EITF ABSTRACTS. Title: Whether an Investor Should Apply the Equity Method of Accounting to Investments Other Than Common Stock

Transcription

1 EITF ABSTRACTS Title: Whether an Investor Should Apply the Equity Method of Accounting to Investments Other Than Common Stock Issue No Dates Discussed: September 11 12, 2002; November 21, 2002; January 23, 2003; March 20, 2003; November 12 13, 2003; March 17 18, 2004; June 30 July 1, 2004 References: FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities FASB Statement No. 128, Earnings per Share FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities FASB Statement No. 160, Noncontrolling Interests in Consolidated Financial Statements FASB Interpretation No. 35, Criteria for Applying the Equity Method of Accounting for Investments in Common Stock Accounting Standards Update No , Technical Corrections to Various Topics AICPA Accounting Research Bulletin No. 51, Consolidated Financial Statements APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock APB Opinion No. 20, Accounting Changes AICPA Accounting Interpretation 2, Investments in Partnerships and Ventures, of APB Opinion No. 18 AICPA Statement of Position 78-9, Accounting for Investments in Real Estate Ventures ISSUE 1. In March 1971, the Accounting Principles Board issued Opinion 18 to prescribe accounting standards for common stock investments under the equity method. Paragraph 17 of Opinion 18 states,... the equity method of accounting for an investment in common stock should also be followed by an investor whose investment in voting stock 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 (emphasis Page 1

2 added). Paragraph 2 of Opinion 18 states that the Opinion also does not apply to investments in common stock other than those described in the Opinion. By inference, the scope of Opinion 18 is restricted to voting common stock. The scope of Opinion 18 was soon questioned, and, in November 1971, the AICPA issued Interpretation 2 of Opinion 18, which reemphasized that APB Opinion No. 18 applies only to investments in common stock of corporations Since 1971, the type and form of investment vehicles have proliferated beyond those in voting common stock; such investment vehicles include convertible debt, preferred equity securities, options, warrants, interests in unincorporated entities, complex licensing and management arrangements, as well as a host of other financial instruments. These investment vehicles can convey by contract, articles of incorporation, indenture, or other means any combination of rights, privileges, or preferences including (a) the right to vote with common stockholders, (b) the right to appoint members of the board of directors, (c) substantive participating rights as described in Issue No , Investor s Accounting for an Investee When the Investor Has a Majority of the Voting Interest but the Noncontrolling Shareholder or Shareholders Have Certain Approval or Veto Rights, (d) protective rights as described in Issue 96-16, (e) cumulative and participating dividends, and (f) liquidation preferences. [Note: See paragraph 19 of the STATUS section.] 1 However, the Interpretation also states that many of the provisions of the Opinion would be appropriate in accounting for investments in these unincorporated entities [partnerships and unincorporated joint ventures].... Page 2

3 3. As a result of rights received through an investment vehicle, an investor may gain the ability to exercise significant influence over the operating and financial policies of an investee 2 without holding an investment in voting common stock of the investee. Some believe that existing authoritative literature already addresses an investor s accounting for a number of those arrangements (for example, Statement 115, Statement 133, and SOP 78-9). 4. The issues are: Issue 1 Whether an investor should apply the equity method of accounting to investments other than common stock Issue 2 If the equity method should be applied to investments other than common stock, how the equity method of accounting should be applied to those investments Issue 3 Whether investments other than common stock that have a readily determinable fair value under paragraph 3 of Statement 115 should be accounted for in accordance with Statement 115 rather than pursuant to this Issue. EITF DISCUSSION 5. The Task Force reached a consensus on Issue 1 that an investor that has the ability to exercise significant influence over the operating and financial policies of the investee should apply the equity method of accounting only when it has an investment(s) in 2 Refer to paragraph 17 of Opinion 18 and paragraph 4 of Interpretation 35. Page 3

