In the past, generally accepted accounting principles, or GAAP, allowed financial statement preparers some flexibility in how they record their company’s returns on investments (ROI) in equity securities. It was common for such securities to be designated as “available for sale” with the corresponding gains or losses on the fair value of those securities recorded through other comprehensive income. In other words, the fair value of the equity investments could be “parked,” with unrealized gains and losses not recognized in net income until the investments were sold. This had the effect of removing the volatility that comes with stock market fluctuations from the company’s net income. The accumulated gains or losses would reside on the balance sheet in “accumulated comprehensive income,” separate from other retained earnings of the business. Now that has all changed.
Equity Investments to Be Measured at Fair Value; Changes Recognized in Net Income
ASU 2016-01, which is newly effective for private companies for fiscal years beginning after December 15, 2018, changes this accounting model. The new standard requires equity investments (excluding those accounted for under the equity method or those that result in consolidation) to be measured at fair value, with changes in fair value recognized in net income.
This means that if a company owns, for example, shares in a publicly traded company, the gains and losses from marking those shares to fair value are currently recognized in net income. Upon adoption, entities will be required to make a cumulative-effect adjustment to the balance sheet as of the beginning of the first reporting period in which the guidance is effective (2019 for calendar year-end private companies). As such, the gains or losses accumulated at the adoption date will be recognized without ever going through net income.
The new standard also affects the accounting for equity securities without readily determinable fair values, as companies are no longer allowed to use the cost method of accounting. For equity investments that do not have readily determinable fair values, the new standard allows companies to adopt a policy of recording those investments at cost less impairment plus or minus any changes that are the result of observable price changes.
Treatment of Observable Price Changes
Limited guidance exists on identifying observable price changes. Generally, observable price changes would be market transactions in that investment that provide some evidence of its fair value (i.e., transactions with outside parties in an identical or similar investment). With regard to identifying impairment, companies may perform a qualitative assessment to determine if any impairment exists that would trigger a write-down in the value of its investment holdings without readily determinable fair values. Impairment indicators include a significant deterioration in earnings performance of the investee, an adverse change in the regulatory or economic environment or a bona fide offer to purchase the investment at an amount below its carrying amount.
There will be challenges in applying the new measurement alternative for equity investments without readily determinable fair values, including developing the process for identifying observable price changes. It’s never too early to reach out to your auditor to discuss the company’s initial adoption thoughts and implementation challenges.