ASU 2014-01 and the Proportional Amortization Method
ASU 2014-01 provides a simplified accounting alternative to the equity method for certain investments in affordable housing that generate tax credits.
The Financial Accounting Standards Board (FASB) provides guidance that simplifies accounting for certain tax equity investments. This guidance introduced the proportional amortization method as an optional alternative for entities investing in projects that generate tax credits. Initially for Low-Income Housing Tax Credit (LIHTC) investments under Accounting Standards Update (ASU) 2014-01, its use was expanded by ASU 2023-02. This update allows the method for a broader range of investments, including New Markets Tax Credits (NMTC) and Renewable Energy Tax Credits (RETC).
The standard was developed to reduce the cost and complexity of other accounting methods. It offers a treatment that better aligns with an investment’s returns, which are derived almost entirely from tax benefits rather than operational profits.
Qualifying for the Proportional Amortization Method
An entity must make an accounting policy election to apply the proportional amortization method, and this choice must be applied consistently to all qualifying investments. To qualify, an investment must be made through an entity structured to pass tax credits and other tax benefits to the investor.
A condition is that the investor’s projected yield must be based almost exclusively on the tax credits and other tax benefits it expects to receive. This means any potential cash flows from the project’s operations are insignificant compared to the value from tax advantages. The investor’s projected yield, based solely on these tax benefits, must be positive.
Another requirement is that the investor cannot have the ability to exercise significant influence over the operating and financial policies of the underlying project. This lack of influence distinguishes these passive investments from those where an investor has a more active role that would require other accounting treatments. The evaluation of these conditions is performed at the time of the initial investment.
Applying the Proportional Amortization Method
Once an investment is eligible, it is recorded on the balance sheet at its cost. The method involves amortizing this initial cost over the period that tax credits are received. This amortization is not done on a straight-line basis but in proportion to the tax credits allocated to the investor in each period.
For example, consider an investment of $1 million in a project expected to generate $1.1 million in tax credits over 10 years. If in the first year, the investor receives $110,000 in tax credits (10% of the total), the investment would be amortized by $100,000 (10% of the initial cost). This amortization expense is recognized as a component of income tax expense.
The tax credits received are also recorded as a reduction to income tax expense. The net effect on the income statement is the difference between the amortization of the investment and the value of the tax credits received. On the balance sheet, the investment is presented net of the accumulated amortization.
This method results in the investment’s performance being shown net of taxes within the income tax line. Because the amortization and tax credits are recognized together, it avoids creating deferred tax assets or liabilities related to the investment, which simplifies the accounting.
Impairment and Disclosures
Entities using the proportional amortization method must periodically assess their investments for impairment. An impairment review is triggered when it becomes more likely than not that the carrying amount of the investment will not be realized. This could be due to changes in the project’s ability to generate the promised tax credits or other adverse events affecting the project’s viability.
If an impairment is identified, the loss is measured as the difference between the investment’s carrying amount and its fair value. This impairment loss is recognized in the financial statements, and any previously recognized impairment loss cannot be reversed in future periods, even if the project’s outlook improves.
The standard also mandates specific disclosure requirements. An entity must disclose the nature of its tax equity investments and report their effect on its financial position and results of operations, including the amount of amortization expense and the value of tax credits recognized during the period.