FASB Improving the Equity Method of Accounting

FASB Improving the Equity Method of Accounting

Introduction.

A revision of topic 323-on equity method of accounting is on the proposition by the FASB (Financial Accounting Standards Board). It aims at revising the Accounting Standard Codification and eliminating the essential obligation for investors to account for the basis difference using the equity method. The basis difference accounts for the difference between the investor`s proportional share of the net asset of the investee and the cost of investment. The cost of the investment includes the fair value of the investee`s identifiable assets and liabilities assumed.  The proportionate share of the net asset of the investee includes a record of his book value and liabilities within the net income in subsequent periods (whitehouse, 2015)

Under the current guidance, the presentation of the investment equity method is similar to that of a single line item in the financial reports of the investor. It is all under topic 805 under the business combinations, the determining factor on the procurement date fair value of the recognizable assets and liabilities assumed by an investor is similar as that of a business combination. A businesses’ proportional share of the variance between fair value of liabilities and assets together with their book value would be reported in the form of net income in the subsequent periods. For the investor to account for the basis difference, an entity must be in a manner consistent with the accounting that would be required if the investee were a consolidated subsidiary.

 

History and Background

The complaint to the FASB came from the stakeholders, who felt the equity method was indeed a costly exercise on their account. From the complaint, the FASB proposed dropping the basis difference requirement. It allowed the recognition of equity method investment by entities at their cost. Thus, entities will not be forced to determine the procurement date fair value of assets and liabilities. The proposal would further cut the condition for equity method investors to allocate retroactively fair value of the basis difference and regulate previous earnings (whitehouse, 2015)

The project on improving the equity method of accounting was not only initiated to simplify the issue of basis difference, but also to simplify the requirement that entity retroactively accepts the equity method of accounting. In a case if a previously accounted for investment using a different method of accounting qualifies to use the equity method due to an increased level of ownership interest.

The FASB decided to initiate this project to identify, examine and improve GAAP areas in which costs and complexities can be minimized while still maintaining the worth of the information necessary for reporting by an entity. The Board observed a couple of issues that led to this project. For instance, since basis differences are followed in memo accounts, users of financial information such as investors may not have any knowledge of their existence. With the simplified equity method, such issues are bound to be eliminated.

Current status of project

Currently, the FASB made amendments to the project that eliminated the requirement to retroactively embrace the equity method of accounting. These amendments require that the stakeholder (investor) using the equity method sum up the amount of obtaining additional interest in the investee to the current basis of the investor’s initially held interest. The investor is also expected to assume the equity method of accounting from the time the investment becomes legible for the method. Once that is done, there will be no need for retroactive adjustments to be made to the investment.

During the board’s meeting on June 5th, 2015, the Board came to an agreement to eliminate the requirement to apply the equity method because it was not cost effective and was time-consuming with very little benefit to the users of the information. Lack of readily available information during application of the equity method could lead to inaccuracies. The Board also considered adding a disclosure to the earnings for all the periods presented that would have been filed if the investment had applied the equity method. However, that alternative was rejected because it would force an entity to perform the same costly process similar to the retroactive adoption of the equity method without much benefit to the users. The idea was also rejected because it would be misleading since the entity had not qualified for the equity method in the initial periods.

All the amendments made are expected to be effective starting from December 15th, 2016. These modifications are operative to all individuals for fiscal years together with interim periods that are in those fiscal years. It is expected that those amendments are applied prospectively on that date or even earlier (FASB, 2016). The amendments will lead to increase in the level of ownership interest that come with the adoption of the equity method of accounting.

Relevant GAAP standards and the proposed changes

Under the current U.S. GAAP (Generally Accepted Accounting Principles), a reporting entity is expected to analyze the differences between the purchasing price of its equity method investee and its share of the essential net assets of the investee. The basis difference is attributed to the identifiable assets and liabilities of the investees whose fair values vary from their book values on the acquisition date. Any cost that is in excess and is not allocated to the identifiable net assets is deemed equity method goodwill. The investor is required to ascertain the deferred tax consequences of the equity method basis differences.

The proposed changes would get rid of the necessity to account for the basis difference of equity method investments separately. Instead, the whole of the basis difference would be considered as part of the investment basis. FASB proposed this change with an aim to reduce complexity since the investor would not have to determine the fair value at the procurement time for the identifiable assets and liabilities of the investee. Besides, there will be no amount of the surplus of the cost of the equity method investment that will be taken to be the equity method goodwill. This means that companies that had elected to amortize goodwill would no longer do that. However, despite these change, the requirement to eliminate intra-entry transactions between investor and investee until the profits or losses are determined, is not affected (Deloitte, The Basis for Simplification FASB Issues Proposed ASU to Amend Equity Method Accounting, 2015)

The disclosure of the difference between the amount at which an investment is valued and the amount of underlying equity in net assets is another U.S. GAAP standard. However, the proposed Accounting Standards Update (ASU) would reject this requirement. However, the equity method investors would still be required to disclose in their interim and annual financial reports for the first year after the adoption date: nature and explanation of the change in accounting principles and the amount of amortization of the basis difference realized in the equivalent prior period.

In relation to the increase in level of ownership, the current GAAP show that if an investor increases their investment in an investee or gains huge influence over the investee, the results of operations together with the investor’s retained earnings shall be regulated retroactively on a slow and gradual basis just like the equity method was being used in all the earlier times the investment was assumed. The recommended changes would eliminate this requirement. Instead, the price of procuring additional interest in the investee would be summed up with the carrying value of the previously held interest of the investor. The equity method of accounting would start its application after the investor obtains the capacity to exercise substantial influence or power over the investee.