4 common stock and/or an investment that is in-substance common stock. This Issue addresses the determination of whether an investment is in-substance common stock and when to perform that evaluation, but does not address the determination of whether an investor has the ability to exercise significant influence over the operating and financial policies of the investee. This Issue does not apply to investments accounted for under Statement 133, non-corporate entities accounted for under SOP 78-9, or to limited liability companies that maintain specific ownership accounts for each investor as discussed in Issue No , Accounting for Investments in Limited Liability Companies. 6. The Task Force reached a consensus that in-substance common stock is an investment in an entity that has risk and reward characteristics that are substantially similar to that entity s common stock. 3 An investor should consider the following characteristics when determining whether an investment in an entity is substantially similar to an investment in that entity s common stock. If the investor determines that any one of the following characteristics indicates that an investment in an entity is not substantially similar to an investment in that entity s common stock, the investment is not in-substance common stock. a. Subordination. An investor should determine whether the investment has subordination characteristics that are substantially similar to that entity s common stock. If an investment has a substantive liquidation preference over common stock, it is not substantially similar to the common stock. However, certain liquidation preferences are not substantive. Accordingly, an investor should determine whether a liquidation preference is substantive. For example, if the investment has a stated liquidation preference that is not significant in relation to 3 Statement 128 defines common stock as a stock that is subordinate to all other stock of the issuer. If an investee has more than one class of common stock, the investor should perform the analysis described in paragraphs 6 and 7 (if necessary) by comparing its investment to all classes of common stock. Page 4

5 the purchase price of the investment, the liquidation preference is not substantive. Further, a stated liquidation preference is not substantive if the investee has little or no subordinated equity (for example, common stock) from a fair value perspective. The Task Force believes that a liquidation preference in an investee that has little or no subordinated equity from a fair value perspective is nonsubstantive because, in the event of liquidation, the investment will participate in substantially all of the investee s losses. b. Risks and rewards of ownership. An investor should determine whether the investment has risks and rewards of ownership that are substantially similar to an investment in that entity s common stock. If an investment is not expected to participate in the earnings (and losses) and capital appreciation (and depreciation) in a manner that is substantially similar to common stock, the investment is not substantially similar to common stock. If the investee pays dividends on its common stock and the investment participates currently in those dividends in a manner that is substantially similar to common stock, then that is an indicator that the investment is substantially similar to common stock. Likewise, if the investor has the ability to convert the investment into that entity s common stock without any significant restrictions or contingencies that prohibit the investor from participating in the capital appreciation of the investee in a manner that is substantially similar to that entity s common stock, the conversion feature is an indicator that the investment is substantially similar to the common stock. The Task Force observed that the right to convert certain investments to common stock (such as the exercise of deep-in-the-money warrants) enables the interest to participate in the investee s earnings (and losses) and capital appreciation (and depreciation) on a substantially similar basis to common stock. c. Obligation to transfer value. An investment is not substantially similar to common stock if the investee is expected to transfer substantive value to the investor and the common shareholders do not participate in a similar manner. For example, if the investment has a substantive redemption provision (for example, a mandatory redemption provision or a non-fair value put option) that is not available to common shareholders, the investment is not substantially similar to common stock. 4 Examples of the application of the above characteristics of in-substance common stock can be found in Exhibit 02-14A. 4 An obligation to transfer value at a specious future date, such as preferred stock with a mandatory redemption in 100 years, should not be considered an obligation to transfer substantive value under this Issue. Page 5

6 7. If an investment s subordination characteristics and risks and rewards of ownership are substantially similar to the common stock of the investee and the investment does not require the investee to transfer substantive value to the investor in a manner in which the common shareholders do not participate similarly, then the investment is in-substance common stock. If the determination about whether the investment is substantially similar to common stock cannot be reached based solely on the evaluation under paragraph 6, the investor should also analyze whether the future changes in the fair value of the investment are expected to vary directly with the changes in the fair value of the common stock. If the changes in the fair value of the investment are not expected to vary directly with the changes in the fair value of the common stock, then the investment is not insubstance common stock. [Note: See STATUS section.] 8. The initial determination of whether an investment is substantially similar to common stock should be made on the date on which the investor obtains the investment if the investor has the ability to exercise significant influence over the operating and financial policies of the investee. That determination should be reconsidered if one or more of the following occur: a. The contractual terms of the investment are changed resulting in a change to any of its characteristics described in paragraphs 6 and 7. 6 b. There is a significant change in the capital structure of the investee, including the investee s receipt of additional subordinated financing. c. The investor obtains an additional interest in an investment in which the investor has an existing interest. As a result, the method of accounting for the cumulative interest is based on the characteristics of the investment at the date at which the 5 [This footnote has been deleted. See STATUS section.] 6 An expected change in the contractual terms of an investment that are provided for in the original terms of the contractual agreement should be considered for purposes of the initial determination under paragraph 6, and not as a reconsideration event. However, a change in the form of the investment (for example, debt to equity or preferred stock to another series of stock) is a reconsideration event. Page 6

