ACCOUNTING

June 2000

RECENT CHANGES IN RECOGNIZING EQUITY METHOD LOSSES

By Robert A. Dyson, CPA, andFriedman, Alpren & Green LLP

For almost 30 years, the basic application of the equity method of accounting for investments in common stock remained virtually unchanged. The general guidance, Accounting Principles Board Opinion (APBO) No. 18, The Equity Method of Accounting for Investments in Common Stock, was issued in March 1971. In the last two years, the Emerging Issues Task Force (EITF) issued two consensus positions with a new interpretation of recognizing losses when the investor holds securities other than voting common stock: EITF Issue 98-13, Accounting by an Equity Method Investor for Investee Losses When the Investor Has Loans to and Investments in Other Securities of the Investee, and EITF Issue 99-10, Percentage Used to Determine the Amount of Equity Method Losses.

Although many accountants associate the EITF with accounting issues applicable to publicly held companies, EITF consensus positions are classified as category (c) pronouncements by SAS No. 69, The Meaning of "Present Fairly in Conformity with Generally Accepted Accounting Principles" in the Independent Auditor's Report, and should be applied in all financial statements prepared in conformity with generally accepted accounting principles.

Review of the Equity Method

The equity method of accounting should be applied to investments in joint ventures and common stock of entities where the investor has the ability to exercise significant influence over operating and financial policies. In addition, the equity method is generally applied to investments in partnerships.

The equity method requires the investor to initially record the investment at cost and, after acquisition, adjust the carrying value to recognize the investor's share of the earnings or losses of the investee and of other changes in the investee's capital. These earnings and losses are adjusted to eliminate intercompany profits and losses and to amortize any difference between the cost of the investment and the amount of the underlying equity in the investee's net assets.

In the simplest case, the investor would recognize as income its share of the investee's income and increase the carrying value of its investment by a like amount. Similarly, the investor would recognize as a loss its share of the investee's loss and decrease the carrying value of its investment. The equity method limits the recognition of losses to the sum of the carrying value of the investment in common stock; the investor's obligation for additional contributions, such as payments on loan guarantees; and the adjusted basis of other investments, as discussed below. The investor presents its net investment in one line on the balance sheet and related net earnings or losses in one line on the income statement, sometimes referred to as a "one-line consolidation."

EITF 98-13

EITF 98-13 requires the recognition of equity method losses after the carrying value of the investment in common stock is reduced to zero if the investor holds other investments in the investee, such as debt securities, mandatory redeemable preferred stock, and loans. This means that equity method losses should first be applied to the carrying value of the investment in common stock, then to the total amount of funds the investor is committed to advance, and third to the adjusted basis of the other investments. The cost basis of other investments is the original cost adjusted for the effects of other-than-temporary write-downs, unrealized gains and losses on securities classified as trading in conformity with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, and amortization of discounts or premiums on debt securities or loans. The adjusted basis is the cost basis adjusted for the valuation allowance computed in conformity with SFAS No. 114, Accounting by Creditors for Impairment of a Loan.

In applying EITF 98-13, the investor should perform the following procedures:

* Apply APBO No. 18 to determine the maximum amount of equity method losses.

* Determine whether the adjusted basis of other investments is positive.

* If the adjusted basis is positive, adjust it for the amount of equity-method loss based on the other investment's seniority, as determined in the reverse order of liquidity. Thus, losses would first be applied to the other investments with the lowest priority in being settled in a bankruptcy proceeding. For investments accounted for in accordance with SFAS No. 115, the adjusted basis becomes the security's basis from which subsequent changes in fair value are measured.

* Equity method losses should no longer be reported when the adjusted basis of the other investments reaches zero. The investor should continue to track the amount of unreported equity method losses. If the investee subsequently reports net income, the investor should resume applying the equity method only after its share of net income equals its share of unreported net losses.

* Revise the adjusted basis of the other investments to reflect unrealized holding gains and losses on investments as required by SFAS No. 115 and valuation allowance on loans as required by SFAS No. 114.

EITF 98-13 is effective for interim or annual periods beginning after December 31, 1998, and should be applied on a prospective basis.

