Prospect Capital's Potential Financial Restatements: Explaining The Current Situation And Its Impacts - Part 1

| About: Prospect Capital (PSEC)


Prospect Capital recently disclosed within its comprehensive report of a company’s performance (10-Q) a possible restatement of financials may occur in the future.

This possible restatement focuses around the topic of “Accounting Codification Standard 946 Financial Services — Investment Companies” (‘ACS 946’).

The Securities and Exchange Commission (‘SEC’) states that certain holding companies within PSEC’s control investment portfolio are deemed “wholly-owned subsidiaries” per “Generally Accepted Account Principles” (‘GAAP’) and should be consolidated.

Prospect Capital is currently appealing the SEC staff's initial determination.

Part 2 of this article will "hypothetically" assess the impacts of PSEC’s restated financials where certain control investments will be consolidated (assuming the initial SEC staff determination is upheld).

Focus of Article:

The focus of this article is to provide a general overview of what recently transpired when Prospect Capital Corp. (NASDAQ:PSEC) released its comprehensive report of a company's performance (10-Q) for the quarter ended 3/31/2014. Part 1 will include a brief description of the topic at hand including the company's current response. Specifically, Part 1 of this article will discuss the accounting literature regarding the Securities and Exchange Commission's ('SEC') initial ruling on the restatement of PSEC's financials to incorporate the consolidation of certain control investments.

Part 2 will pick up where Part 1's discussion ends and assess the potential impacts this consolidation could have on PSEC's past and present financial statements. Specifically, Part 2 will focus on the following PSEC financial statements: 1) consolidated statement of assets and liabilities; and 2) consolidated statement of comprehensive income. This will be followed by the impact on PSEC's dividend. Part 2 will be available to readers in the near future.

Overview of the SEC's Initial Ruling Regarding PSEC's Financial Statements:

Side Note: As stated in PSEC's 10-Q for the fiscal third quarter of 2014, a definitive ruling on this possible restatement of financials is pending due to PSEC's appeal to the SEC's Chief Accountant. The SEC's Chief Accountant/Commission can rule in favor of PSEC where no financial restatement is necessary/mandatory. The SEC's Chief Accountant/Commission could rule in favor of the SEC's staff initial ruling whereas PSEC would need to consolidate certain control investments (described further below). The SEC's Chief Accountant/Commission could also issue an amended ruling where the initial ruling is only partially upheld. Readers should understand each potential outcome will have varying effects on certain aspects of PSEC's financial statements.

With that being said, let us now discuss the issue at hand.

As stated in PSEC's 10-Q for the fiscal third quarter of 2014, an issue arose that dealt with the specific presentation of certain control investments within PSEC's financial statements.

As defined in the Investment Company Act of 1940, if PSEC (which is classified as an investment company) has more than 25% ownership of a portfolio company's outstanding voting securities, it is deemed to exercise "control" over these specific investments. As such, further financial disclosures and footnotes are necessary for "control investments" when compared to non-control investments. PSEC currently reports such additional disclosures/footnotes in the company's financials so this is not the issue at hand. I just mention this aspect for additional clarity. This is where an issue starts to arise and gets more complex for readers.

However, for most (if not all) of PSEC's "wholly-owned" control investments, the portfolio company's outstanding voting securities are held in "holding companies" of the controlled investments. This is an important concept to understand as will be discussed shortly. In turn, these holding companies typically wholly-own/fund the underlying controlled operating companies. Some of PSEC's controlled investments have more complex organizational structures. However, for purposes of this article, let us try and keep it simplified. As such, PSEC wholly-owns certain holding companies of controlled investments which in turn wholly-own/fund the underlying operating companies.

Per the "Accounting Codification Standard 946 Financial Services-Investment Companies" ('ACS 946'), it states when an investment company's voting stock ownership (controlling equity stake) in an investment is determined to be wholly-owned, the control investment should be consolidated into the parent's financial statement. In other words, this means certain holding companies of control investments within PSEC's investment portfolio would be deemed a "wholly-owned subsidiary". Section 2(a), paragraph 43 of the Investment Company Act of 1940 defines a wholly-owned subsidiary as 95% or more ownership of the outstanding voting securities of a subsidiary.

In the past few years, there have been ongoing debates regarding this particular topic. However, a majority of accounting boards/committees (including the Financial Accounting Standard Board ['FASB'] and American Institute of Certified Public Accountants [AICPA]) have stated a wholly-owned subsidiary should be consolidated into the parent. As such, the SEC staff has originally gone from "recommending" a few years back to currently "requiring" an investment company to consolidate a wholly-owned or substantially-owned subsidiary (the holding companies of the control investments) in its financial statements when that subsidiary is basically an extension of the parent. The FASB and AICPA (amongst other accounting peers) have also termed certain entities with similar structures to PSEC's controlled holding companies as "blocker entities". Some committee members/expert panelists are in agreement that an investment company should consolidate a wholly-owned blocker entity as well.

