An investment without a stated liquidation preference, or with a nonsubstantive liquidation preference, over the investee’s common stock, may be substantially similar to common stock and further analysis of the other criteria will be needed. In contrast, an investment with a substantive liquidation preference over common stock is not substantially similar to that entity’s common stock. An investor should consider the following when assessing if a stated liquidation preference is substantive:
Example EM 1-1, Example EM 1-2, and Example EM 1-3 illustrate the evaluation of whether an investment has substantially similar subordination as common stock. EXAMPLE EM 1-1 On January 1, 20X1, Investor purchased 200,000 shares of preferred stock of Investee in exchange for $20,000,000 ($100 par value, liquidation preference of $100 per share). On January 1, 20X1, the fair value of Investee’s outstanding common stock was $300,000. Investor has the ability to exercise significant influence over Investee’s operating and financial policies through its investment in Investee. Are the subordination characteristics of Investor’s investment in the preferred stock of Investee substantially similar to the subordination characteristics of Investee’s common stock? Analysis The liquidation preference stated in the preferred stock of Investee is equal to the purchase price (and fair value) of the preferred stock on the date of purchase. Therefore, the stated liquidation preference is significant in relation to the purchase price of the investment. However, the fair value of Investee’s common stock ($300,000), compared to the fair value of Investee’s preferred stock ($20,000,000), indicates that Investee’s common stock has little fair value compared to the investment. In the event of liquidation, Investor’s investment, while preferred stock, would likely participate in substantially all of Investee’s losses. As a result, it’s likely that the liquidation preference in its investment in the preferred stock of Investee is not substantive and that the subordination characteristic of its investment in the preferred stock of Investee are substantially similar to that of the Investee’s common stock. Investor should also evaluate the risks and rewards of ownership (see EM 1.2.1.2) and obligation to transfer value (see EM 1.2.1.3) to determine whether its investment in the preferred stock of Investee is in-substance common stock. EXAMPLE EM 1-2 On January 1, 20X1, Investor purchased 200,000 shares of preferred stock of Investee in exchange for $20,000,000 ($100 par value, liquidation preference of $1 per share). On January 1, 20X1, the fair value of Investee’s outstanding common stock was $100,000,000. Investor has the ability to exercise significant influence over Investee’s operating and financial policies through its investment in Investee. Are the subordination characteristics of Investor’s investment in the preferred stock of Investee substantially similar to the subordination characteristics of Investee’s common stock? Analysis The liquidation preference stated in the preferred stock of Investee is equal to 1% ($1 per share divided by $100 per share) of the purchase price (and fair value) of the preferred stock on the date of purchase. The fair value of Investee’s common stock ($100,000,000), as compared to the fair value of Investee’s preferred stock ($20,000,000), indicates that Investee has significant value associated with its common stock from a fair value perspective. Given that the liquidation preference is only 1% of the purchase price, Investor is likely to conclude that the liquidation preference of its investment is not substantive and that the subordination characteristic is substantially similar to the subordination characteristics of Investee’s common stock. Investor should also evaluate the risks and rewards of ownership (see EM 1.2.1.2) and obligation to transfer value (see EM 1.2.1.3) criteria in its determination of whether its investment in the preferred stock of Investee is in-substance common stock. EXAMPLE EM 1-3 On January 1, 20X1, Investor purchased 200,000 shares of preferred stock of Investee in exchange for $20,000,000 ($100 par value, liquidation preference of $100 per share). On January 1, 20X1, the fair value of Investee’s outstanding common stock was $100,000,000. Investor has the ability to exercise significant influence over Investee’s operating and financial policies through its investment in Investee. Are the subordination characteristics of Investor’s investment in the preferred stock of Investee substantially similar to the subordination characteristics of Investee’s common stock? Analysis The liquidation preference stated in the preferred stock of Investee is equal to the purchase price (and fair value) of the preferred stock on the date of purchase and, consequently, the stated liquidation preference is significant in relation to the purchase price of the investment. Further, the fair value of Investee’s common stock ($100,000,000), as compared to the fair value of Investee’s preferred stock ($20,000,000), indicates that the Investee common stock has significant fair value. Therefore, in the event of liquidation, Investor’s investment in the preferred stock of Investee would likely be protected through the existence of Investee’s common stock, which would most likely absorb a substantial portion of the losses of Investee. As a result, Investor might conclude that the liquidation preference in its investment in the preferred stock of Investee is substantive and that the subordination characteristics of its investment in the preferred stock of Investee are not substantially similar to the subordination characteristics of Investee’s common stock. If so, the preferred stock would not be considered in-substance common stock. Investor would not be required to evaluate the risks and rewards of ownership and obligation to transfer value criteria once the subordination criterion is not met. Page 2
In accordance with ASC 323-30-25-1, investors in partnerships, unincorporated joint ventures, and limited liability companies (LLCs) should generally account for their investment using the equity method of accounting by analogy if the investor has the ability to exercise significant influence over the investee. However, there may be situations when significant influence does not exist but the equity method of accounting applies.
