Companies with equity investments in other businesses may face some unexpected reporting requirements regarding those investments—especially if they missed the latest guidance on how to determine whether the investment is significant enough to compel more detailed disclosures.
It can be tricky to determine whether an investment in a separate business entity (such as a joint venture or other type of partnership) is significant enough that investors need more detailed information about how that entity is performing. The Securities and Exchange Commission provided some new guidance in late 2010 intended to make the determination a little easier.
The new guidance will allow companies to skip the expanded disclosures in some cases, or may compel expanded disclosures where they might not have been required before, says Scott Ruggiero, a partner focused on SEC regulatory matters with audit firm Grant Thornton. “It just depends on what the facts are,” he says.
The disclosure in question is required under Regulation S-X when a company has a significant equity investment in another business entity, but not a controlling interest. If a company holds only a small equity interest in a separate business, the effect of that investment will appear as no more than a line item in financial statements. But if a company's investment in another entity is somewhere in the range of 20 to 50 percent equity, Reg S-X says that's significant enough that investors will naturally want more detailed financial information to understand how the entity is performing. Companies may be required to include summarized financial information on the entity in their own interim financial statements, or they might be required to provide a full set of financial statements on the entity when submitting their own Form 10-K to the SEC.
The disclosure itself is not new, says John May, a partner with PwC. Rather, when SEC staff updated their Financial Reporting Manual in 2010, they tweaked the guidance companies must follow to test the significance of their investment; that determines when the detailed disclosure requirement will apply, he says. The change in the guidance, coupled with today's unpredictable economic conditions, could catch some companies flatfooted.
“This disclosure can come up as a surprise, particularly if there are periods where there were unusual events, like impairments or restructuring charges,” he says. “The requirement can have an unusual impact in interim periods.”
“Something that wasn't significant in the past could all of a sudden become significant in the past, even if it's not significant today.”
—Jeff Lenz,
Partner, National SEC Practice,
BDO
With the update to the Financial Reporting Manual, the SEC staff changed the manner in which companies perform the “income test” to determine whether a particular investment is significant enough to trigger detailed disclosures.
Under the income test, a company must calculate its share of the entity's pretax income or loss from continuing operations. Companies used to take into account such factors as impairment charges at the investor level, certain gains or losses from the sale of stock, any dilution gains or losses resulting from the entity's own stock sales, and any preferred dividends recorded by the company. The new guidance excludes those items from the calculation.
John Nester, a spokesman for the SEC, says the staff changed the calculation for several reasons. First, the objective of the disclosure requirement is to provide detailed financial information related to investment in another entity when it is material. “The best way to make that evaluation is based directly on the separate financial statements of the entity,” he says. “Historically, there were a number of adjustments to determine the numerator and the new interpretation eliminated those adjustments.”
PWC TIP
Below is a ”practical tip” from PwC on applying financial reporting requirements:
Rule 10-01(b)(1) of Regulation S-X requires companies to include in their interim
financial statements separate summarized income statement information for each
equity investee if:
1. separate financial statements of the investee would be required for annual periods,
and
2. the investee would be required to file Part I of Form 10-Q if the investee were an SEC
registrant.
Companies should use the investment test and the income test specified in Rule 1-02(w)
of Regulation S-X (substituting 20% for 10%) to determine whether criterion #1 is met.
The investment test should be performed using both the most recent
balance sheet and the balance sheet as of the end of the most recently
completed fiscal year that are included in the particular filing (e.g., Form
10-Q).
The income test should be performed using year-to-date interim income
statements included in the particular filing (the current year-to-date
income statement and the prior year comparative year-to-date income
statement).
Note: The SEC staff does not permit companies to use any type of income averaging
when evaluating significance in interim periods. This is different from how the
calculations may be performed when assessing significance for an annual period.
Exchange Act Rules 13a-13 and 15d-13 provide a list of registrants that are not required
to file Part I of Form 10-Q (e.g., foreign private issuers, asset-backed issuers, mutual life
insurance companies and certain mining companies). This list may be helpful in
assessing whether criterion #2 is met.
When summarized interim financial information is required, it only needs to be provided
for investees that are significant based on the calculations described above. The
minimum disclosures below must be included for each significant investee and may be
aggregated with such minimum disclosure for other significant investees. The
information must be presented for both the current and prior comparative year-to-date
periods included in the interim financial statements:
net sales or gross revenues,
gross profit (or, alternatively, costs and expenses applicable to net sales or gross
revenues),
income or loss from continuing operations before extraordinary items and cumulative
effect of a change in accounting principle,
net income or loss, and
net income or loss attributable to the registrant.
Note: If significance is met for any year-to-date interim period included in the particular
report (e.g., Form 10-Q), then the company should present the minimum disclosure for
both the current and prior comparative year-to-date periods included in that quarterly
report regardless of whether significance is met for both year-to-date interim periods.
Source: PwC Tip on Applying Financial Reporting Requirements.
The staff also sought a course-correction after many years of modifications and adjustments, Nester says. “The revised interpretation is more consistent with the intent of the rule,” he says. Finally, it's just easier. “We believed the new guidance was simpler and clearer and would be applied on a more consistent basis,” he says.
Jeff Lenz, a partner in the national SEC practice at auditing firm BDO, says the SEC no doubt saw instances where the prescribed method of testing significance led companies to make disclosures that just weren't necessary or didn't make sense, especially in recent years where investment values have eroded and companies have recorded a number of impairments and adjustments.
It's feasible for such impairments, both for the investing company and the investee entity, to result in big swings in the apparent significance of the investment, he says; that sometimes compels the inclusion of full financial statements where they just didn't seem relevant. “It can leave you scratching your head, asking, ‘Is this really significant?'” he says. “The SEC staff asked that question, and the answer is in some cases you just don't need all that information.”
May says the change in guidance means companies must follow it for all periods presented. “In other words, an investee that previously was determined to be significant might now be considered insignificant, retroactively, for a prior year,” and vice versa, he says. That means companies may need to recast prior periods that are included in current filings, if the new calculation method changes the determination of whether an investment is significant.
According to Lenz, that could lead to some surprises. “Something that wasn't significant in the past could all of a sudden become significant in the past, even if it's not significant today,” he says. Any change in a company's accounting principle or any discontinued operations, for example, could produce such an effect, he says.
Chris Wright, managing director at consulting firm Protiviti, says the new guidance provides some computational relief, but could produce headaches in other ways. Companies may be faced with a requirement to get full financial information from an entity where they may have influence, but not control. If they need it provided in a particular way under a tight deadline, things could become tense.
“If you're going to be at the mercy of algebra at the end of a period, you should have that conversation at the forefront of your planning,” he says. “So should you need the data, you can get it in the form and the timeframe you need it.”
Ruggerio says he routinely encourages companies to make sure their internal controls take the disclosure requirement and the new triggers into account. “Even when you have an investment that you think is small, the facts and circumstances can change over time,” he says. “You need a process in place to assure at least once a quarter you look at all your equity investments to make sure something hasn't changed.”
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