U.S. accounting rules for investments differ in several respects from International Accounting Standards -- now called International Financial Reporting Standards. As the U.S. moves towards adopting IFRS, companies must change the way they report investments on the balance sheet, including the circumstances under which they use the equity method.
The Move to IFRS
In the United States, the Financial Accounting Standards Board, which sets accounting rules for companies, will converge with the International Accounting Standards Board in 2016. At the time of publication, the U.S. has agreed to adopt the international standards and, where there are differences to existing rules, companies will be required to make changes to their reporting processes and policies. One area where significant differences exist is in the reporting of investment assets. IFRS has different criteria than U.S. GAAP for the use of alternate methods of accounting in several areas, including fair value reporting, the use of the equity method and the reporting of joint venture investments.
Fair Value Versus Historical Cost
Under Financial Accounting Standard 159- The Fair Value Option for Financial Assets and Financial Liabilities, companies that use the equity method for accounting can report those investments on a fair value basis instead. That means that investments that have significantly increased in value since purchase can be more accurately reflected on the balance sheet, rather than being reported at the original cost of the investment. Under International Accounting Standard 28, most companies are required to use the equity method of accounting for this type of investment.
Significant Influence Versus Control
U.S. accounting rules dictate the circumstances under which an investment has to be recorded at original cost, or fair market value, using the equity method or consolidation. A company must use the equity method or fair market value if the entity owns more than 20 percent of the voting shares but less than 51 percent. In addition, the entity must be able to exert significant control over the operations of the company. An investment must be consolidated in the investor's financial statements if the investor owns 51 percent or more of the voting stock. Under the new IFRS, companies must also consider the concept of de facto control- meaning that, in certain situations, a company with less than 51 percent of the voting stock can use other influences to control the direction of the company. In this case, the company must consolidate, rather than use the equity or fair market value methods.
Rules for accounting for joint ventures differ under U.S. GAAP and IFRS. In the U.S., joint ventures must be reported using the equity method, except for a few industries, such as construction, that have traditionally used proportional consolidation. IFRS allows either the equity method or proportional consolidation, but, as of the time of publication, U.S. standards will be adopted by the IFRS by 2016.
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