A general partnership interest in assets, liabilities, earnings, and losses accrues directly to the individual partners. No “corporate veil” exists between the partners and the related investment. General partners in a general partnership usually have the inherent right, absent agreements in partnership articles to the contrary, to influence the operating and financial policies of a partnership. An interest in a general partnership usually provides an investor with the ability to exercise significant influence over the operating and financial policies of the investee. As such, assuming an investor does not hold a controlling financial interest, a general partnership interest is generally accounted for under the equity method of accounting.
Generally, interests in a limited partnership or unincorporated joint venture when the investor does not have a controlling financial interest would be accounted for under the equity method of accounting by analogy. ASC 323-30-S99-1 describes the SEC staff’s view on the application of the equity method to investments in limited partnerships. This guidance requires a limited partner to apply the equity method of accounting to its investment unless the limited partner’s interest is so minor that the limited partner has virtually no influence over the operating and financial policies of the partnership. An ownership interest greater than 3-5% in limited partnerships is presumed to provide an investor with the ability to influence the operating and financial policies of the investee. This differs from the threshold of 20% of outstanding voting securities presumed to create influence for an investment in common stock or in-substance common stock of a corporation. See EM 2.1 for further discussion. See EM 1.3.3 for guidance on whether a limited liability company should be viewed as a limited partnership or a corporation for purposes of determining whether the equity method of accounting is appropriate.
Limited liability companies frequently have characteristics of both corporations and partnerships. Investors must determine whether a limited liability company should be viewed as similar to a corporation or a partnership for purposes of determining whether its investment should be accounted for under the equity method of accounting. Per ASC 323-30-35-3, a noncontrolling investment in a limited liability company that maintains a specific ownership account (similar to a partnership capital account structure) for each investor should be viewed similarly to an investment in a limited partnership when determining whether the investment provides the investor with the ability to influence the operating and financial policies of the investee. An investment in a limited liability company that does not maintain specific ownership accounts for each investor should be viewed similar to an investment in a corporation when determining whether to apply the equity method of accounting.
ASC Master Glossary
Joint venture: An entity owned and operated by a small group of businesses (the joint venturers) as a separate and specific business or project for the mutual benefit of the members of the group. A government may also be a member of the group. The purpose of a joint venture frequently is to share risks and rewards in developing a new market, product, or technology; to combine complementary technological knowledge; or to pool resources in developing production or other facilities. A joint venture also usually provides an arrangement under which each joint venturer may participate, directly or indirectly, in the overall management of the joint venture. Joint venturers thus have an interest or relationship other than as passive investors. An entity that is a subsidiary of one of the joint venturers is not a joint venture. The ownership of a joint venture seldom changes, and its equity interests usually are not traded publicly. A minority public ownership, however, does not preclude an entity from being a joint venture. As distinguished from a corporate joint venture, a joint venture is not limited to corporate entities. Joint ventures are often used to create alliances to enter new markets or expand business operations while sharing risks and expertise with other investors. Joint ventures are not limited by the type or legal form of the entity and can be formed as corporations, partnerships, and limited liability companies. The most distinctive characteristic of a joint venture is the concept of joint control. Refer to EM 6 for discussion around identifying and accounting for a joint venture.
Other entities, such as trusts, can take a variety of forms, and may maintain specific ownership accounts. When evaluating investments in these entities, it is often appropriate to analogize to the guidance for limited liability companies (EM 1.3.3) to determine what level of ownership requires the use of the equity method of accounting. Investors should consider all relevant facts and circumstances.
Companies, particularly financial institutions, may invest in limited partnerships or limited liability companies that operate qualified affordable housing projects or invest in entities that operate qualified affordable housing projects. These investors earn federal tax credits as the principal return for providing capital to facilitate the development, construction, and rehabilitation of low-income rental property. Per ASC 323-740, investors in these entities may be eligible, subject to meeting a number of criteria, to elect to apply the proportional amortization method rather than the equity method of accounting. Under the proportional amortization method, investors amortize the cost of their investment as a component of income taxes in the income statement. See TX 3.3.6 for additional information. In order to be eligible for the election, one of the criteria is that the investor cannot have the ability to exercise significant influence over the operating and financial policies of the entity. This is evaluated using the indicators of significant influence for determining eligibility for the equity method of accounting (see EM 2.2). The guidance in EM 2.1 includes certain ownership levels at which it is presumed that the equity method should be applied to limited partnerships and similar entities. That guidance should not be considered when determining if significant influence exists for the purpose of this analysis. Therefore, care should be taken when evaluating the existence of significant influence for these entities. Investors that do not qualify for the proportional amortization method (or do not elect to apply it) would account for their investments in these partnerships under the equity method if the investor has a more than minor interest in the investee. When accounting for investments in low-income housing tax credit partnerships under the equity method, the hypothetical liquidation at book value model would typically be used. See EM 4.1.4.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. |
When an investor uses the equity method to account for investments in common stock
Pos Terkait
Copyright © 2024 ketiadaan Inc.
