Speech by SEC Staff:
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Good afternoon. Today I would like to spend some time talking about two issues that often arise when evaluating entities for consolidation and one equity method accounting issue that is not new, but we have been considering in recent months.
First, both the guidance related to consolidation of partnerships in EITF 04-51 and the guidance on variable interests in FIN 46R2 describe barriers that, if present, might preclude investors from exercising their right to kick-out3 a general partner or decision maker. Although barriers to kick-out are currently assessed in EITF 04-5 and FIN 46R for different reasons, the staff believes that the assessments of barriers in either case is critical when distinguishing the difference between a party that controls an entity from a party that is only a hired service provider.
Both EITF 04-5 and FIN 46R provide a list of potential barriers that may prevent investors from exercising their kick-out rights. Those barriers include:
Conditions that make it unlikely that the kick-out rights will be exercisable, for example, conditions that narrowly limit the timing of exercise;
Financial penalties or operational barriers associated with replacing the decision maker that would act as a significant disincentive for removal;
The absence of an adequate number of qualified replacement decision makers or inadequate compensation to attract a qualified replacement;
The absence of an explicit reasonable mechanism in the contractual arrangement, or in the applicable laws and regulations, by which the parties holding the rights can call for and conduct a vote to exercise those rights; and
The inability of parties holding the rights to obtain the information necessary to exercise them.
The staff believes that determining whether a barrier exists, and whether the barrier would prevent an investor from exercising their kick-out rights, often requires significant judgment.
Although kick-out rights may be granted for many different purposes, the staff understands that it is sometimes the case that a decision maker is willing to grant kick-out rights because the decision maker has concluded that the risk of removal is remote. Although the fact that the risk of removal is remote is not in itself a barrier to exercise, analysis of the reasons why the risk of removal is remote may shed light on the presence of a potential barrier. For instance, if the risk of removal is remote solely by virtue of the fact that the decision maker expects its investors to opt to redeem their investment rather than exercise their kick out rights, a barrier to exercise may not exist. However, if the risk of removal is remote, in part, due to the fact that the transition to another qualified replacement decision maker would likely disrupt the operations of the entity causing significant financial harm to the investors, a barrier may exist.
Next I would like to discuss the definition of related parties in the context of paragraph 5(c) of FIN 46R. Although the definition of a related party is certainly not new, the staff has recently addressed the scope of the definition in this context.
Under paragraph 5(c) an entity is subject to FIN 46R if the voting rights of some investors are not proportional to their obligations to absorb the expected losses of the entity, their rights to receive the expected residual returns of the entity, or both; and substantially all of the entity’s activities either involve or are conducted on behalf of an investor that has disproportionably few voting rights. Further, footnote 11 to paragraph 5(c) clarifies activities that involve or are conducted on behalf of the related parties of an investor with disproportionately few voting rights shall be treated as if they involve or are conducted on behalf of that investor.
In the context of paragraph 5(c) of FIN 46R, the staff has been asked whether certain close business associates may be considered related parties under Statement 574 or paragraph 16 of FIN 46R. In this context, the staff believes that close business associates may only be considered related parties if one party can control or can significantly influence the other party to an extent that one of the parties might be prevented from fully pursuing their own separate interest should that party choose to do so. That being the case, the mere past practice or future intent of close business associates to collaborate would be insufficient to conclude the parties are related. The staff believes that this is consistent with the definition of a related party included in Paragraph 24 of Statement 57.
I would next like to cover an equity method accounting issue where an equity method investee may enter into a refinancing transaction. After repayment of the existing financing, and other expenses, it is not uncommon for the investee to distribute the remaining proceeds from the refinancing to its investors.
If the cash distribution received by an equity method investor is in excess of the investor’s carrying value of the investment, questions have existed for some time as to whether it would be appropriate for the investor to recognize the excess as a gain in certain circumstances.
Although this is not a new issue, I would like to confirm that the staff would not object to gain recognition in these circumstances, provided that the investor is not liable for the obligations of the investee nor otherwise committed to provide financial support. The staff believes that its view is consistent with the guidance in paragraph 19(i) of APB 185 , which requires an investor to discontinue application of the equity method of accounting when the investment is reduced to zero, unless the investor has guaranteed obligations of the investee or is otherwise committed to provide further support. The staff also believes that a similar conclusion was reached in AICPA Technical Practice Aids Section 2200.15.
That concludes my remarks, thank you.
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