Accounting for joint ventures moves closer to convergence: are financial statement users better off?
Joint ventures are an important tool for business expansion and collaboration. In a joint venture, two or more entities cooperate to create a new business organization. The following am some of the reasons for forming a joint venture:
* Easing entry into new technologies or markets (often necessary when entering markets with restrictions on foreign ownership)
* Benefiting from economies of scale in either joint research or production efforts
* Sharing, and consequently reducing, the costs and risks of efforts beyond the feasibility of the company
* Accessing resources and knowledge beyond the company's capabilities.
Joint ventures are established using a multitude of structures and legal forms. Exhibit I shows new joint venture formation activity worldwide between 1990 and 2010. The formation of joint ventures peaked in 1995 but has since declined. Two factors contributed to this decline: the reduction in regulations prohibiting foreign ownership in developing and developed countries, and the economic global downturn of recent years. Nonetheless, joint ventures are still viewed and used as integral tools for expansion and collaboration--for example, Burger King recently announced that it will use a joint venture in order to expand from 63 restaurants in China to more than 1,000.
Given the global importance of joint ventures, the achievement of convergence or close convergence of the accounting for joint ventures under IFRS and U.S. GAAP seems worthy of celebration by financial statement users. Unfortunately, the weight of academic research does not support the IASB's decision to require the equity method. More specifically, it has found that the use of proportionate consolidation is more beneficial than the equity method in predicting both future return on shareholders' equity and bond ratings. Although the IASB did eliminate the policy choice of accounting for joint ventures using proportionate consolidation, it also added new disclosure requirements for joint ventures through the issuance of IFRS 12, Disclosure of Interests in Other Entities. The key issue is whether the new disclosure requirements will offset the effect of eliminating proportionate consolidation; another issue is whether eliminating an accounting policy choice is a positive development.
The discussion below provides an overview of the accounting for joint ventures under U.S. GAAP and IFRS. A real-world example illustrates and compares the equity method with proportionate consolidation. Finally, the implications of the IASB's new guidance for users, preparers, auditors, and standards setters are discussed.
Accounting for Joint Ventures
The equity method and proportionate consolidation have been the two principal approaches to the accounting for joint ventures used under U.S. GAAP and IFRS, although proportionate consolidation is more prevalent under IFRS.
In general, under the equity method (referred to by some as one-line consolidation), the venturer's interest in the joint venture is initially recorded at cost as a one-line item, typically investments, on the venturer's balance sheet. Subsequently, the initial investment amount reported on the venturer's balance sheet is increased for the venturer's share of net income (or decreased for the venturer's share of a net loss) and decreased for any dividends received from the joint venture. In addition, the carrying amount is adjusted for changes in the investor's proportionate interest in the investee arising from changes in the investee's other comprehensive income. On the income statement, the venturer's share in the net income (or loss) of the joint venture is typically reported below operating income as a one-line item.
Under proportionate consolidation, in contrast, the venturer's proportionate share of each of the joint venture's assets, liabilities, revenues, and expenses is combined with the venturer's own similar assets, liabilities, revenues, and expenses, and this amount is reported in the venturer's consolidated financial statements.
Under both approaches, the effect of the joint venture on the venturer's net income and retained earnings is the same. The key difference between the two approaches lies in the level of aggregation or disaggregation reported in the venturer's financial statements. Compared with proportionate consolidation (i.e., disaggregation), the equity method's one-line consolidation approach (i.e., aggregation) has the effect of "netting out" information about the joint venture on the financial statements.
U.S. GAAP. As noted earlier, joint ventures are generally accounted for using the equity method under U.S. GAAP; however, exceptions to the general rule are possible, depending upon accounting policy election (fair value option), legal structure, and industry. With respect to structure, joint ventures can be organized through a separate entity or without an entity. When a separate entity is used, it can be either an incorporated (corporation) or unincorporated (partnership) entity. In the case of a corporation, Accounting Standards Codification (ASC) Topic 323, "Investments--Equity Method and Joint Ventures," clearly states that the equity method is required for corporate joint ventures unless the venturer has elected to measure the investment as a financial instrument at fair value under the fair value option.
