In 2016, the Financial Accounting Standards Board (FASB) issued ASU 2016-01, which adopts a new standard that will require companies to generally change the way they account for equity investments of less than 20%.
The new standard, which has largely flown under the radar to date, will apply to all investments in equity securities and other ownership interests (including investments in partnerships, unincorporated joint ventures and limited liability companies) other than those that are consolidated in the financial statements of the investor or accounted for using the equity method. In practice, that means it will apply to most equity investments below a 20% ownership threshold, absent other indicia of control that could require use of the equity method. The new standard goes into effect for public companies in 2018 and is available here.
The standard will require companies to account for minority equity investments as set forth below:
- Equity investments with readily determinable fair values: Must be measured at fair value on the balance sheet, with changes reported through net income — for each reporting period.
- Equity investments without readily determinable fair values: Companies must either
(a) account for these investments at fair value, consistent with the above approach, or (b) elect to account for the investment under the “practicability exception” described below, which permits measurement of these investments at cost, minus impairments, plus or minus observable changes in price — for each reporting period.
The changes from past practice are significant. First, current requirements apply to both debt and equity securities and require companies to account for those securities with readily determinable fair values either as held for trading or as available-for-sale, with changes in value of the latter run through other comprehensive income (below net income as a component of comprehensive income). The new standard does not permit a distinction between trading and available-for-sale equity investments and requires all changes in the value of equity investments to be reflected in net income. Second, current requirements permit companies to account for equity investments without readily determinable fair values at cost minus impairment and do not require tracking of observable price changes with respect to those investments. Accordingly, current requirements do not require companies ever to mark up the value of those investments (and run those increases through net income, as will now be required). As a result, the new standard could have a significant ripple effect on a company’s balance sheet and results of operations from period to period, particularly for those corporates with “venture capital” arms that make small acquisitions in start-ups and other private companies for strategic and developmental purposes.
The Practicability Exception – Accounting for Nonmarketable Equity Investments
Companies must either comply with the fair value reporting requirement or opt into the practicability exception separately for each qualifying equity investment they hold, and if selected, the practicability exception will apply until the equity investment no longer qualifies for the exception (i.e., if an investment continues to have no “readily determinable fair value,” a company cannot change to the fair value method simply because it decides it now has or wants to invest in the resources to make a full fair value determination going forward). The practicability exception will permit companies to measure certain nonmarketable equity investments without a readily determinable fair value at cost minus impairment, but these investments still must be adjusted each reporting period for (1) impairment and (2) “observable price changes.”
To determine impairment, companies that elect the practicability exception must perform a qualitative impairment assessment test that mirrors the existing test each reporting period for each equity investment. The new standard eliminates, for minority equity investments, the distinction between temporary impairment, which need not be immediately recognized as a loss, and non-temporary impairment. Accordingly, if an indication of impairment exists after performing the qualitative test, impairment must be valued quantitatively, the value of the investment written down and the change recognized in net income in the current reporting period.
Observable Price Change Determination
Reportable “observable price changes” are defined as price changes in “orderly transactions” for the identical or a similar investment of the same issuer (e.g., a subsequent capital raising round). An orderly transaction is defined as one that “assumes exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary.” Whether a security issued by the same issuer is similar turns on the rights of the security holders and obligations of the issuer to them. A company is also required to make a “reasonable effort” to identify price changes that are known or that can reasonably be known.
Companies that avail themselves of the practicability exception must disclose the following items for all qualifying investments for each reporting period:
- the carrying amount of these investments
- impairment charges and adjustments
- upward adjustments made because of observable price changes
- narrative information sufficient to permit financial statement users to understand the information the company considered in making any downward or upward adjustments
These disclosures can be made in the aggregate for qualifying investments, but in some cases may require investment-specific disclosure (particularly the narrative information explaining changes where one investment may have been adjusted for the period while others were not).
The implications of the change for companies that make small equity investments, discussed below, are not insignificant. It remains to be seen which path most companies will take, but we expect that the practicability exception will be the preferred course for most investments for which it is available. That said, some companies, particularly those with the resources to perform and maintain ongoing valuations, may prefer to comply with the full fair value standard.
- Compliance will require additional resources
Whether they must comply with the new fair value standard or are able to avail themselves of the practicability exception, companies will incur additional cost. Compliance with fair value reporting will require companies either to dedicate internal resources to determining the fair value of their equity investments or to hire third-party providers to perform ongoing valuations for them. Companies relying on the practicability exception will need to dedicate resources not only to performing an impairment assessment as currently required, but also to determining whether an observable price change has occurred, in each case on a quarterly basis. Companies planning to elect the practicability exception should consider:
- Establishing procedures for making and documenting the election for each equity investment. Although not required by the standard, we believe documentation of the election is prudent.
