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Summary

  • Part 1 of this article stated 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.
  • 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 but Part 2 takes a look at a “hypothetical” analysis of what changes would be performed in such a consolidation.
  • If such a consolidation is required, the presentation of Prospect Capital’s consolidated statement of assets and liabilities and consolidated statement of operations would be materially impacted (look much different).
  • Part 2 also took a look at the impact a potential restatement of financials would do to PSEC’s dividend which is based on the Internal Revenue Code (‘IRC’) methodology.

Author's Note: PART 2 of this article is a continuation from PART 1 which was discussed in a previous publication. Please see PART 1 of this article for an initial discussion on the accounting literature regarding the Securities and Exchange Commission's ('SEC') initial ruling on the restatement of Prospect Capital Corp's (NASDAQ:PSEC) financials to incorporate the consolidation of certain "wholly-owned" holding companies. PART 1 helps lead to a better understanding of the topics and analysis that will be discussed in PART 2. The link to PART 1's analysis is provided below:

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

Focus of Article:

The focus of this article is to provide a "hypothetical" analysis assuming PSEC needs to restate the company's financials to consolidate its "wholly-owned subsidiaries" (the holding companies of certain control investments) to be in accordance with GAAP per the initial interpretation/ruling of the SEC staff. This analysis will focus on "Accounting Standard Codifications" ('ASC') 805, 810, and 946. Due to the extremely high demand / questions posed on this topic, I felt it would be both valuable and educational to provide readers such an analysis.

Side Note: As stated in PSEC's 10-Q for the quarter ended 3/31/2014, 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 staff's initial ruling whereas PSEC would need to consolidate the company's wholly-owned subsidiaries (analyzed 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.

As such, the potential impacts that will be described within PART 2 of this article (concerning financial restatements) are merely for general discussion purposes only. The hypothetical analysis that will be performed is assuming the SEC staff's initial ruling is upheld by the SEC's Chief Accountant/Committee. Again, this analysis is only hypothetical to show what would occur regarding PSEC's restated financials if a consolidation of certain wholly-owned subsidiaries is required. 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. The SEC's argument is that PSEC's wholly-owned subsidiaries (the holding companies of certain 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 subsidiaries (the holding companies of certain control investments) are also considered investment companies and should be consolidated at the parent level.

To discuss the potential impacts of PSEC's wholly-owned subsidiaries being consolidated at the parent level, this article will focus on the following financial statements: 1) consolidated statement of assets and liabilities; and 2) consolidated statement of operations. This will be followed by the impact on PSEC's dividend.

1) Potential Impacts of PSEC's Restated Consolidated Statement of Assets and Liabilities:

The first topic to discuss is PSEC's restated consolidated statement of assets and liabilities. First, let us start off with showing PSEC's consolidated statement of assets and liabilities for the past several fiscal quarters (excluding the consolidation of the company's wholly-owned subsidiaries). This way, it will be easier to see the general impacts the potential restatement would have on PSEC's "balance sheet."

Table 1 - PSEC Consolidated Statement of Assets and Liabilities (Excluding Consolidation of Wholly-Owned Subsidiaries)

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(Source: Table created entirely by myself, using PSEC data obtained from the SEC's EDGAR Database)

Using Table 1 above as a reference, PSEC's "control investments" account (first row of data) was valued at $1.56, $1.16, and $0.95 billion at 3/31/2014, 12/31/2013, and 9/30/2013, respectively. A material portion of this account's balance consisted of PSEC investments (both debt and equity) that were made through the company's wholly-owned subsidiaries (the holding companies of certain control investments). Within these holding companies, PSEC owned at least 95% ownership of the outstanding voting securities of these entities. This could include ownership of common stock, preferred stock, and/or membership units (including future warrants). As such, the holding companies of certain control investments are deemed to be wholly-owned by PSEC. Since the SEC staff has determined the holding companies are "an extension" of PSEC's main operations (distributing loans for investment income and capital appreciation) to the operating companies, they are termed wholly-owned subsidiaries and need to be consolidated on the parent's financial statements.