7 investor obtains the additional interest (that is, the characteristics that the investor evaluated in order to make its investment decision), and will result in the investor applying one method of accounting to the cumulative interest in an investment of the same issuance. 9. The determination of whether an investment is similar to common stock should not be reconsidered solely due to losses of the investee. 10. If an investor obtains the ability to exercise significant influence over the operating and financial policies of an investee subsequent to the date that the investor obtained the investment, the investor should perform an initial determination, pursuant to paragraphs 6 and 7, using all relevant and necessary information that exists on the date that the investor obtains significant influence. 11. The Task Force was not asked to reach a consensus on Issues 2 and 3. In regard to Issue 3, the Task Force observes that an investor should apply the equity method of accounting in all cases, within the scope of this Issue, in which an investor has the ability to exercise significant influence over the operating and financial policies of the investee and owns common stock or in-substance common stock of the investee. 12. The Task Force also observes that it did not address consolidation accounting pursuant to ARB 51 and its related amendments and interpretations or the determination of earnings per share pursuant to Statement 128 and its related amendments and interpretations in this Issue. Page 7

8 Transition 13. The consensuses in this Issue should be applied in reporting periods beginning after September 15, For investments in which the investor has the ability to exercise significant influence over the operating and financial policies of the investee, the investor should make an initial determination about whether investments existing as of the date the consensuses in this Issue are first applied are in-substance common stock; that initial determination should be based on circumstances that exist on the date of adoption of this Issue, rather than on the date that the investment was made. 15. For investments that are in-substance common stock but were not accounted for under the equity method of accounting prior to the consensuses in this Issue, the equity method of accounting should be applied effective for reporting periods beginning after September 15, The effect of adopting the consensuses in this Issue should be reported in the beginning of the reporting period of adoption similar to a cumulative effect of a change in accounting principle pursuant to Opinion 20. If the determination of the cumulative effect of retroactive application is impracticable, the cumulative effect should be determined as the difference between the investor s carrying amount of the investment and the investor s share of the investee s reportable net assets determined in accordance with GAAP as of the date of initial application of the consensuses in this Issue. Pro forma disclosure of the effect of the change in accounting principle in periods presented prior to the initial application of these consensuses is not required. Page 8

9 16. For investments that are not common stock or in-substance common stock, but were accounted for under the equity method of accounting prior to the consensuses in this Issue, the equity method of accounting should be discontinued effective for reporting periods beginning after September 15, Previously recognized equity method earnings and losses should not be reversed. The investor should evaluate whether the investment should be prospectively accounted for under Statement 115 or accounted for using the cost method under Opinion The SEC Observer noted that, in the past, the SEC staff has required registrants with significant influence over an investee to apply the equity method to interests that were other than common stock interests in situations in which it was obvious that there were no substantive differences between the instrument and the common stock of the investee. In those situations, the SEC staff has required restatement for correction of an error. The SEC staff will continue to require restatement for correction of an error in those instances. Board Ratification 18. At its July 16, 2004 meeting, the Board ratified the consensuses reached by the Task Force in this Issue. STATUS 19. Statement 160 replaced all instances of minority interest(s) with noncontrolling interest(s) but did not amend equivalent terms such as minority shareholder(s), minority public ownership, and minority ownership. These equivalent terms were amended by paragraph A19 of Update This included a change to the title of Issue Page 9

10 20. Paragraph 7 and footnotes 7 and 8 are amended to change be highly correlated to vary directly and footnote 5 has been deleted to reflect changes made in codifying this Issue in the FASB Accounting Standards Codification. This was done because as footnote 5 had indicated, the term be highly correlated differs from the definition in Statement 133, and the phrase vary directly is aimed at capturing the essence used in this Issue. 21. No further EITF discussion is planned. Page 10

11 Exhibit 02-14A EXAMPLES OF THE APPLICATION OF THE CHARACTERISTICS OF IN- SUBSTANCE COMMON STOCK The following examples illustrate the application of the characteristics described in paragraph 6 to various investments. Each example provides sufficient information to reach a conclusion about whether the investment contemplated in the example has the characteristic of in-substance common stock being demonstrated in the example. In each example, assume that the investor is performing the analysis because it has determined that it is not required to consolidate the investee under ARB 51 or its related interpretations, that it has the ability to exercise significant influence over the operating and financial policies of the investee, and that its investment does not meet the definition of a derivative under Statement 133. Example 1 Application of Paragraph 6(a) Subordination Investor A organized Investee and acquired all of the common stock of Investee on January 1, On January 1, 2004, Investee sells 100,000 shares of preferred stock to a group of investors in exchange for $10,000,000 ($100 par value; liquidation preference of $100 per share). The fair value of the entity s common stock is approximately $100,000 on January 1, In this example, the stated liquidation preference is equal to the fair value of the preferred stock. However, the fair value of the common stock ($100,000), when compared with the fair value of the preferred stock, indicates that Investee has little or no common stock Page 11

