Chapter 3 — Applying the Equity Method of Accounting

3.2 General Presumption

ASC 323-10

15-7 Determining the ability of an investor to exercise significant influence is not always clear and applying judgment is necessary to assess the status of each investment.

An investor may have investments in an investee that include common stock or in-substance common stock and instruments other than common stock (e.g., preferred stock, warrants, or debentures). The equity method of accounting is applicable only when the investor has an investment in common stock or in-substance common stock and, accordingly, should not be applied when an investment in common stock does not exist, even if the investor holds other investments that allow it to exercise significant influence over the investee. However, if the investor holds both common stock and other investments, it should consider the rights provided by all such instruments in evaluating whether, in combination, they provide it with the ability to exercise significant influence over the investee. In addition, as further discussed in Section 3.2.6, only existing voting rights should be considered.

Example 3-1

Entity A holds the following interests in Corporation B:

Common stock representing 15 percent of the voting rights in B.
Preferred stock that does not meet the requirements to be considered in-substance common stock that provides A with two of the five seats on B’s board of directors.
In evaluating whether A has significant influence over B, A must use judgment and consider the rights provided by all such instruments.

The ability to exercise significant influence over the operating and financial policies of an investee is primarily driven by an investor’s ownership interest and the associated voting rights held through its investment in the investee’s common stock. The presumed levels of ownership that provide the investor with the ability to exercise significant influence vary depending on the legal form of the investee.

The table below summarizes presumed levels of ownership for each legal form of an investee that typically allow an investor to exercise significant influence. Intended as a general guide, the table does not establish bright lines at specific ownership levels (e.g., the difference between a 20 percent and a 19.9 percent investment in common stock or in-substance common stock or both may not be substantive). Therefore, evaluating an investor’s ability to exert significant influence requires judgment, and the investor should evaluate all facts and circumstances when determining how to account for any investment.

Table 3-1 Presumed Levels of Ownership Based on the Legal Form of the Investee That Generally Allow an Investor to Exercise Significant Influence

Legal Form of an Investee	Roadmap Discussion	Investment in Common Stock or In-Substance Common Stock (Assuming Consolidation Is Not Required)
Legal Form of an Investee	Roadmap Discussion	5% or Less	More Than 5% but Less Than 20%	20% or More
Corporations (other than joint ventures)	Section 3.2.1	Rebuttable presumption exists that an investor does not have significant influence.		Rebuttable presumption exists that an investor does have significant influence.
LLCs that do not maintain specific ownership accounts (e.g., similar to partnership capital accounts)	Section 3.2.2	Rebuttable presumption exists that an investor does not have significant influence.		Rebuttable presumption exists that an investor does have significant influence.
LLCs that do maintain specific ownership accounts (e.g., similar to partnership capital accounts)	Section 3.2.2	Equity method required unless interest is “so minor” (per ASC 323-30-S99-1) that investor has virtually no influence (generally less than 3 percent), in which case the investor should generally account for the interest under ASC 321. In certain instances, it may be acceptable to account for investments of less than 3 to 5 percent under the equity method, depending on the facts and circumstances.	Equity method required.
Partnerships and unincorporated joint ventures	Section 3.2.3	Equity method required unless interest is “so minor” (per ASC 323-30-S99-1) that investor has virtually no influence (generally less than 3 percent), in which case the investor should generally account for the interest under ASC 321. In certain instances, it may be acceptable to account for investments of less than 3 to 5 percent under the equity method, depending on the facts and circumstances.	Equity method required.
General partnership interests in partnerships	Section 3.2.4	Equity method required.
Entity that meets the definition of corporate joint venture (i.e., shared control)	Section 3.2.5	Equity method required.

In the case of corporations and LLCs that do not maintain specific ownership accounts, a presumption may exist that an investor has the ability to exercise significant influence, but such a presumption may be overcome (see Section 3.3.1 for conditions indicating lack of significant influence). Similarly, a presumption may not exist if an investor does not meet the levels of ownership described above; however, that ownership interest, in combination with other interests and indicators (see Section 3.3), may indicate that the investor has the ability to exercise significant influence. Each of the types of investments described in the table above is discussed further below.