Moving down the organization hierarchy, some of PSEC's wholly-owned subsidiaries (the holding companies of certain control investments) have at least a "controlling" interest (in some cases 100% voting interests) in the underlying operating companies where debt and equity investments were made on PSEC's behalf.

As such, if PSEC needs to reclassify a portion of the company's investments made in these types of entities, its control investment account balance will most likely be materially reduced (as will be explained shortly). PSEC would need to reduce the amount of the company's debt and equity investments in its wholly-owned subsidiaries (the holding companies of certain control investments) and state all (100%) of the holding companies' assets and liabilities at the parent level. Since some of the holding companies have a controlling interest (in some cases 100% of the voting interests) in the underlying operating companies, consolidation at the wholly-owned subsidiary level may be appropriate as well.

For example, within PSEC's 10-Q for the quarter ended 3/31/2014 (see link above), the following disclosure is provided:

"…Credit Central Holdings of Delaware, LLC, an entity that we own 100% of the membership interests, owns 74.8% of Credit Central Holdings, LLC, which owns 100% of each of Credit Central, LLC, Credit Central South, LLC, Credit Central of Texas, LLC, and Credit Central of Tennessee, LLC, the operating companies.."

So in the example above, PSEC wholly-owns Credit Central Holdings of Delaware, LLC who then possibly has a controlling interest in Credit Central Holdings, LLC. This second holding company then has a 100% ownership in four operating subsidiaries.

Side Note: Generally, ownership of the majority voting interests of an entity determines who has a controlling interest within a subsidiary. However, this is not "always" true. If explicitly stated within an entity's articles of incorporation (or similar legal binding document) that a minority party has controlling interest, this would supersede the majority voting interests concept.

Another example is as follows:

"…Valley Electric Holdings I, Inc., an entity that we own 100% of the common stock, owns 100% of Valley Electric Holdings II, Inc. ("Valley II"). Valley II owns 96.3% of Valley Electric Co. of Mt. Vernon, Inc., the operating company. Our debt investments are with both Valley Electric Holdings I, Inc. and Valley Electric Co. of Mt. Vernon, Inc…"

So in the second example above, PSEC wholly-owns Valley Electric Holdings 1, Inc. who then possibly has a controlling interest in Valley Electric Holdings II, Inc. This second holding company then has a 96.3% ownership in Valley Electric Co. of Mt. Vernon, Inc. (the operating subsidiary).

Per ASC 805 - Business Combinations, when an acquirer (in this case PSEC) obtains control of an acquiree (the holding company of certain control investments), the acquirer must recognize the assets acquired, liabilities assumed, and any noncontrolling (minority) interests in the acquiree. As such, the wholly-owned subsidiary's assets and liabilities would be consolidated on a "line-by-line" basis within PSEC's consolidated statement of assets and liabilities. Currently, PSEC shows the debt investments that were provided first to the company's wholly-owned subsidiaries (holding companies of certain control investments) which were then provided to the underlying operating companies as a single line item within its investment account (an asset). PSEC also shows the acquired voting interest (equity investments) in regards to the wholly-owned subsidiaries (holding companies of certain control investments) within the company's investment account (an asset).

To show the impacts on PSEC's possible restated financials where the company would need to consolidate its wholly-owned subsidiaries (the holding companies of certain control investments), Table 2 is provided below.