So from the SEC's perspective, the problem that arises is PSEC first provides financing/capital to the wholly-owned subsidiaries (holding companies of the controlled investments). PSEC's wholly-owned holding companies then fund the underlying operating companies of the controlled investment. As such, the SEC's argument is that PSEC's wholly-owned subsidiaries (the holding companies of the control investments) are basically an "extension" of PSEC's business operation and thus should also be considered an investment company per GAAP. Therefore, PSEC's wholly-owned investment company subsidiaries (the holding companies of the controlled investments) should be consolidated into the parent's financials. Since the holding companies typically own/are affiliated with the underlying operating companies, the entire organizational entity (assets, liabilities, equity, and earnings) should be consolidated with intercompany balances reconciled and non-controlling/minority interests reversed-out. Per the SEC's argument, if the holding company was not deemed "an investment company" itself, then consolidation would not be necessary. The previous statement is an important concept to understand.

As such, in PSEC's earnings conference call for the fiscal third quarter of 2014, Chairman and Chief Executive Officer ('CEO') John Barry states the following:

"…It's very common for a leverage buyout firm to buy a company and put the equity in a hold company and then put it down as equity into the operating company. So, we have done that. Now we understand, how do we simply not use a holding company but, this is my understanding, had we not used the holding company but had simply put all the debt at the operating company, my understanding is that there would not be an issue. So, in other words, because we used the holding company there is an issue that would not exist without a holding company… I can tell you that going forward in the future, we now know and we have to put the debt that we did it in these buyouts, we have to put it at the operating company..."

From the quote above, PSEC seems to understand the organizational structuring "flaw" that caused the SEC's ruling to consolidate all wholly-owned subsidiaries (and all entities that the holding companies have a proportional stake in/are affiliated with). Again, the wholly-owned holding companies of the control investments are deemed investment company subsidiaries and are seen as PSEC's wholly-owned subsidiaries per GAAP. As such, consolidation would seem appropriate.

While in the earnings call transcript PSEC's CEO seemed to understand this concept, management stated in the financials the company is still appealing this interpretation of ASC 946. Directly quoting PSEC's 10-Q for the fiscal quarter ended 3/31/2014 (see link above), the following disclosure was provided on 5/6/2014:

"…In connection with the SEC staff's review of our filing on Form N-14 for the acquisition of Nicholas Financial, Inc., the staff of the SEC has asserted that some of our wholly owned companies are investment companies for accounting purposes and are required to be consolidated by us. Based on our assessment of generally accepted accounting principles ('GAAP'), we disagree with the staff's assertion and intend to appeal to the SEC's Chief Accountant and, if necessary, the Commission itself…"

The disclosure goes on to further say:

"…The staff asserts that these wholly owned holding companies should be accounted for as investment companies. We disagree with the staff's assertion…We believe the consolidation position of the staff is not supported by any written guidance within existing GAAP and that it is not appropriate to account for such holding companies of the operating companies as investment companies, as these holding companies do not meet the definition of an investment company under current GAAP…Based on existing accounting standards, we believe the consolidated financial statements set forth herein were compiled in accordance with GAAP and fairly depict the financial condition and results of operations of the Company…"

As the above disclosure states, PSEC currently is appealing the SEC staff's initial ruling regarding the consolidation of all wholly-owned investment company subsidiaries (the holding companies of certain control investments). PSEC states these wholly-owned investment company subsidiaries are not really a part of the "day-to-day" operations of the controlled operating company and thus should not be considered as an investment company (subject to consolidation rules).

Conclusions Drawn:

In my professional opinion, both sides bring some valid arguments to the table. However, I would currently side with the SEC staff on this specific scenario. PSEC's comments during the earnings conference call seem to help solidify this viewpoint. As such, I currently believe PSEC will need to restate the company's financial statements to incorporate the consolidation effect of its wholly-owned subsidiaries (the holding companies of certain control investments.)

Due to the "uncertainty" out there in the markets on this topic, I wanted to get the initial discussion/explanation out there for readers to digest. As such, I have decided to break this article out into two separate parts. Part 2 of this article will show the direct impact of this possible financial restatement to incorporate the consolidation effect of PSEC's wholly-owned subsidiaries (the holding companies of certain control investments.) This will be provided through only a hypothetical example by showing some general impacts.

It should also be noted that the fair market value ('FMV') of PSEC's controlled investment portfolio was approximately 20%-25% of the company's total investment portfolio over the past several fiscal quarters. Part of this balance is the portion subject to possible restatement. Again, PART 2 will get into this topic.

Final Note: This is only Part 1 of this article. As such, a finalized conclusion will not be provided yet. In order to state a proper and thorough conclusion, the entire article should be provided. I believe this situation was an "extraordinary event" and readers wanted access to the information discussed in Part 1 fairly quickly. As such, I decided to break the article into two parts so Part 1 would be available to readers faster. I should also note these articles are researched and prepared in my spare/leisure time and is separate from my full-time profession.

While I am not currently selling any portion of my PSEC holdings, I will be cautious with further acquisitions even at the discounted price of $10.14 per share as of 5/9/2014. This is just my personal viewpoint. Readers need to understand the impacts this event has and will continue to cause regarding attitudes of fellow market participants. This factor also considers the S&P and Russell Indices realignment still hanging over the Business Development Company ('BDC') sector for the time being.

Disclosure: I am long PSEC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.