EXHIBIT 1 Number of Worldwide Joint Ventures, by Year Year Number of Joint Ventures 1990 3,034 1991 5,193 1992 5,208 1993 6,139 1994 7,527 1995 8,044 1996 4,296 1997 5,540 1998 4,910 1999 5,043 2000 5,512 2001 3,759 2002 2,501 2003 2,362 2004 2,102 2005 2,538 2006 3,567 2007 3,962 2008 3,946 2009 742 2010 210 Source: IASB, http://www.ifrs.org/Alerts/ProjectUpdate/Documents/IFRS11 _Effectanalysis.pdf
In the case of a joint venture structured through an unincorporated entity, U.S. GAAP generally leads to the equity method; however, in certain specialized industries (e.g., construction and extractive), there are exceptions that allow proportionate consolidation. For a joint venture structured through a contractual arrangement and not involving an entity--in other words, involving jointly controlled assets and operations or undivided interests--the general rule is to apply proportionate consolidation. But there is an exception to this general rule: the use of the equity method is required in the real estate industry in situations where assets are jointly controlled. Exhibit 2 summarizes the accounting for joint arrangements under U.S. GAAP.
EXHIBIT 2 Summary of U.S. GAAP for Joint Arrangements Structure General Rule Exception Joint arrangement Equity method Elect fair value through a separate option entity, and the entity is a corporation Joint arrangement Equity method Construction or through a separate extractive industry entity, and the exception allows entity is proportionate unincorporated consolidation Joint arrangement not Proportionate Real estate joint structured through a consolidation ventures subject to separate vehicle joint control use equity method
IFRS. IFRS 11 replaces International Accounting Standard (IAS) 31, Interests in Joint Ventures, and is effective for fiscal years beginning on or after January 1, 2013. The IASB issued the new standard in response to two concerns with the previous guidance. First, under IAS 31, the structure of the arrangement was the only determinant of the accounting, resulting in potentially different treatments for similar circumstances. More specifically, in cases where a separate entity was not used--that is, under arrangements involving jointly controlled operations or jointly controlled assets--each venturer recognized its share of each asset, liability, revenue, and expense of the venture in its own financial statements (i.e., each used proportionate consolidation).
When a joint venture was structured through an entity that was jointly controlled, however, the venturer was given the choice of accounting for the venture using either proportionate consolidation or the equity method. This gave rise to the IASB's second concern: comparability of financial. statements. By giving venturers the choice of proportionate consolidation or equity when accounting for jointly controlled entities, arrangements that gave parties similar rights and obligations could potentially be accounted for differently, whereas arrangements that gave parties different rights and obligations could be accounted for in the same manner. Moreover. IAS 31 compounded the comparability problem, because once the choice of proportionate consolidation or the equity method was made, it required the same accounting for all interests in jointly controlled entities.
In order to address this concern, IFRS 11 define a joint arrangement as "an arrangement of which two or more parties have joint control." It then defines joint control as "the contractually agreed sharing of control of an arrangement, which exists only when decisions about the relevant activities (i.e. activities that significantly affect the returns of the arrangement) require the unanimous consent of the parties sharing control." Under [FRS 11, two types of joint arrangements exist: joint operations and joint ventures. Joint operations are arrangements "where the parties with joint control of the arrangement have rights to the assets, and obligations for the liabilities, relating to the arrangement." In contrast, a joint venture is a joint arrangement where the controlling joint venturers have rights to the net assets of the arrangement, rather than to the individual assets and liabilities.
Unlike under IAS 31, legal structure no longer drives classification of the arrangement under IFRS 11. Instead, it is principles-based, in that judgment is applied when assessing whether a joint arrangement is a joint operation or a joint venture. (For a discussion of principles-based standards, see Steven M. Mintz, "Ethics, Professional Judgment, and Principles-based Decision Making Under IFRS," The CPA Journal, January 2011, pp. 68-72.) Thus, in determining the classification of the arrangement. the venture needs to consider its rights and obligations from the arrangement. This requires consideration of the structure and legal form of the arrangement; the terms agreed upon by the parties in the contractual arrangement; and, when relevant, other facts and circumstances. In other words, the substance--not just the form--of the joint arrangement must be considered. Once the classification of the arrangement is determined, the accounting follows.
