“Judgement in accounting for joint arrangements (part 2)” by Martin C. Guantes (October 3, 2011)
SUITS THE C-SUITE By Martin C. Guantes
Business World (10/03/2011)
In last week’s article, we introduced the recently issued accounting standard, Joint Arrangements (International Financial Reporting Standards, or IFRS 11), which takes effect for annual periods beginning on or after Jan. 1, 2013.
We discussed factors that should be considered in determining whether a joint arrangement is present. Once that is determined, we can now look at classifications for joint arrangements.
In general, joint arrangements may be equity-based or non-equity-based.
An equity-based joint arrangement benefits public/private/special interest groups. A non-equity joint arrangement — also known as cooperative agreement — is one in which the parties seek, for example, technical services, management contracts, rental agreements, brand or franchise use, or one-time construction contracts.
Joint venture or joint operation?
Once a joint arrangement is identified, it is then classified as either a joint venture or a joint operation.
However, entities would need to exercise judgment to determine whether a joint arrangement’s legal form, contractual terms and facts and circumstances give parties either (1) rights to net assets of the arrangement (i.e., a “joint venture”), or (2) rights to assets and obligations for liabilities of the arrangement (i.e., “joint operation”).
Indeed, unlike in IAS 31 where structure or legal form of a joint arrangement was the sole factor in determining appropriate accounting, IFRS 11 focuses more on the nature and substance of rights and obligations arising from the arrangement — structure is only one of the elements to be considered.
If a joint arrangement is not structured through a separate vehicle, it is a joint operation.
If it is so structured, the entity should further assess whether the legal form of the separate vehicle, terms of the contractual arrangement and/or other facts and circumstances (e.g., commitments, restrictions, finance, guarantees and responsibilities), extend to the parties’ rights to the assets, and obligations for the liabilities, of the arrangement.
Should this be the case, the arrangement also qualifies as a joint operation; otherwise, such an arrangement may be considered a joint venture.
Joint venturers still have to assess whether such joint arrangements, especially those that are not equity-based, qualify as joint ventures as defined in IFRS 11.
Joint venturers will use the equity method, as the International Accounting Standards Board eliminated the option of proportionate consolidation.
A joint operator will recognize its share of assets, liabilities, revenues and expenses and/or its share of those items, if any. Joint venturers would then have to change their accounting, depending on facts and circumstances surrounding their arrangements.
Many jointly controlled entities are expected to be classified as joint ventures, although careful assessment is needed, depending on facts and circumstances of each case.
It is possible that a jointly controlled entity might now be classified as a joint operation. In many cases, accounting for a joint operation might look similar to proportionate consolidation.
Entities that currently use proportionate consolidation for jointly controlled entities should not automatically assume that they will have to switch from the equity method.
They should first confirm whether their joint arrangement will qualify as a joint operation or a joint venture under the new standard. Sufficient care should be exercised in the assessment since a shift from proportionate consolidation to equity method may require changing the entities’ performance metrics (e.g., revenues might decrease and, if so, income and assets and liabilities would be collapsed into one net line item in the income statement and the balance sheet).
In accounting for their rights and obligations under IFRS 11, entities should exercise appropriate level of care. Although guidance is provided, this new standard requires more time, effort and exercise of considerable judgment than was required under the previous standard, because it removed some of existing “bright lines.”
Accounting personnel are unlikely to be in a position to make such judgments alone and will require input from other sources such as operations personnel and legal counsel.
Management should be closely involved in this assessment, and entities may also wish to bring in their audit committees and independent auditors to discuss areas of material judgment and document key discussions.
Management should plan accordingly and begin this process early, as assessment and monitoring of the impact of the new standard require substantial management involvement and coordination.
There is a need to analyze thoroughly contractual arrangements, develop robust accounting policies, modify performance metrics and debt covenants, and revise or enhance systems and processes to address the change in standard.
These are essential in order to make the appropriate judgments and to provide needed information to comply with new disclosure requirements.
(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.