructuring ABC Corp’s debt. Therefore, application of the equity method is appropriate.