Chapter 3 — Applying the Equity Method of Accounting

3.3 Other Indicators of Significant Influence

ASC 323-10

15-6 Ability to exercise significant influence over operating and financial policies of an investee may be indicated in several ways, including the following:

Representation on the board of directors
Participation in policy-making processes
Material intra-entity transactions
Interchange of managerial personnel
Technological dependency
Extent of ownership by an investor in relation to the concentration of other shareholdings (but substantial or majority ownership of the voting stock of an investee by another investor does not necessarily preclude the ability to exercise significant influence by the investor).

As discussed in Section 3.2, there are presumed levels of ownership (depending on the legal form of the investee) that generally provide an investor with the ability to exercise significant influence over the investee. For example, an investment of less than 20 percent leads to a presumption that, in the absence of evidence to the contrary, an investor does not have the ability to exercise significant influence over a corporate investee. However, the determination of whether the investor has the ability to exercise significant influence over the investee’s reporting and financial policies should not be limited to the evaluation of voting rights (which can be conferred by instruments other than common stock as discussed in Section 2.5) given that significant influence may be exhibited through other means. Accordingly, the investor should consider all facts and circumstances, including, but not limited to, those outlined in ASC 323-10-15-6 and further discussed in the table below when determining whether it has the ability to exercise significant influence over the investee.

Table 3-2 Indicators of Significant Influence

Indicator	Comment
Representation on the board of directors	Representation on the board of directors (through contractual agreement or otherwise) allows an investor to influence the operating and financial policies of an investee by virtue of its presence and participation at the board of directors’ meetings. Therefore, any board representation is an indicator of significant influence notwithstanding an investor’s ownership in the legal entity, even if the amount of board representation is mathematically less than 20 percent of the board of directors. That is, we do not believe that the presumption related to a 20 percent voting interest, as discussed in Section 3.2, applies to board representation because such representation itself is frequently an indication that the investor is able to obtain the ability to influence the investee’s policies. However, not all representation on the board of directors carries the same weight. For example, if an investor has one of four seats (25 percent representation), that would be a clear indication of significant influence in the absence of strong factors indicating otherwise. Conversely, if an investor has one out of ten seats (10 percent representation), that may be less indicative of significant influence; however, since any board representation is an indicator that an investor may be able to exercise significant influence, all facts and circumstances should be considered, including but not limited to: Which presumption the investor is analyzing (i.e., whether the investor owns 20 percent or more of the voting stock of an investee and must overcome the presumption of significant influence vs. owning less than 20 percent of voting stock). Whether the investor is guaranteed a certain number of board seats as long as the investor’s ownership percentage is above an existing threshold (e.g., 10 percent voting interest). We believe that an investor’s guaranteed representation on the board is a stronger indicator of significant influence than an investor’s ability to obtain representation by voting its ownership interest, especially in instances in which the voting stock held by the investor in an investee is less than 20 percent. Whether the investor has the right to appoint a disproportionately higher number of directors as compared with its ownership percentage or if an investor, in addition to its board representation, participates on significant investee committees, such as the executive committee or the finance committee.
Participation in policy-making processes	An investor can participate in policy-making processes through its voting rights, veto rights, and other participating rights. The right and ability to participate in these processes are fundamental to the analysis; the investor is not required to participate. Further, the investor may not assert that it does not have significant influence merely because it does not have the intent to exercise its rights. If an investor does not have a right to appoint a board member but may appoint an “observer” to the board of directors’ meetings (a right that generally does not provide the observer with voting ability), the investor should exercise judgment when determining whether the observer seat allows it to exercise significant influence over the investee. The investor’s access to the confidential information discussed at the board meeting would usually not, in and of itself, mean that the investor would have the ability to exercise significant influence. Sometimes, an investor holding a minority interest is granted substantive participating veto rights over certain actions that are described with phrases such as “other than in the ordinary course of business.” When such a phrase, describing what would otherwise be “participating rights” under ASC 810-10-25-12, is vaguely defined, it does not, in the SEC staff’s view, cause a participating veto right to be considered nonparticipating.
