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Decision usefulness of alternative joint venture reporting methods.

SYNOPSIS: Depending on the country and circumstances, reporting rules for intercorporate investments may require the cost method, the equity method, proportionate consolidation, or full consolidation, and may yield dramatically different accounting numbers. In the post-Enron environment there is a particular focus on investments for which liabilities remain off balance sheet. We compare the information content of alternative accounting treatments for a sample of Canadian firms reporting joint ventures under proportionate consolidation. We restate their financial statements using the equity method, and we compare the information content of the two accounting methods in predicting accounting return on common shareholders' equity. We find evidence consistent with the view that financial statements prepared under proportionate consolidation provide better predictions of future return on shareholders' equity than do financial statements prepared under the equity method. We conclude that, for these firms, proportionate consolidation provides information with greater predictive ability and greater relevance than does the equity method.

INTRODUCTION

Intercorporate investments in the form of joint ventures have increased considerably over the past 20 years. Firms in many industries partner to share risks, to share capital costs, and to generate synergy between companies. Examples include process technologies, production capacity, distribution networks, and access to raw materials. In particular, international joint ventures represent an increasingly attractive way to expand into foreign markets while minimizing political and economic risks like expropriation and currency shocks inherent in international business activities (Goldberg and Wolf 1993; Freedman 1996). The prescribed accounting treatment for joint ventures varies across nations, with two principal alternatives in wide use: (1) the equity method, required in some or all situations in the United States, the United Kingdom, Australia, and New Zealand; and (2) proportionate consolidation, required in Canada and preferred by International Accounting Standards (1AS No. 31) and continental countries in the European Union.

This study provides evidence relevant to the decision-usefulness of joint venture accounting by analyzing joint venture reporting of Canadian firms over the period 1995-2001. Specifically, we compare the predictive ability of venturer financial statements prepared under proportionate consolidation (reported) with financial statements prepared under the equity method (restated). The Financial Accounting Standards Board's (FASB 1990) Conceptual Framework identifies predictive value as a characteristic of relevance that, along with reliability, makes information useful for economic decisions. Our results indicate that financial statements for firms with joint ventures prepared under proportionate consolidation provide better predictions of future profitability than under the equity method.

While joint ventures are one type of intercorporate investment whose use is growing, the underlying accounting issues are common to other investment types currently reported under the cost, equity, or consolidation methods. Hence, in addition to providing evidence on the predictive ability of alternative accounting methods for joint ventures, this study suggests the importance of research on alternative accounting methods for other types of intercorporate investments.

ACCOUNTING FOR INTERESTS IN JOINT VENTURES

Accounting for interests in joint ventures varies, as many countries require the equity method, at least in some circumstances. Under the equity method, the venturer's net investment in the joint venture is shown as a single line item on the venturer's balance sheet. Similarly, the venturer's share of the joint venture's net income or loss appears as a single line item on the venturer's income statement. In Canada, the equity method is not acceptable and proportionate consolidation is required. Under proportionate consolidation, the venturer's share of each of the joint venture's financial statement items is combined on a line-by-line basis with its counterpart in the venturer's financial statements, thereby eliminating the need for the equity method's single line items.

Figure 1 provides a numerical illustration of the differences between proportionate consolidation and the equity method. In the illustration, Partner Ltd. is assumed to be a 40 percent partner in the joint venture JV Inc. Partner's financial statements are prepared first under proportionate consolidation and then under the equity method. Partner's assets and liabilities are both higher under proportionate consolidation than under the equity method, but shareholders' equity is the same under both methods. Similarly, Partner's revenues and expenses are higher under proportionate consolidation, but both methods produce the same net income (loss).

In a recent G4+1 report, Milburn and Chant (1999) conclude that the equity method is the more appropriate method for accounting for interests in joint ventures, primarily because jointly controlled assets and liabilities do not meet the control criterion required for full consolidation with the venturer. (1) Milburn and Chant (1999) note that a single venturer in a joint venture cannot control (that is, use or direct the use of) its pro rata share of joint venture assets. Because financial statements prepared under proportionate consolidation report the pro rata shares of joint venture assets and liabilities as the venturer's assets and liabilities, Milburn and Chant (1999) argue that such reporting is inappropriate.

Similarly, they argue that it is "wrong in principle for a venturer enterprise to reflect a pro rata share of a joint venture's debt that is not a present obligation of the venturer enterprise" (Milburn and Chant 1999, 3.13), although they agree that joint venture debt for which the venturer is contingently liable is an exception. As with any other contingent liability, the venturer should disclose the contingency and/or record a provision, depending on the probability that the venturer will have to assume this debt.

Proponents of proportionate consolidation argue that the equity method can present a misleading image of the venturer's financial position and performance. Bierman (1992), for example, suggests that joint venture debt is relevant even if the venturer is protected from the debts of the joint venture. Using a Modigliani and Miller (1958) analysis, Bierman (1992) concludes that ventures financed by different levels of debt create different returns to venturers because of the savings from the tax deductibility of interest. The equity method may present, inappropriately, levered and unlevered ventures as equivalent investments. Moreover, under proportionate consolidation, firms cannot use joint ventures to keep liabilities off the balance sheet (Freedman 1996; Bailey 2001).