12 from a fair value perspective. An investor should therefore conclude that the liquidation preference is not substantive and that the subordination characteristics of its preferred stock investment are substantially similar to the subordination characteristics of Investee s common stock. The investor should also evaluate whether the preferred stock has the characteristics in paragraphs 6(b), 6(c), and 7 (if necessary) in order to reach a conclusion about whether the preferred stock is in-substance common stock. Example 2 Application of Paragraph 6(a) Subordination Assume the same facts and circumstances as in Example 1, except that the fair value of Investee s common stock is approximately $15,000,000 on January 1, In this example, the stated liquidation preference is equal to the fair value of the preferred stock. In addition, Investee has adequate subordinated equity from a fair value perspective (more than little or no subordinated equity) to indicate that the liquidation preference is substantive. An investor therefore should conclude that the subordination characteristics of its preferred stock investment are not substantially similar to the subordination characteristics of Investee s common stock. Accordingly, the preferred stock investment is not in-substance common stock. Evaluation of the characteristics in paragraphs 6(b), 6(c), and 7 is not required. Page 12

13 Example 3 Application of Paragraph 6(b) Participation in Risks and Rewards of Ownership Investor purchases a warrant in Investee for $2,003,900 on July 1, 20X4. The warrant enables Investor to acquire 100,000 shares of Investee s common stock at an exercise price of $1.00 per share (total exercise price of $100,000) on or before June 30, 20X5; the warrant does not participate in dividends. The fair value of the common stock is approximately $21.00 per share. The warrant is exercisable at any time. Investor does not expect Investee to declare dividends prior to exercise. Investor should evaluate whether the warrant is expected to participate in Investee s earnings (and losses) and capital appreciation (and depreciation) in a manner that is substantially similar to common stock. In order to evaluate the extent to which the warrant is expected to participate with the common shareholders in Investee s earnings (and losses), Investor should evaluate whether the warrant allows Investor to currently participate in dividends on a basis substantially similar to common stock. In this example, Investor does not participate in dividends. Investor, however, can exercise the warrant (convert into common stock) at any time, thereby enabling Investor to participate in Investee s earnings (and losses) on an equivalent basis to common stock. Since Investor does not expect Investee to declare dividends prior to exercise, Investor participates in Investee s earnings in a manner substantially similar to common stock. In addition, warrants that are exercisable into common stock are designed to participate equally with the common shareholders in increases in the Investee s fair value. Therefore, the warrant participates in Investee s capital appreciation. Page 13

14 Investor should also evaluate whether the warrant is expected to participate in Investee s capital depreciation in a manner substantially similar to common stock. An investor has alternatives for making this evaluation. In this example, Investor could compare the current fair value of Investee s common stock with the fair value of the warrant (on an equivalent unit basis) to determine whether the warrant is exposed to capital depreciation in a manner that is substantially similar to the entity s common stock. 7 The current fair value of the Investee s common stock of $21.00 is substantially similar to the current fair value of each warrant of $20.04 (on an equivalent unit basis). Therefore, the warrant s expected participation in Investee s capital depreciation is substantially similar to the common shareholders participation. Accordingly, Investor should conclude that, prior to exercise, the warrants are expected to participate in Investee s earnings (and losses) and capital appreciation (and depreciation) in a manner that is substantially similar to common stock. Investor should also evaluate whether the warrant has the characteristics in paragraphs 6(a), 6(c), and 7 (if necessary) in order to reach a conclusion about whether the warrant is in-substance common stock. 7 This comparison of fair values is different from the paragraph 7 evaluation that is performed (if necessary) to determine whether the future changes in fair value of the investment are expected to vary directly with the changes in the fair value of the entity s common stock. [Note: See STATUS section.] Page 14