For arrangements classified as joint operations, IFRS requires venturers to recognize and measure the assets and liabilities (and related revenues and expenses) in relation to their interest in the arrangement, in accordance with the applicable IFRS guidance for the particular assets, liabilities, revenues, and expenses. On the other hand, the equity method must be applied for arrangements classified as joint ventures. The choice of electing proportionate consolidation is no longer available for such arrangements. Exhibit 3 summarizes the accounting for joint arrangements under IFRS.
EXHIBIT 3 Summary of IFRS for Joint Arrangements Structure General Rule Exception Joint arrangement through Equity method None a separate entity, and the separation is substantive Joint arrangement through Proportionate None a separate entity, and the consolidation separation is not (line-by-line accounting substantive of separate assets and liabilities) Joint arrangement not Proportionate None structured through a consolidation separate vehicle (line-by-line accounting of separate assets and liabilities)
In addition to following the accounting requirements of IFRS 11, venturers in joint ventures must follow the new disclosure requirements in IFRS 12. The purpose of these requirements is to provide financial statement users with an understanding of the nature of the risks associated with interests in other entities and the effects of those interests on financial position, performance, and cash flows. To achieve this, IFRS 12 requires that venturers present a list and description of investments in all joint arrangements that are material. The new disclosure requirements of IFRS 12 are more thorough and detailed than those of IAS 31. In particular, as shown in Exhibit 4, IFRS 12 requires significant additional information about the assets, liabilities, revenues, and expenses of the joint venture. Entities are also required to disclose summarized financial information for each material joint venture on a "100%" basis and reconcile to the carrying amount of their investment in the joint venture.
Closer convergence. The IASB has noted that IFRS 11. will result in closer convergence with U.S. GAAP., however, some differences will remain, due to U.S. GAAP's exceptions for certain industries and adherence to the legal form of the joint venture. One important consideration is Whether financial statement users will be able to make better decisions as a result of the change. More specifically, does the elimination of the proportionate consolidation election for joint venture accounting improve users' decision making? To address this question, the following section contrasts the two methods from a user's perspective.
Comparison of Proportionate Consolidation and the Equity Method
Academic research has examined the merits of and differences between financial statements using the equity method versus those using proportionate consolidation. In these studies, researchers typically use the note disclosures to convert financial statements from one method to the other. They then calculate various ratios from the financial statements and study the relationship between the ratios and the future performance or concurrent market measures of equity return or credit risk. The majority of these studies have found that financial statements prepared using proportionate consolidation are more relevant--that is, they are better predictors of or are more closely associated with market measures--than those prepared using the equity method.
To illustrate how the two methods impact financial ratios, the authors' examined the financial statements of the Serco Group, a FTSE 100 outsourcing company based in the United Kingdom, which provides a broad range of services globally to both public- and private-sector customers. Serco uses joint ventures extensively to supply specialized services in select locales, including prisoner escort services in the United Kingdom and garrison support services in Australia. Its interests in these joint ventures are reported in the financial statements, using the proportionate consolidation method.
Exhibit 5 compares the financial statements that Serco prepared by using proportionate consolidation, with the pro forma equity method financial statements created using Serco's joint ventures note. Serco's total assets, liabilities, revenues, and expenses are higher under proportionate consolidation, with Serco's sham of each of the joint venture financial statement items being added on a line-by-line basis to Serco's financial statements. In contrast, under the equity method, the net investment in joint ventures is presented as a single-line, noncurrent asset item on Serco's balance sheet, and Serco's sham of its joint ventures' net income is displayed as a single-line item (investment revenue) on its income statement Both methods produce the same shareholders' equity and net income.
The financial ratios highlight the financial statement differences between the proportionate consolidation and equity methods. While return on equity is the same under the two methods, its decomposition reveals meaningful differences. Profit margin (net income/revenue) appears superior wider the equity method (.046), as opposed to the ratio under proportionate consideration (.038). Rather than combining Serco's joint venture revenues of [pounds sterling]819.3 million with its consolidated revenues, as is done under proportionate consolidation, joint venture revenues are included net of expenses in investment revenue under the equity method. In spite of the same reported net income, the lower revenues under the equity method drive the profit margin higher, even though no real profitability difference exists. Although the equity method reports joint venture profits, it fails to separately report the joint venture revenues that generated those profits.