Table 2 - Illustrative Example of Consolidated Statement of Assets and Liabilities (Including Consolidation of a Parent's Subsidiary)

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Source: Table is an illustrative example of a fictional consolidation between a parent entity and its subsidiary courtesy of the Financial Accounting Standard Board's (FASB) Privately-Assessed Database [link provided above]

Side Note: Table 2 is NOT an example of PSEC's potential consolidated statement of assets and liabilities. Only PSEC's management team can perform a "precise" restatement of the company's financials to incorporate a consolidation of its wholly-owned subsidiaries for several reasons. First, PSEC's wholly-owned subsidiaries (the holding companies of certain control investments) have varying percentages of ownership of certain operating company subsidiaries which changes over the course of time. Second, some of these wholly-owned subsidiaries have organizational hierarchies that are "multi-tiered." Third, the operating company subsidiaries are private entities where financial statements are not readily available to the public (nor does PSEC provide this information via disclosures). The purpose of this article is to educate and show readers how PSEC's accounts could possibly change and the impacts these changes would have on the company's consolidated financial statements. While I know what accounts need to be changed if the wholly-owned subsidiaries need to be consolidated, "exact" figures are not possible by ANYONE outside management.

Using Table 2 above as a reference, all "intercompany" debt investments that involve PSEC and the company's wholly-owned subsidiaries (the holding companies of certain control investments) would need to be reversed out (eliminated) from the company's consolidated statement of assets and liabilities (see adjustment reference "23" in Table 2 above). This occurs because these kinds of debt investments would be considered intercompany transactions which would need to be eliminated upon consolidation at the parent level. Also, all equity investments that involve PSEC and the company's wholly-owned subsidiaries (the holding companies of certain control investments) would need to be reversed out (eliminated) from the company's consolidated statement of assets and liabilities (see adjustment references "24", "25", and "26" in Table 2 above). This occurs because these kinds of equity investments would be considered intercompany transactions which would need to be eliminated upon consolidation.

Instead of the currently-shown debt and equity investments on PSEC's consolidated statement of assets and liabilities (refer back to Table 1), PSEC would need to consolidate all (100%) of the wholly-owned subsidiaries' (the holding companies of certain control investments) assets and liabilities (see Table 2 above) excluding all intercompany transactions.

This general concept sounds fairly straightforward but could get complicated for a few reasons. First, PSEC's ownership of the company's wholly-owned subsidiaries (the holding companies of certain control investments) changes over the course of time. When this occurs, varying degrees of ownership would cause different considerations in regards to consolidation. Furthermore, PSEC's wholly-owned subsidiaries (the holding companies of certain control investments) could also have proportional changes in ownership of the operating company subsidiaries.

Second (as stated earlier), some of these wholly-owned subsidiaries have organizational hierarchies that are "multi-tiered." While some organization structures are fairly straightforward, others are more complex. As such, PSEC "technically" partially owns multiple operating company subsidiaries within just one wholly-owned subsidiary. While all wholly-owned subsidiary intercompany balances would offset, the accounting alone down below the parent level would be much more complex when compared to the current balances being reported in PSEC's consolidated statement of assets and liabilities (prior to the wholly-owned subsidiaries being consolidated at the parent level).

Third, if PSEC's wholly-owned subsidiaries (the holding companies of certain control investments) are not 100% owned, a new account is created at the parent level called the "noncontrolling" interest. Per ASC 810 - Consolidation, a noncontrolling interest is the portion of equity (net assets) in a subsidiary not attributable, directly or indirectly, to a parent. The proportional share of the noncontrolling/minority interest is typically shown within a separate section of the parent's equity section of the consolidated statement of assets and liabilities (see adjustment reference "28" in Table 2 above).

As such, PSEC's assets, liabilities, and net assets (equity) would be impacted as a result of the potential restatement of the company's financials to incorporate a consolidation of its wholly-owned subsidiaries. PSEC's net asset section would be impacted as well from past income statement results of the company's wholly-owned subsidiaries (a one-time cumulative adjustment; discussed in the next section of the article). Depending on the amount of assets, liabilities, and noncontrolling/minority interests consolidated at the parent level, PSEC's net asset value ('NAV') would be directly impacted.

The presentation of PSEC's consolidated statement of assets and liabilities could be shown within one cumulative column. However, it could also be broken-out to multiple columns as shown in Table 2 above. Further discussion of the SPECIFIC presentation of the potential restated financials is beyond the scope of this article due to the fact several methods are currently acceptable under GAAP (as long as the same general methodology is applied and consolidation occurs).