3.2.1 Corporations

ASC 323-10

15-8 An investment (direct or indirect) of 20 percent or more of the voting stock of an investee shall lead to a presumption that in the absence of predominant evidence to the contrary an investor has the ability to exercise significant influence over an investee. Conversely, an investment of less than 20 percent of the voting stock of an investee shall lead to a presumption that an investor does not have the ability to exercise significant influence unless such ability can be demonstrated. The equity method shall not be applied to the investments described in this paragraph insofar as the limitations on the use of the equity method outlined in paragraph 323-10-25-2 would apply to investments other than those in subsidiaries.

If an investor holds more than a 20 percent interest (directly or indirectly, as discussed in Section 3.2.6) in an investee that has a legal form of a corporation, it is presumed that the investor has the ability to exercise significant influence in the absence of evidence to the contrary (see Section 3.3.1). Similarly, if the same investor holds less than a 20 percent interest in an investee, it may, in combination with other indicators, have the ability to exercise significant influence over that investee (see Section 3.3).

3.2.2 Limited Liability Companies

As discussed in Section 2.2.1, an investment in an LLC that does not maintain specific ownership accounts for each investor should be evaluated in the same manner as an investment in a corporation, which is further discussed in the previous section. An investment in an LLC that does maintain specific ownership accounts for each investor should be evaluated in the same manner as an investment in a partnership, which is further discussed in the next section.

3.2.3 Partnerships and Unincorporated Joint Ventures

ASC 323-30 — SEC Materials — SEC Staff Guidance

SEC Staff Announcement: Accounting for Limited Partnership Investments

S99-1 The following is the text of SEC Staff Announcement: Accounting for Limited Partnership Investments.

The SEC staff’s position on the application of the equity method to investments in limited partnerships is that investments in all limited partnerships should be accounted for pursuant to paragraph 970-323-25-6. That guidance requires the use of the equity method unless the investor’s interest “is so minor that the limited partner may have virtually no influence over partnership operating and financial policies.” The SEC staff understands that practice generally has viewed investments of more than 3 to 5 percent to be more than minor.

In EITF Topic D-46 (codified in ASC 323-30-S99-1), the SEC acknowledged that, in practice, investments in limited partnerships of more than 3 percent to 5 percent have generally been viewed as “more than minor” and thus are subject to the equity method. Because profits and losses are allocated to individual partner accounts, the partner’s share of earnings is allocated for income tax purposes, and the nature of partnership interests usually gives rise to some degree of influence (stated or unstated), it is presumed that either consolidation or the equity method should be used to account for all partnership interests. This approach de-emphasizes significant influence, instead requiring the equity method of accounting because it enables noncontrolling investors to reflect the underlying nature of their investments.

Because the SEC staff refers to a range of “3 to 5 percent” in EITF Topic D-46, investments of more than 3 percent to 5 percent have generally been viewed as “more than minor.” Thus, any investment of more than 5 percent is subject to the equity method, and any investment from 3 percent to 5 percent should be accounted for under the equity method unless the presumption of significant influence is overcome. However, an investment of less than 3 percent is typically considered “minor” and therefore may be accounted for at fair value in accordance with ASC 321 (unless the measurement alternative is elected)1 or under the equity method in accordance with ASC 970-323-25-6.

In a speech at the 2019 AICPA Conference on Current SEC and PCAOB Developments, then OCA Professional Accounting Fellow Erin Bennett provided the SEC’s perspectives on assessing whether an investor’s interest is “more than minor” in an LLC structure with separate capital accounts or whether it is so minor that the investor may have virtually no influence over the LLC’s operating and financial policies.

Ms. Bennett noted that when evaluating whether an entity’s interest is more than minor, the SEC staff assesses LLC structures with separate capital accounts in the same manner as partnerships under ASC 323-30-35-3. She described a consultation in which the registrant held a 25 percent interest in the member units of an LLC with separate capital accounts. The registrant argued that the “virtually no influence” threshold did not apply to its investment since this threshold was (1) intended for real estate companies with “less complicated fact patterns” and (2) not appropriate for an investment whose nature and intent were “passive.” Accordingly, the registrant believed that it would be more appropriate to evaluate the indicators of significant influence. Ms. Bennett provided the following insights into the staff’s position and ultimate objection to the registrant’s view:

For investments in limited partnerships, the SEC staff has stated that the equity method should be applied unless the investor’s interest is so minor that the investor may have virtually no influence over partnership operating and financial policies, with practice generally viewing investments of more than 3-5% to be more than minor.

