“Joint venture accounting: changes and challenges” by Martin C. Guantes (Jul 12, 2010)

SUITS THE C-SUITE By Martin C. Guantes
Business World (07/12/2010)

As projects get bigger and bigger, joint ventures are becoming more and more common in today’s business world.

However, for entities that plan to enter into joint ventures, management has to carefully review the proposed joint venture arrangements in light of Exposure Draft (ED) 9 on Joint Arrangements.

ED 9 is another step in the short-term convergence project between the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB). It is intended to replace International Accounting Standard (IAS) 31 on Interests in Joint Ventures and is expected to be issued sometime in the third quarter of 2010. It is intended principally to address two aspects of IAS 31 that are considered stumbling blocks to high-quality reporting of joint arrangements, i.e., that the form or structure of the arrangement primarily determines the accounting and that an entity has a choice of treatment — either proportionate consolidation or equity method — for accounting for “interests in jointly controlled entities.”

A joint arrangement is a strategic alliance involving the cooperative business agreement of parties, with each agreeing to share resources, risk, expertise, profit, loss or control. These are common in the extractive, construction, as well as real estate and property development industries where high costs and risks often lead entities to enter into risk-sharing arrangements.

To be clear, joint arrangements that are casually described as “joint ventures” do not always satisfy the definition of a joint venture under IAS 31. The key characteristics of a joint venture under IAS 31 are: the venturers are bound by a contractual arrangement and the parties undertake an economic activity that is subject to joint control.

IAS 31 identifies three broad forms of joint ventures, namely: jointly controlled operations (JCO), jointly controlled assets (JCA) and jointly controlled entities (JCE), and prescribes how each venturer should recognize the assets, liabilities, income and expenses of the joint venture.

The legal form of a joint venture determines its substance, classification and corresponding accounting. Thus, the economic substance of a JCA and a JCE may actually be similar, but the difference in the form of these joint ventures would require different accounting treatment for each type.

Instead of focusing on the legal form of the joint arrangement, ED 9 shifts the focus in accounting to the contractual rights and obligations within the joint arrangement. ED 9’s core principle is that the parties in a joint arrangement should recognize their contractual rights and obligations arising from the arrangement so that these rights and obligations, rather than the form (which is just one of the considerations), will dictate the accounting.

The IASB has tentatively decided that “joint operations” and “joint assets” (which ED 9 proposed to replace JCO and JCA, respectively) should be merged into a single type of joint arrangement called “joint operation.”

Meanwhile, ED 9 retains “joint venture” to describe joint arrangements that are subject to joint control and in which the parties have an interest only in a share of the outcome of the economic activities.

ED 9 proposes that every joint arrangement should be accounted for either as a joint operation or as a joint venture or a combination of both. ED 9 requires that each party should account for its own contractual rights and obligations and record the assets it controls.

This means, therefore, that many terms within the joint arrangement may comprise both a joint operation and a joint venture.

In such cases, each party must carefully analyze rights and obligations under the arrangement and determine which part of the arrangement constitutes joint operations and which part make up the joint venture, which is to be accounted for using the equity method.

As a result, it can happen that the parties to a joint arrangement may account for their respective interests differently.

By requiring the parties to recognize their contractual rights and obligations under the arrangement, ED 9 proposes to eliminate the option of proportionate consolidation for “joint ventures” because it can lead to the recognition of assets that are not controlled by, and liabilities that are not obligations of, the venturer. For example, a venturer could recognize cash which it could not spend without approval of other parties; or, a venturer could recognize liabilities for which it has no present obligation.

Also, proportionate consolidation can lead to an entity not recognizing its assets and liabilities. For instance, when the joint arrangement gives a party direct control over the assets and direct obligations relating to activities that are housed in a separate legal entity, these assets and liabilities should be recognized in the venturer’s financial statements.

However, if the venturer opted to account for such joint venture using the equity method, it does not recognize such assets and liabilities even though it has contractual rights and obligations relating to individual assets and liabilities of the joint arrangement.

These are but a few examples of how the option of either proportionate consolidation or equity method can lead to similar transactions being accounted for in different ways, which impairs comparability of the financial statements.

The complexity that ED 9 brings is the possibility that, in any one structure, there may be a number of different arrangements, each of which would need to be separately accounted for. For example, a mining company’s production sharing contracts and risk service contracts might involve a degree of joint control. A party to such arrangement has to assess whether it has: (1) a right to use the assets (i.e., a “joint operation”); or (2) a right to a share of the outcome generated by a group of assets and liabilities carrying on an economic activity (i.e., a “joint venture”). In the latter case, the party would account for its share in the arrangement under the equity method.

In line with this, it is expected that JCEs currently accounted for using proportionate consolidation will be the ones most affected; these will be accounted for under the equity method. On the other hand, it is expected that fewer JCEs that are currently equity-accounted will be joint operations.

What also adds to the accounting complexity is the proposed retrospective application of the new standard, which means that all comparative prior period financial statements presented will have to be restated.

Beyond understanding the new standard and revising the financial statements, it is imperative for management to assess the practical impact that a revised set of financial statements would have on other aspects of its business, such as in terms of the entity’s compliance with financial covenants, credit rating, accreditation or certification, or financial projections, especially those already announced to stakeholders.

For entities that are in the stage of entering into joint arrangements, management has to carefully review the joint arrangements, determine the required accounting and assess how this would affect the entity’s financial objectives and business plans.

(Martin C. Guantes is a Partner of SGV & Co.)

This article was originally published in the BusinessWorld newspaper. It is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.