The total asset turnover ratio (revenue/total assets) is also affected by the method applied, falling from 1.46 under proportionate consolidation to 1.35 under the equity method. Both revenue and total assets are greater under proportionate consolidation than under the equity method. Under the equity method, Serco's joint venture revenue is reported, net of expenses, as [pounds sterling]63.6 million in investment revenue, and its joint venture assets are presented, net of liabilities, as an investment of [pounds sterling]38.6 million. The apparent worsening of Sego's ratio under the equity method is due to its joint ventures having a better total asset turnover (2.0) than the rest of the company. This ratio will rise under the equity method when joint venture assets produce relatively fewer revenues than the venture as a whole. Due to the equity method's aggregation approach, the asset turnover ratio of the consolidated company fails to properly reflect the contributions of its joint ventures.
As long as a joint venture holds some debt, the leverage ratio (total assets/shareholders' equity) will always be lower under the equity method, suggesting a less levered company. As indicated previously, Serco's joint venture assets of [pounds sterling]390 million are presented net of its joint venture liabilities of [pounds sterling]351.4 million as an investment asset of [pounds sterling]38.6 million. This reduces reported total assets and, with shareholders' equity unchanged. triggers a substantial drop in Serco's leverage ratio from 3.17 to 2.82 under the equity method. A difference of this magnitude will likely gain the attention of analysts and ratings agencies. Regardless of whether Serco is legally responsible for the debts of its joint ventures, Serco's reputation would clearly suffer if one of its joint ventures was unable to satisfactorily service its debt. The financial statements under proportionate consolidation better reflect this responsibility.
The operating profit margin (operating profit/revenue) is particularly interesting to analysts because it focuses on the pretax profitability of a company's core business activities. Fundamentally, proportionate consolidation considers joint venture revenues and profits as integral to the company as a whole. In contrast, the equity method deems joint ventures as separate, noncom business activities. Serco's reported operating profits drop from [pounds sterling]266.2 million (under proportionate consolidation) to [pounds sterling]184.6 million (under the equity method), with the operating profit ratio plunging to .048 from .057 under proportionate consolidation. Serco's joint ventures produce an operating profit margin of .099, with [pounds sterling]81.6 million in operating profits on [pounds sterling]819.1 million in revenues--a margin that far exceeds the .048 margin of the rest of the company.
Liquidity ratios are also affected by the method used to incorporate joint ventures in consolidated financial statements, with the direction and magnitude of the effect depending on the liquidity characteristics of the joint ventures relative to the company. Serco's current ratio (current assets/current liabilities) decreases from 1.06 under the proportionate consolidation method to 1.04 under the equity method. This apparent deterioration in liquidity results from relatively liquid joint ventures being detached and reported separately as a noncurrent investment under the equity method. The equity method segregates Serco's joint ventures that have a current ratio of 1.24 from the remainder of the company, as if joint venture cash was unavailable to Servo to meet its current obligations. This view contrasts with Serco's actual practice of withdrawing 100% of joint venture profits as cash dividends.
As the above analysis shows, many of the commonly used financial ratios that rely on less aggregated financial statement items will differ under the proportionate consolidation and equity methods, even though net income and stockholders equity will remain the same under both. This could lead to differing, or even incorrect, interpretations if a financial statement user is unaware of the effect that these methods have on the reported results. In the case of Serco, the disclosures presented under IAS 31's requirements enabled this comparative analysis.
Additional information on Serco's joint ventures would further facilitate the analysis. Assuming Serco concludes that these arrangements are joint ventures, as defined under IFRS 11, the company will have to switch from proportionate consolidation to the equity method. Furthermore, the new disclosures required by IFRS 12 should permit a more detailed analysis, which would provide a better understanding of the joint ventures' effect on Serco.
