In March 2016, the ASU 2016-07 – “Simplifying the Transition to the Equity Method of Accounting” was issued. The result? Investors can now report a change to the equity method of accounting prospectively rather than retrospectively! Let’s review the equity method of accounting under ASC 323 before we take a closer look at the changes.

As a general rule of thumb, an investment of 20% - 50% of the voting stock gives the investor “significant influence.”

But what are other indicators of significant influence? Some of the most common include:

• Representation on the board of directors
• Participation in policy-making decisions
• Material intra-entity transactions between investor and investee
• Interchange of managerial personnel between investor and investee

In our example, Chubby Hubby only holds a 19.8% interest in the voting stock. The fact that they have representation on the BOD, participate in policy-making decisions, and are a key supplier to Ben and Jerry’s indicates that they have significant influence. As a result, they will likely apply the equity method of accounting.

When investments are booked under the equity method, they are included on the balance sheet at cost. Each year the investor’s share of earnings and losses are included in their profit & loss statement, often referred to as the “equity pick-up”. Pretty straightforward. But what would happen if there is an increase in ownership percentage (or another qualifying event) that would trigger the use of the equity method for an existing investment? Without significant influence, the existing investment would most likely be accounted for the under the cost method if it was non-marketable (ASC 325-20) or as an available-or-sale security if it was marketable (ASC 320). The company would have still booked the investment on the balance sheet, but would only include dividend income on their P&L each year. So what exactly is the process when moving from cost method to equity method? Let’s look at another example:

Under the old method, the investor would have had to retrospectively apply the equity method. This would require an adjustment of the investment, results of operations, and retained earnings for all prior periods presented on the financial statements. Not only was this a time-consuming, tedious process, but the additional benefit to the financial statements was minimal.

As a result of the new guidance in ASU 2016-07, we are able to apply the equity method prospectively, as of the date that significant influence was achieved. In this example, $5 million would be reclassed out of available-for-sale securities to a long-term investment account. After adding in the $20 million purchase price, the investment account on the balance sheet would total $25 million. Chunky Monkey would also start including their pro-rata share of income or loss on their P&L statement. In addition, because it is an available-for-sale security, unrealized gains and losses had been booked to OCI (Other Comprehensive Income). On the date of change, those unrealized gains and losses are reclassed and realized on the P&L statement. It is helpful to think about this transaction as a new investment. The available-for-sale securities were given up in exchange for a new equity investment in the company, which is why the realization event took place.

This is a welcome change to U.S. GAAP! It will reduce costs and complexity related to the implementation of the equity method of accounting. I hope this helps your understanding of the changes. This is just one of the many topics covered in our annual 2017 GAAP update course! If you have any questions, please feel free to contact us!

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