Example of specific cases that may have influenced the proposed change

FASB’s project on the equity method of accounting will go a long way in reducing complexities in areas of GAAP without interfering with the validity of information provided by entities in their financial statements. These proposed changes must have been influenced by some real day-to-day cases such as the recent Coca-Cola case. The largest soft drinks company described its recent 32% investment in Coca-Cola FEMSA which is a bottling firm with its headquarters in Mexico. The Coca-Cola Company uses the equity method of accounting for most of its investments. In its annual report presented recently, Coca-Colas shows that its consolidated net income is inclusive of their portion of the net income and the loss of the companies they build their investment. Their carrying values of their equity method of investments are either decreased on increased depending on their proportionate share of net income or loss together with the (OCI) Other Comprehensive Income of the companies in which they invest (Company, 2013)

In the business world today, it is normal to hear such information where corporate investors obtain possession stocks of both local and foreign companies. The investments vary from the acquisition of minimal shares to the achievement of total control. Although such purchases of corporate equity securities such as in the case of Coca-Cola are familiar, they create many financial reporting issues due to the close relationship founded without the investor having gained definite control. Such issues have what influenced the proposed change in the equity method of accounting for investment so that these issues can be addressed.

The impact of proposed change on stakeholders

Stakeholders in the accounting industry are in a description as individuals or company who have an interest in accounting information. These include investors, employees, financial companies and many others. Real examples of businesses affected by the proposed change by FASB include PricewaterhouseCoopers and Deloitte & Touche, which are both accounting firms operating globally.

Pricewaterhouse Coopers showed that they support the elimination of the requirement to adopt the equity method retroactively but were against the proposed elimination of the accounting for the basis difference. They felt that the second proposal would reduce the validity of financial reports because there would be a lack of faithful representation of the performance of investment concerning its underlying economics. The company felt that the proposal would lead to inflated assets and earnings which would, in turn, mislead the users of that information. According to them, that proposal would also reduce the ability to compare two entities that have similar investments. The proposed change would also cause returns or losses that would be incompatible with the economics of an operation at the time an investee’s assets are traded (PricewaterhouseCoopers, 2016)

The company felt that there was a need for more research on the equity method of accounting. To them, adopting the change on the elimination of the accounting for basis difference was taken as a question of ethics since they felt it did not portray the real picture. They, therefore, pushed for the accounting for basis differences to be linked to the underlying assets of an investee and also asked that any reporting equity that wanted to continue using the current equity method be permitted to do so. It is evident that the proposal on basis difference would impact negatively on what they do which would be bad for their business (PricewaterhouseCoopers, 2016)

For the case of Deloitte, they supported all the proposed changes. However, they had fears that the simplification of the equity method of accounting would give rise to new challenges related to the underlying principles of accounting leading to other complexities. They were especially concerned with the elimination of the requirement to account for basis difference which they felt would cause an inappropriate overstatement of the equity method investment. Also, the proposed change could also result in varying financial results for similar assets which would mislead the user of the information. The company recommended that the Board consider limiting the application of accounting of basis difference to one or a few predominant assets. They also proposed the application of the same method be limited to groups of similar assets. This would ensure That FASB achieves its objectives without changing the validity of the financial information and the accounting companies would avoid cases of misrepresentation of information. (Deloitte, 2016)

Conclusion

This project on improving the equity method of accounting initiated by FASB is aimed at reducing complexities and costs in areas of GAAP without altering the information to be reported so that it is still meaningful and accurate. However, there seem to be concerns about the adoption of the proposed changes especially the elimination of the requirement to account for basis differences. Stakeholders feel that this will alter the quality of information they provide to the users which will go against the whole objective of the FASB project.

Therefore, there is need for further research to be done if such an important change is to be adopted. FASB needs to assess the way in which reporting using the equity method meets the needs of the users as compared to other methods such as cost or fair value. The Board should also re-evaluate abandonment of the one-line consolidation that occurs due to the elimination of the accounting for basis difference. This is a significant change that if not carefully thought over and analyzed, could completely disconnect the equity method from its basic foundational concept. Accounting information reporting is done mainly for the users of information to guide them in decision making. If there are discrepancies in the representation of this information, it could lead to massive losses for the users such as investors or financial institutions. The whole sense of improving the accounting methods will be lost. Therefore, unless there is complete assurance that the methods proposed will impact positively and achieve the intended objective, it is best to put adoption of the changes on hold and work on making them error proof.

References

Company, T. C.-C. (2013). Intercorporate Investments: An Overview. Cambridge Publications, 3-4.

Deloitte. (2015). The Basis for Simplification FASB Issues Proposed ASU to Amend Equity Method Accounting. Heads Up, 1-3.

Deloitte. (2016, March 17). Online comment letters. Retrieved from FASB Web site: http://www.fasb.org/cs/BlobServer?blobkey=id&blobnocache=true&blobwhere=1175831522798&blobheader=application%2Fpdf&blobheadername2=Content-Length&blobheadername1=Content-Disposition&blobheadervalue2=699570&blobheadervalue1=filename%3DEQMTHD.ED.0028.DELOIT

FASB. (2016). Accounting Standards Update 2016-17. Financial Accounting Series.

PricewaterhouseCoopers. (2016, March 17). Online comment letters. Retrieved from FASB Website: http://www.fasb.org/cs/BlobServer?blobkey=id&blobnocache=true&blobwhere=1175831485051&blobheader=application%2Fpdf&blobheadername2=Content-Length&blobheadername1=Content-Disposition&blobheadervalue2=685776&blobheadervalue1=filename%3DEQMTHD.ED.0012.PRICEW

whitehouse, T. (2015). FASB plans changes to stock Compensation, Equity Rules. Compliance Weekly, 7.

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