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Introduction

Good morning.  I would like to share observations related to consultations the Office of the Chief Accountant (OCA) has received related to equity method accounting and the new leases standard.[1] 

Application of Equity Method

My first topic relates to the application of equity method accounting.  The equity method generally applies when an investor does not control an investee, but instead is able to exert significant influence over the operating and financial policies of an investee.  The levels of ownership and threshold for applying the equity method vary depending on the nature of the investee.  For example, for investments in corporations, it is generally presumed that a 20% or more voting interest results in the ability to exercise significant influence.[2]  For investments in limited partnerships, the SEC staff has stated that the equity method should be applied unless the investor’s interest is so minor that the investor may have virtually no influence over partnership operating and financial policies, with practice generally viewing investments of more than 3-5% to be more than minor.[3]     

A recent consultation with OCA focused on whether the equity method should be applied to a registrant’s investment in a limited liability company (LLC).  The registrant held over 25% of the LLC’s member units, which were entitled to a preferential allocation of profits.  The registrant did not have board representation or voting rights over key operating and financial decisions, but did have certain limited rights, most of which were protective in nature.  Furthermore, the registrant had significant ongoing commercial arrangements with the LLC.

In performing its evaluation of whether the equity method applied to its investment, the registrant first concluded that its investment in the LLC was similar to an investment in a limited partnership because the LLC was required to maintain specific ownership accounts for each member.[4]  The registrant noted that the limited partnership guidance states that investors in partnerships should apply the equity method if the investor has the ability to exercise significant influence.[5]  The registrant also considered the staff’s position that the application of the equity method to investments in limited partnerships should be applied unless the investor’s interest is so minor that the limited partner may have virtually no influence over partnership operating and financial policies.  The registrant observed that the “virtually no influence” guidance cited in the SEC staff’s position was originally written in the context of investments in real estate companies with less complicated fact patterns than the registrant’s facts.  The registrant believed that the nature and intent of its investment was truly passive, such that an assessment of the overall significant influence indicators was more relevant, irrespective of the form of the ownership.  Therefore, based on the complex terms of its investment, including no voting rights and a preferential profit allocation, the registrant concluded that it did not have significant influence and the equity method did not apply.  The registrant also believed that not applying the equity method would better reflect the economics of its investment.

In this fact pattern, the staff objected to the registrant’s conclusion that the equity method did not apply.  The staff concluded that the staff’s longstanding position on the application of the equity method to investments in limited partnerships should be applied.  Given the registrant’s significant ownership interest, certain limited rights other than protective rights, and ongoing commercial arrangements, the staff concluded the registrant had more than “virtually no influence” over the LLC.

ASC 842 and Collectibility

We continue to be engaged in monitoring implementation of the new lease accounting standard.  I would like to share observations from a recent consultation about assessing collectibility for lessors.  Under ASC 842, lessors are required to evaluate whether collectibility of the lease payments, including any amount necessary to satisfy a residual value guarantee, is probable at lease commencement date.  In a sales-type lease, if collectibility is not probable, the lessor should not derecognize the asset and should defer recognition of any income or loss.  The lessor would instead recognize lease payments received as a deposit liability until either:  (a) collectibility becomes probable or (b) the contract has been terminated or the lessor has taken back the asset, and the lease payments are nonrefundable.[6]

OCA staff recently considered a fact pattern where the registrant enters into sales-type leases of equipment.  The lessee is required to make a down payment and also make periodic lease payments, generally over a four-year contractual period.  The registrant has historically experienced a high rate of payment delinquencies, leading to defaults that result in termination of the contract and, in most cases, repossession of the equipment.  Based on historical experience, the registrant collects an average of 60% of the contractual lease payments.  The registrant continues to expect a high rate of defaults and structures its leases to compensate for the high credit risk of its customers through a high rate implicit in the lease, a residual value guarantee, and the intent and ability to repossess the equipment if the customer defaults.

The registrant concluded collectibility of the lease payments was probable at lease inception.  The registrant asserted that at the lease commencement date, the customer had the intent and ability to pay as evidenced by a credit evaluation and a substantive down payment, among other factors.[7]  Further, the registrant asserted that the historical lessee defaults were generally due to a change in the lessee’s circumstances subsequent to the lease inception.

The staff objected to the registrant’s view and concluded that there was not a sufficient basis to assert that collectibility of the lease payments was probable at the lease commencement date.  In reaching this conclusion, the staff considered all factors including the registrant’s assessment of the lessee’s credit quality and the registrant’s history of collections with similar lessees.  

Conclusion

Thank you for your kind attention today.