Financial Accounting Standards Board

September 29, 1999

The member organizations of the G4+1 have recently issued a Special Report, Reporting Interests in Joint Ventures and Similar Arrangements. The G4+1 members include representatives from the accounting standards boards of Australian, Canada, New Zealand, the United Kingdom, and the United States. Representatives of the International Accounting Standards Committee (IASC) participate as observers. In connection with the issuance of this Special Report, the Financial Accounting Standards Board (FASB or Board) is soliciting comments from interested constituents on certain issues that the Board must address in the future if it were to pursue its project on unconsolidated entities. Unlike a comprehensive Discussion Memorandum, the Special Report does not address all of the issues associated with accounting for an investment in a joint venture. Unlike an Exposure Draft, the Board has not deliberated the issues or conclusions contained in the Special Report. The Board is interested in receiving comments on the specific issues listed below. Respondents are urged to explain the basis for their conclusions even if they agree with the stated conclusion for an issue. 1. The Position Paper provides definitions of joint venture and joint control. The definition of joint venture specifically requires that the joint venture must carry on activities with its own assets and liabilities and have a separate decision-making identity (a separate entity). [paragraphs 2.14 and 2.15] Do you agree with the essential elements of those definitions? If not, why not? Do you agree with the requirement that a joint venture must be a separate entity? If not, why not? What type of additional guidance, if any, is needed to determine if a separate entity exists? 2. The proposed definition of joint venture does not require that the venturer have an equal ownership interest. [paragraph 2.14] Do you agree that the definition does not need to include a provision with respect to equal ownership interest? If not, why not? 3. The Position Papers proposed concept of a joint venture as an entity would not include many forms of cooperative or other arrangements to share costs and revenues. The Position Paper proposes that those other arrangements be accounted for on the basis of their particular contractual or constructive terms within existing accounting principles, without reference to special joint control issues. [paragraph 2.16] Do you agree with that view? If not, why not? Do you believe that the distinction between the proposed concept of a joint venture and other arrangements is operational? If not, why not? 4. The Position Paper discusses liabilities for which a reporting enterprise is jointly and severally liable. It states that a reporting enterprise would include in its balance sheet the portion (if any) of this liability for which, in contractual agreement with the other parties, it has primary responsibility. The Position Paper presumes that a reporting

enterprises responsibilities for repaying a debt (whether primary, secondary, or none) can always be determined from the contractual constructive terms of the arrangement between the parties. [paragraphs 2.23-2.25] Is the presumption correct? Can the allocation of responsibility be based solely on agreement among the liable parties or does the party to whom the liability is owed need to participate? Does this discussion conflict with the derecognition of liability guidance in FASB Statement No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities? 5. The Position Paper identifies three different methods for reporting an investment in a joint venture. Those methods are the equity method of accounting, the proportionate consolidation method, and the expanded equity method of accounting. After considering each method, the Position Paper indicates that the equity method of accounting is the most appropriate method for reporting an interest in a joint venture in the financial statements of the investor. [paragraphs 3.1 and 3.27] Do you agree with that view? If not, why not? 6. The Position Paper provides suggested disclosures for when an entity has significant involvement in joint ventures. [paragraph 4.3] Do you believe the proposed disclosures provide useful information to users of financial statements? If not, why not? Are there any other disclosures in this area that you believe a user of financial statements would find useful? The deadline for submitting comments is January 31, 2000. Please address comments to: Director of Research and Technical Activities Financial Accounting Standards Board 401 Merritt 7 P.O. Box 5116 Norwalk, CT 06856-5116 Comments can also be submitted by electronic mail to director@fasb.org. Your cooperation is greatly appreciated. Thank you in advance for your time and consideration. Sincerely

Timothy S. Lucas

NO. 201-E | SEPTEMBER 1999 Financial Accounting Series

SPECIAL REPORT

Reporting Interests in Joint Ventures and Similar Arrangements

J. Alex Milburn Peter D. Chant Principal Authors

Australian Accounting Standards Board Canadian Accounting Standards Board International Accounting Standards Committee New Zealand Financial Reporting Standards Board United Kingdom Accounting Standards Board United States Financial Accounting Standards Board

For additional copies of this Special Report and information on applicable prices and discount rates contact: Order Department Financial Accounting Standards Board 401 Merritt 7 P.O. Box 5116 Norwalk, Connecticut 06856-5116 Please ask for our Product Code SRRIJV.

G4 + 1 Special Reports Reporting Interests in Joint Ventures and Similar Arrangements, by J. Alex Milburn and Peter D. Chant Reporting Financial Performance: A Proposed Approach, by Kathryn Cearns Reporting Financial Performance: Current Developments and Future Directions, by L. Todd Johnson and Andrew Lennard International Review of Accounting Standards Specifying a Recoverable Amount Test for Long-Lived Assets, by Jim Paul Accounting for Leases: A New Approach, Recognition by Lessees of Assets and Liabilities Arising under Lease Contracts, by Warren McGregor Provisions: Their Recognition, Measurement, and Disclosure in Financial Statements, by Andrew Lennard and Sandra Thompson Major Issues Related to Hedge Accounting, by Jane B. Adams and Corliss J. Montesi Future Events: A Conceptual Study of Their Significance for Recognition and Measurement, by L. Todd Johnson

Reporting Interests in Joint Ventures and Similar Arrangements

J. Alex Milburn Peter D. Chant Principal Authors

Australian Accounting Standards Board Canadian Accounting Standards Board International Accounting Standards Committee New Zealand Financial Reporting Standards Board United Kingdom Accounting Standards Board United States Financial Accounting Standards Board

Copyright 1999 by Financial Accounting Standards Board. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the Financial Accounting Standards Board.

