ASC 323: First Principles
My Company’s Investment Became More Valuable. How Should We Account for It?
Consider this, your company owns 30% of another privately held business. During the year, that business earns $10 million. No dividend is declared. Instead, the profits are reinvested to expand operations.
Here’s the question, “has your company’s investment become more valuable?”
The answer is obviously, “yes!” The investee has generated earnings, increased its net assets, and become more valuable than it was at the beginning of the year.
Since your company owns 30% of that business, the economic value of the investment has increased as well.
That naturally leads to the accounting question, “how should your company recognize its share of that increase?”
That question is the heart of ASC 323.
How Should We Measure the Increase?
Once we’ve concluded that the investment became more valuable, the accounting challenge changes. We’re no longer asking whether the investment increased in value, now we’re asking, “how do we measure that increase faithfully?”
One possibility is to wait until the investee pays a dividend, but that doesn’t really represent what happened.
The investment became more valuable when the investee generated earnings. A future dividend doesn’t create additional value. It simply transfers part of that value from the investee’s bank account to yours.
Another possibility is to measure the investment at fair value. For publicly traded companies, that’s often the best answer because the market continually reflects the changing value of the investment. However, privately held businesses rarely have observable market prices.
So if there isn’t a reliable market value, what is the most faithful evidence that your investment became more valuable? The investee’s financial results. If your company owns 30% of the investee, then its share of the investee’s earnings provides the best available measure of how much the investment increased during the period.
That is the foundation of the equity method.
Why Doesn’t Everyone Use This Method?
That leads us to the next logical question, which is, “if the investee’s earnings provide such a useful measurement, why doesn’t every investor use the equity method?”
That’s because not every investor has the same relationship with the investee.
If your company owns a small number of publicly traded shares, it generally doesn’t receive detailed financial information throughout the year. Even if it did, an observable market price already provides a better measurement of the investment’s value.
A different relationship exists when your company has significant influence over another business. Your company may have representation on the board of directors, it might participate in strategic decisions, and it likely receives detailed financial information on a regular basis.
In other words, your company has both the information and the relationship necessary for the investee’s financial results to become a faithful measure of the investment’s changing value.
Significant influence isn’t the objective of ASC 323. Rather, it’s what makes the equity method an appropriate measurement.
Why Dividends Aren’t Income
This idea also explains one of the most misunderstood aspects of the equity method. When the investee eventually pays a dividend, no additional income has been earned.
The income was earned when the investee generated its profits, while the dividend simply converts part of your company’s investment into cash.
That’s why dividends reduce the carrying amount of the investment instead of creating additional income.
Once you understand that your investment increased when the investee earned the money, this accounting treatment becomes almost inevitable.
Bringing It All Together
Your company’s investment became more valuable because the investee generated earnings.
The accounting challenge isn’t determining whether the investment increased in value, it’s determining how to measure that increase faithfully.
When an investment changes in value, accounting should recognize that change using the most faithful measurement available.
Sometimes that measurement is a quoted market price, while other times it’s the investor’s proportionate share of the investee’s earnings.
ASC 323 exists because, for investments over which an investor has significant influence, the investee’s financial results often provide the most faithful measurement of the investment’s changing value.
Once you understand that, the rest of the standard becomes a matter of applying that principle.