Material intra-entity transactions	Routine, intra-entity transactions that involve nonspecialized goods or services (i.e., goods or services that are readily available in the market), even if material to the investee (as either a purchaser or supplier of such goods or services), may not give the investor the ability to exercise significant influence over the investee. However, other factors related to intra-entity transactions may suggest that the investor, along with its interest in voting common stock, has significant influence over the investee. These factors may include, but are not limited to, the following: The level of specialization associated with the good or service. Consideration should be given in the context of the investee’s providing or acquiring such goods or services to or from the investor. Market availability of the goods or services provided by the investor to the investee and the potential cost to the investee of switching service providers or suppliers. The scarcer a good or service is in the market, the more likely it may be that the investee is dependent on the investor. Investee sales to the investor (generally of more specialized goods or services) as a percentage of total sales as well as the total number of investee customers (including consideration of the investee’s substantive ability to expand its customer base).
Interchange of managerial personnel	When an investor’s management also serves in a management capacity at an investee (e.g., CEO, CFO, COO), it may indicate that the investor has the ability to exercise significant influence over the investee. However, such a determination requires significant judgment. Among other things, the investor should consider the level of responsibility given to individuals in management. It should also consider the role, responsibilities, and composition of the investee’s board of directors, including its level of oversight and control over management and its level of independence from the investor’s board of directors (i.e., the existence of interchange of managerial personnel at the board level).
Technological dependency	An investor may provide technology to an investee that is critical to its operational ability. Such a situation may cause the investee to be technologically dependent on the investor and, as a result, allow the investor to exert some level of influence over the investee. When determining the level of influence it can exercise, the investor should consider the terms of the licensed technology. For example, the technology granted to the investee for a period that would give the investor an option not to renew such a license would be more indicative of significant influence than if the investee had already obtained a perpetual license to such technology. As mentioned in “Material intra-entity transactions” above, when evaluating whether the investee’s technological dependency provides the investor with significant influence, the investor should also consider the technology alternatives available to the investee and the costs that the investee might reasonably be expected to incur were it to license alternative technology. For example, if the investee could license similar technology from other companies without incurring significant costs, such a licensing agreement would usually not provide the investor with the ability to exercise significant influence over the operating and financial policies of the investee.
Extent of ownership by an investor in relation to the concentration of other shareholdings	An investor should consider its extent of ownership in relation to the concentration of other shareholdings. A majority ownership interest in the investee may be concentrated among a small group of investors. Alternatively, the voting interests may be widely dispersed (with no investor holding a significant voting interest). Accordingly, an investor holding less than a 20 percent voting interest in a widely dispersed corporate investee may have the ability to exercise significant influence when all other investors, individually, have considerably smaller ownership interests. In addition, although one investor may hold a majority ownership interest in an investee (e.g., 70 percent), that does not necessarily preclude other investors with smaller ownership interests (e.g., 30 percent) from having the ability to exercise significant influence over that investee.