A recent consultation with OCA focused on whether the equity method should be applied to a registrant’s investment in a limited liability company (LLC). The registrant held over 25% of the LLC’s member units, which were entitled to a preferential allocation of profits. The registrant did not have board representation or voting rights over key operating and financial decisions, but did have certain limited rights, most of which were protective in nature. Furthermore, the registrant had significant ongoing commercial arrangements with the LLC.

In performing its evaluation of whether the equity method applied to its investment, the registrant first concluded that its investment in the LLC was similar to an investment in a limited partnership because the LLC was required to maintain specific ownership accounts for each member. The registrant noted that the limited partnership guidance states that investors in partnerships should apply the equity method if the investor has the ability to exercise significant influence. The registrant also considered the staff’s position that the application of the equity method to investments in limited partnerships should be applied unless the investor’s interest is so minor that the limited partner may have virtually no influence over partnership operating and financial policies. The registrant observed that the “virtually no influence” guidance cited in the SEC staff’s position was originally written in the context of investments in real estate companies with less complicated fact patterns than the registrant’s facts. The registrant believed that the nature and intent of its investment was truly passive, such that an assessment of the overall significant influence indicators was more relevant, irrespective of the form of the ownership. Therefore, based on the complex terms of its investment, including no voting rights and a preferential profit allocation, the registrant concluded that it did not have significant influence and the equity method did not apply. The registrant also believed that not applying the equity method would better reflect the economics of its investment.

In this fact pattern, the staff objected to the registrant’s conclusion that the equity method did not apply. The staff concluded that the staff’s longstanding position on the application of the equity method to investments in limited partnerships should be applied. Given the registrant’s significant ownership interest, certain limited rights other than protective rights, and ongoing commercial arrangements, the staff concluded the registrant had more than “virtually no influence” over the LLC. [Footnotes omitted]

Note that while the guidance in EITF Topic D-46 is intended for public entities, in practice, it is generally applied to investments held by nonpublic entities.

3.2.4 General Partnership Interest in Partnerships

If a GP does not control the partnership, it should account for its investment in the partnership under the equity method of accounting, regardless of its ownership percentage (see Section 2.2.3).

3.2.5 Corporate Joint Ventures

All joint venture investments in which the investor shares in joint control, incorporated or unincorporated, should be accounted for under the equity method without regard to the investor’s ownership percentage.

3.2.6 Potential Voting Rights

ASC 323-10

15-9 An investor’s voting stock interest in an investee shall be based on those currently outstanding securities whose holders have present voting privileges. Potential voting privileges that may become available to holders of securities of an investee shall be disregarded.

An investor may hold certain rights that allow it to acquire additional voting interests in an investee. For example, an investor may have a call option to purchase additional equity in an investee that is not a partnership, or a limited partner may have the contractual right to purchase partnership interests held by other partners. Potential voting rights may also exist through other types of securities that are convertible into voting interests (e.g., convertible securities).

In the determination of whether significant influence exists, ASC 323-10-15-9 applies only to “[a]n investor’s voting stock interest” and not to potential voting interests, such as stock options, convertible debt, or derivatives thereof. However, ASC 323-10-15-13 lists several characteristics that might indicate that an investment (other than an investment in common stock) is in-substance common stock (see Section 2.5). Therefore, when determining whether the use of the equity method is appropriate, an investor should consider investments in common stock and investments that are in-substance common stock, which may include, but not be limited to, the following:

As stated in Section 3.2, if an investor holds both common stock and other investments (including in-substance common stock), it should consider the rights afforded by all such instruments in evaluating whether, in combination, they provide it with the ability to exercise significant influence over an investee. To be considered in the assessment, such voting rights must be currently exercisable.
An investor with an investment that qualifies as in-substance common stock may be able to exercise its voting rights on an as-if-converted basis or may be precluded from exercising voting rights until the in-substance common stock is converted into common stock. In the latter instance, despite the investment’s qualifying as in-substance common stock, such voting rights would not be considered in the assessment of significant influence because they are not currently exercisable (i.e., the voting rights are contingent upon conversion).