A third alternative is to allow firms to choose their reporting method. At overlapping times within the past 30 years, both Canada and Australia allowed venturers to choose between some form of the equity method and proportionate consolidation. WhiRred and Zimmer (1994) found evidence that venturers in the Australian extractive and real estate industries tended to choose the method that provided the most relevant information to joint venture debt holders, suggesting that the ability to choose a reporting method decreases contracting costs. Both Canada and Australia have since eliminated the ability to choose. Canadian standard setters in particular were uncomfortable with what they considered to be unjustified alternative accounting methods (Willett 1995), as discussed next.

The Canadian Experience with Joint Venture Accounting

The history of joint venture accounting in Canada illustrates many of the issues raised in the prior section. Prior to 1974, Canadian GAAP required venturers to use the equity method to report their interests in joint ventures. Ludwick and Simpson (1973) describe the case of Fairview Corporation, a Canadian real estate firm that held significant investments in joint ventures. Fairview's management argued that accounting for these investments using the equity method could result in significant understatement of the company's cash and other assets. To overcome these perceived deficiencies, Fairview's management opted in 1972 for side-by-side dual presentation of the firm's financial statements; one column used the equity method for joint venture interests and the other column reported proportionate consolidation of the joint venture interests. Interestingly, the external auditors' report included separate, clean opinions for each set of financial statements.

The Canadian Institute of Chartered Accountants (CICA) began studying the question of investments in joint ventures in 1974 and in September 1974 began allowing the use of proportionate consolidation for corporate joint ventures. In 1977, new Section 3055 was added to the CICA Handbook specifically allowing firms to use either the equity method or proportionate consolidation to account for interests in corporate or unincorporated joint ventures (Mulcahy 1977).

A number of factors prompted the CICA to reconsider joint venture accounting in the early 1990s (Willett 1995). First, the number of joint ventures, both domestic and international, increased significantly from 1970 to 1994. Second, the CICA Accounting Standards Board found that some companies used proportionate consolidation to report interests in some joint ventures and the equity method to report interests in other similar joint ventures. The Board believed that such reporting was evidence of unjustified alternative accounting methods. Third, according to the Ontario Securities Commission, companies had trouble applying Section 3055, particularly with respect to the recognition of gains and losses on the transfer of assets to a joint venture. The Ontario Securities Commission asked the CICA to provide some additional guidance. Finally, the International Accounting Standards Committee published LAS No. 31, Financial Reporting of Interests in Joint Ventures, in January 1991. IAS No. 31 recommended the use of proportionate consolidation to account for investments in jointly controlled entities.

In 1994, the CICA revised Section 3055 to require the use of proportionate consolidation. Revised Section 3055 also requires the venturer to disclose the following information related to its interest in joint ventures:

(1) current assets and long-term assets;

(2) current liabilities and long-term liabilities;

(3) revenues, expenses, and net income;

(4) cash flows resulting from operating, financing, and investing activities; and

(5) the venturer's share of any contingencies and commitments when the venturer is contingently liable for the other venturers' shares of the joint venture's liabilities (CICA 2000).

In practice, the extent of joint venture disclosure among Canadian from varies widely. An example of one of the more detailed disclosures, from the 2000 financial statements of Armbro Enterprises, appears in the Appendix.

A SAMPLE OF VENTURERS USING PROPORTIONATE CONSOLIDATION

We began with an initial sample of 158 companies from the 1999 Standard & Poor's Disclosure file of Canadian company financial statements whose financial statements include the keywords "proportionate consolidation." Eighty of these either did not report joint ventures or did not report specific data. The remaining 78 provided disclosures about a joint venture during the 1995-2001 period. We collected the venturers' financial statement information and footnote disclosures on their joint ventures for the 1995-2001 period from either the Disclosure file or the System for Electronic Document Analysis and Retrieval (SEDAR, http://www.sedar.com/), that contains filings with the Canadian Securities Administrators that are accessible to the public via the web.

Distribution of Joint Ventures across Industries

Figure 2 shows the 78 venturers categorized by two-digit SIC code industry. The lightly shaded bars in Figure 2 show the total number of sample finns in each industry. The venturers are distributed across eight of the nine industries identified by the U.S. Department of Commerce; the Retail Trade industry is the lone exception. The Mining, Manufacturing, and Transportation and Public Utilities industries have the most firms represented in the sample (13, 25, and 14). The darker shaded bars in Figure 2 show the average number of joint ventures per venturer within each industry that could be specifically identified in the venturers' notes. Firms in the Mining and Finance, Insurance, and Real Estate industries have the highest average number of joint ventures (15 and 6). Within the Mining industry, oil and gas firms report the most joint ventures, mainly related to oil and gas exploration and development, and pipelines. Real estate firms within the Finance, Insurance, and Real Estate industry have many joint ventures related to land development and project management.