In addition to the indicators noted above, the following conditions may indicate that an investor can exercise significant influence over an investee:

The investee is, in effect, a joint venture in which the investor shares in joint control.
The investor has a firm agreement to increase the investment to 20 percent or greater in the subsequent year.
The investor’s significant stockholders, parent company, other subsidiaries of a common parent, or officers hold additional investments in the investee.
The investor has exercised significant influence over decisions of the investee on several occasions.

Many questions have arisen about whether to apply the equity method to an investment or to account for it at fair value in accordance with ASC 321 (unless the measurement alternative is elected),2 particularly in situations involving a less than 20 percent investment in common stock that may be coupled with one or more contractually provided seats on the board of directors. In separate speeches (summarized below), the SEC staff provided its perspectives on several of the considerations discussed above, including the evaluation of whether an investor (1) must apply the equity method of accounting to an investment in common stock (1999 speech) and (2) has significant influence (2020 speech).

Specifically, the SEC staff does not use bright-line tests in the application of ASC 323-10. In the 1999 speech, then Professional Accounting Fellow Paul Kepple noted that when considering whether an investor must apply the equity method of accounting to an investment in common stock, the staff has evaluated:

The nature and significance of the investments, in any form, made in [an] investee. The staff does not consider the difference between a 20 percent common stock investment [and] a 19.9 percent investment to be substantive, as some have asserted in applying [ASC 323-10]. [T]he staff will consider whether [an] investor has other forms of investments or advances, such as preferred or debt securities, in [an] investee in determining whether significant influence results. [In addition, the staff will consult the guidance in ASC 323-10-15-13 through 15-19 to determine whether other forms of investments or advances are in-substance common stock. See Section 2.5 for further discussion on investments in in-substance common stock.]
The capitalization structure of [an] investee. The [staff] would consider whether [an] investee effectively is being funded by common or [noncommon] stock investments and how critical the investments made by [an] investor are to the investee’s capitalization structure (e.g., [whether the investor is] the sole funding source).
Voting rights, veto rights, and other protective and participating rights held by [an] investor. The greater the ability of [an] investor to participate in the financial, operating, or governance decisions made by [an] investee, via any form of governance rights, the greater the likelihood that significant influence exists.
Participation on [an] investee’s board of directors (or equivalent), whether through contractual agreement or not. The staff [would] consider, in particular, whether any representation is disproportionate to the investment held. For example, an investor that is contractually granted 2 of 5 board seats, coupled with a 15 percent common stock investment, will [most] likely be viewed [as having] significant influence over [an] investee.
Other factors as described in [ASC 323-10-15]. . . .

While the starting point in any evaluation of significant influence is [an] investor’s common stock ownership level in [an] investee, the staff does not believe that a “bright line” approach is appropriate and will consider . . . all of the factors noted above in [reaching conclusions about any] given set of facts and circumstances. [Footnotes omitted]

Subsequently, in the 2020 speech, which was given at the 2020 AICPA Conference on Current SEC and PCAOB Developments, then OCA Professional Accounting Fellow Jeffrey Nick addressed investments in entities other than limited partnerships and LLCs without separate capital accounts (i.e., investments subject to ASC 323-10). He discussed a consultation related to whether the equity method should be applied to a registrant’s investment in a corporation in which the registrant held less than 20 percent of the investee’s outstanding voting stock. The registrant also (1) had access to nonpublic information about the corporation as a result of various informal arrangements with the corporation, (2) shared with the corporation certain managerial personnel, and (3) “was a party to a contractual agreement with certain other investors to vote in concert with respect to electing members to the board of directors.” Mr. Nick provided the following insights into the staff’s assessment of the existence of significant influence and ultimate objection to the registrant’s view:

An investor generally accounts for an investment in common stock or in-substance common stock of a corporation that it does not consolidate under the equity method if it can exercise significant influence over operating and financial policies of the investee. The evaluation of significant influence for investments in corporations, as described in Accounting Standards Codification (“ASC”) Topic 323-10, requires the exercise of judgment and the consideration of whether certain indicators exist that provide evidence of the existence or lack of significant influence.

Consider a fact pattern presented to OCA staff where a registrant evaluated whether it had significant influence over an investee in which it held less than 20% of the outstanding voting stock. This registrant was a party to a contractual agreement with certain other investors to vote in concert with respect to electing members to the board of directors. The aggregation of the voting stock among the group provided the group with the ability to directly appoint specified individuals to the board of directors, and the specified individuals comprised the majority of the board and included representatives from the registrant. Without the registrant’s contribution or input, the aggregate vote encompassed by the contractual agreement would not have been sufficient to guarantee the appointment of the specified individuals to the board of directors. In addition to this contractual right that it shared with other parties, the registrant shared various at-will managerial personnel with the investee pursuant to separate employment agreements, and had access to confidential information of the investee pursuant to certain informal arrangements. The registrant evaluated the factors that could indicate the existence of significant influence and concluded that, because the registrant did not have a contractual right on its own to place representation on the board of directors or contractual rights related to any of the other indicators, it did not meet the requirements for applying the equity method of accounting.

Based on the total mix of information presented in this fact pattern, OCA staff objected to the registrant’s conclusion that it did not have significant influence over the investee. [Footnotes omitted]

On the basis of the facts as described by the SEC staff, we assume that the registrant only needed to vote in concert with others to appoint the specified individuals to the board of directors but that the contractual agreement did not require the specified individuals on the board to vote as a group on matters at board meetings. That is, we assume that each appointed director would be permitted to vote in his or her best interest.

