abp18

The Equity Method of Accounting for
Investments in Common Stock

Para.No.

Introduction
1	This opinion sets forth the Board's views on the equity method of accounting for investments in common stock.
3	Definition of terms
	a.	"Investor"--a business entity that holds an investment in voting stock of another company.
	b.	"Investee"--a corporation that issued voting stock held by an investor.
	c.	"Subsidiary" refers to a corporation which is controlled by another corporation. The usual condition for control is ownership of a majority (over 50%) of the outstanding voting stock.
	d.	"Corporate joint venture" refers to a corporation owned an operated by a small group of businesses as a separate business or project for the mutual benefit of the group.
	e.	"Dividends" refers to dividends paid or payable in cash, other assets, or another class of stock and does not include stock dividends or splits.
	f.	"Earnings or losses of an investee" and "financial position of an investee" refer to net income or net loss and financial position of an investee determined in accordance with accounting principles in the United States.
Discussion
6	ARB No. 51 states that "There is a presumption that consolidated statements are more meaningful than separate statements and that they are usually necessary for a fair presentation when one of the companies in the group . . . has a controlling financial interest in the other companies."
	In practice, consolidation has been limited to subsidiary companies, although under certain circumstances valid reasons may exist for omitting a subsidiary from consolidation.
5	Investments are sometimes held in stock of companies other than subsidiaries, namely corporate joint ventures and other noncontrolled corporations. These investments are usually accounted for by one of two methods--the cost method or the equity method.
6	A summary of the two principal methods
	a.	The cost method. An investor records an investment in the stock of an investee at cost, and recognizes as income dividends received that are distributed from net accumulated earnings of the investee since the date of acquisition by the investor. The net accumulated earnings of an investee subsequent to the date of investment are recognized by the investor only to the extent distributed by the investee as dividends. Dividends received in excess of earnings are considered a return of investment and are recorded as reductions of cost of the investment. A series of operating losses or other factors concerning the investee may indicate that a decrease in value of the investment has occurred which is other than temporary and should be recognized.
	b.	The equity method. An investor initially records an investment in the stock of an investee at cost, and adjusts the carrying amount of the investment to recognize the investor's share of the earnings or losses of the investee after the date of acquisition. The amount of the adjustment is included in the determination of net income by the investor, and such amount reflects adjustments similar to those made in preparing consolidated statements, including adjustments to eliminate intercompany gains and losses, and to amortize any difference between investor cost and underlying equity in net assets of the investee at the date of investment. Dividends received from the investee reduce the carrying amount of the investment. A series of operating losses or other factors concerning the investee may indicate that a decrease in value of the investment has occurred which is other than temporary and should be recognized even thought the decrease in value is in excess of what would otherwise be recognized by application of the equity method.
7	Under the cost method dividends are the basis for recognition by an investor of earnings from an investment. Financial statements of an investor prepared under the cost method may not reflect substantial changes in the affairs of an investee. Dividends included in the income of an investor for a period may be unrelated to the earnings (or losses) of an investee for that period. An investee may pay no dividends for several periods and then pay dividends substantially in excess of the earnings of a period. Losses of an investee of one period may be offset against earnings of another period because the investor reports neither in results of operations at the time they are reported by the investee. Some dividends received from an investee do not cover the carrying costs of an investment whereas the investor's share of the investee's earnings more than covers those costs. The above characteristics of the cost method may prevent an investor from reflecting adequately the earnings related to an investment in common stock--either cumulatively or in the appropriate periods.
10	Under the equity method an investor recognizes its share of the earnings or losses of an investee in the periods for which they are reported by the investee in its financial statements. An investor adjusts the carrying amount of an investment for its share of the earnings or losses of the investee subsequent to the date of investment and reports the recognized earnings or losses in income. Dividends received reduce the carrying amount of the investment.
	The equity method is an appropriate means of recognizing increases or decreases measured by generally accepted accounting principles in the economic resources underlying the investments. The equity method more closely meets the objectives of accrual accounting than does the cost method since the investor recognizes its share of the earnings and losses of the investee in the periods in which they are reflected in the accounts of the investee.
11	Under the equity method, an investment is common stock is generally shown in the balance sheet of an investor as a single amount. An investor's share of earnings or losses from its investment is ordinarily shown in its income statement as a single amount.
12	The equity method tends to be most appropriate if an investment enables the investor to influence the operating or financial decisions of the investee. Influence tends to be more effective as the investor's percent of ownership in the voting stock of the investee increases.
Opinion
14	The equity method is not a valid substitute for consolidation. (FAS No. 94)
17	The equity method should be followed by an investor whose investment gives it the ability to exercise significant influence over operating and financial policies of an investee even though the investor holds 50% or less of the voting stock. Ability to exercise significant influence may be demonstrated in several ways: representation on the board of directors participation in policy making processes material intercompany transactions interchange of managerial personnel technological dependency Another important consideration is the extent of ownership by an investor 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. Determining the ability to exercise significant influence is not always clear and judgment is necessary to assess the status of each investment. To achieve a reasonable degree of uniformity, an investment of 20% or more of the voting stock of an investee should lead to the presumption that in the absence of evidence to the contrary an investor has the ability to exercise significant influence over an investee. Conversely, an an investment of less than 20% should lead to the presumption that an investor does not has the ability to exercise significant influence unless such ability can be demonstrated.
19	Applying the equity method.
	a.	intercompany profits and losses should be eliminated until realized by the investor or investee.
	b.	A difference between the cost of an investment and the amount of underlying equity in net assets of an investee should be accounting for as if the investee were a consolidated subsidiary.
	c.	The investment in common stock should be shown in the balance sheet of an investor as a single amount, and the investor's share of earnings or losses of an investee should ordinarily be shown in the income statement as a single amount, except for (d) below.
	d.	The investor's share of extraordinary items and prior period adjustments reported in the financial statements of the investee should be classified in a similar manner on the investor's income statement unless they are immaterial.
	f.	Sales of stock of an investee by an investor should be accounted for as gains or losses equal to the difference at the time of sale between selling price and carrying amount of the stock sold.
	h.	A loss in value of an investment which is other than a temporary decline should be recognized the same as a loss in value of other long-term assets.
	i.	An investor's share of losses of an investee may equal or exceed the carrying amount of an investment accounted for by the equity method. . . The investor should ordinarily discontinue applying the equity method when the investment is reduced to zero and should not provide for additional losses. . . . If the investee subsequently reports net income, the investor should resume applying the equity method only after its share of that net income equals the share of net losses not recognized during the period that the equity method was suspended. Illustration
	k.	When an investee has outstanding cumulative preferred stock, an investor should compute its share of earnings (losses) after deducting the investee's preferred dividends, whether or not such dividends are declared.
	l.	If the investor's investment in voting stock of an investee company falls below the level necessary to be able to exercise significant influence, the investor should discontinue the use of the equity method. This reduction may occur for several reasons, such as sale of a portion of an investment by the investor, sale of additional stock by an investor, or by other transactions. Any earnings or losses that relate to the stock retained by the investor and that were previously accrued should remain as part of the carrying amount of the investment. Illustration
	m.	An investment that was previously accounted for on other than the equity method may become qualified for use of the equity method by an increase in the level of ownership. The investment, results of operations (current and prior periods presented) and retained earnings of the investor should be adjusted retroactively. . . . Illustration

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