[FIGURE 2 OMITTED]

The Effect of Joint Ventures on the Venturers' Financial Statements

This section compares proportionate consolidation financial statements to equity method financial statements. The equity method presents an investment at its net book value on the venturer's balance sheet, equal to the venturer's share of joint venture assets less the venturer's share of joint venture liabilities. We can create proforma equity method balance sheets from proportionate consolidation balance sheets by subtracting joint venture liabilities from the venturer's total assets and from the venturer's total liabilities. Similarly, on the venturer's income statement, the equity method presents the income from the joint venture at its net amount, the venturer's share of joint venture revenues less the venturer's share of joint venture expenses. We create equity method income statements from proportionate consolidation income statements by eliminating joint venture revenues and expenses, and adding the difference between joint venture revenues and expenses to the venturer's other revenues and expenses. (2) Figure 3 illustrates the procedure for converting proportionate consolidation balance sheets and income statements to the equity method.

Table 1 reports the effect on the venturers' financial statements of converting from proportionate consolidation to the equity method. On average, the conversion reduces assets (liabilities) by 7.35 percent (14.18 percent). The conversion does not affect net income or loss, but on average, sales (expenses) are reduced by 13.5 percent (11.96 percent). Because the median effects are somewhat smaller, there are some very large individual effects. For example, at the 25th percentile, conversion to the equity method reduces total assets only 0.86 percent, while at the 75th percentile, total assets are reduced by 9.25 percent and liabilities, sales, and expenses by more than 15 percent.

Table 2 indicates that 79.3 percent (83.2 percent) of joint ventures reported positive earnings (cash flow) over our examination period. Further, 84.9 percent (87.2 percent) of venturers reported positive overall income (cash flow). Investing cash flows are typically negative both for the joint ventures, and the venturers while financing cash flows are generally positive. The extent of disclosure varies across firms with more firms reporting joint venture earnings (308) than joint venture cash flows (279).

Thus, the average joint venture generates positive earnings and operating cash flows and, therefore, boosts reported earnings and operating cash flows for the venturers. Further, average cash flows from investing activities are negative and cash flows from financing activities are positive, suggesting the joint ventures are ongoing investments for the venturers. Next we examine how financial statement differences affect financial ratios, and the extent to which those differences affect predictions of future ratios.

PREDICTIVE ABILITY: PROPORTIONATE CONSOLIDATION VERSUS THE EQUITY METHOD

Research Design

This study uses the well-known DuPont Model, which disaggregates the rate of return on common shareholders' equity (ROCSE) as follows:
TABLE 1

Effect of Conversion to the Equity Method on Ventures' Financial
Statements (a)

                                   n          Mean          25%

Difference in total assets        309       -$161,016     -$4,085
Difference as a percentages
  of reported assets                          7.35%        0.86%
Difference in total
  liabilities (b)                 309       -$161,016     -$4,085
Difference as a percentages
  of reported liabilities                    14.18%        2.05%
Difference in total sales         309       -$125,574     -$6,021
Difference as a percentages
  of reported sales                          13.50%        2.20%
Difference in total expenses      308       -$125,574     -$4,085
Difference as a percentages
  of reported expenses                       11.96%        1.85%

                                Median         75%       Std. Dev.

Difference in total assets     -$20,214     -$115,103    $371,088
Difference as a percentages
  of reported assets             4.35%        9.25%       10.51%
Difference in total
  liabilities (b)              -$20,214     -$115,103    $371,088
Difference as a percentages
  of reported liabilities        8.29%       17.59%       20.89%
Difference in total sales      -$20,214     -$129,100    $371,088
Difference as a percentages
  of reported sales              7.39%       15.53%       18.78%
Difference in total expenses   -$20,214     -$119,190    $371,088
Difference as a percentages
  of reported expenses           6.97%       15.25%       15.91%

(a) Ventures are Canadian firms reporting proportionately consolidated
joint ventures for at least one year during 1995-2001.

(b) The difference in total assets equals the difference in total
liabilities because both are determined by subtracting joint venture
liabilities (see Figure 3).


(1) ROCSE = Profit Margin x Total Assets Turnover x Leverage Ratio

where:

ROCSE = Net Income/Average Common Shareholders' Equity;

Profit Margin = Net Income/Sales;

Total Assets Turnover = Sales/Average Total Assets; and

Leverage Ratio = Average Total Assets/Average Common Shareholders' Equity.