Side Note: Due to the potential restated financials, management stated in PSEC's earnings conference call for the fiscal third quarter of 2014 the company will refrain from issuing new common stock under the at-the-market (ATM) offering program and from issuing new debt via Prospect Internotes®. However, management also stated the company has no outstanding debt on the company's revolving credit facility as of early May 2014 and currently has unused cash and cash equivalents via money market fund holdings. Management went on to say PSEC had approximately $900 million of capacity as of early May 2014. With that being said, I am projecting modest non-control loan originations will continue to occur throughout the rest of the quarter. However, I am also projecting PSEC will refrain from investing material amounts in control investments for the remainder of the quarter (due to the current situation at hand).

To sum up PSEC's possible restated consolidated statement of assets and liabilities, PSEC would need to report all (100%) of the wholly-owned subsidiaries' assets and liabilities. PSEC would also show the proportional share of any noncontrolling equity interests. All intercompany debt and equity investments that involve PSEC and the company's wholly-owned subsidiaries (the holding companies of certain control investments) would need to be eliminated from the company's consolidated statement of assets and liabilities. All of PSEC's wholly-owned subsidiaries' assets and liabilities will vary according to each entity's organization structure.

2) Potential Impacts of PSEC's Restated Consolidated Statement of Operations Income:

The second topic to discuss is PSEC's restated consolidated statement of operations. First, let us start off with showing PSEC's consolidated statement of operations for the past several fiscal quarters (excluding the consolidation of the company's wholly-owned subsidiaries). This way, it will be easier to see the general impacts the potential restatement would have on PSEC's "income statement."

Table 3 - PSEC Consolidated Statement of Operations (Excluding Consolidation of Wholly-Owned Subsidiaries)

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Source: Table created entirely by myself, partially using PSEC data obtained from the SEC's EDGAR Database [link provided below Table 1]

Within PSEC's 10-Q for the quarter ended 3/31/2014 (see link above), management stated the following three "general impacts" would likely occur within the company's consolidated statement of operations if its wholly-owned subsidiaries were consolidated at the parent level: 1) a decrease in historical net investment income ('NII') by the amount of interest income and structuring fees (other income) paid by the wholly-owned subsidiaries in excess of the amount of income that can be reported as dividend income based on taxable earnings and profits; 2) a possible offset to the 1st general impact being a decrease in operating expenses from reduced income incentive fees partially offset by an increase in management fees; and 3) an increase in historical "net increase in net assets resulting from operations" (also known as earnings per share ['EPS']).

Side Note: Management also disclosed a fourth general impact in relation to the company's taxable income. Since this account/figure has no impact on PSEC's possible restated consolidation statement of operations, this impact will be discussed in the next section of the article (impact on PSEC's dividend).

Simply put, within PSEC's consolidated statement of operations, many accounts would most likely be impacted if the company's wholly-owned subsidiaries (the holding companies of certain control investments) were consolidated at the parent level. Using Table 3 above as a reference, the following PSEC accounts within the company's consolidated statement of operations would generally be affected: 1) "interest income" on control investments; 2) "dividend income" on control investments; 3) "other income" on control investments; 4) "base management fee"; 5) "income incentive fee"; 6) miscellaneous expenses in direct relation to the wholly-owned subsidiaries; 7) net realized gain (loss) on investments; and 8) net unrealized appreciation (depreciation) on investments.

I feel grouping the eight accounts listed above within PSEC's three general impacts stated earlier would be the most appropriate and effective way to discuss the potential effects to the company's consolidated statement of operations when its wholly-owned subsidiaries were consolidated at the parent level. To better show the impacts on PSEC's possible restated consolidated statement of operations, Table 4 is provided below.