EITF 99-10

EITF 99-10 requires that the percentage an investor uses to recognize equity method losses take into account other investments the investor holds in the trustee. Under these circumstances, the investor should recognize equity method losses based on either A) the ownership level of the particular investee security or loan/advance held by the investor or B) the change in the investor's claim on the investee's book value. In arriving at this conclusion, the EITF observed that other approaches might also be acceptable. In order to apply approach A, the investor would have to know the total securities or loans outstanding in order to determine its relative ownership level; presumably the EITF concluded that investors not capable of obtaining this information probably do not have significant influence. The EITF further noted that a reporting entity should use only one approach and disclose the approach selected. The consensus is effective for interim or annual periods beginning after September 23, 1999.

Example

Facts: For the period from January 1, 2000, to December 31, 2002, Bravo Company owned 25% of the outstanding voting stock and 40% of the outstanding preferred stock of Alpha Company. In addition, Bravo extended loans representing 20% of Alpha's total loans. Bravo accounted for the preferred stock as available for sale securities in conformity with SFAS No. 115 and the loans in conformity with SFAS No. 114.

The assumptions used in this example are summarized in Table 1, and Alpha's balance sheet is as shown in Table 2. Bravo recognizes its equity method losses based on the ownership level of the particular security or loan/advance held.

Year ended December 31, 2000. Bravo should apply its share of Alpha's $440 operating loss first to the carrying value of the common stock, then to the adjusted basis of the preferred stock (the security with the least priority in the event of Alpha's bankruptcy). Bravo should apply the first $40 of Alpha's loss to reduce its investment in Alpha common stock ($10) to zero (25% of $40). Because it owns 40% of Alpha's preferred stock, Bravo should recognize an additional equity method loss of $160 (40% of $400), representing its share of the remaining loss ($400) and a corresponding reduction of the adjusted basis of its investment in Alpha's preferred stock. The journal entry recording Bravo's equity method loss would be as follows:

dr. Equity method loss	170
cr. Investment - Alpha	(10)
cr. Preferred stock investment	(160)

In conformity with SFAS No. 115, Bravo should record the mark-to-market adjustment for the available for sale preferred stock investment. The carrying value should be adjusted from the $140 balance calculated above ($300 less $160) to the fair value of $290, with a corresponding charge to other comprehensive income (OCI).

dr. Preferred stock investment	150
cr. Unrealized gain - OCI	(150)

In conformity with SFAS No. 114, Bravo should record a valuation allowance for the impaired loan.

dr. Loan loss expense	20
cr. Loan loss valuation allowance	(20)

Bravo will recognize a loss on the above of $190, which consists of an equity method loss of $170 plus the $20 loan loss expense. The effect of the equity method transactions on Bravo's balance sheet as of December 31, 2000, is shown in Table 3.

The future equity method losses are limited to the total adjusted basis of $320 (assuming no additional purchases or future sales of Alpha's securities) and not the carrying value on the financial statements of $470. The difference between the carrying values of the other investments (to be displayed on the balance sheet) and the adjusted basis is the accumulated OCI, which is not available to absorb future losses.

In applying the equity method losses first against the adjusted basis of preferred stock, Bravo made its decision based on priority in liquidation. Bravo would expect its loan to be settled before the preferred stock and therefore will keep the loan balance intact until after it writes off the higher risk preferred stock.

As implied by EITF 98-13's definition of cost basis, Bravo would not recognize any equity method losses against preferred stock if it were classified as a trading security. In this example, the equity method losses of $160 would be offset by the $150 in unrealized gains. The net effect on current income would be the $10 decrease in market value. Equity method losses can be applied against securities classified as available for sale because the restoration of the carrying value of the security to fair value goes through OCI and not the current year income.

Year ended December 31, 2001. Bravo should apply its share of Alpha's $710 operating loss first to the adjusted basis of the preferred stock and then to the adjusted basis of the loan, the next most senior security. Bravo should apply the first $350 of Alpha's loss to reduce the adjusted basis of its investment in Alpha preferred stock ($140) to zero (40% of $350). As it holds 20% of Alpha's loans, Bravo should recognize an additional equity method loss of $72, representing its share of the remaining loss (20% of $360), and reduce the adjusted basis of its loan to Alpha. The following journal entry should be recorded:

dr. Equity method loss	212
cr. Preferred stock investment	(140)
cr. Loan receivable	(72)

Bravo should record the mark-to-market adjustment of the preferred stock by adjusting its carrying value from the $150 balance calculated above ($290 less $140) to the fair value of $270 at December 31, 2001, with a corresponding charge to unrealized gain in OCI:

dr. Preferred stock investment	120
cr. Unrealized gain in OCI	(120)

Bravo will recognize an equity method loss of $212. The effect of the equity method transactions on Bravo's balance sheet as of December 31, 2001, is shown in Table 3.