ASC 323-10 does not address whether related-party interests should be included in an investor’s ownership percentage in the evaluation of whether the investor has significant influence over the investee. While investments held by related parties (e.g., a parent company, other subsidiaries of a common parent, or officers) are one of the conditions indicating that significant influence could exist, we believe that the interest held by the investor’s related parties should not automatically be included in the evaluation of whether the investor has significant influence over the investee. Rather, all facts and circumstances should be considered, including the nature of the related-party relationship and the design and purpose of the related-party holding. Circumstances in which related-party interests should be combined in the determination of whether the investor has significant influence include, but are not limited to, those in which:

The investor used a related party to increase its influence or interest in an attempt to avoid accounting for the investment under the equity method.
The investor and the investor’s employee (for example) hold an investment in the same investee and the investor has the ability to influence how the employee votes with respect to its ownership interest or board representation.

3.3.1 Conditions Indicating Lack of Significant Influence

ASC 323-10

15-10 Evidence that an investor owning 20 percent or more of the voting stock of an investee may be unable to exercise significant influence over the investee’s operating and financial policies requires an evaluation of all the facts and circumstances relating to the investment. The presumption that the investor has the ability to exercise significant influence over the investee’s operating and financial policies stands until overcome by predominant evidence to the contrary. Indicators that an investor may be unable to exercise significant influence over the operating and financial policies of an investee include the following:

Opposition by the investee, such as litigation or complaints to governmental regulatory authorities, challenges the investor’s ability to exercise significant influence.
The investor and investee sign an agreement (such as a standstill agreement) under which the investor surrenders significant rights as a shareholder. (Under a standstill agreement, the investor usually agrees not to increase its current holdings. Those agreements are commonly used to compromise disputes if an investee is fighting against a takeover attempt or an increase in an investor’s percentage ownership. Depending on their provisions, the agreements may modify an investor’s rights or may increase certain rights and restrict others compared with the situation of an investor without such an agreement.)
Majority ownership of the investee is concentrated among a small group of shareholders who operate the investee without regard to the views of the investor.
The investor needs or wants more financial information to apply the equity method than is available to the investee’s other shareholders (for example, the investor wants quarterly financial information from an investee that publicly reports only annually), tries to obtain that information, and fails.
The investor tries and fails to obtain representation on the investee’s board of directors.

15-11 The list in the preceding paragraph is illustrative and is not all-inclusive. None of the individual circumstances is necessarily conclusive that the investor is unable to exercise significant influence over the investee’s operating and financial policies. However, if any of these or similar circumstances exists, an investor with ownership of 20 percent or more shall evaluate all facts and circumstances relating to the investment to reach a judgment about whether the presumption that the investor has the ability to exercise significant influence over the investee’s operating and financial policies is overcome. It may be necessary to evaluate the facts and circumstances for a period of time before reaching a judgment.

ASC 323-10-15-10 lists several indicators (not all-inclusive) that may suggest that the significant influence presumption is overcome when an investor holds 20 percent or more of the outstanding voting common stock of an investee. In addition, the following conditions may indicate that an investor lacks the ability to exercise significant influence:

The chairperson of the investee owns a large, but not necessarily controlling, block of the investee’s outstanding stock; the combination of the chairperson’s substantial shareholding and his or her position with the investee may preclude the investor from being able to influence the investee.
Adverse political and economic conditions exist in foreign countries (especially restrictions on the repatriation of dividends) in which the investee is located.
The investor has less than 20 percent ownership of the investee with an option to acquire additional ownership that would increase the investor’s stake to 20 percent or more, but there is no substantive plan or agreement to do so in the near future.
The investee is to settle its litigation, particularly when that litigation involves bankruptcy, by issuing shares to the settling parties, and it is probable that the new shares, when issued, will reduce the investor’s ownership percentage to less than 20 percent.
The investee actively and publicly resists the exercise of influence by the investor.

None of the circumstances above are necessarily conclusive that the investor is unable to exercise significant influence over the investee’s operating and financial policies. The investor should evaluate all facts and circumstances related to the investment when determining whether the presumption of significant influence over the investee is overcome.

In addition, the fact that an investor has not exercised significant influence in the past or does not intend to exercise it in the future does not indicate that the general presumption of significant influence is overcome. See Section 3.3 for additional details on the 2020 speech that addresses significant influence.

Footnotes

See footnote 1.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.