Table 4 - Illustrative Example of Consolidated Statement of Operations (Including Consolidation of a Parent's Subsidiary)

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Source: Table is an illustrative example of a fictional consolidation between a parent entity and its subsidiary courtesy of the Financial Accounting Standard Board's (FASB) Privately-Assessed Database [link provided above]

Side Note: Table 4 is NOT an example of PSEC's potential consolidated statement of operations. Only PSEC's management team can perform a "precise" restatement of the company's financials to incorporate a consolidation of its wholly-owned subsidiaries for several reasons. First, PSEC's wholly-owned subsidiaries (the holding companies of certain control investments) have varying percentages of ownership of certain operating company subsidiaries which changes over the course of time. Second, some of these wholly-owned subsidiaries have organizational hierarchies that are "multi-tiered." Third, the operating company subsidiaries are private entities where financial statements are not readily available to the public (nor does PSEC provide this information via disclosures). The purpose of this article is to educate and show readers how PSEC's accounts could possibly change and the impacts these changes would have on the company's consolidated financial statements. While I know what accounts need to be changed if the wholly-owned subsidiaries need to be consolidated, "exact" figures are not possible by ANYONE outside management.

So PSEC's first general impact is a historical decrease in NII. This is directly affected by the first six accounts I listed earlier. Using Table 4 above as a reference, the portion of interest income received by PSEC through the wholly-owned subsidiary (the holding companies of certain control investments) would need to be eliminated upon consolidation (see adjustment reference "21" in Table 4 above). At the wholly-owned subsidiary level, the portion of interest expense paid to the parent would also need to be eliminated upon consolidation (see adjustment reference "21" in Table 4 above). Furthermore, all intercompany structuring, fee, and servicing income at the parent level and expenses at the wholly-owned subsidiary level (the holding companies of certain control investments) would need to be eliminated upon consolidation. As stated earlier, all intercompany transactions between PSEC and the company's wholly-owned subsidiaries (the holding companies of certain control investments) needs to be eliminated upon consolidation at the parent level.

Similar to the company's consolidated statement of assets and liabilities, PSEC would have to account for all (100%) the income and expenses of the wholly-owned subsidiaries (the holding companies of certain control investments) at the parent level. Since some of the holding companies have a controlling interest (in some cases 100% of the voting interests) in the underlying operating companies, consolidation at the wholly-owned subsidiary level may be appropriate as well. A new account called "net income attributable to noncontrolling interest" (or a similar described account) would show the remaining proportional share of the various "minority interests" in the consolidated wholly-owned subsidiaries (see adjustment reference "22" in Table 4 above). Since the wholly-owned subsidiaries' non-intercompany accounts are now being consolidated at the parent level, the "net income attributable to controlling interest" (or a similar described account) would also be reversed out (see adjustment reference "21" in Table 4 above).

Simply put, a decrease in NII would most likely occur because all of PSEC's once classified interest, structuring, fee, and servicing income attributed to the wholly-owned subsidiaries would be considered intercompany transactions and thus eliminated upon consolidation at the parent level. This income would be replaced by 100% of the wholly-owned subsidiaries' non-related revenue, expenses, and net capital gains (losses). Any noncontrolling/minority interest would also be included at the parent level. If the wholly-owned subsidiaries' share of revenue and expenses are greater than the previously recorded intercompany income accrued, NII would decrease as a result.

PSEC's second general impact is the income incentive and base management fees (which is also part NII). This is directly affected by the fourth and fifth accounts I listed earlier. As discussed within PSEC's consolidated statement of assets and liabilities, it was determined there was a possibility the company's assets and liabilities could increase since its wholly-owned subsidiaries would be consolidated at the parent level. As such, PSEC's base management fee could also retroactively increase since the fee calculation is directly correlated to the amount of "gross total assets" on the company's consolidated statement of assets and liabilities. However, the possible increase in base management fee would most likely be offset by a reduced income incentive fee. This would occur because this fee would be adjusted to exclude the interest, structuring, fee, and servicing income from the intercompany debt and equity investments originally included this calculation. Instead, all non-related revenue and expenses of the wholly-owned subsidiaries would be added to this calculation. Based on management's statement, the "hurdle rate" of the income incentive fee would be harder to obtain (based on a "waterfall" calculation). Between these potential increase in base management fees and decrease in income incentive fees, there would be a partial mitigation effect.