Year ended December 31, 2002. Bravo should apply its share of Alpha's $600 operating income to restore the adjusted basis of other investments in reverse order of the application of the equity method losses. In other words, Bravo will first restore the carrying value of the loan, then the carrying value of the preferred stock. As Bravo holds 20% of Alpha's loans, Bravo should recognize equity method income and increase the adjusted basis of its loan to Alpha by $72 (20% of $360). Bravo should then apply the remaining equity method income of $240 to restore the adjusted basis of its investment in Alpha preferred stock by $96 (40% of $240). The following journal entry should be recorded:

dr. Preferred stock investment	96
dr. Loan receivable	72
cr. Equity method income	(168)

Bravo should record the mark-to-market adjustment of the preferred stock by adjusting its carrying value from the $366 balance calculated above ($270 plus $96) to the fair value at December 31, 2002, of $300, with a corresponding charge to unrealized loss in OCI:

dr. Unrealized loss - OCI	66
cr. Preferred stock investment	(66)

In conformity with SFAS No. 114, the valuation allowance for the loan should be adjusted to reflect the expected future cash flows from the loan.

dr. Loan loss valuation allowance	20
cr. Loan loss expense	(20)

Bravo will recognize equity method income on the above transactions of $188, consisting of equity method income of $168 plus the reversal of $20 loan loss expense. The effect of the equity method transactions on Bravo's balance sheet as of December 31, 2002, is shown in Table 3.

If Bravo were to recognize its equity loss under approach B--recognize equity method losses based on the change in its claim on the investee's book value--the calculations would be as shown below.

It should be noted that equity method losses are applied to the adjusted basis of the investments in the same way as approach A. As a result, the amount of equity method loss and income calculated using approach B would often be the same as approach A, although the EITF noted that differences could occur. In addition, reporting entities applying approach B should apply SFAS Nos. 114 and 115 in the same way as in approach A.

Year ended December 31, 2000. If Alpha hypothetically liquidated its assets at book value at December 31, 2000, it would have $1,350 available for distribution to creditors and stockholders. Bravo would receive $340 [$200 (representing Bravo's 20% share of a priority claim from the $1,000 loan) plus $140 (representing Bravo's 40% of the remaining $350 in assets available to the preferred stock)]. Because the carrying value of its investment in Alpha was $510 (the sum of the investment in common stock, preferred stock, and the loan) at January 1, 2000, Bravo would recognize the decrease of $170 in its claim on Alpha's book value as its share in Alpha's losses. The journal entry recording Bravo's equity method loss would be as follows:

dr. Equity method loss	170
cr. Investment - Alpha	(10)
cr. Preferred stock investment	(160)

Year ended December 31, 2001. If Alpha hypothetically liquidated its assets at book value on December 31, 2001, it would have $640 available for distribution to creditors and stockholders. Bravo would receive $128, representing its 20% share of a priority claim on the $1,000 loan (20% of $640). Thus, Bravo would recognize the decrease of $212 ($340 less $128) in its claim on Alpha's book value as its share in Alpha's losses. The journal entry recording Bravo's equity method loss would be as follows:

dr. Equity method loss	212
cr. Preferred stock investment	(140)
cr. Loan receivable	(72)

Year ended December 31, 2002. If Alpha hypothetically liquidated its assets at book value on December 31, 2002, it would have $1,240 available for distribution to creditors and stockholders. Bravo would receive $296 [$200 (representing Bravo's 20% share of a priority claim from the $1,000 loan) and $96 (representing Bravo's 40% of the remaining $240 in assets available to the preferred stock)]. Thus, Bravo would recognize the increase of $168 in its claim on Alpha's book value as its share in Alpha's income. The journal entry recording Bravo's equity income would be as follows:

dr. Preferred stock investment	96
dr. Loan receivable	72
cr. Equity method income	(168)

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