“Significant influence” is a term used in accounting and finance to describe the power an investor has to participate in the financial and operating policy decisions of an investee, without necessarily having control or joint control over those policies.
The concept of significant influence is important when applying the equity method of accounting. Under the equity method, if an investor has significant influence over an investee (typically evidenced by owning between 20% and 50% of the voting stock of the investee), the investor adjusts the value of its investment in the investee to reflect its share of the investee’s profit or loss.
Key indicators of significant influence include:
- Representation on the Board of Directors: If the investor has the ability to appoint or elect a member to the board of the investee, it can indicate significant influence.
- Participation in Policy-Making Decisions: Even if the investor does not have majority voting rights, it might still have the power to participate in financial and operating policy decisions.
- Material Transactions: If there are substantial transactions between the investor and the investee, it could be an indicator of significant influence.
- Exchange of Managerial Personnel: If the two entities swap managerial personnel, it could indicate a strong influence.
- Provision of Essential Technical Information: If one entity provides critical know-how to another, it might have significant influence.
It’s important to note that the mere ownership of 20% or more of an investee’s voting stock typically leads to a presumption of significant influence, but it’s not conclusive. Both qualitative and quantitative factors need to be assessed. Conversely, ownership of less than 20% could still result in significant influence if the investor can demonstrate such influence in practice.
Example of Significant Influence
Let’s delve into a hypothetical scenario to illustrate the concept of “significant influence.”
Scenario: AlphaTech and BetaSoft
- AlphaTech: A prominent technology company known for its cutting-edge software products.
- BetaSoft: An emerging software start-up specializing in cloud-based solutions.
- Investment: AlphaTech sees potential in BetaSoft’s innovations and decides to invest in the start-up. It acquires a 30% stake in BetaSoft for $10 million.
- Board Representation: As part of the investment agreement, AlphaTech is granted the right to appoint two members to BetaSoft’s seven-member board of directors.
- Collaborations: AlphaTech and BetaSoft start collaborating on several projects. BetaSoft also benefits from AlphaTech’s extensive network, gaining valuable introductions to potential clients and partners.
- Technical Exchange: AlphaTech provides BetaSoft with access to some of its proprietary technologies, enabling BetaSoft to enhance its cloud solutions.
Assessment of Influence:
- Even though AlphaTech’s 30% ownership doesn’t give it control over BetaSoft, the significant stake and other factors suggest AlphaTech wields substantial influence over BetaSoft’s operations and financial policies.
- The ability to appoint board members provides AlphaTech with a direct voice in BetaSoft’s strategic and policy decisions.
- Regular collaborations and the exchange of technical know-how further bind the two companies, with AlphaTech playing a guiding role in many of BetaSoft’s initiatives.
Accounting Implications: Given the significant influence exerted by AlphaTech over BetaSoft:
- AlphaTech would use the equity method to account for its investment in BetaSoft. This means that when BetaSoft reports a profit or a loss, AlphaTech would adjust the carrying value of its investment on its own balance sheet by its share (30% in this case) of that profit or loss.
- If BetaSoft declares dividends, AlphaTech would reduce the carrying amount of its investment by the dividends received.
- Any significant transactions between the two entities would also need to be disclosed appropriately in the financial statements to ensure transparency and avoid potential double-counting of revenues or expenses.
This example illustrates how an entity can exert significant influence over another entity without necessarily having outright control. The implications of such influence are crucial for transparent and accurate financial reporting.