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2.2 Other indicators of significant influence
Publication date: 29 Feb 2024
us Equity method of accounting guide
The determination of significant influence is not limited to the evaluation of voting interests and the level of ownership interest an investor holds. An investor must consider all relationships and interests (voting and nonvoting) in an investee, including any means through which the investor might influence the operating and financial policies of an investee. Examples include board representation, veto rights, or participating rights conveyed by a security other than voting common stock. An investor should also consider the capitalization structure of the investee, how significant its investment is to the investee’s capitalization, and the rights and preferences of other investors.
ASC 323-10-15-6 provides a list of indicators that investors should consider when evaluating whether or not it has the ability to exercise significant influence over the operating and financial policies of an investee.
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).
The list of factors in ASC 323-10-15-6 is not all-inclusive, and the determination of whether other factors provide an investor with the ability to exercise significant influence over the financial and operating policies of an investee requires significant judgment and consideration of all relevant facts and circumstances.
2.2.1 Representation on the board of directors
An investor that has representation on the board of directors can influence the operating and financial policies of an investee through its presence and participation at the board of directors meetings. An investor may conclude that the combination of board representation, with a less than 20% investment in the voting common stock of an investee, may result in significant influence. Specific consideration should be given to board representation that is disproportionate to an investor’s ownership interest in the voting securities of the investee. Additionally, consideration should be given to the number of board seats relative to the total size of the board (e.g., holding one seat on a smaller board of five may be more indicative of significant influence than holding one seat on a larger board of 20) as well as the circumstances under which the board seats are obtained (e.g., a guaranteed seat specified through a contractual agreement may be more representative of significant influence than a seat voted by general shareholder election). Example EM 2-7 illustrates how significant influence may be demonstrated through representation on the board of directors.
EXAMPLE EM 2-7
Representation on the board of directors
Representation on the board of directors
Investor has a 19.5% ownership interest in the voting common stock of Investee. Investor also holds one of five seats on Investee’s board of directors. There are no other indicators that Investor has the ability to exercise significant influence over the operating and financial policies of Investee.
Does Investor have the ability to exercise significant influence over the operating and financial policies of Investee?
Analysis
Investor is likely to conclude that the combination of its voting common stock ownership interest and its representation on the board of directors provides it with the ability to exercise significant influence over the operating and financial policies of Investee. Careful consideration should be given whenever an investor has an ownership interest of less than 20% and investee board representation. The number of representatives and the size of the board are important considerations when determining whether the equity method of accounting is appropriate.
2.2.2 Participation in policy-making processes
An investor should evaluate its ability to participate in the operating and financial decision making of the investee through voting rights, veto rights, or other participating rights or arrangements. For example, in some cases, investors attend board of directors meetings in an “observer” capacity. While observers usually do not vote with the board, attendance alone may provide the investor with the ability to exercise influence as the investor is able to obtain confidential materials and participate in discussions at the board meetings. Therefore, investors should evaluate whether an observer seat at board of directors meetings provide it with the ability to exercise significant influence. Example EM 2-8 illustrates how participation in policy-making processes should be considered in assessing significant influence.
EXAMPLE EM 2-8
Significant influence consideration of observer seat on the board of directors
Significant influence consideration of observer seat on the board of directors
Investor owns a less than 20% ownership interest in the voting common stock of Investee. Investor also has an observer seat on the board of directors. There are no other indicators that Investor has the ability to exercise significant influence over the operating and financial policies of Investee.
Does Investor have the ability to exercise significant influence over the operating and financial policies of Investee?
Analysis
Investor’s observer seat on the board of directors usually provides an investor with the ability to exercise some level of influence over policy making. As such, Investor should consider whether the combination of its voting common stock ownership interest and its observer seat on the board of directors provide it with the ability to exercise significant influence.
2.2.3 Material intra-entity transactions
An investor may enter into material transactions with an investee that may provide the investor with the ability to exercise significant influence. The related facts and circumstances should be evaluated. For example, routine intra-entity transactions, such as purchases and sales of non-specialized inventory (e.g., commodity inventories), may not provide an investor with the ability to exercise significant influence, even if those transactions are material. However, the sale or purchase of highly specialized goods or services may provide the investor with significant influence. Consideration should be given to the investee's ability to source goods or services from alternative providers, considering any significant cost barriers associated with such alternatives. Additionally, when evaluating transactions involving sales from the investee to the investor, consider both the volume of sales as well as the concentration of customers when determining whether the transaction provides the investor with significant influence.
2.2.4 Interchange of managerial personnel
Key members of management at an investor may serve in significant management roles (e.g., CEO, CFO) at the investee level. Investor employees serving in such roles at the investee level may provide an investor with the ability to exercise significant influence over the operating and financial policies of the investee. However, consideration should be given to the level of responsibilities of the employees as well as potential oversight and control by the investee board of directors (while considering any common directors with the investor board of directors).
2.2.5 Technological dependency
An investee may be technologically dependent upon an investor in the operation of its business. This technological dependence may provide the investor with the ability to exercise significant influence, even if the investor’s ownership interest in the voting common stock of investee is less than 20%. Additionally, the nature of the technology should be considered. For instance, a time-limited license rather than a perpetual one gives the investor the discretion to choose not to renew the license and may serve as an indication that the investor has significant influence compared to a scenario in which the investee holds a perpetual license for the same technology. Example EM 2-9 illustrates how significant influence may be demonstrated through technological dependency.
EXAMPLE EM 2-9
Significant influence consideration of technological dependency
Significant influence consideration of technological dependency
Investor owns a less than 20% voting interest in Investee. Investee’s operations are dependent upon a type of technology that is licensed to it by Investor for a 5-year term. Investee could license similar technology from a small number of other companies. However, Investee would incur significant termination fees, higher licensing fees, and significant effort to incorporate the alternative technology into its operations.
Does Investor have the ability to exercise significant influence over the operating and financial policies of Investee?
Analysis
Investor should consider whether the combination of its voting interest and its licensing agreement provides it with the ability to exercise significant influence over the operating and financial policies of Investee. Investee is dependent upon Investor’s technology and would have to incur significant costs and effort to choose an alternative technology supplier. Additionally, in this particular case, the license is not perpetual; it has a duration of 5 years, affording Investor the option to decline renewal. Therefore, Investor may have significant influence over Investee through a combination of its equity interest and licensing agreement.
2.2.6 Ownership in relation to the concentration of other shareholdings
An investor should consider the extent of its ownership interest in an investee in relation to the ownership interests held by other investors. There may be a few investors, each with significant voting interests in an investee or interests in an investee may be more widely held, with no single investor holding a significant voting interest.
An investor that holds a substantial or majority ownership interest in the voting stock of an investee does not preclude another investor from having the ability to exercise significant influence. For example, absent predominant evidence to the contrary (see EM 2.3), an investor that owns a 25% voting interest in an investee is presumed to have the ability to exercise significant influence, even if a single investor owns the remaining 75% voting interest in the investee.
An investor that holds a less than 20% voting interest may be able to demonstrate significant influence in a widely-held investee when all other investors, individually, have substantially smaller ownership interests. Judgment will need to be applied.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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