Significant Influence

Definition

Significant influence is the power to participate in the financial and operating policy decisions of an entity, without having control or joint control over it. This concept is crucial for determining how an investment is accounted for, as it distinguishes between varying levels of ownership interest and their implications in financial reporting. It typically arises when an investor holds 20% to 50% of the voting power of an investee, but also considers other factors that may demonstrate influence, such as representation on the board or participation in policy-making decisions.

5 Must Know Facts For Your Next Test

1. An investor typically is presumed to have significant influence if they own 20% or more of the voting power in another entity.
2. Significant influence can also be established through non-voting shares, board representation, or participation in policy decisions.
3. Entities with significant influence must account for their investments using the equity method, where they report their share of profits or losses in their income statement.
4. If significant influence is lost, the accounting method changes to fair value accounting, which can impact financial results significantly.
5. In related party transactions, entities must disclose relationships that suggest significant influence to ensure transparency in their financial statements.

Review Questions

• How does significant influence affect the accounting treatment of an investment?
  • When an investor has significant influence over an investee, it must use the equity method to account for its investment. This means that the investor will recognize its share of the investee's earnings or losses in its own income statement. This approach reflects a more integrated view of financial performance between the investor and investee compared to other methods like cost accounting, which do not capture this relationship.
• Discuss the indicators that can demonstrate significant influence beyond ownership percentage.
  • While ownership of 20% or more typically indicates significant influence, other indicators include having representation on the board of directors, participating in policy-making processes, and sharing in decisions related to dividends and financing. These factors help paint a broader picture of how an investor may exert influence over an investee's operations and financial strategies, which is essential for proper accounting treatment.
• Evaluate the implications of losing significant influence on an investment's accounting treatment and financial reporting.
  • Losing significant influence requires a shift from the equity method to fair value accounting for the investment. This change can significantly impact reported earnings since any unrealized gains or losses are now recognized directly in profit or loss rather than through share of income. Additionally, this shift may affect other financial metrics and ratios, influencing stakeholders' perceptions and decisions regarding the company’s performance and financial health.

Related terms

Equity Method:

A method of accounting for investments where the investor recognizes its share of the investee's profits and losses, reflecting significant influence.

Control:

The ability to direct the financial and operating policies of an entity, typically through ownership of more than 50% of the voting rights.

Joint Control: A contractual agreement whereby two or more parties share control over an arrangement, requiring unanimous consent for decisions that significantly affect the activity.