Remarks before the 2020 AICPA Conference on Current SEC and PCAOB Developments
Professional Accounting Fellow, Office of the Chief Accountant
Dec. 7, 2020
The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author’s views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.
Good afternoon. It is a privilege to speak before you today. With my time, I would like to speak about equity method investments and the concept of significant influence, and to discuss some complexities in the voting interest entity portion of the consolidation analysis.
Equity Method Investments
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.
Consolidation under the Voting Interest Entity Model
Moving to my second topic, the consolidation framework set forth in ASC Topic 810-10 differentiates between voting interest entities and variable interest entities. If a legal entity that is not a limited partnership is a voting interest entity, a reporting entity evaluates if it should consolidate the legal entity by considering voting rights and evaluating whether parties other than the holder of a majority of those voting rights can effectively participate in certain significant financial and operating decisions of the investee that are made in the ordinary course of business.
Consider a fact pattern presented to OCA staff relating to the consolidation analysis for a voting interest entity. This legal entity, a limited liability corporation with governing provisions that are the functional equivalent of a regular corporation, had its equity ownership divided between two investors, of which the reporting entity was one. These investors had a long-standing relationship, where one, the reporting entity, historically provided funding for investments, and the other provided know-how relating to identifying the investment opportunity and managing the investment on an ongoing basis. The shares in the legal entity conveyed economic rights in varying degrees at varying times, initially providing the registrant with the bulk of the economics of the legal entity until a stated rate of return was achieved, at which point the economics shifted to more equally distribute earnings among the parties. While the registrant held a majority voting interest through its share ownership, the other investor’s consent was required to effect certain significant decisions, including approving or modifying operating and capital budgets. In the event of a disagreement in these circumstances requiring the other investor’s consent, the arrangement included a buy/sell clause by which three outcomes could occur: either party could acquire the other party’s shares at fair value, or consent could be provided on the decision subject to disagreement. The registrant concluded that the buy/sell clause provided the registrant with the ability to break a deadlock unilaterally, believing that the other investor would not disagree with the registrant and risk its own removal from the venture. For this reason, the registrant concluded that the other investor did not have substantive participating rights, and thus that the registrant should consolidate the investee.
OCA staff objected to the registrant’s conclusion that it should consolidate the legal entity under the voting interest entity model.
Thank you for your time and please enjoy the remainder of the conference.