Each ratio is calculated twice, first using the proportionate consolidation data from the venturers' reported financial statements and second after converting the venturers' financial statements to the equity method. ROCSE under proportionate consolidation equals ROCSE under the equity method because net income and shareholders' equity are the same under both accounting methods. However, the example in Figure 1 indicates that assets and sales are smaller under the equity method. The lower sales reported under the equity method causes the absolute value of the profit margin to be larger than under proportionate consolidation. The lower level of assets reported under the equity method causes the leverage ratio to be smaller than under proportionate consolidation. (3) Because sales and assets are both lower under the equity method, the observed difference between proportionate consolidation turnover and equity method turnover has no particular economic interpretation.

We examine the predictive ability of the components of ROCSE using a set of regression models. These models regress current-year ROCSE on combinations of prior-year ROCSE, prior-year DuPont ratios based on proportionate consolidation, and/or prior-year DuPont ratios based on the equity method. The precise regression models are explained in the results section.

To predict profitability with financial statement data requires a systematic relation across years in financial statement data. Therefore, if the predictive ability of financial statements under proportionate consolidation differs from that under the equity method, then the explanatory power of regressions under the two methods should also differ.

RESULTS

Descriptive Statistics

Table 3 presents comparative descriptive statistics for ROCSE and its components under the proportionate consolidation and equity methods of accounting. The variables represent ROCSE for the reporting year, t, and the Profit Margin, Asset Turnover, and Leverage Ratio for the same firms for the prior year, t-1. Because these calculations require three years of balance sheet data and two years of income statement data, we have enough data for 219 firm-year observations.

The mean (median) ROCSE is 7.66 percent (9.41 percent) with a standard deviation of 15.08 percent. The mean profit margin under proportionate consolidation is 4.55 percent, and 4.63 percent under the equity method. This follows from our observation that the absolute value of the profit margin is generally greater under the equity method since income is the same under either method but equity method sales are generally lower. Similarly, the result that the mean leverage ratio is 2.55 under proportionate consolidation and 2.33 under the equity method is not surprising; total assets is generally greater under proportionate consolidation and shareholders' equity is the same under either method. Finally, the mean asset turnover ratio under proportionate consolidation is 1.03, and 0.99 under the equity method. We had no prior expectations regarding the effect of joint venture reporting method on the asset turnover ratio.

Table 3 also indicates that the standard deviation of the profit margin is much higher under the equity method (24.73 percent) than under proportionate consolidation (13.05 percent). The greater variation in profit margin ratios under the equity method is due to those cases where joint venture sales are a large proportion of total sales. In those cases, subtracting the venturer's share of joint venture sales from proportionately consolidated sales dramatically reduces the denominator of the profit margin ratio while the numerator is constant.

The two asset turnover ratios under the two accounting methods are highly correlated with each other ([r.sub.p] = 9883, p-value = .0001) as are the two leverage ratios ([r.sub.p] = .9660, p-value = .0001) Such strong correlations suggest that evaluations of trends in asset turnover and leverage ratios will differ little between the proportionate consolidation and equity methods of accounting for joint ventures. The profit margin ratios are significantly correlated ([r.sub.p] = .8260,p-value = .0001), but less so than are the asset turnover and leverage ratios. The smaller correlation for the two profit margins suggests evaluation of trends will differ across the two accounting methods.

ROCSE Regression Results

Table 4 presents the results of regressions of ROCSE on the combinations of prior-year ROCSE and prior-year DuPont ratios presented below:

(a) [ROCSE.sub.t] = [a.sub.0(t-1)] + [a.sub.1][ROCSE.sub.(t-1)] + e

(b) [ROCSE.sub.t] = [b.sub.0(t-1)] + [b.sub.1][ROCSE.sub.(t-1)] + [b.sub.2][EQPM.sub.(t-1)] + [b.sub.3][EQTURN.sub.(t-1)] + [b.sub.4][EQLEV.sub.(t-1)] + e

(c) [ROCSE.sub.t] = [c.sub.0(t-1)] + [c.sub.1][ROCSE.sub.(t-1)] + [c.sub.2][PCPM.sub.(t-1)] + [c.sub.3][PCTURN.sub.(t-1)] + [c.sub.4][PCLEV.sub.(t-1)] + e

(d) [ROCSE.sub.t] = [d.sub.0(t-1)] + [d.sub.1][ROCSE.sub.(t-1)] + [d.sub.2][EQPM.sub.(t-1)] + [d.sub.3][EQTURN.sub.(t-1)] + [d.sub.4][EQLEV.sub.(t-1)] + [d.sub.5][PCPM.sub.(t-1)] + [d.sub.6][PCTURN.sub. (t-1)] + [d.sub.7][PCLEV.sub.(t-1)] + e

where ROCSE is Return on Common Shareholders' Equity, PM is Profit Margin, TURN is Asset Turnover, and LEV is the Leverage Ratio. EQ denotes pro forma equity method venturer ratios, calculated from the reported consolidation data, as shown in Figure 3. PC denotes venturer ratios calculated when joint ventures are proportionately consolidated and t equals a reporting year.