G4+1 MEMORANDUM OF UNDERSTANDING ON OBJECTIVES Shared Objectives of Member Organizations G4+1 organizations share an objective of providing quality financial standards for the primary purpose of providing information useful to capital market participants. G4+1 organizations share an objective of seeking common solutions to financial reporting issues. A single, quality financial reporting approach is more useful to capital market participants than multiple approaches. G4+1 organizations share the view that financial reporting standards should be based on a conceptual framework. It follows that membership of the G4+1 requires acceptance of a conceptual framework similar to that of other members. G4+1 organizations share the view that seeking common solutions to financial reporting issues requires members to have the willingness and ability to commit resources to the resolution of those issues within the context of a conceptual framework. G4+1 Objectives G4+1 organizations seek to further their shared objectives through analyses and discussions of financial reporting issues. Those analyses and discussions help participants from member organizations develop a common understanding of the issues, a common language and tools for discussing and analyzing the issues, and an understanding of the views and constraints in each others jurisdictions. G4+1 organizations seek to learn more about the timing and approach of standard-setting agenda projects in other jurisdictions. That knowledge can help them identify and take advantage of opportunities to coordinate their efforts and thereby further their shared objectives. G4+1 organizations seek to further their shared objectives by exchanging new ideas and approaches to financial reporting issues and standard-setting processes that can be applied in their own jurisdictions. G4+1 organizations seek to further their shared objectives by pursuing projects that have the potential to bring about convergence of financial reporting standards across member jurisdictions at a high level of quality.

PREFACE This paper has been developed as a result of a lack of consensus as to the appropriate accounting by venturer enterprises for interests in a joint venture. The unique problems of accounting for interests in a joint venture arise because the idea of an enterprise jointly controlling, or sharing control over, assets or operating activities with other enterprises does not seem to fit well within a conceptual framework that defines assets and consolidated reporting enterprises in terms of exclusive control. There is concern about the apparent lack of consistency between the accounting standards and practices of G4+1 members, as well as other jurisdictions, on these issues. The differences are fundamental and significant. They relate to what should be considered a joint venture and the appropriate methods of recognition, measurement, and presentation of interests in a joint venture, however it is defined. In particular, some G4+1 members permit or require proportionate consolidation of some or all jointly controlled arrangements, while others require the equity method of accounting in the same situations. The practical effects of those differences can be significant. This paper brings together and examines the conceptual issues and arguments and practical considerations relating to these matters. It reasons within accepted conceptual frameworks of the G4+1 members in addressing these matters, and it proposes: 1. A definition of joint venture for accounting purposes and how a joint venture may be distinguished from other forms of joint arrangements 2. Accounting for a joint venture (as defined) using the equity method of accounting (rather than using proportionate consolidation) and how accounting for certain other forms of joint arrangements may be determined from the contractual or constructive terms of those arrangements 3. Appropriate disclosures of interests in a joint venture and other forms of joint arrangements. The fundamental objective of this paper is to develop a common understanding of the issues and to propose an appropriate conceptual and practical basis for the development of international consensus on the basic questions of accounting for and presentation and disclosure of interests in a joint venture. This paper is the eighth in a series of studies prepared to promote discussion of issues that may assist standards setters in developing improved accounting standards. Members of the working group were: Australia Ken Spencer, Chairman Australian Accounting Standards Board Warren McGregor, Executive Director Australian Accounting Research Foundation Canada Peter Chant, former Chairman, Accounting Standards Board The Canadian Institute of Chartered Accountants Tricia OMalley, Vice-Chair, Accounting Standards Board The Canadian Institute of Chartered Accountants Sylvia Smith, Director, Accounting Standards The Canadian Institute of Chartered Accountants

International Accounting Standards Committee Sir Bryan Carsberg, Secretary-General Liesel Knorr, Technical Director New Zealand April Mackenzie, Director, Accounting and Professional Standards Institute of Chartered Accountants of New Zealand

United Kingdom Sir David Tweedie, Chairman Accounting Standards Board Allan Cook, Technical Director Accounting Standards Board United States of America Edmund L. Jenkins, Chairman Financial Accounting Standards Board James J. Leisenring, Vice Chairman Financial Accounting Standards Board Although members of the working group represented the standard-setting bodies with which they were affiliated, the views that they expressed during the course of the discussions were their own and had not been officially deliberated by the bodies themselves.

Request for Comments We hope that this paper is useful in helping others formulate thoughts on the issues it addresses and that, by so doing, it may contribute to the further harmonization of international accounting standards. Please address any comments to one of the following: Executive Director Australian Accounting Research Foundation 211 Hawthorne Road Caulfield, Victoria 3162 Australia E-mail: standard@aarf.asn.au Director, Accounting Standards The Canadian Institute of Chartered Accountants 277 Wellington Street West Toronto, Ontario Canada M5V 3H2 E-mail: Error! Bookmark not defined. defined.ed.accounting@cica.ca Secretary-General International Accounting Standards Committee 166 Fleet Street London EC4A 2DY United Kingdom E-mail: commentletters@iasc.org.uk Director, Accounting and Professional Standards Institute of Chartered Accountants of New Zealand P.O. Box 11-342 Wellington New Zealand E-mail: april_mackenzie@icanz.co.nz Technical Director Accounting Standards Board Holborn Hall 100 Grays Inn Road London WC1X 8AL United Kingdom E-mail: joint.ventures@asb.org.uk

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Director of Research and Technical Activities Financial Accounting Standards Board 401 Merritt 7 P.O. Box 5116 Norwalk, CT 06856-5116 United States of America E-mail: director@fasb.org

ACKNOWLEDGMENTS The principal authors of this paper are J. Alex Milburn, consultant to the Canadian Institute of Chartered Accountants, and Peter D. Chant, partner of Deloitte & Touche in Toronto, Canada. Special appreciation is expressed for the contributions of Ian P. N. Hague, principal, accounting standards, the Canadian Institute of Chartered Accountants; Sylvia Smith, former director, accounting standards, the Canadian Institute of Chartered Accountants; and Francis E. Scheuerell, Jr., project manager, research and technical activities, the Financial Accounting Standards Board (USA). Mary Huydic, also on the FASB staff, edited this Special Report and prepared it for production.

