Equity Investments: Fair Value Booking For Better Returns

When it comes to investing, determining the worth of an investment is crucial. The fair value method is a technique where the investor company reports the investment at its fair market value on its balance sheet and records any changes in value as gains or losses in the income statement. The decision to use the fair value method depends on various factors, such as the level of influence the investor has over the investee and the objectives of the investment. If the investor has little or no influence over the investee, the fair value method is usually the more appropriate choice. Additionally, if the investor's objective is to make a short-term profit, the fair value method may be more suitable.

Fair value vs. equity method

Fair value is a measure of a product or asset's current market value and a reflection of the price at which an asset is bought or sold when a buyer and a seller agree. Many factors go into determining the fair value of an asset, including a comparison of recent transactions for similar assets, an estimate of the expected earnings of the asset, and an estimate of the cost to replace the asset.

The fair value method is used when a company owns less than 20% of the outstanding shares of the company they have invested in and the investor does not have significant influence. When the fair value method is used, the company would classify the investment as "trading" or "available-for-sale".

The equity method of accounting does not apply to all investments. It does not apply to investments in common stock held by a non-business entity, such as an estate, trust, or individual. It also does not apply to an investment in common stock that represents a controlling financial interest.

The main difference between the fair value method and the equity method is the amount of ownership the company has in another entity. If the company owns less than 20% of the outstanding shares for the company they invested in, then the fair value method is used. If the company owns between 20% to 50% of the outstanding shares, then the equity method is used.

There are exceptions to this rule. A company can own less than 20% but still have significant influence, in which case the equity method will be used. A company can also own greater than 20% but not have significant influence, in which case the fair value method can be elected. Anything over 50% requires consolidation.

When to use the fair value method

Fair value accounting is a method of measuring a business's liabilities and assets based on their current market value. It is the practice of determining a product or asset's current market value and the price at which an asset is bought or sold when a buyer and seller agree.

The fair value of an asset is based on the market conditions on the date of measurement, rather than historical transactions. It is also important to note that the holder's intention should be irrelevant when calculating fair value. For example, if the holder intends to sell the asset immediately, it could lead to a rushed sale and a lower price.

Fair value is based on orderly transactions where there is no pressure on the seller to sell, which is why it does not apply to companies in the process of liquidation. It is understood to be derived from the sale to a third party, rather than a corporate insider or someone related to the seller.

There are several methods to determine fair value, and the most accurate method may depend on the asset under consideration. Here are some common styles of fair value calculation:

• Comparable information calculation: This method involves using fair comparisons, such as comparing prices in the market by checking stores or searching online, and then averaging those prices to find a fair value.
• Cash flow calculation: This method involves calculating the potential cash flow per year for an investment opportunity and measuring it against any potential expenses, such as interest paid on credit lines. The fair value can be determined by taking the resulting value and subtracting the initial cost of the investment.
• Change assessment calculation: This strategy is useful for assessing assets with changing worth. Fair value can be calculated by comparing the original value with the changes.

The fair value method can be used when there is a need to determine the current market value of an asset or liability. It is useful when a business wants to understand the financial health of a company, maintain accurate financial records, or make informed decisions related to an asset.

The fair value method can also be applied when a company wants to provide a true value to all its assets and expected income to develop better financial plans and protect itself from inaccurate financial estimates. Additionally, the fair value method can be used when a company has assets that have undergone depreciation and wants to save money through tax write-offs.

In summary, the fair value method is a versatile and accurate tool for assessing the worth of an asset, good, or service. It is widely used in business and investing due to its adaptability, accuracy, and ability to limit income manipulation.

When to use the equity method

The equity method of accounting is used to record investments in associated companies or entities. It is typically applied when a company's ownership interest in another company is valued at 20%–50% of the stock in the investee.