For businesses that are involved in joint ventures, academic studies suggest that proportionate consolidation provides more useful information than the equity method. Nonetheless, the IASB eliminated proportionate consolidation as a choice in the accounting for joint ventures. The result moves IFRS closer to convergence with U.S. GAAP. Presumably, because U.S. GAAP only allows proportionate consolidation in limited and specific settings, this will assist users by improving the comparability of financial statements on a global basis; however, comparability comes at a cost in this case, eliminating an approach that provides more useful financial statement information. Cognizant of this, the IASB has provided for additional and enhanced disclosures with respect to investments in joint ventures.
The key question is whether the improved information provided by the enhanced disclosures will outweigh the information lost as a result of the elimination of proportionate consolidation. Data that will help to answer this question will be available starting in 2014, when financial statements prepared for the 2013 calendar year become available. If the answer is yes, the enhanced disclosure outweighs lost information previously provided by proportionate consolidation: comparability will be improved with no reduction in information. If the answer is no, then both the IASB and FASB should reconsider whether the equity method is truly the appropriate choice for the reporting of investments in joint ventures.
EXHIBIT 5 Comparison of Serco's 2011 Financial Statements Proportionate Consolidation versus Equity Method (All figures in millions of pounds [[pounds sterling]]; JV = joint venture) Proportionate Consolidation Serco's 12/31/12 Balance Sheet Current assets 1,129.0 Noncurrent assets 2,053.1 Total assets 3,182.1 Current liabilities 1,061.6 Noncurrent liabilities 1,116.7 Shareholders' equity 1,003.8 Liabilities plus equity 3,182.1 Serco's 2012 Income Statement Revenues 4,646.4 Operating profit 266.2 Investment revenue 12.2 Finance costs and taxes (103.2) Net income 175.2 Key Financial Ratios Return on equity .175 Profit margin .038 Total asset turnover 1.46 Leverage 3.17 Operating profit margin .057 Current ratio 1.06 Equity Method Serco's 12/31/12 Balance Sheet Current assets (1,129.0 - 955.4 171.6 JV current assets) JV investment (390.0 JV 38.6 assets - 351.4 JV liabilities) Other noncurrent assets 1,834.7 (2,053.1 - 218.4 JV noncurrent) Total assets 2,830.7 Current liabilities (1,061.6 - 138.9 922.7 JV current liabilities) Noncurrent liabilities (1,116.7 - 904.2 212.5 JV noncurrent) Shareholders' equity 1,003.8 Liabilities plus equity 2,830.7 Serco's 2012 Income Statement Revenues (4,646.4 - 3,827.1 819.3 JV revenues) Operating profit (266.2 - 81.6 184.6 JV operating profit) Investment revenue (includes 73.1 63.6 JV net income) Finance costs and taxes (82.5) (103.2 - 20.7 JV taxes) Net income 175.2 Key Financial Ratios Return on equity .175 Profit margin .046 Total asset turnover 1.35 Leverage 2.82 Operating profit margin .048 Current ratio 1.04
RELATED ARTICLE: EXHIBIT 4 Financial Statement Line-Item Disclosures for Joint Arrangements under IFRS
Old Disclosures (IAS 31)
* Current assets
* Long-term assets
* Current liabilities
* Long-term liabilities
New Disclosures (IFRS 12)
* Current assets
* Noncurrent assets
* Current liabilities
* Noncurrent liabilities
* Profit or loss from continuing operations
* Posttax profit or loss from discontinued operations
* Other comprehensive income
* Total comprehensive income In addition, for each joint venture that is material to the reporting entity, the following must be disclosed:
* Cash and cash equivalents, included in current assets
* Current financial liabilities (excluding trade and other payables and provisions) included in current liabilities
* Noncurrent financial liabilities (excluding trade and other payables and provisions) included in noncurrent liabilities
* Depreciation and amortization
* Interest income
* Interest expense
* Income tax expense
Luis Betancourt, PhD, CPA, is an associate professor of accounting at James Madison University, Harrisonburg, Va.
Charles. P. Barg PhD, CPA, is a professor of accounting and the Frank & Company Faculty Scholar, also at James Madison University.
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|Title Annotation:||international accounting|
|Author:||Betancourt, Luis; Baril, Charles P.|
|Publication:||The CPA Journal|
|Date:||Feb 1, 2013|
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