SPECIAL REPORT Reporting Interests in Joint Ventures and Similar Arrangements

CONTENTS Page Chapter 1!The Basic Problems ............................................................................................ X Chapter 2!Defining a Joint Venture ....................................................................................... X The Concept of Control.................................................................................................... X Joint Control over Another Enterprise................................................................................ X Proposed Definitions ....................................................................................................... X A Joint Venture Is an Enterprise....................................................................................... X The Concept of Joint Control............................................................................................ X Comparison with Existing Definitions ................................................................................ X Chapter 3!Methods for Reporting an Interest in a Joint Venture ............................................... X The Equity Method in Comparison with Proportionate Consolidation .................................... X Summary Observations ............................................................................................. X The Expanded Equity Method.......................................................................................... X Conclusion..................................................................................................................... X Chapter 4!Disclosure of Interests in a Joint Venture............................................................... X Joint Venture.................................................................................................................. X Joint Arrangements Other Than a Joint Venture................................................................. X Display Issues ............................................................................................................... X

CHAPTER 1!THE BASIC PROBLEMS 1.1 At present, there is no international consensus on basic aspects of accounting for joint venture interests, more specifically on (a) what should be considered a joint venture for accounting purposes and (b) the appropriate methods of recognition, measurement, and presentation of interests in a joint venture. 1.2 The various practices followed by G4+1 members provide ample illustration of the significant inconsistencies in joint venture accounting: IASC and Canadian standards 1 define joint venture in broad terms, as a contractual arrangement between two or more parties to undertake an economic activity that meets a criterion of being under joint control. The IASC standard recommends as a benchmark practice, and the Canadian standard mandates, proportionate consolidation of a venturers interest in a joint venture in the venturers financial statements. In contrast, in the United States, Accounting Principles Board (APB) Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock,2 requires a venturer to use the equity method of accounting for an incorporated joint venture. In certain limited situations, a venturer in an unincorporated joint venture may report its share of the assets, liabilities, revenues, and expenses of the venture in its financial statements. New Zealand Statement of Standard Accounting Practice (SSAP) 25, Accounting for Interests in Joint Ventures and Partnerships,3 strictly limits the practice of proportionate recognition to a number of circumstances involving unincorporated business ventures in which the venturers receive shares of the output from the venture. The standard in Australia on joint venture accounting had been similar to that of New Zealand. However, the Australian Accounting Standards Board (AASB) issued a

International Accounting Standards Committee, IAS 31, Financial Reporting of Interests in Joint Ventures (London: IASC, revised 1998); and Canadian Institute of Chartered Accountants, CICA Handbook, Section 3055, Interests in Joint Ventures (Toronto: CICA, 1994).
2

Accounting Principles Board, APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock (New York: AICPA, March 1971).
3

New Zealand Society of Accountants, SSAP-25, Accounting for Interests in Joint Ventures and Partnerships (Wellington: Institute of Chartered Accountants of New Zealand, 1990).

revised standard, AASB 1006, Interests in Joint Ventures, in December 1998, 4 that distinguishes joint venture entities from joint venture operations. It requires use of the equity method for joint venture entities and reporting of the venturers share of the assets, liabilities, revenues, and expenses of joint venture operations. In the United Kingdom, Financial Reporting Standard (FRS) 9, Associates and Joint Ventures,5 issued in November 1997, distinguishes between a joint venture, which it defines as a jointly controlled entity that is engaged in an independent trade or business, and other joint arrangements. It requires that a joint venture be accounted for on a gross equity basis under which the venturers proportionate interest in the aggregate assets, liabilities, and revenues of the joint venture are disclosed as an amplification of net equity amounts in the venturers financial statements.

1.3 It is difficult to assess the differences in definitions of joint venture that are used in different jurisdictions. This is in part because joint arrangements may take a wide variety of forms in different jurisdictions, with differences in views as to the implications of these forms for accounting. Existing definitions are open to different interpretations as to their application to particular forms of joint arrangements and legal structures. Differences in definitions may also reflect varying concerns about the extent to which a distinct accounting method (in particular, proportionate consolidation) has applicability to any form of investment. 1.4 Current accounting methods f ll into two generic groups. The first is the equity method of a accounting, which recognizes a venturers interest in a joint venture in terms of its net equity in the venture. The second is proportionate consolidation, which accounts for a venturers interest by consolidating its share of the venturers individual assets, liabilities, revenues, and expenses within the venturers financial statements. Another method, sometimes referred to as the expanded equity method of accounting, attempts to be a compromise between the equity method of accounting and proportionate consolidation. The expanded equity method of accounting presents the venturers proportionate interest in major classes of assets, liabilities, revenues, and expenses of a joint venture as separate line items within the venturers financial statements. (The gross equity method in place in the United Kingdom differs from the expanded equity method in that the net equity in a joint venture is recorded in the venturers financial statements and the venturers proportionate interest in at least the aggregate assets, liabilities, and revenues of the joint venture are shown on the face of the financial statements as a supplementary amplification of the net equity figures.) The practical effects of these differences in definitions of joint ventures and in financial accounting and presentation practices can be very significant. 1.5 The lack of comparability between financial statements caused by the diversity in accounting practice is a significant concern given that evidence indicates that joint ventures are frequently employed as a form of business operation around the world. For example: A search of the Securities and Exchange Commissions Electronic Data Gathering, Analysis, and Retrieval (EDGAR) database of financial statements of U.S. public enterprises disclosed that 965 of 6,611 active U.S. enterprises with December 31 year-ends referred to joint ventures in their 1995 financial statements. A survey of 1997 annual financial statements of 200 Canadian public companies indicated that 92 reported interests in 1 or more joint ventures.6

4 5

Australian Accounting Standards Board, AASB 1006, Interests in Joint Ventures (Caulfield: AASB, 1998).

Accounting Standards Board, FRS 9, Associates and Joint Ventures (Central Milton Keynes: ASB Publications, 1997).
6

Clarence Byrd and Ida Chen, Financial Reporting in Canada, 23 ed. (Toronto: Canadian Institute of Chartered Accountants, 1998), p. 252.

