ED 9 Joint Arrangments
Reaction towards the proposed changes in ED 9 would suggest that the International Accounting Standards Board should give greater consideration to the amendments it wishes to make to joint venture accounting, argues Fergus Condon.
One could be reminded of the saying ‘from little acorns, big oak trees grow’ when following the progress of ED 9 from first publication up to the closure of the comment period which occurred on 11 January last. The objective of the change was to remove one of the alternative accounting treatments in IAS 31 Interests in Joint Ventures and thus reach another milestone on the road to convergence with US GAAP. When the ED was published it appeared as though that objective would be achieved without much opposition; not so when the constituents affected by the subject began writing their comment letters!
So what does ED 9 say?
The ED establishes the core principle that parties to a joint arrangement are to recognise their contractual rights and obligations on the basis of the substance of those contractual rights and obligations arising under a joint arrangement rather than the arrangement’s legal structure. The three types of arrangement identified are substantively the same as those outlined in IAS 31 though there have been changes to the definitions and terminology.
ED 9 defines a joint arrangement as a contractual agreement whereby two or more parties undertake an economic activity together and share decision-making relating to that activity. Such joint arrangements are to be classified as joint operations, joint assets or joint ventures, based on the substance of the contractual rights and obligations.
‘Joint operation’ (previously a jointly controlled operation) is one in which the parties to the arrangement use their own assets and other resources and share revenues and expenses incurred in common in undertaking an activity. As each party controls its own assets and incurs its own obligations, it accounts for those assets and liabilities in accordance with applicable IFRSs, together with its share of revenue and expenses from activities.
A ‘joint asset’ (referred to as a jointly controlled asset in IAS 31) is an asset to which each party has rights, often with joint ownership. Each party takes a share of the output from and shares the costs of operating the asset. Each party recognises its share of the joint asset in accordance with applicable IFRS; say IAS 16 Property, Plant and Equipment, and liabilities it incurs, together with its share of any liabilities incurred jointly with the other parties, revenue from the sale of its share of the output of the asset and expenses incurred in respect of its interest in the joint arrangement.
‘Joint venture’ (known as a jointly controlled entity in IAS 31) is an arrangement that is jointly controlled by venturers arising from a contractual agreement to share the power to govern the operating and financial policies of the venture to obtain benefits. In such an arrangement, venturers do not have rights to individual assets or obligations for expenses of the venture; instead each party shares in the outcome of the activity. Joint ventures are to be accounted for using the equity method of accounting, thus proportionate consolidation will no longer apply.
Loss of control
The ED 9 approach to loss of control of a joint venture is based on the upcoming changes to IAS 27 Consolidated and Separate Financial Statements. Where joint control is lost and the investment does not become an associate, any retained investment is measured at fair value. The gain or loss on the loss of control is then calculated as the difference between:
a. The sum of the fair value of the interest retained and the proceeds from the interest disposed of; and
b. The carrying value of the interest in the joint venture.
In such circumstances, any amounts included in the other comprehensive income or another component of equity in relation to the joint venture are to be recognised on the same basis as if the joint venture had disposed of the related assets and liabilities directly.
Any amount that, as a result, is taken to profit or loss is a reclassification adjustment per the revised IAS 1 Presentation of Financial Statements.
For the IASB to suggest that adoption of ED 9 would result in convergence with US GAAP is not strictly true. Under the US framework, companies in the construction and extractive industries are permitted to use proportionate consolidation where there is a long-standing practice of its use in these industries.
Unless the FASB eliminates proportionate consolidation entirely, these are two key industries where convergence will not be achieved.
Whilst the removal of proportionate consolidation may achieve convergence in some respects, the question arises as to whether use of the equity method will provide more meaningful information. Indeed, one of the criticisms of the ED is that it does not clearly justify the appropriateness of the use of the equity method of accounting over proportionate consolidation.
Sir David Tweedie has in the past publicly indicated that he does not consider equity accounting to be a method of reporting which usefully reflects the manner in which such investments are managed or provide a return to their investors. Whilst it may be a number of years before equity accounting is replaced by a better method of reporting, is it right to remove proportionate consolidation in order to achieve partial convergence?
Many of the constituents, particularly those in the extractive industries, in their comment letters have indicated that they feel that proportionate consolidation provides greater transparency of the results and net assets of their joint arrangements.
Furthermore, it is reflective of the way in which they manage their investments in business ventures. For such companies, this will mean preparation of two types of financial information for joint ventures; one which reflects management’s view of the business and another for the public presentation of the financial information arising from equity accounting. There is an obvious cost associated with changes in systems required to gather such information and restatement of prior year data.
The Board have indicated that relevance of information is a high priority when it comes to developing sound accounting principles for a global market place. The principles of IFRS 7 Financial Instruments:
Disclosures and IFRS 8 Operating Segments which require information to reflect the way in which management view results and manage risks within the business supports the Board’s wish for increased relevance of financial information. Approval of ED 9 in its current format would certainly detract from this position. It is, of course, one of the consequences of developing accounting standards before a sound conceptual framework has been put in place.
The reaction towards the proposed changes in ED 9 would suggest that the Board should give greater consideration to the amendments it wishes to make to joint venture accounting. Whilst roundtable discussions with preparers of financial statements might slow up the completion of a final standard, it would probably ensure a better end product. Thus, it remains to be seen whether the future of reporting interests in joint arrangements will be influenced more by the need to make progress on the road to convergence or by the goal of wanting to develop IFRSs which result in useful and relevant information.
Fergus Condon is Director of the Financial Reporting Advisory Group at Ernst & Young.