We compare information content by assessing the ability of the different combinations of past ratios to explain current year ROCSE. This approach facilitates comparing information sets based on proportionate consolidation reporting with information sets based on equity method reporting. We use the regression [R.sup.2]s from models (a) through (d) to compare relative explanatory power--which combination of ratios explains current year ROCSE the best? We also use the differences in the regression [R.sup.2]s from models (a) through (d) to assess the incremental explanatory power of either proportionate consolidation or equity method ratios over the other (Biddle et al. 1995).

Relative Explanatory Power

Panel A of Table 4 reports the [R.sup.2]s from regressions (a) through (d), where column (a) reports the [R.sup.2]s from regression (a), and so on. The [R.sup.2]s measure the ability of the prior year ratios in the regressions to explain current year ROCSE.

Results for relative explanatory power reported in Panel A indicate that regressions including proportionate consolidation ratios have more explanatory power for current-year ROCSE than do regressions with prior-year ROCSE alone or in combination with prior-year equity method ratios. Column (a) indicates that prior year ROCSE explains 12.55 percent of current year ROCSE. In column (b), adding equity method ratios to ROCSE improves explanatory power to 16.97 percent.

However, explanatory power improves more when proportionate consolidation ratios are included. Proportionate consolidation ratios combined with ROCSE explain 22.15 percent of current year ROCSE and combining ROCSE with both equity method and proportionate consolidation ratios explains 23.69 percent of current ROCSE. (4)

The [R.sup.2]s reported in Table 4 are not adjusted for the number of variables included in the each regression. Therefore, only the [R.sup.2]s presented in columns (b) and (c)--between ROCSE and either three equity method ratios or proportionate consolidation ratios--can be directly compared. For those two columns, the proportionate consolidation method has greater relative explanatory power than the equity method.

Incremental Explanatory Power

Panel B of Table 4 presents the incremental explanatory power of the equity method and proportionate consolidation ratios over the other information. Columns (e) and (g) report the incremental explanatory power of equity method ratios and columns (f) and (h) report the incremental explanatory power of the proportionate consolidation ratios. We compute incremental explanatory power as the difference in the [R.sup.2]s of regressions (a) through (d). We then use a general linear test to assess the statistical significance of this incremental explanatory power (Neter and Wasserman 1983, 94-96).

Both the equity method and the proportionate consolidation ratios provide significant incremental explanatory power beyond ROCSE. However, the incremental explanatory power of the proportionate consolidation ratios exceeds the incremental explanatory power of the equity method ratios. Column (e) indicates that the incremental explanatory power of prior-year equity method ratios beyond prior-year ROCSE alone is 4.42, derived by subtracting the regression (a) [R.sup.2] (12.55) from the regression (b) [R.sup.2] (16.97). Similarly, Column (f) indicates that the incremental explanatory power of prior-year proportionate consolidation ratios over prior-year ROCSE alone is 9.60.

Column (g) reports the incremental explanatory power ([R.sup.2]) from adding equity method ratios to regressions with ROCSE and proportionate consolidation ratios. The incremental [R.sup.2] (1.54 percent) is small and not statistically different from zero. However, column (h) reveals that adding proportionate consolidation ratios to regressions including ROCSE and equity method ratios increases the incremental [R.sup.2] (6.72 percent) and makes it statistically significant. Taken together, these results suggest that the proportionate consolidation ratios subsume virtually all of the predictive power in the equity method ratios and provide significant incremental predictive power beyond that of the equity method ratios. (5)

Limitations and Further Tests of Explanatory Power

Our research regression models (a) through (at) are linear. However, Equation (1) indicates that the correct functional form for the regression of ROCSE on profit margin, asset turnover, and leverage is multiplicative. Regressions of multiplicative models require converting variables on both sides of the regression model to logarithms. However, our data contain 109 cases (approximately 23 percent) with net losses and, hence, negative ROCSE and profit margin. Converting to logarithms eliminates these observations, significantly reducing sample size. The results from log-transformed variables (not reported here) are qualitatively similar to the linear model results presented in Table 4.

Specifically, the regressions result in [R.sup.2]s of 22.36 percent for the proportionate consolidation variables and 14.06 percent for the equity method variables. We report the linear model results because the linear model allows us to utilize more fully the available data.

We also investigated the relation of the ROCSE components to share price movements. We regressed the venturers' 12-month cumulative monthly share price returns ending three months after the venturers' year-ends on current-year ROCSE components. Although the details are not reported, the adjusted [R.sup.2] was 0.11 for the regression containing proportionate consolidation ratios versus 0.08 for the regression containing equity method ratios. Proportionate consolidation ratios therefore explain slightly more of the variation of stock returns.

The robustness of these results to other samples, time periods, and functional forms can be assessed only indirectly. However, our initial tests of the explanatory power of equity method and proportionate consolidation ratios were limited to years before 2000. When data from 2000 and 2001 were added to the tests, the difference between the explanatory power of the two methods increased. This gives some confidence that results are not driven by unusual time periods.

