When the fair value of an equity investment cannot be readily determined, the accounting treatment becomes critical for investors and financial statement preparers. There are several key requirements under both IFRS and US GAAP that need close attention. This article will summarize the core principles and requirements for accounting for equity investments without readily determinable fair values, focusing on concepts such as cost method, equity method, impairment, and subsequent remeasurement.
Use cost method for available-for-sale investments
For available-for-sale equity investments without readily determinable fair value, the cost method should be applied for initial and subsequent measurement. Under the cost method, the equity investment is recorded at historical cost at initial recognition. Going forward, the carrying amount is not adjusted except for impairment and other-than-temporary declines in value. Impairment losses are recognized in net income while an increase in value will not be recognized until the investment is ultimately sold or disposed.
Apply equity method for investments without significant influence
For equity investments in which the investor cannot exercise significant influence, the equity method is generally the appropriate accounting. Under the equity method, the investment is initially recorded at cost, same as the cost method. Subsequently, the carrying amount is increased/decreased each period to recognize the investor’s proportionate share of the investee’s earnings/losses. The investor’s share of the investee earnings and losses will directly flow through to net income.
Assess fair value periodically for cost method investments
For equity investments accounted for using the cost method, companies need to periodically evaluate whether the fair value has become readily determinable. If fair value does become measurable, companies should discontinue the cost method and measure the investment at fair value. Any unrealized gains/losses from the date fair value became measurable will flow through net income.
Recognize impairment losses in net income
Under both the cost method and equity method, companies need to regularly assess their equity investments for impairment. An impairment charge should be recognized in net income representing the amount by which the carrying amount exceeds the fair value of the investment. Fair value would be estimated using discounted cash flows or other valuation techniques when market prices are unavailable.
In summary, accounting for equity investments without readily determinable fair values centers around using the cost or equity method initially, assessing for impairment, and remeasuring at fair value when it becomes available. Impairment charges hit the income statement while fair value gains generally go to OCI.