The equity method is used to record an investor's share of the investee's profits and losses. The initial investment amount is recorded as an asset on the investing company's balance sheet. The investing company records its share of profit or loss in the income statement for the year; at the same time, profit increases the investment value, while losses would decrease the investment amount on the balance sheet.

The equity method also makes periodic adjustments to the value of the asset on the investor's balance sheet. This is because the investor has a 20%-50% controlling investment interest in the investee.

The equity method should be used when an investment results in a significant amount of control or influence in the company being invested in. This is usually determined by the percentage of voting stock owned, which typically falls between 20% and 50%. However, it is important to note that the influence is the more important factor when determining whether to use the equity method.

Other indicators of significant influence could include:

• A seat on the board of directors
• Material transactions between entities
• Personnel exchanges between entities
• Dependence on shared technology

The equity method should not be applied when the fair value option is elected or when the proportionate consolidation method is used.

Reporting requirements

The reporting requirements for equity investments booked at fair value can vary depending on the specific circumstances and accounting standards being followed. Here are some key points to consider:

• US GAAP and ASC 820: Under US GAAP, investments in equity securities are generally required to be carried at fair value, with changes in fair value included as a component of earnings. The ASC 820 standard provides guidance on fair value measurements and disclosures.
• SEC Registrants: SEC registrants with equity method investments, including those accounted for under the fair value option, are required to provide financial information about any significant equity method investees in their filings with the SEC. They must identify all investments accounted for under the equity method and measure their significance using applicable tests and thresholds under SEC Regulation S-X.
• Separate Financial Statements: If an equity method investee is considered significant, the registrant may need to provide separate financial statements of the investee or summarized financial information in the footnotes to their financial statements. The level of information disclosed depends on the investee's significance level.
• Summarized Financial Information: Registrants must perform significance tests on all equity method investees individually and as a group to determine if summarized financial information is required in their annual financial statements. Summarized income statement information may also be required in interim financial statements if the investee is significant during the interim period.
• Practical Expedient: If an investment does not have a readily determinable fair value, it may qualify for a practical expedient where reporting entities can use the net asset value (NAV) without adjustment to measure certain types of investments. However, specific disclosures are required in this case, and the total fair values by level in the fair value hierarchy may not agree with the balance sheet.
• Equity Method of Accounting: The equity method of accounting does not apply to all investments. It generally applies when an investor has significant influence over the investee but does not have a controlling financial interest. Certain types of investments, such as those held by non-business entities or investment companies, may be exempt from the equity method and may be accounted for at fair value or using other methods.
• Fair Value Option: Reporting entities may elect the fair value option for eligible items, including equity method investments. This option allows them to measure and present those investments at fair value at each reporting period, with changes in fair value reported in the income statement. However, this option is not available if the investor's interest includes a significant compensatory element.
• Proportionate Consolidation Method: Proportionate consolidation is appropriate in limited circumstances, such as in the construction and extractive industries, where investors display investments in separate unincorporated legal entities. This method involves reflecting the investor's pro-rata share of the venture's assets, liabilities, revenues, and expenses in their financial statements.

Advantages and disadvantages of the fair value method

The fair value method is a technique where the investor company reports the investment at its fair market value on its balance sheet and records any changes in value as gains or losses in the income statement. This method is used when the investor has little or no influence over the investee company.

Advantages of the Fair Value Method

• Provides more up-to-date information about the value of investments.
• Allows for greater comparability between different investments.
• Provides a more accurate reflection of market conditions.
• Can be adapted to apply to all types of assets and liabilities.
• Provides a more accurate valuation of your assets.
• Limits your ability to manipulate reported net income.

Disadvantages of the Fair Value Method

• Can be more volatile than the equity method.
• Can be more complex and time-consuming to implement.
• Can lead to more subjective valuations.
• Can lead to large swings in value that take place frequently throughout the year, particularly if your business deals with volatile assets.
• Can lead to investor dissatisfaction.
• The observed value of the asset in the market may not be indicative of its fundamental value.

Frequently asked questions