Finally, PSEC's third general impact is in reference to the company's EPS. This is directly affected by NII and the seventh and eighth accounts I listed earlier. On top of the decrease in NII discussed above, intercompany eliminations of all net realized gains (losses) and unrealized capital appreciation (depreciation) on PSEC's wholly-owned subsidiaries (the holding companies of certain control investments) would need to occur upon consolidation at the parent level. Through detailed spreadsheet on past fair market valuations (NYSE:FMV), it is a safe assumption to state PSEC's control investments have a cumulative net realized loss/unrealized capital depreciation through 3/31/2014. However, since all the intercompany activities of PSEC's wholly-owned subsidiaries need to be reversed out, once recorded net realized losses/unrealized depreciation also needs to reversed-out and eliminated upon consolidation at the parent level. Simply put, these intercompany net losses and net unrealized depreciation should have never been recorded in the first place when consolidation is incorporated at the parent level. As such, this should increase PSEC's EPS even when considering the offsetting effects of a modestly lower NII.

Side Note: There are additional complexities when accounting for the consolidation of a parent's subsidiary. One example is how a subsidiary is treating the parent's intercompany loan interest expense. Different impacts would be seen if the subsidiary was expensing 100% of the costs of the parent's intercompany loan versus if the interest was capitalized and expensed over the life of the company's intercompany loan. Another example is what specific type of equity interest was held by the parent of the subsidiary. There are different considerations for different type of equity interests (common stock, preferred stock, membership units, warrants, voting, non-voting, etc.). Another complexity which could come up (which directly applies to PSEC) is certain wholly-owned subsidiaries received shares of PSEC's common stock at the time of acquisition. This causes certain wholly-owned subsidiaries to have minority interests in regards to PSEC's equity. As such, non-controlling/minority interests are seen in both directions of the organization hierarchy. In my opinion, more of the complex issues that could arise from this consolidation will not be discussed within this article as it is beyond the scope of this site's "core" audience.

Therefore, it is a safe assumption to state PSEC's consolidated statement of operations would look materially different when the company's wholly-owned subsidiaries are consolidated versus its recent presentation. The analysis above helps readers better understand what a "potential" restated consolidated statement of operations would look like. Now let us discuss probably what most readers on this site are most concerned about, PSEC's dividends.

3) Impact on PSEC's Dividend:

The last topic to discuss is the impact of the possible restated financials on PSEC's dividend. For most investors, this seems to be the highest propriety/concern. Investors have been asking if the dividend is safe due to the assumption NII will be retroactively lower if PSEC has to restate the company's financials to incorporate a consolidation of its wholly-owned subsidiaries (holding companies of certain control investments). While some readers, contributors, and analysts have "lived or died" by a BDC's quarterly NII for dividend sustainability, I have ALWAYS stated this is not entirely valid. The potential restatement of PSEC's financials has now better highlighted the differences between NII and net investment company taxable income (ICTI).

In past PSEC and other business development company ('BDC') dividend sustainability articles, I have addressed the notion that NII is a GOOD indicator of a company's dividend sustainability. However, I stated a regulated investment company's ('RIC') MAIN determinant for dividend sustainability is an entity's net ICTI. While NII is based on GAAP methodologies, net ICTI is based on Internal Revenue Code ('IRC') methodologies. Since I have analyzed both PSEC's NII and net ICTI in past articles, I will not do so again in this article to reduce redundancy. As such, the links to my most recent dividend sustainability articles are as follows:

Prospect Capital's Dividend And Net Asset Value Sustainability Analysis (Post Fiscal Q2 2014 Earnings) - Part 1

Prospect Capital's Dividend And Net Asset Value Sustainability Analysis (Post Fiscal Q2 2014 Earnings) - Part 2