SUMMARY AND CONCLUSIONS

This study documents differences in the predictive power of certain financial statement ratios when joint ventures are reported using the proportionate consolidation and equity methods of accounting. Our sample of Canadian firms reports proportionately consolidated joint ventures with sufficient detail to separate out the effects of the joint ventures on the venturers' financial statements. The joint venture disclosures enable us to calculate pro forma equity method financial statements and compare them to venturers' proportionately consolidated financial statements. Then we compare the ability of the two accounting methods to predict accounting return on common shareholders' equity.

We find the components of return on common shareholders' equity (profit margin, asset turnover, and the leverage ratio) predict future return on common shareholders' equity better when the ratios are based on proportionate consolidation than on the equity method. Our results suggest that for joint ventures in Canada the proportionate consolidation method provides incremental information content beyond that provided by the equity method. More broadly, our results suggest that the equity method's "one-line consolidation" provides less information for predicting future profitability than does proportionate consolidation, an accounting method that reflects the venturer's proportionate share of assets, liabilities, revenues, and expenses throughout the financial statements.

The results of this study highlight the importance of research on alternative accounting methods for intercorporate investments. Because the reporting issues for joint ventures are those for intercorporate investments generally, our study suggests revisiting the use of the equity method for other investments. At a minimum, regulators may consider requiring disclosure of key numbers based on proportionate consolidation even if they decide to continue to use the equity method.
APPENDIX

EXAMPLE OF A JOINT VENTURE Disclosure: Armbro Enterprises Inc. 2000

4 JOINT VENTURES

The Company participates in several incorporated joint ventures and the
consolidated financial statements include the Company's proportionate
share of the assets, liabilities, revenues, expenses, net income, and
cash flows of these joint ventures.

(a) The following table sets out the Company's proportionate share of
the assets, liabilities, ventures' equity, revenues, expenses net
income and cash flows of these joint ventures.

                                 2000              1999

Assets
  Current                    $ 135,051           $ 84,890
  Capital                       26,202              3,253
  Other                          1,428              1,812
                             $ 162,681           $ 89,955
Liabilities
  Current                    $ 151,271           $ 69,997
  Long-term                      6,250                473
  Venturers' equity              5,160             19,485
                             $ 162,681           $ 89,955

Revenues                     $ 298,286           $ 35,038
Expenses                       305,917             27,531
Net income (loss)            $ (7,631)            $ 7,507
Cash flows from
  Operating activities       $  36,886            $ 4,597
  Investing activities         (1,312)            (3,512)
  Financing activities           8,079              (777)
                              $ 43,653              $ 308

(b) The Company is either contingently or directly liable for
obligations of its joint venturers. The assets of the joint ventures
are available for the purpose of satisfying such obligations.

(c) The Company enters into transactions in the normal course of
operations with its joint ventures, which are measured at the amount
of consideration established and agreed to by the parties involved.
During the year, the Company generated revenues of $13,914 (1999, $297)
from its joint venture partners. At December 31, 2000, the Company
included in accounts receivable $15,641 (1999, $9,110) owing from its
joint venturers. At December 31, 2000, the Company included in accounts
payable and accrued liabilities $556 (1999, $ nil) owing to
its joint venturers.

FIGURE 1

Proportionate Consolidation versus the Equity Method: A Numerical
Example

Partner Limited owns 40 percent of JV Incorporated. Key year-end
balance sheet and income statement figures appear below. Assume that
book values approximate market value and that Partner's figures do not
include any JV results.

                                        Partner     JV
  Balance sheet
  Assets (other than investments)           100     30
  Liabilities                                50     20

  Income statement
  Revenues                                   60     20
  Expenses                                   40     15

Partner's year-end balance sheet and income statement, under
proportionate consolidation and under the equity method, would appear
as follows:

PROPORTIONATE CONSOLIDATION

Partner Ltd.: Balance Sheet
Assets [100 4- (40% x 30)]                 $112

Total assets                               $112
Liabilities [50 + (40% x 20)]                58
Shareholders' equity                         54
Liabilities plus shareholders' equity      $112

Partner Ltd.: Income Statement
Revenues [60 4- (40% x 20)]                 $68
Expenses [40 4- (40% x 15)]                  46

Net income                                  $22

Key financial ratios
Return on Common Equity ($22/$54)          0.41
Profit Margin ($22/$68)                    0.32
Total Assets Turnover ($68/$112)           0.61
Leverage ($112/$54)                        2.07

EQUITY METHOD

Partner Ltd.: Balance Sheet

Other assets                               $100
Investment in JV [40% x (30 - 20)]            4
Total assets                               $104
Liabilities                                  50
Shareholders' equity                         54
Liabilities plus shareholders' equity      $104

Partner Ltd.: Income Statement

Revenues                                    $60
Expenses                                     40
Share of JV income [40% x (20 - 15)]          2
Net income                                  $22

Key financial ratios
Return on Common Equity ($22/$54)          0.41
Profit Margin ($22/$60)                    0.37
Total Assets Turnover ($60/$104)           0.58
Leverage ($104/$54)                        1.93

Financial ratio formulae:
  Return on Common Equity = Net Income/Shareholders' Equity;
  Profit Margin           = Net Income/Revenue;
  Total Assiets Turnover  = Revenue/Assets; and
  Leverage                = Assets/Shareholders' Equity.