15 Example 4 Application of Paragraph 6(b) Participation in Risks and Rewards of Ownership Investor purchases a warrant in Investee for $288,820 on July 1, 20X4. The warrant enables Investor to acquire 100,000 shares of Investee s common stock at an exercise price of $21.00 per share (total exercise price of $2,100,000) on or before June 30, 20X5; the warrant does not participate in dividends. The fair value of the common stock is approximately $21.00 per share. The warrant is exercisable at any time. Investor does not expect Investee to declare dividends prior to exercise. Investor should evaluate whether the warrant is expected to participate in Investee s earnings (and losses) and capital appreciation (and depreciation) in a manner that is substantially similar to common stock. In order to evaluate the extent to which the warrant is expected to participate with the common shareholders in Investee s earnings (and losses), Investor should evaluate whether the warrant allows Investor to currently participate in dividends on a basis substantially similar to common stock. In this example, Investor does not participate in dividends. Investor, however, can exercise the warrant (convert into common stock) at any time, thereby enabling Investor to participate in Investee s earnings (and losses) on an equivalent basis to common stock. Since Investor does not expect Investee to declare dividends prior to exercise, Investor participates in Investee s earnings in a manner substantially similar to common stock. In addition, warrants that are exercisable into common stock are designed to participate equally with the common shareholders in increases in Investee s fair value. Therefore, the warrant participates in Investee s capital appreciation. Page 15

16 Investor should also evaluate whether the warrant is expected to participate in Investee s capital depreciation in a manner substantially similar to common stock. An investor has alternatives for making this evaluation. In this example, Investor could compare the current fair value of Investee s common stock with the current fair value of the warrant (on an equivalent unit basis) to determine whether the warrant is exposed to capital depreciation in a manner that is substantially similar to the entity s common stock. 8 The current fair value of the Investee s common stock of $21.00 is substantially different from the current fair value of each warrant of $2.88 (on an equivalent unit basis). Therefore, the warrant s expected participation in Investee s capital depreciation is substantially different from the common shareholders participation. Accordingly, Investor should conclude that, prior to exercise, the warrants are not expected to participate in Investee s earnings (and losses) and capital appreciation (and depreciation) in a manner that is substantially similar to common stock and, accordingly, the warrants are not in-substance common stock. Evaluation of the characteristics in paragraphs 6(a), 6(c), and 7 is not required. Example 5 Application of Paragraph 6(c) Investee s Obligation to Transfer Value Investor purchases redeemable convertible preferred stock in Investee for $2,000,000. The investment can be (a) converted into common stock valued at $2,000,000 or (b) redeemed for $10,000 at the option of the Investor. The common shareholders do not have a similar redemption feature. 8 This comparison of fair values is different from the paragraph 7 evaluation that is performed (if necessary) to determine whether the future changes in fair value of the investment are expected to vary directly with Page 16

17 Investor should evaluate whether exercise of the $10,000 redemption feature obligates Investee to transfer substantive value to Investor and whether the common shareholders do not participate in a similar manner. In this example, the $10,000 redemption feature is not substantive. Accordingly, Investor should conclude that redeemable convertible preferred stock does not require Investee to transfer substantive value to Investor and that common shareholders do not participate. Investor should also evaluate whether the redeemable convertible preferred stock has the characteristics in paragraphs 6(a), 6(b), and 7 (if necessary) in order to reach a conclusion about whether the redeemable convertible preferred stock is in-substance common stock. Example 6 Application of Paragraph 6(c) Investee s Obligation to Transfer Value Investor purchases redeemable convertible preferred stock in Investee for $2,000,000. The investment can be (a) converted into common stock valued at $2,000,000 or (b) redeemed for $2,000,000 at the option of the Investor. The common shareholders do not have a similar redemption feature. Investor expects that Investee will have the ability to pay the redemption amount. Investor should evaluate whether exercise of the $2,000,000 redemption feature obligates Investee to transfer substantive value to Investor and whether the common shareholders do not participate in a similar manner. In this example, the $2,000,000 redemption feature is substantive because (a) the redemption amount is substantive as compared to the fair value of the investment and (b) based on Investor s expectation as of the date that the investment was made, Investee has the ability to pay the redemption amount. the changes in the fair value of the entity s common stock. [Note: See STATUS section.] Page 17

18 Accordingly, Investor should conclude that redeemable convertible preferred stock requires Investee to transfer substantive value to Investor and that common shareholders do not participate. Accordingly, the redeemable convertible preferred stock is not insubstance common stock. Evaluation of the characteristics in paragraphs 6(a), 6(b), and 7 is not required. Page 18

19 Suggested Index Entries for Issue No , Whether an Investor Should Apply the Equity Method of Accounting to Investments Other Than Common Stock INVESTMENTS: EQUITY METHOD Criteria for Applying.. Whether an Investor Should Apply the Equity Method of Accounting to Investments Other Than Common Stock Page 19