Within those past articles, I disclose PSEC's quarterly NII and net ICTI (which is adjusted at the end of each calendar tax year). As one can see, there are subtle yet material cumulative differences between PSEC's NII and net ICTI. If PSEC needs to restate the company's financials, NII and net ICTI will materially decouple (even more from an already somewhat differing quarterly/cumulative running balance). As management stated, net ICTI will not be negatively impacted by the potential restated financials because this is a situation factoring around GAAP presentation. The entities' organizational hierarchies/tax structures are NOT affected by this potential consolidation of PSEC's wholly-owned subsidiaries. As such, the IRC methodologies will not be impacted. Again, GAAP versus the IRC are two differing sets of methodologies. GAAP is based on the accrual method of accounting while the IRC is essentially based on the cash method of accounting.

I refer readers to the following quoted statement given by management from PSEC's 10-Q for the quarter ended 3/31/2014 (see link above):

"…While the potential effect of the staff's proposed accounting change is still being evaluated, should a restatement be required, we expect that on a historical basis such consolidation and restatement would: (1) increase our historical taxable net income available for distribution (as the tax status of the underlying entities will remain unchanged), which we believe is an important measure of our ability to generate recurring cash income distributions to our shareholders…"

Even more recent, I refer readers to the following quoted statement provided by management in a press release dated 5/13/2014:

"…Because the tax basis of these entities would not change, we expect there would be no negative effects on our taxable income from consolidation. At least 90% of taxable income is required to be distributed to shareholders to maintain our Federal income tax status as a regulated investment company. As a result, we expect no negative change in our dividend paying capacity or change in our dividend policy through consolidation…"

As such, PSEC's management believes the company's dividend is not materially at risk SOLELY from the possible restated financials to consolidate its wholly-owned subsidiaries. Through past analysis of PSEC's net ICTI, I concur with this assessment. Again, since this situation is still pending, I can't say this assessment is fact. However, I feel it is an opinion based on sound research and data-driven evidence. Any past, present, or future dividend distributions that are determined to be in excess of PSEC's net ICTI would be classified as "return on capital" ('ROC') which lowers an investor's cost basis within the stock.

For readers who do not have a complete understanding of general IRC methodologies, I will provide a link to an even earlier article I wrote on such a topic. Specifically, I refer readers to the section titled, "Discussion of RIC Classification per the IRC" within the following linked article:

Prospect Capital Corp.'s Dividend Sustainability Analysis (Post Fiscal Q4 2013 Earnings) - Part 1

Long story short, dividends are ultimately based on net ICTI and not NII. If restated financials do come to fruition in the future (whereby NII materially decouples from net ICTI), the dividend per share amount will be determined directly from PSEC's estimate of the company's net ICTI. PSEC compared the company's past dividend distributions with NII because NII this is a required disclosure under GAAP. Net ICTI is a non-GAAP measurement which is not a mandatory disclosure under GAAP. With that being said, other BDC peers directly provide investors net ICTI or an account similar to an entity's taxable income. Unfortunately, PSEC was never one of these BDC companies.

Conclusions Drawn:

To reiterate what was performed in this article, a "hypothetical" analysis was performed assuming PSEC needed to restate the company's financials to consolidate its wholly-owned subsidiaries (the holding companies of certain control investments) to be in accordance with GAAP per the initial interpretation/ruling of the SEC staff. As such, this article focused on the following PSEC financial statements: 1) consolidated statement of assets and liabilities; and 2) consolidated statement of operations. This was followed by the impact on PSEC's dividend.

Regarding PSEC's restated consolidated statement of assets and liabilities, the company would need to report all (100%) of the wholly-owned subsidiaries' assets and liabilities. PSEC would also show the proportional share of any noncontrolling equity interests. All intercompany debt and equity investments that involve PSEC and the company's wholly-owned subsidiaries (the holding companies of certain control investments) would need to be eliminated from the company's consolidated statement of assets and liabilities. All of PSEC's wholly-owned subsidiaries' assets and liabilities will vary according to each entity's organization structure.