Research into the use of joint ventures in Australia disclosed that 95 of 289 companies reviewed disclosed interests in 1 or more joint ventures.7

Chris Lambert and Cecilia Lambert, Adoption of Proportional Consolidation for Corporate Joint Venture Arrangements (working paper, Queensland University of Technology, November 1996) pp. 910.

1.6 The unique problems of defining and accounting for a joint venture arise because the idea that enterprises may share control over assets and business activities with other enterprises seems to be inconsistent with an accounting framework that defines assets and accounting enterprises in terms of exclusive control relationships. An asset is defined as a resource controlled by the enterprise. . . .8 The objective of consolidated financial statements is to include the accounts of all the subsidiary enterprises controlled by the parent enterprise. 9 This framework does not seem to provide an evident basis for determining how to represent assets and enterprises over which control is shared with other enterprises. The reciprocal problem exists for liabilities for which responsibility is shared in some way with other parties. 1.7 The first task, which is the subject of Chapter 2, is to develop an operational and conceptually sound definition of joint venture for accounting purposes. A wide range of cooperative activities between enterprises are variously labeled as joint ventures. It is proposed that many of these can be separated out, because they do not involve the central problem of shared control over enterprise activities. Some of those arrangements may appear on the surface to involve joint control over enterprise activities, but careful analysis of the contractual and constructive provisions of the arrangements reveals that they result in assets, liabilities, revenues, and expenses that are controlled outright by individual participants and do not require any consideration of special accounting. 1.8 Chapter 2 proposes a definition of joint venture for accounting purposes, and it examines the basic elements of that definition and its implications. It then relates the definition to the broader range of cooperative activities, how they may be distinguished, and why they are not subject to the unique joint control problem. Finally, the chapter compares the proposed definition with those of existing standards of G4+1 members. 1.9 Chapter 3 addresses alternative methods of reporting for interests in joint ventures, as defined. The conceptual and practical attributes of each method are considered. The analysis concludes that the equity method is conceptually consistent with the proposed definition of joint venture, and with the conceptual framework of the G4+1 jurisdictions. Further, it concludes that the equity method is practical and useful when supplemented with appropriate disclosures (which are discussed in Chapter 4). 1.10 Chapter 4 examines presentation and disclosure issues. 1.11 No attempt is made to address issues of accounting for capital contributions to, and transactions with, joint venturers, or issues related to implementing the equity and proportionate consolidation bases of accounting. There are some potentially difficult issues here, but they are outside the scope of this paper. (It is anticipated that a number of these issues will be considered as part of a separate G4+1 study on equity accounting.)

International Accounting Standards Committee, Framework for the Preparation of Financial Statements (London: IASC, revised 1998), par. 49(a).
9

International Accounting Standards Committee, IAS 27, Consolidated Financial Statements for Investments in Subsidiaries (London: IASC, reformatted 1994), par. 12.

CHAPTER 2!DEFINING A JOINT VENTURE 2.1 An enterprise may enter into cooperative arrangements with other enterprises for many reasons. These include: The size of the operation may be beyond a single enterprises grasp. The partners may have complementary skills. Economies of scale may exist for a larger project. Risk sharing may be necessary to enable a project to be viable or to achieve above-average profit possibilities. There may be tax deferral or tax saving opportunities. Sharing debt load may improve an enterprises ability to work within existing loan covenants or enable increased leverage. A cooperative approach may provide the basis for achieving or maintaining control over a resource or market. 10

2.2 In addition, there may be financial accounting motivations. A prominent authority on project financing, for example, has openly stated that the accounting rules for financial consolidation present some interesting opportunities for off-balance sheet financing through the use of jointly owned corporations or partnerships in which the sponsor owns 50% or less.11 2.3 In different situations one or more of these reasons may predominate, and the ways in which risks, rewards, and control may be shared are many and varied. A cooperative business arrangement may take a multitude of legal forms and organizational structures and may be simple or highly complex. The term joint venture has been variously used in referring to virtually the whole range of cooperative business activities.

10 11

Peter K. Nevitt, Project Financing, 4th ed. (London: Euromoney Publications, 1983), p. 97. Nevitt, p. 5.

2.4 It is proposed, however, that for accounting purposes, a joint venture should be more narrowly defined and that the focus should be on an enterprise that has operations over which participant interests (venturers) have joint control with respect to the strategic operating, investing, and financing decisions. It is the jointness of control over the essential activities of an enterprise that gives rise to unique joint venture accounting issues. The Concept of Control 2.5 The concept of control is essential to the definition of an asset in financial accounting. Asset is defined in IASC standards as: . . . a resource controlled by the enterprise arising as a result of past events and from which future economic benefits are expected to flow to the enterprise. [IASC Framework, paragraph 49(a); emphasis added.] This definition is generally consistent with definitions in the standards of the G4 member countries. 2.6 Different assets comprise different bundles of ownership, use, or contractual rights. One must examine the rights that characterize a particular asset, and any restrictions upon them, in order to understand exactly what is the resource controlled by the enterprise. Asset rights may constitute outright ownership and control of physical assets (for example, property, plant, and equipment and inventories), or they may be contractual rights to future cash flows (receivables of various kinds), and they may be conditional on certain future events (for example, rights under warranties, guarantees, or options). A particular assets rights may be restricted in some way, which will affect the assets value but not its status as an asset. 2.7 Some assets take the form of equity investments in other enterprises; those assets provide the investor with residual rights in the investees net assets. Equity investments may be of a passive portfolio nature, in which case the investor has no ability to control the individual assets of the investee. It may be, however, that the investors equity investment is sufficient to give it control of the investee. In this case, the investor can be considered to have control over the individual assets of the investee and expected to consolidate the investees accounts with its own for external reporting purposes. 2.8 Thus, the concept of control is fundamental to determining the consolidated reporting enterprise. For this purpose, control is defined by the IASC as: . . . the power to govern the financial and operating policies of an economic activity so as to obtain benefits from it. [IAS 31, paragraph 2] 2.9 The FASB Exposure Draft, Consolidated Financial Statements: Purpose and Policy, 12 has proposed a more specific definition of control. Paragraphs 6(a) and 10 of the Exposure Draft state: Control [is] the ability of an entity to direct the policies and management that guide the ongoing activities of another entity so as to increase its benefits and limit its losses from that other entitys activities. Control . . . involves the presence of two essential characteristics: (a) a parents nonshared decision-making ability that enables it to guide the ongoing activities of

12

Financial Accounting Standards Board, FASB Exposure Draft, Consolidated Financial Statements: Purpose and Policy (Norwalk: FASB, 1999).

its subsidiary and (b) a parents ability to use that power to increase the benefits that it derives and limit the losses that it suffers from the activities of that subsidiary.