Example 3-2

Entity A holds a 15 percent voting common stock interest in Entity B, as well as convertible preferred stock that will allow it to acquire an additional 10 percent voting common stock interest in B in three years. Entity A’s ownership of the convertible preferred stock, if converted, would give A a 25 percent voting common interest in B. However, this would not lead to a presumption that A exercises significant influence over B given that A’s investment in convertible preferred stock does not provide it with exercisable voting rights because of the time restriction and the requirement to convert the instrument to exercise the voting rights.

Although the convertible preferred stock may qualify as in-substance common stock in three years when the conversion feature becomes exercisable, A would continue to be precluded from considering the potential voting rights in assessing significant influence at that time because A will possess such voting rights only upon conversion.

3.2.7 Direct and Indirect Interest in an Investee

In determining whether it has the ability to exercise significant influence over an investee, an investor should consider all voting interests, which include investments that are both direct and indirect (i.e., those held by the investor’s other investees). In certain instances, an investor that does not have the ability to exercise significant influence through its direct interests may have such ability through a combination of direct and indirect interests.

The examples below illustrate the consideration of direct and indirect interests. Each example assumes that the investor and the investee(s) are corporations.

Example 3-3

Direct Investment in an Investee’s Consolidated Subsidiary

Entity A owns a 30 percent voting interest in Entity B that is accounted for under the equity method of accounting (i.e., A has the ability to exercise significant influence over B) and a 15 percent voting interest in Entity C. Entity B owns an 80 percent voting interest in C that is considered a controlling financial interest, requiring B to consolidate C under ASC 810-10.

Because B controls C, and A has the ability to exercise significant influence over B, A has the ability to exercise significant influence over C, despite the fact that A has only a 15 percent direct voting interest in C. Therefore, A should account for its investment in C under the equity method of accounting.

Example 3-4

Investment of 20 Percent or Greater That Does Not Qualify for Equity Method of Accounting

Assume the same facts as in the example above, except that Entity B owns an 18 percent voting interest in Entity C. In this scenario, Entity A has a 20.4 percent interest in C, which is the sum of its 15 percent direct interest and 5.4 percent indirect interest (30 percent × 18 percent) through B.

As reflected in Table 3-1, an investment in common stock of 20 percent or greater leads to a presumption that an investor has the ability to exercise significant influence and should therefore apply the equity method of accounting. However, in the example above, the ownership percentage alone would not provide A with the ability to exercise significant influence over C since neither A nor B has that ability. Although A has significant influence over B, that does not indicate that it has the ability to significantly influence how B exercises its 18 percent voting interest in C. Entity A should evaluate other indicators of significant influence (see Section 3.3) to determine whether it has significant influence over C. If not, A should not account for its investment in C under the equity method of accounting.

Example 3-5

Investment Held by Commonly Controlled Subsidiaries

Entity A has a controlling financial interest in, and therefore consolidates each of, Entity B, Entity C, and Entity D under ASC 810-10. Entities B, C, and D each own a 10 percent voting interest in Entity E.

Entity A indirectly owns less than a 20 percent voting interest in E (i.e., 6 percent through B, 7 percent through C, and 6 percent through D). However, given that A consolidates B, C, and D, A effectively controls 30 percent of the voting interests in E. Thus, it is presumed that A has the ability to exercise significant influence over E (in the absence of evidence to the contrary).

Entity A’s ability to exercise significant influence over E, however, is not determinative as to how each subsidiary should account for its individual investments in preparing its stand-alone financial statements. Thus, each subsidiary should separately evaluate its individual facts and circumstances in determining whether it has the ability to exercise significant influence over E. Investments held by related parties may be one of the factors to consider in such an evaluation (see Section 3.3).

3.2.7.1 Earnings or Losses of an Investee’s Subsidiary

If an investor accounts for direct interests in both an investee and an investee’s subsidiary under the equity method of accounting, it should ensure that it does not double count the earnings or losses of the investee’s subsidiary. That is, the investor should record only its proportionate share of (1) the earnings or losses of the investee and (2) the earnings or losses of the investee’s subsidiary. When determining its proportionate share of the investee’s earnings or losses, the investor should adjust the investee’s financial information to exclude the earnings or losses of the investee’s subsidiary in which the investor has a direct interest. See additional considerations related to subsequent measurement in this scenario in Section 5.1.7.2.

Footnotes

See ASC 321-10-35-2.

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% 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% 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% or more of the voting stock of an investee and must overcome the presumption of significant influence vs. owning less than 20% 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% 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.