FIGURE 3

Converting Proportionate Consolidation Financial Statements to the
Equity Method

Venturer Balance Sheet Conversion

Other     +   Share of     =   Other     +   Share of       Share-
Assets        Joint            Liabi-        Joint          holders'
              Venture          lities        Venture        Equity
              Assets                         Liabi-
                                             lities

          -   Share of                   -   Share of
              Joint                          Joint
              Venture                        Venture
              Liabi-                         Liabi-
              lities                         lities

Other     +   Equity in    =   Other                    +   Share-
Assets        Joint            Liabi-                       holders'
              Ventures         lities                       Equity

Venturer Income Statement Conversion

Other     +   Share of     -             -   Share of   =   Net Income
Revenues      Joint                          Joint
              Venture                        Venture
              Revenues                       Expenses

          -   Share of                   +   Share of
              Joint                          Joint
              Venture                        Venture
              Expenses                       Expenses

Other     +   Income       -   Other                    =   Net Income
Revenues      from Joint       Expenses
              Venture

TABLE 2

The Percentages of Joint Ventures and Venturers with Positive
Earnings and Cash Flows (a)

                        n     Joint Ventures   Venturers

Earnings               308       79.34%         84.92%
Operating Cash Flow    279        83.23         87.22
Investing Cash Flow    278        24.66         10.11
Financing Cash Flow    266        58.82         67.58

(a) Venturers are Canadian firms reporting proportionately
consolidated joint ventures.

TABLE 3

Descriptive Statistics of Variables in the Return on Equity
Regression (a)

                           Mean      25%     Median    75%        Std.
                                                                  Dev.

Return on Common
  [Equity.sub.t]           7.66%    3.10%    9.41%    13.93%     15.08%

Proportionate Consolidation Ratios

Profit [Margin.sub.t-1]    4.55%    1.77%    5.28%     8.91%     13.05%
Total Assets
  [Turnover.sub.t-l]       1.03     0.43     0.78      1.14       1.11
Leverage [Ratio.sub.t.1]   2.55     1.88     2.36      2.92       1.02

Equity Method Ratios

Profit [Margin.sub.t-1]    4.63%    1.97%    5.72%    10.34      24.73%
Total Assets
  [Turnover.sub.t-1        0.99     0.39     0.77      1.09       1.13
Leverage [Ratio.sub.t-1]   2.33     1.76     2.19      2.61       0.86

* As reported proportionate consolidation and proforma equity method
financial statements of a sample of Canadian venturer firms with joint
ventures over the period 1995-2001. Return on Equity equals venturer
net income/average common shareholders' equity (shown as a percentage).
Profit Margin equals net income/sales, Asset Turnover equals
sales/total average assets, and the Leverage Ratio equals average
assets/average common shareholders' equity. t equals a reporting year.

TABLE 4

Explaining ROCSE: Relative and Incremental Power of Joint Venture
Reporting Methods

Panel A: Relative Explanatory Power (a)

                  a                           b
 n       [R.sup.2.sub.ROCSE]        [R.sup.2.sub.ROCSE&EQ]
219             12.55                       16.97

Panel B: Incremental Explanatory Power (b)

                  e                           f
                (b-a)                       (c-a)
 n      [R.sup.2.sub.EQ\ROCSE]      [R.sup.2.sub.PC\ROCSE]
219            4.42 **                     9.60 ***

Panel A: Relative Explanatory Power (a)

                  c                           d
 n      [R.sup.2.sub.ROCSE&PC]     [R.sup.2.sub.ROCSE&EQ&PC]
219             22.15                       23.69

Panel B: Incremental Explanatory Power (b)

                  g                           h
                (d-c)                       (d-b)
 n     [R.sup.2.sub.EQ\ROCSE&PC]   [R.sup.2.sub.PC\ROCSE&EQ]
219              1.54                      6.72 ***

*, **, ***, denote significant incremental explanatory power at
p-values [less than or equal to] .05, .01, respectively.

(a) Relative explanatory power is measured as the [R.sup.2] from
regressions of current-year ROCSE (return on common shareholders'
equity) on combinations of prior-year ROCSE, prior-year DuPont ratios
based on proportionate consolidation (PC), and/or prior-year DuPont
ratios based on the equity method (EQ). Registrations models (a)
through (d), corresponding to columns (a) through (d) in Panel A, are
presented in the text.

(b) Incremental explanatory power equals the [R.sup.2]s from the two
Panel A columns in the parentheses in Panel B.