Joint Control over Another Enterprise 2.10 Some equity investments provide the investor with a right to share control over the activities of another enterprise with one or more other investors. Clearly, right of joint control gives the investor much more influence than a noncontrolling interest, but it does not give the investor the ability to control the individual assets or activities of the investee as a parent can control the assets and activities of a subsidiary. 2.11 On the one hand, compressing the investment in a jointly controlled enterprise into a single line on the investors balance sheet may seem inadequate. On the other hand, the joint venturer controls only its investment in a joint venture enterprise. It does not control, but only shares control over, the individual assets of the joint venture. 2.12 Thus, an interest in a jointly controlled enterprise seems to be in a category of its own, between control and noncontrol. It also seems to have unique economic characteristics that merit careful consideration to assess whether some distinctive accounting presentation, measurement, and/or disclosure is necessary in order to fairly present a common control interest in the investors balance sheet and income and cash flow statements. 2.13 The first step in this process of analyzing presentation, measurement, and disclosure possibilities is to define exactly what it is that characterizes a joint venture and joint control, so that jointly controlled interests can be clearly distinguished from other forms of investment and cooperative arrangements.

Proposed Definitions 2.14 The following definitions are proposed: Joint venture A joint venture is an enterprise that is jointly controlled by the reporting enterprise and one or more other parties. Joint control Joint control over an enterprise exists when no one party alone has the power to control its strategic operating, investing, and financing decisions, but two or more parties together can do so, and each of the parties sharing control (joint venturers) must consent. The essential elements of these definitions, and their more important implications, are discussed in the following paragraphs. A Joint Venture Is an Enterprise 2.15 The above definition states that, for accounting purposes, a joint venture must be an enterprise, that is, it must be a separate entity that carries on activities with its own assets and liabilities. The essence of the definition is that unless the joint venture is a separate entity carrying on its own activities with its own resources to achieve its own distinct purposes, it does not have a separate decision-making identity so as to be capable of independent control by external joint venturers. It may be incorporated or may not be. A joint venture does not necessarily have to be a profit-seeking enterprise, and not-for-profit organizations may participate in joint ventures. As an example, several hospitals may set up a joint venture to provide a laundry service that is a separate entity with its own resources and decision-making identity. 2.16 Many forms of cooperative or joint arrangements are not joint ventures under this definition. 13 It is proposed that these other arrangements can be accounted for on the basis of their particular contractual or constructive terms within existing accounting principles, without reference to special joint control problems. In order to demonstrate this, the distinctions between joint ventures, as defined, and other forms of cooperative or joint activities need to be clearly drawn. The basic distinctions and their implications are discussed in the following paragraphs. 2.17 Joint operations. Under many joint operations, each participant uses its own resources and carries out its own part of a joint operation separately from the activities of other participants. Each participant owns and controls its own resources (for example, property, plant, and equipment and inventories) that it uses in the joint operation, and it incurs its own expenses and raises its own financing. Such a contractual arrangement would be expected to specify how the goods or services outputs of the joint operation, and any revenues from their sale, and any common expenses, are to be shared among the participants. 2.18 As an example, different parts of a manufacturing process may be carried out by different parties, each using its own resources, as when one company manufactures the wings of an aircraft,

13

For example, certain arrangements that are commonly characterized in Australia as joint ventures would not be joint ventures as defined in paragraph 2.14 above, but rather are of the nature of jointly controlled assets (as discussed in paragraphs 2.202.22) or other joint arrangements to share costs. (This latter type of arrangement is discussed in paragraph 2.26.)

another the body, and another the engine. They share the revenues from the sale of the aircraft, and the common costs, as contractually agreed among themselves. 2.19 There are no unique joint venture accounting issues here, as there is no separate enterprise with jointly controlled assets or liabilities. Disclosure of the economic dependence on the other participants in a joint operation, and of any cross guarantees, may be necessary to the fair presentation of a venturers financial statements in such a situation. 2.20 Jointly controlled assets. Another form of cooperative arrangement involves the joint ownership of a single asset that is not a separate enterprise. Examples may include the joint ownership of a mine or an oil pipeline. The arrangement may be to share the output from the mine or to share the pipeline to transport oil and share operating expenses on an agreed basis. (The operation of the mine or pipeline may be the responsibility of one party rather than being subject to joint control.) 2.21 In such a case, the reporting enterprise will record as an asset its interest in the underlying property (presumably its initial carrying value would be its cost) on its balance sheet and record its share of the expenses and any revenues in its income statement. The only question is how to describe the asset in its balance sheet. Some might argue that joint ownership of such an asset (for example, a 50 percent joint interest in a mine) does not technically meet the definition of an asset, which is a resource controlled by the entity, not jointly controlled. But the distinction must be made between the mining property per se and the reporting enterprises rights in it. The reporting enterprises asset is its contractual joint ownership rights. The enterprise controls these rights and the benefits that flow from them. It can determine how to use them, and it may decide to sell them, hold them, or pledge them as collateral. 2.22 One legal form of a jointly controlled asset is an undivided interest in a property. An undivided interest may be defined as an ownership interest in which two or more parties jointly own property in which title is held individually to the extent of each partys interest.14 Undivided interests are interests in which there is unity of possession, but separate and distinct titles. . . . the only essential being a possessory right, as to which all are entitled to equal use and possession.15 An undivided interest in a property will generally be unincorporated, but in some jurisdictions it may be conveyed in an incorporated form. An undivided interest should be accounted for as a jointly controlled asset regardless of whether it takes an unincorporated or incorporated form. 2.23 Joint liabilities. If a liability is the primary responsibility of a reporting enterprise, it should, of course, be recorded as its liability in its balance sheet, regardless of whether it is financing joint venture assets. However, if a liability is the primary responsibility of a separate joint venture enterprise, it is reported as the joint ventures liability, and questions of how it should be accounted for within the venturers financial statements are subsumed within the issues of accounting for joint ventures (addressed in Chapter 3). Of course, the venturer reporting enterprise may be secondarily liable as a guarantor of the debt of the joint venture should the joint venture default. If so, the venturer will have to account for, and disclose, this guarantee. 2.24 A special case involves a liability for which a reporting enterprise is jointly and severally liable. Websters Dictionary defines joint and several in part as . . . liabilities