Regarding PSEC's restated consolidated statement of operations, many accounts would be impacted. The portion of interest income received by PSEC through the wholly-owned subsidiary (the holding companies of certain control investments) would need to be eliminated upon consolidation. At the wholly-owned subsidiary level, the portion of interest expense paid to the parent would also need to be eliminated upon consolidation. Furthermore, all intercompany structuring, fee, and servicing income at the parent level and expenses at the wholly-owned subsidiary level (the holding companies of certain control investments) would need to be eliminated upon consolidation. As stated earlier, all intercompany transactions between PSEC and the company's wholly-owned subsidiaries (the holding companies of certain control investments) needs to be eliminated upon consolidation at the parent level. Similar to the company's consolidated statement of assets and liabilities, PSEC would have to account for all (100%) the income and expenses of the wholly-owned subsidiaries (the holding companies of certain control investments) at the parent level. Since some of the holding companies have a controlling interest (in some cases 100% of the voting interests) in the underlying operating companies, consolidation at the wholly-owned subsidiary level may be appropriate as well. A new account called net income attributable to noncontrolling interest would show the remaining proportional share of the various minority interests in the consolidated wholly-owned subsidiaries. Simply put, it is a safe assumption to state PSEC's consolidated statement of operations would look materially different when the company's wholly-owned subsidiaries are consolidated versus its recent presentation.

Regarding PSEC's dividend, the company's net ICTI (which is based on IRC methodologies) has always been a better indicator of future dividend sustainability versus NII (which is based on GAAP methodologies). Since PSEC never "directly" provided net ICTI, most analysts just used NII as the best indicator (which I have always stated as not being entirely accurate). If PSEC was required to consolidate the company's wholly-owned subsidiaries, management stated the company would start disclosing an equivalent to net ICTI. This would be necessary because the possible restated financials would cause a material de-coupling effect between NII and net ICTI. As management inferred, net ICTI will not be negatively impacted by the potential restated financials because this is a situation factoring around GAAP presentation. The entities' organizational hierarchies/tax structures are NOT affected by this potential consolidation of PSEC's wholly-owned subsidiaries. As such, the IRC methodologies will not be impacted.

Therefore, there would be material impacts to PSEC's financials if a restatement is required (per the SEC) to incorporate the company's wholly-owned subsidiaries. Readers should be aware as such. However, regarding taxable income/the dividend, this possible GAAP restatement should have minimal impacts as the underlying IRC methodologies have not changed.

Final Note: As stated in PART 1, I have remained cautious in regards to adding to my position in PSEC even at the currently discounted price. This is just my personal opinion and will not fit every investor's strategy. However, I believe the market is still taking this potential restatement into consideration and trying to assess the various impacts (from both a GAAP and IRC standpoint). Varied opinions will continue to persist since definitive conclusions/outcomes are still pending. As seen on 5/13/2014, I expect continued volatility in PSEC (in both directions) as new information is presented to the markets in regards to this specific SEC situation. Readers should remain vigilant regarding this particular situation. This situation could be resolved as early as August 2014 when PSEC files the company's annual audited financial statements (10-K). However, any delays in the appeal process (or if further appeals are needed) will extend a final outcome on this situation into PSEC's fiscal year 2015.

Personally, I continue to HOLD MY EXISTING POSITION within the stock and will refrain from acquiring additional shares (excluding dividend reinvestment) unless additional information is presented. I do not "day trade" and do not anticipate performing this strategy in the future. I'm not saying this strategy could not be lucrative regarding the heightened volatility in the stock. However, due to my full-time profession, I choose not to engage in this specific type of trading. If PSEC's stock price trades down to a heavily discounted price, I would begin to accumulate my position (approximately a 15% discount to CURRENT NAV). Again, this strategy would change as times passes and additional information is presented. All investors should understand each buy, sell, or hold decision is based on one's risk tolerance, time horizon, and dividend income goals.

Source: Prospect Capital's Potential Financial Restatements: Explaining The Current Situation And Its Impacts - Part 2