Significant Influence

Significant influence is the power an investor has to participate in the financial and operating policy decisions of a company it has invested in (the investee). Think of it as having a seat at the table and a voice that gets heard, but without having the final say. It's a middle ground between being a passive shareholder and having outright control. Under both US GAAP and IFRS, the general rule of thumb is that owning between 20% and 50% of a company's voting shares creates a presumption of significant influence. This relationship is crucial because it dictates a specific accounting treatment called the equity method, which can offer value investors a much clearer view of an investment's true economic performance than just looking at the dividends received.

While the 20-50% ownership stake is a handy guideline, it's not absolute. Accountants and savvy investors look for qualitative evidence, which can sometimes prove significant influence exists even with less than 20% ownership. These signs point to a deeper relationship between the two companies.

• Board Representation: The investing company has a representative on the investee's board of directors or an equivalent governing body.
• Policy-Making Participation: The investor is actively involved in discussions and decisions about dividends, strategic direction, and other key policies.
• Material Transactions: There are significant business dealings between the investor and the investee, such as being a major customer or supplier.
• Managerial Swap: There's an interchange of managerial personnel between the two companies.
• Essential Know-How: The investor provides essential technical information or expertise that the investee depends on.

If these factors are present, an investor can have a powerful voice in the investee's affairs, regardless of the exact percentage of shares held.

Understanding significant influence is more than an accounting quirk; it’s a tool for uncovering value and understanding corporate strategy. When significant influence is established, the investor must use the equity method to account for the investment, and this changes everything.

Instead of just recording dividend income, the equity method provides a more dynamic and insightful picture. Here’s how it works:

• On the Income Statement: The investor company recognizes its proportional share of the investee’s net income (or loss) in its own income statement. This is often listed as “Earnings from affiliate” or “Equity in earnings of associate.”
• On the Balance Sheet: The investment is initially recorded at cost. It is then increased by the investor's share of the investee's profits and decreased by its share of losses and any dividends received.

This is powerful. It means you see the underlying profitability of the investment, not just the cash it happens to pay out. A fast-growing associate might be reinvesting all its profits and paying no dividend, but an investor using the equity method will still show a growing stream of earnings from that investment. Conversely, it also exposes a struggling associate that is dragging down the investor's results.

Let's say ValueCo buys 30% of GrowthCorp for $30 million.

1. In Year 1, GrowthCorp earns a profit of $10 million and decides to pay out $2 million in total dividends.

Here’s the impact on ValueCo's financial statements:

• Income Statement: ValueCo recognizes $3 million in earnings (30% x $10 million profit), giving a true sense of the value GrowthCorp generated for it. If it weren't for the equity method, ValueCo would only report the dividend income.
• Cash Flow: ValueCo receives $600,000 in cash (30% x $2 million dividend).
• Balance Sheet: The value of ValueCo's investment in GrowthCorp is adjusted.
  1. Start: $30,000,000
  2. Add share of profit: + $3,000,000
  3. Subtract dividend received: - $600,000
  4. End of Year Value: $32,400,000

As a value investor analyzing ValueCo, you get to see that its investment is generating $3 million in earnings, not just the $600,000 in cash it received. This prevents you from undervaluing ValueCo and gives you a reason to dig into GrowthCorp's performance to see if that earnings stream is sustainable. An equity method investment can be a hidden gem or a hidden liability on a company’s balance sheet, and a sharp investor knows to look for it.