14

American Institute of Certified Public Accountants, Accounting Standards Executive Committee, Issues Paper, Joint Venture Accounting (New York: AICPA, July 1979), par. 3.
15

De Mik v. Cargill, Okl., 485 P. 2d 229, 223, as cited in Blacks Law Dictionary, 6th ed., pp. 14651466.

of two or more persons for which they may be held liable either together or separately (as a note where all makers can be held for the full amount). In this case, it would be expected that the reporting enterprise would include in its balance sheet the portion (if any) of this liability for which, in contractual agreement with the other parties, it has primary responsibility. It would then consider itself to be secondarily liable for the balance, that is, the equivalent of a guarantee against the default of the other parties. It would appropriately account for and disclose this guarantee. 2.25 It is presumed that a reporting enterprises responsibility for repaying a debt (whether primary, secondary, or none) can always be determined from the contractual and constructive terms of the arrangements between the parties. 2.26 Joint arrangements to share costs and, possibly, revenues. The concept of a joint venture as an enterprise (paragraph 2.15) would rule out arrangements to share costs and revenues. Under such arrangements, each of the assets and liabilities of the activity may be held by the respective parties as undivided interests and joint and several liabilities. Alternatively, a corporation or trust may be set up to hold these assets and liabilities on behalf of the two or more participating parties. The effect is the same; the activity is not an enterprise as defined but is simply an operation to manage assets and liabilities on behalf of the parties and to pass through the costs and revenues. Under such arrangements, any holding corporation or trust does not control or benefit from the assets and assumes no responsibility for the liabilities, except as agent for the participating parties. It is simply an extension of the underlying operations of the participating parties. Each party may be considered to have the equivalent of an undivided interest in each of the assets and joint and several responsibility for any liabilities, because all expenses, revenues, gains, and losses resulting from the assets and liabilities are passed on to each party on the basis of its respective share. Thus, each party would reflect its share of each of the assets and liabilities, revenues, expenses, gains, and losses in its financial statements. This is not proportionate consolidation of a separate entity, but simply accounting by each party for its share of the assets, liabilities, expenses, revenues, gains, and losses of the activity. 2.27 For example, suppose that enterprises A and B together acquire a mine and agree to share the output between them on a specified basis, to sell any surplus production, and to share costs and revenues. This activity may be set up in several different ways: a. In some jurisdictions, A and B may hold an undivided interest in each of the assets of the mine (the mining property, buildings, equipment, working capital, etc.) and assume joint and several responsibility for any liabilities. Management is appointed to manage the mine on behalf of A and B, with costs and revenues being allocated to them for net cash settlement. (Either A or B may act as manager.) In this case, A and B will each reflect their undivided interest in the assets and share of the liabilities and will record their share of revenues and costs as an extension of its business operations. A and B would be expected to disclose the undivided interest nature of these assets and liabilities and any contingent liabilities. b. The economic equivalent of (a) above would exist if the assets and liabilities of the mine were placed in a holding corporation or trust, managed on the same basis, with costs, revenues, gains, and losses being passed through as above. In this case, the accounting of A and B should be identical to that in (a). c. A different economic arrangement could be established under which the mine is set up as a joint venture, that is, as a separate enterprise, as described in paragraph 2.15. In this case, rather than share costs and revenues, the joint venture would have a contract with A and with B under which each would commit to acquire amounts of the output of the mine (perhaps at fixed or variable prices under a take-or-pay contract). A and B would then have a joint interest in the venture and would be entitled to share in the net profits or losses of the enterprise in accordance with their respective joint venture interests, regardless of the amount of profits or losses that resulted from each ventures transactions with the joint venture.

The Concept of Joint Control 2.28 Distinction from common share ownership. Joint control over an enterprise may be distinguished from normal common share ownership. A common shareholder in an enterprise controls the rights related to the shares he or she owns, that is, rights will be set out in the share agreement and in law. These rights generally include the right to vote at shareholder meetings, the right to declared dividends, the right to a share of the residual equity in the company if it were to close down, and the right to sell or pledge the shares as collateral. It may be that a particular shareholder has sufficient shares, and/or through other means, can control the enterprise, in which case it would be the parent, and the investee its subsidiary. Financial statements of subsidiaries would normally be consolidated in the parents financial statements. 2.29 Even if no party alone has the power to control an enterprise, joint control does not exist unless two or more parties can together control it, and each of the parties sharing control must consent to all the essential decisions relating to the strategic operating, investing, and financing activities of the enterprise. 2.30 Noncontractual joint venture. Normally, a joint control arrangement will be a written contractual arrangement or set of arrangements. An arrangement need not be in writing, however, and in some cases may be deduced from the actions of the venturers. In some cases, joint control could be the result of a circumstance. An example of such a circumstance would be where two shareholders each own 50 percent of the shares of an enterprise and there is no other agreement or factor that effectively gives either of them control. In this example, the conditions of joint control are metneither shareholder alone has the power to control, but the two together do, and each must consent to decisions essential to the operation of the enterprise. 2.31 Veto power. In some cases, joint control may be achieved by parties having veto rights over all essential decisions relating to the strategic operating, investing, and financing activities of an enterprise. Veto power could amount to joint control if that veto can be exercised to effectively require the vetoing partys or parties consent to the essential decisions to govern an enterprise. However, veto rights would not amount to joint control if another party or parties could ultimately override them, that is, if a veto could only delay, not overturn, decisions. 2.32 What if a government body or labor union or creditors can veto certain decisions of management of an enterprise? Could this amount to joint control? Such veto rights are likely to be situational and specific to certain matters only and, therefore, are unlikely to amount to joint control. Management of any enterprise can expect to be constrained to obey laws, not to pay out dividends if doing so would render the enterprise insolvent, to meet contractual terms of debt covenants and labor union agreements, and so forth. Such normal constraints on particular aspects of a companys operations do not constitute joint control. 2.33 Determining whether a joint venture exists will require careful assessment of the contractual and/or constructive arrangements. For example, suppose that A controls 50 percent of the voting shares of enterprise X and that independent parties B and C each control 25 percent. Some may believe that As position is equivalent to that of a joint venturer, sharing control with B or C. A does not have the power to control the essential decisions about X, but A, in combination with B or C, can. However, lacking any agreement to share control with B and/or C, this is not a joint venture, because the proposed definition of joint control requires that each of the parties to a joint venture must consent to essential decisions, and in this case neither B nor C has comprehensive veto power. This would be a joint venture if A had a common control arrangement with, say, B, in which case A and B would jointly control X (and C would have a noncontrolling investment interest [paragraph 2.35]).

