Prospect Capital (NASDAQ:PSEC) reported earnings yesterday, but all eyes are on a few particular items in the company's recent filings.

The quarterly report reveals that the SEC may require Prospect Capital to restate its historical financials to account for its operating companies.

The specifics
Prospect Capital is chock-full of operating companies -- companies in which it owns a majority stake. Normally, the financial results of majority-owned, or "control" companies would have to be included in the financials of the public company.

For example, Prospect Capital owns First Tower, one of its biggest operating companies. Because it holds 100% ownership of a holding company that owns 80.1% of the operating company, the financials for First Tower and other majority-owned companies, the SEC argues, should be included in the financials at Prospect Capital.

Right now, Prospect Capital does not consolidate the results from First Tower in its own financials. Instead, First Tower maintains its own balance sheet. What insight we have into a company like First Tower is limited to the disclosures in the company's SEC filings. The recent quarterly report shows third-party debt, total assets at First Tower, and finance receivables (First Tower loans to customers), but not fully fledged financials.

Does it matter?
Yes, for two reasons.

First, Prospect Capital management noted on the conference call that it had previously recorded more interest and fee income from its operating companies than the operating companies earned. They insist that their focus remains on cash flow, and thus, so long as cash flow covers cash paid back to Prospect by their operating companies, there shouldn't be a problem.

If consolidated, however, Prospect Capital would only be able to report a portfolio company's reported net income in any given quarter. Since the companies' net income has been historically lower than the amount of interest and dividends paid to Prospect Capital, restated earnings would be lower.

Secondly, there's the issue of leverage. BDCs are limited to 1:1 leverage. Should the financials of its operating companies be consolidated into Prospect Capital's results, Prospect Capital will have significantly higher debt levels than reported today. In First Tower's case, there is roughly $272 million of additional, third-party debt that would have to be reported on the Prospect Capital balance sheet, which could affect its required 1:1 leverage limit imposed on BDCs.

The dizzying world of BDC accounting
The complexities of the current accounting methodologies make it difficult to understand the true profitability of Prospect Capital's operating companies.

This quarter, Nationwide Acceptance and Credit Central, two of Prospect Capital's operating companies, paid Prospect Capital dividends of $5 million and $2 million respectively. However, this same quarter, Prospect Capital invested a combined $6.5 million in the two companies.

The accounting as it exists today makes this a bit of a shell game to those looking in from the outside. Prospect loaned its portfolio companies $5.525 million, added $975,000 in equity, then paid itself dividends of $7 million.

Said another way, $6.5 million left Prospect Capital to go to Nationwide Acceptance and Credit Central. Then, $7 million came back to Prospect Capital (on the income statement) as a dividend. Of course, there are adjustments to the equity valuations likely as a result of the dividends paid, but the impact is murky at best.

Equity is valued with "unobservable inputs," and any adjustment to expected future business volumes, a change in unknown discount rates, or movement in default rates on Nationwide Acceptance and Credit Central's loan book, etc. could have just as much effect on the equity line as a dividend. 

Prospect Capital is appealing the SEC's request to consolidate its financials, so for now, it's just one giant waiting game.

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Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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