- Establishing procedures and internal controls to identify observable prices for the same or similar securities and determining what constitutes a reasonable effort to determine price changes that can reasonably be known. Although in most cases existing investors receive notice of subsequent financing rounds that would cause an observable price change (whether by virtue of preemptive rights, quarterly information rights or otherwise), the right to be informed of subsequent financings is likely to find its way more formally into equity investment documentation.
- Adopting policies establishing what types of securities will be considered similar securities.
- Establishing procedures and internal controls to ensure that each equity investment subject to the practicability exception is evaluated each reporting period for impairment and observable price changes.
- Establishing procedures and internal controls to ensure that each equity investment subject to the practicability exception is evaluated each reporting period to ensure it continues to qualify for the exception (i.e., that no readily determinable fair value exists).
- Establishing procedures to obtain necessary financial information from investees. Companies that make equity investments knowing they will comply with the fair value method may going forward always require investees to provide them with quarterly financial statements and other financial information. However, for companies with earlier quarterly reporting deadlines than their investees, compliance with the fair value standard may prove difficult.
- Companies with multiple investments will need to establish policies for making election decisions and disclosing those elections and their potential impact
Companies with multiple equity investments will need to determine whether to make a separate election with respect to each investment, or whether to apply a single election to all of their investments (in the case of the practicability exception, assuming it is available). There may be logistical and strategic reasons for making individual decisions – companies may have greater access to management and financial information with respect to certain investments, making a fair value determination easier for those investees; companies may want to apply the fair value standard to certain investments that would otherwise cause too much volatility in net income if they adjust for observable price changes alone; or in other cases, particularly with respect to investees undergoing consistent rounds of financing, companies may find it easy and accurate to rely on the exception. Time will tell whether auditors will have a preference for applying a consistent standard to all or most of a company’s investments, and whether companies will find it easier and less costly to comply if they aggregate their investments under a single standard. It will be important for companies to explain the elections they make beginning in their Q1 2018 10-Qs, including the potential impact on their financial reporting. We expect that companies will address these changes in their descriptions of critical accounting policies and in the notes to their financial statements, but they may also consider including risk factors and/or “known trend” disclosure in MD&A addressing the potential impact on net income of downward changes in observable prices.
- Companies will need to address the inconsistent and misleading effects on net income that may result from changes in the value of certain equity investments
Calendar year companies will need to make an election with respect to each of their equity investments prior to the issuance of their financial statements for the first quarter of 2018. They will be required to adopt their new election through a cumulative effect adjustment to retained earnings as of the beginning of the period of adoption, i.e., January 1, 2018 for calendar year companies. Over time, companies with investments that experience sudden increases in observable prices will have to grapple with the fact that those changes may cause a positive effect on net income that does not reflect their core business. On the other hand, over time, companies will also have to address the potential negative effect on net income of observable price changes or an actual IPO exit or sale at a price below prior price changes. Companies that invest in high-growth startups (which frequently access new capital) may be particularly susceptible to the distorting effects of those investments on net income, as high-growth companies tend to attract high valuations, which allow them to raise capital, which is then spent to generate more growth and raise valuations again. If those prior valuations do not prove accurate at the time of an IPO or sale exit, the investing companies will then experience a distorting negative effect on net income. Although this will not affect operating income, we expect companies to develop disclosure to explain the one-off nature of such changes, and we also expect that companies may develop a non-GAAP net income measure that excludes the effect of equity investments altogether — to maintain consistency in net income reflecting their core business on a period-to-period basis.
- Multiple companies with ownership stakes in the same target company may elect to report differently
The choice inherent in the new standard leaves open the possibility that Investor A determines to do a fair value assessment each quarter while Investor B avails itself of the practicability exception, in each case with respect to the same investee. In such a case, Investor A may report gains (or losses) while Investor B maintains the investment at cost on its balance sheet until there is an observable price change. In some cases, these differences may not be discernible due to aggregation of multiple investments in one line item under one election. But if discernible, and if Investor A reports a large gain because of a change in its fair value determination attributable to something inherent in the business and not an observable price change, Investor B, which may be a competitor, cannot flip back and forth between complying with the standard and availing itself of the exception simply to put itself on par with Investor A. This may result in companies having to spend more time during earnings calls and in their disclosure discussing these types of investments when they have previously never been discussed or disclosed.
 Debt securities also may be categorized as held to maturity.
 It is also possible that private companies may consider the accounting election their potential investors intend to make when choosing investors and, potentially, may require investors to make representations ad warranties regarding such expectations. Private companies that do not want their valuation to be readily transparent to the market on an ongoing basis may even disqualify investors intending to use the fair value method.
 For example, both Google and Intel invested in Cloudera, a chip manufacturer, prior to Cloudera’s IPO. Google invested at a $1.8 billion valuation and Intel at a $4.1 billion valuation. Cloudera went public at a $2 billion valuation.