Minority Active Investments and the Equity Method for Financial Reporting

A minority investor company can hold material influence over the investee company and this commonly occurs at the 20% to 50% voting rights ownership level.

Significant Influence Indicators: Example indicators of significant influence are: investor seats on the board of the investee, sharing of management by investor and investee, or a shared technology dependency between investor and investee.

Equity Method for Minority Active Investment Reporting on Investor Company Balance Sheet (GAAP & IFRS).

• GAAP and IFRS require that companies apply the equity method of accounting to report for minority active investments (i.e. less than 50% ownership, but significant investor influence over investee).

• Note: the Share of the Investee’s Net Income may be adjusted due to goodwill carried on the investor’s balance sheet resulting from an acquisition price greater than its book value.

Equity Method Important Points

• Fair Value & the Equity Method: A change (reduction) to the fair value of the equity investment on the minority active investor’s balance sheet is not recognized unless there is a permanent impairment in value.
• Analyst Thinking & the Equity Method: If there is a material divergence between the fair value reported on the equity investor company’s balance and the current market value of the equity investment, then a financial analyst would look to adjust the investor company’s financials to reflect the market value.
• Net Income, Cash Flows, & the Equity Method: Net Income from the investee company is non-cash income for the investor company and therefore does not impact the investor company’s cash flows.
• Dividends & the Equity Method: Dividends received by the minority active investor from an equity investee are part of the investor’s operating cash flow. Dividend from Equity Investee = reported income from equity investee on the investor’s income statement minus the change in the investment in investee on the investor’s balance sheet.
• Equity Investment Changes over Time: The equity method, in effect, treats investee net income as reinvested earnings, which increases or decreases (in the event of losses) the value of the equity investment reported on the investor’s balance sheet over time.

Equity Method Issues

Investment Cost in Excess of the Investee’s Book Value

BV of Investee = BV of Total Assets – BV of Total Liabilities

Commonly when a company makes a minority active investment, the price paid exceeds the proportional book value of its stake in the investee.  For example, an investor company may pay 60% of the book value to acquire a 50% stake in another company.

The equity method has a two-step approach for reconciling the difference between the book value of the equity investment and the cost of the investment, where book value = bv of assets – bv of liabilities.

Impairment and the Equity Method

A minority active investor company’s equity investments must be tested for impairment.

Example: Assume that a large pharmaceutical company has made an investment in a small laboratory.  The laboratory is focused on the development of a single drug.  In the event that this drug fails its approval tests by government regulators shortly after the investor company reports its financial statements to the public, then the balance sheet value of the large pharmaceutical company’s stake in the small lab is likely to have declined.

Impairment: When the fair value of the equity investment falls permanently below its carrying value on the investor’s balance sheet, then an impairment loss must be recognized on the investor’s income statement and the value of the investment on the balance sheet is reduced to its fair value.

US GAAP & Impairment: reversal of impairment losses is not allowed.

IFRS & Impairment: reversal of impairment losses is allowed.