Accounting for Equity Method Goodwill

When an investor gains significant influence over another company, it uses the equity method to account for the investment. This method reflects the economic substance of the relationship. Significant influence is presumed if the investor holds between 20% and 50% of the company’s voting stock, though other factors like board representation can also establish it. A component that can arise from this transaction is equity method goodwill, which is the premium paid by the investor above its share of the fair value of the investee’s net assets.

Unlike goodwill from a business acquisition, equity method goodwill is not a separate asset on the investor’s balance sheet but is embedded within the investment account. The accounting for this embedded goodwill follows U.S. Generally Accepted Accounting Principles (GAAP), specifically Accounting Standards Codification (ASC) 323.

Calculating the Initial Investment and Goodwill

The process begins by recording the initial purchase at cost, the amount paid to acquire the ownership stake. Following this, the investor must analyze the investment’s value to identify its components. This involves comparing the purchase price to the investor’s share of the book value of the investee’s net assets (its assets minus liabilities). The difference between the investment cost and the investor’s share of the investee’s net asset book value is the basis difference.

This difference must be allocated, first to the investor’s share of any discrepancy between the fair market value and book value of the investee’s specific assets and liabilities. For example, an investee might own land carried at its original cost, which is now significantly lower than its market value. After allocating the basis difference to these identifiable assets and liabilities, any remaining excess amount is classified as equity method goodwill.

Consider an example: Investor Corp. buys 30% of Investee Co. for $500,000. At the time of purchase, Investee Co.’s net assets have a book value of $1,000,000 and a fair value of $1,200,000. The $200,000 difference between fair and book value is due to undervalued land. The investor’s share of the book value is $300,000 (30% of $1,000,000), making the total basis difference $200,000 ($500,000 cost – $300,000). Next, the investor allocates its share of the fair value adjustment for the land, which is $60,000 (30% of the $200,000 land value increase). The remaining unallocated basis difference of $140,000 is the equity method goodwill.

Ongoing Adjustments to the Investment Account

In periods following the acquisition, the investment account is adjusted to reflect the investee’s ongoing performance and distributions. The primary adjustment comes from the investee’s earnings, where the investor increases the investment account by its proportional share of net income and decreases it for any net loss.

When the investor receives dividends from the investee, these payments are considered a return of investment capital and therefore decrease the carrying value of the investment account. This reflects that the investee’s distribution of cash reduces its net assets.

The basis differences identified during the initial calculation also require ongoing attention. The portion of the basis difference allocated to depreciable or amortizable assets must be amortized over those assets’ useful lives. This amortization expense reduces the income the investor recognizes from the investee each period, which in turn reduces the investment account balance.

Impairment of the Equity Method Investment

The embedded goodwill is not tested for impairment on its own; instead, the entire investment account is treated as a single unit for impairment testing. This test is not performed annually but is triggered only when events or changes in circumstances suggest that the investment’s value may have permanently declined.

Indicators that might trigger a review include a history of continued operating losses at the investee, the loss of a major customer, or a significant and prolonged decline in the fair value of the investment below its carrying amount. When an indicator is present, the investor compares the fair value of its investment to the investment’s carrying amount.

If the fair value is less than the carrying amount, an impairment loss is recognized for the difference. This loss is recorded on the investor’s income statement, and the investment account on the balance sheet is written down. Once an impairment loss is recognized for an equity method investment, it cannot be reversed in future periods, even if the investment’s fair value subsequently recovers.

Disclosures and Presentation on Financial Statements

On the balance sheet, the investment is presented as a single line item within non-current assets, which includes the initial cost and all subsequent adjustments. Similarly, on the income statement, the investor’s share of the investee’s earnings is shown as a single line item, often titled “Equity in earnings of affiliate.” This presentation separates the investment’s results from the investor’s primary operations.

The footnotes to the financial statements provide detailed context. Required disclosures include:

• The name of the investee and the investor’s percentage of ownership.
• The accounting policies applied to the investment.
• Summarized financial information for the investee, such as its total assets, liabilities, revenues, and net income.
• The fair value of the investment, if it is readily determinable.