The authors acknowledge Bob Lipe and anonymous reviewers for their helpful comments. The authors also thank research assistants Christopher Graham and Susan Hagberg of Oregon State University and Jill Powell of the University of Manitoba whose help made this study possible.

(1) The Group of Four Plus One (G4+ 1) was an informal working group composed of the International Accounting Standards Committee and representatives of accounting standard-setting bodies from Canada, the United States, the United Kingdom, Australia and, later, New Zealand. Established in 1993 (and disbanded in 2001), the G4+1 responded to issues on the agendas of member organizations, with a view to facilitating "a convergence of financial reporting standards across member jurisdictions at a high level of quality" (Beresford 2000, 16). While the G4+1 had no formal standard-setting authority, its conclusions influenced standard setting in many jurisdictions (Lipe 2001).

(2) Our conversion of proportionate consolidation financial statements to equity method financial statements requires that venturers provide supplementary schedules of their proportionate shares of their joint venture's assets, liabilities, revenues, and expenses. An alternative accounting method for joint ventures, described in Davis and Largay (1999) and Milburn and Chant (1999), presents the reporting firm's share of joint venture assets and liabilities on the face of its balance sheet and the reporting firm's share of joint venture revenues in its income statement. This expanded (or gross) equity method is used in the United Kingdom.

(3) Although this statement holds only for firms with positive book value of equity, we note that the leverage ratio is not meaningful for firms with negative book values. None of the firm-years included in our tests have negative book value of equity.

(4) Adding ratio data from years t-2 and t-3 to the regression increased the regression [R.sup.2] to as much as 34 percent. The results are similar to the t-1 regression results presented here in that the proportionate consolidation ratios consistently outperform the equity method ratios. However, due to reduced sample sizes, this difference is not always statistically significant.

(5) The statistical tests we use assume that the regression residuals are uncorrelated across firms and across time. Since we use all available firm-years in the regressions, a given firm may appear in the sample more than once, possibly leading to correlated residuals. Therefore, we reestimate the regressions using a single, randomly chosen observation for each firm. Results are qualitatively the same as those reported in Table 4. Hence, our results are not driven by correlated residuals.

REFERENCES

Bailey, W. J. 2001. The impact of joint venture accounting methods and the guarantee of joint venture debt on corporate lending decisions and debt covenant restrictions. Working paper, University of California, Riverside.

Beresford, D. R. 2000. G4+l: A newcomer on the international scene. The CPA Journal 70 (March): 14-19.

Biddle, G. C., G. S. Seow, and A. Siegel. 1995. Relative versus incremental information content. Contemporary Accounting Research (Fall): 1-23.

Bierman, H., Jr. 1992. Proportionate consolidation and financial analysis. Accounting Horizons (December): 5-17.

Canadian Institute of Chartered Accountants (CICA). 2000. CICA Handbook. Toronto, Ontario: CICA.

Davis, M. L., and J. A. Largay III. 1999. Financial reporting of "significant influence" equity investments: Analysis and managerial issues. Journal of Managerial Issues (Fall): 280-298.

Financial Accounting Standards Board (FASB). 1980. Qualitative Characteristics of Accounting Information. Statement of Financial Accounting Concepts No. 2. Stamford, CT: FASB.

Freedman, W. 1996. Fortunes in footnotes, JVs obscure companies' true worth. Chemical Week 158 (September 11): 27-30.

Goldberg, I., and R. M. Wolfe. 1993. Accounting for real estate joint ventures. Journal of Corporate Accounting and Finance (Autumn): 105-112.

Lipe, R. C. 2001. Lease accounting research and the G4+1 proposal. Accounting Horizons (September): 299310.

Ludwick, A. M., and K. W. Simpson. 1973. The case of the missing property or when does 50% = 1/2? Canadian Chartered Accountant (April): 17-29.

Milburn, J. A., and P. D. Chant. 1999. Reporting Interests in Joint Ventures and Similar Arrangements. Financial Accounting Series Special Report. Norwalk, CT: FASB.

Modigliani, F., and M. H. Miller. 1958. The cost of capital, corporation finance and the theory of investments. American Economic Review (June): 261-297.

Mulcahy, G. 1977. Research: Investments in corporate and unincorporated joint ventures. CA Magazine (August): 56-59.

Neter, J., W. Wasserman, and M. H. Kutner. 1983. Applied Regression Models. Homewood, IL: Irwin.

Whittred, G., and I. Zimmer. 1994. Contracting cost determinants of GAAP for joint ventures in an unregulated environment. Journal of Accounting and Economics (January): 95-102.

Willett, P. 1995. Joint enterprise. CA Magazine (June/July): 59-62.

Roger C. Graham is a Professor at Oregon State University, Raymond D. King is a Professor at the University of Oregon, and Cameron K. J. Morrill is an Assistant Professor at the University of Manitoba.

Submitted: November 2001

Accepted: January 2003

Corresponding author: Roger C. Graham

Email: roger, graham@bus.oregonstate.edu
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Date:Jun 1, 2003
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