2.34 The significance of active involvement. Some have advocated that, for a joint venture to exist, each venturer must be actively involved in determining essential decision policies. This would seem to be the position taken in the United Kingdom in FRS 9, for example. 16 On the other hand, the IASC and Canadian standards define control as the continuing power to determine strategic operating, investing, and financing policies. The concept of joint control defined in paragraph 2.14 proposes that it is the power to exercise joint control that should govern. A joint venturer may not seem to be active as long as it is content with the essential management policies and decisions. The rights that constitute the power to exert joint control should be objectively determinable from the contractual agreements or constructive circumstances.

16

FRS 9 states, Each venturer that shares control should play an active role in setting the operating and financial policies of the joint venture, at least at a general strategy level. However, it further explains that this does not preclude one venturer managing the joint venture provided that the ventures principal operating and financial policies are collectively agreed by the venturers and the venturers have the power to ensure that those policies are followed (paragraph 11).

2.35 Passive investor interests. A joint venture may have passive investors in addition to joint venturers. Passive investors might, for example, be issued a special class of shares, or participation units, under which they share in some way in the returns of the joint venture without participating in joint control over it. Such passive investor interests should be accounted for as such, and they do not negate the existence of joint control on the part of the joint venturers. 2.36 Jointness of return. Some argue that the definition of a joint venture proposed in paragraph 2.14 is insufficient. They advocate that an additional condition be added specifying that a joint venture can exist only if there is provision for a return to joint venturers that will be collectively determined, that is, determined on a joint basis. The definition of a joint venture in paragraph 2.14 does not specify this as a separate condition because it is proposed that it follows necessarily from the concept of joint control. The returns provided to joint venturers, in their capacity as joint venturers, must be determined on a joint basis because each venturer must consent to the basis on which returns are shared among them. 2.37 It may be, however, that a joint venturer is also a customer, supplier, creditor, or passive investor in the joint venture enterprise. In that case, the return for providing goods, services, or financing to the enterprise will be determined on a separate basis from the jointly determined benefits received as a joint venturer. 2.38 For example, a venturer in a construction consortium may commit to provide heavy equipment to the consortium for a period of time on the basis of a daily or weekly charge. For accounting purposes, that equipment would be considered to be leased to the consortium, and it would be treated as an asset of the venturer rather than of the joint venture. Thus, the return to the venturer in this case would be lease payments rather than joint venture returns. This example illustrates the importance of examining the substance of contractual arrangements to determine their appropriate accounting. 2.39 Joint control on a continuing basis. Some believe that an interest in a jointly controlled enterprise should be treated as an ordinary passive investment if it is held to be disposed of in the near future. This is not a condition incorporated within the definition in paragraph 2.14 because it is considered that joint control exists, regardless of managements intention to sell its interests, until such time as joint control has actually been surrendered. However, joint control may not exist if the joint venture is operating under restrictions that effectively impair its ability to implement essential decisions, including the ability to transfer funds. 2.40 A particular type of circumstance that may warrant careful assessment involves arrangements under which an operating division or segment of an enterprise is transferred into a separate entity, which is then jointly operated with another party, with the long-term intention that the other party will ultimately acquire full control of it. Such arrangements have become a quite common means of disposing of business segments in a way that enables a period of transitional sharing of control with the potential acquirer so that it can gain a full understanding of the business before taking full control of it.17 Depending on how such a joint activity is structured, it could be a joint venture enterprise, perhaps with one or both venturers having some form of option to buy out the other party. Where this is the case, it would be accounted for as an interest in a joint venture until such time as control is surrendered. In some cases, however, the contractual terms of an arrangement may indicate that one or the other party has control, so that it is not a joint venture enterprise.

17

See, for example, Ashish Nanda and Peter J. Williamson, Use Joint Ventures to Ease the Pain of Restructuring, Harvard Business Review (NovemberDecember 1995), pp. 119128.

