“Judgement in accounting for joint arrangements (part 1)” by Martin C. Guantes (September 26, 2011)
SUITS THE C-SUITE By Martin C. Guantes
Business World (09/26/2011)
First of two parts
The International Accounting Standards Board (IASB) recently issued a new standard — IFRS (International Financial Reporting Standards) 11 Joint Arrangements — which takes effect for annual periods starting Jan. 1, 2013.
IFRS 11 replaces Interests in Joint Ventures (IAS 31) and SIC (Standard Interpretations Committee) 13 Jointly Controlled Entities — Non-Monetary Contributions by Venturers.
The Philippine Financial Reporting Standards Council and the Securities and Exchange Commission have adopted IFRS 11. Entities most likely affected by changes include those that operate in construction, real estate, oil and gas or mining industries which commonly participate in joint arrangements.
A “joint arrangement” is defined in IFRS 11 as a contractual arrangement in which two or more parties have joint control.
The scope of IFRS 11 remains the same despite the change in the standards’ title from “joint ventures” to “joint arrangements” that might suggest otherwise. The term, “joint venture,” is commonly used in practice; however, it is narrowly defined by IFRS 11 as just one of two types of joint arrangements.
The key difference between IFRS 11 and IAS 31 lies in the question of what drives accounting for arrangements between two or more parties. In IAS 31, accounting is driven solely by the legal form of the entity through which arrangements were structured. On the other hand, in IFRS 11, accounting is driven by the core principle that parties should recognize their rights and obligations — either as rights to assets and obligations for liabilities or right to net assets arising from arrangements.
In essence, IFRS 11 ensures that the economic substance of the arrangement is properly reflected in accounting. Thus, the assessment of accounting is required to extend beyond the legal structure and well into the nature of rights and obligations under the arrangements.
When analyzing their arrangements with other parties, there are two main aspects on which entities are expected to focus their assessment: (1) whether they control or jointly control an arrangement, and (2) assessment of the nature of their rights and obligations arising from the arrangements.
The first aspect determines whether an arrangement is within or outside the scope of IFRS 11, while the second aspect determines the classification of the joint arrangement.
Is it a joint arrangement?
The initial step is for entities to assess whether their arrangements fall within the scope of IFRS 11. The question is whether there is joint control.
The term, “control,” in “joint control” is based on the new definition of control in a new standard, IFRS 10 Consolidated Financial Statements, which was issued by IASB together with IFRS 11 and IFRS 12 Disclosure of Interests in Other Entities, and similarly presents areas of significant judgment.
A different conclusion as to whether the arrangement is jointly controlled could then arise from this new definition.
IFRS 10 provides that an investor controls an investee when it is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee.
In many instances, it is clear that whoever holds a majority of voting rights controls the investee, particularly when decision making is controlled by voting rights, and such voting rights entitle an entity to returns.
In other instances, however, it may not be clear, and further analysis is needed. Each of the factors in the above definition of control needs to be considered in more detail to determine which investor controls an investee, if any.
Joint control is defined in IFRS 11 as “the contractually agreed sharing of control of an arrangement which exists only when the decisions about the relevant activities require the unanimous consent of the parties sharing control.”
Given this definition, the key aspects of joint control, which may require judgment in assessment, are: (1) contractually agreed, (2) control and relevant activities, and (3) unanimous consent.
For instance, it is the norm that contractual arrangements are — but not always — written and such written agreement provides the terms of arrangement.
However, there are instances when only general terms or principles are agreed on, but no specific terms that could help in assessing whether there is joint control.
In assessing joint control, entities also have to familiarize themselves with new rules in IFRS 10, which describe how to assess whether a party has control, and how to identify relevant activities.
Meanwhile, unanimous consent exists when the parties to an arrangement have collective control over the arrangement and no single party has control. In the same vein, contractual arrangements may not always be explicit to sufficiently demonstrate existence of unanimous consent.
Furthermore, it is not always clear at what level (i.e., the unit of account) to assess a joint arrangement to determine whether joint control exists.
In several instances, it is at the contract level where the assessment may be made, although some contracts may contain more than one joint arrangement.
In such a case, each arrangement within the contract must be assessed.
For example, a master agreement may contain terms and conditions for numerous entities and/or numerous activities that may each constitute a joint arrangement. This is particularly relevant to the real estate and construction industries, where long-term contracts may comprise several joint arrangements that may be classified as either joint ventures or as joint operations.
Only if all requirements for joint control are present would the arrangement be considered a joint arrangement. Otherwise, the arrangement falls outside the scope of IFRS 11 and should be accounted for according to appropriate standards.
In the second part of this article, we will look into the steps and issues with regard to classifying joint arrangements.
(To be concluded on Oct. 3.)
(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.