2.41 Legal structure and substance of a joint arrangement. A joint venture may appear in unincorporated or incorporated form. The existence of a joint venture does not depend on the existence of a specific legal form. It is emphasized, however, that one must carefully examine the contractual and constructive provisions of a cooperative arrangement against the conditions that are contained within the definitions of a joint venture and joint control, to determine whether an arrangement is a joint venture. Comparison with Existing Definitions 2.42 The definitions of joint venture and joint control in existing accounting standards are to some extent inconsistent, or incomplete, in relation to the definitions proposed in this paper. 2.43 In the United States, APB Opinion 18 defines corporate joint venture as an enterprise owned and operated by a small group of businesses (the joint venturers) as a separate and specific business or project for the mutual benefit of the members of the group. It goes on to state: A corporate joint venture also usually provides an arrangement under which each joint venturer may participate, directly or indirectly, in the overall management of the joint venture. Joint venturers thus have an interest or relationship other than as passive investors. [paragraph 3] 2.44 Accounting Interpretation 2 of APB Opinion 18 states that that definition only applies to investments in common stock of enterprises and does not cover investments in partnerships and unincorporated joint ventures (also called undivided interests in ventures). It further states that many of the provisions would, however, be appropriate for these unincorporated entities.18 2.45 Taken all together, the U.S. definition of a corporate joint venture may be generally consistent with the definition proposed in this paper, except that its application to unincorporated entities is not clearly defined, and it is less specific with respect to the nature of the participation by joint venturers (i.e., it indicates only that each joint venturer may participate, directly or indirectly, in the overall management of the joint venture, and have an interest or relationship other than as passive investors). The United States does not have an authoritative defined concept of joint control. 2.46 In the United Kingdom, FRS 9 defines joint venture as an entity in which the reporting entity holds an interest on a long-term basis and is jointly controlled by the reporting entity and one or more other venturers under a contractual arrangement (paragraph 4). Differences with the definition proposed in paragraph 2.14 appear to be in the following areas: FRS 9 requires a contractual arrangement, while paragraph 2.30 of this paper proposes that joint control could be the result of circumstances. FRS 9, paragraph 11, appears to require active participation by joint venturers, while this paper proposes that it is the power to jointly make essential decisions that should govern (paragraphs 2.312.34). FRS 9, paragraphs 8 and 9, specifies certain more restrictive conditions for when an enterprise can qualify as a joint venture. These include that it must carry on a trade or business that is not part of the venturers trade or business and that any trade with investors must be on the same terms as available in the market. FRS 9 requires that the reporting entity hold a joint venture interest on a long-term basis. The proposed definition in paragraph 2.14 does not include this condition (paragraphs 2.39 and 2.40).

18

Accounting Principles Board, AICPA Accounting Interpretation 2, Investments in Partnerships and Ventures, of APB Opinion 18 (New York: AICPA, November 1971).

2.47 In New Zealand, SSAP-25 defines a joint v enture as a contractual association, other than a partnership, between two or more parties to undertake a specific business project in which the venturers have several liability in respect of costs and liabilities of the project and share any resulting output (paragraph 31). 2.48 Canadian and IASC concepts of joint ventures are very similar. 19 IAS 31 specifies that a joint venture is a contractual arrangement whereby two or more parties undertake an economic activity which is subject to joint control (paragraph 2). This is a much broader concept than proposed in this paper, in that it is not restricted to enterprises but includes jointly controlled assets and joint operations. The concept of joint control within the Canadian standard and IAS 31 would seem to be generally consistent with that proposed in this paper, except that they require a contractually agreed sharing of control. 2.49 In Australia, the recently revised standard, AASB 1006, issued in December 1998, defines a joint venture in identical terms to the IASC and CICA standards. However, the Australian standard goes on to distinguish a joint venture entity to be accounted for by the venturer on an equity basis from a joint venture operation (under which the venturer accounts for its share of the assets, liabilities, revenues, and expenses of the venture).

19

IAS 31 and Section 3055 in the CICA Handbook.

CHAPTER 3!METHODS FOR REPORTING AN INTEREST IN A JOINT VENTURE 3.1 Chapter 1 identified three methods for reporting a joint venture interest: The equity method of accounting, which portrays the venturers interest by presenting its investment in the net assets of the joint venture The proportionate consolidation method, which presents the venturers interest as a pro rata portion of each of the assets, liabilities, revenues, and expenses of the venture The expanded equity method of accounting, which combines elements of the equity method of accounting and the proportionate consolidation method by recognizing summarized proportional amounts of the assets, liabilities, revenues, and expenses of the joint venture as separate line items within the venturers financial statements.

3.2 This chapter analyzes those methods in terms of their conceptual basis, as well as in terms of certain practical implications. Clearly each method for presenting an interest in a joint venture sends a message about the rights and responsibilities inherent in the relationship between the venturer and the venture. In practical terms, the consequences of choosing one method over another will have a significant impact on such matters as the reported cash resources and financial leverage of the venturer. These are not conceptual matters but important practical considerations arising from the choice of a specific reporting method. 3.3 The conclusion of the analysis is that the equity method best presents the attributes of joint ventures as defined, and it is recommended that this method be adopted internationally as the single method of presenting the interest of venturers in a joint venture. It is recognized, however, that this method needs to be supplemented by appropriate disclosures. Disclosures are considered in Chapter 4. 3.4 The three methods considered do not exhaust the list of all possible methods. Two additional possibilities, cost and fair value, should be mentioned. 3.5 Cost. The investment in a joint venture might be carried at its net cost to the venturer. Cost has the advantage of being simple. Income from a joint venture would be recognized only as income distributions (dividends) are paid out or, perhaps, at the point that the joint venturers approve their distribution. This might be justified on the basis that since an individual venturer cannot unilaterally control the distribution of joint venture earnings, it is appropriate to wait and recognize these earnings only when they are realized or are clearly realizable as a result of a specific agreement to distribute profits among the venturers. It may be argued that a venturers share of the undistributed income of a joint venture does not meet the definition of an asset of the venturer until such time as it becomes a resource controlled by the venturer. 3.6 The disadvantage of the cost method is that it gives no recognition to the performance of the investment, the extent of the joint activities, or the value added by joint venture operations. There is now little acceptance of the cost method for accounting for interests in joint ventures, and its adoption for an investment in a joint venture is inconsistent with existing general acceptance for equity accounting for investments in enterprises over which the investor has only significant influence (which is generally less than joint control). 3.7 Fair value. Some may argue that the only truly relevant accounting is to carry the net investment in a joint venture at its fair value. However, none of the G4+1 members are advocating this at this time. To do so would take accounting beyond currently accepted concepts and practice under which it is generally not considered appropriate to anticipate future earnings from such investments. In other words, until a joint venture has earned income through its operating activities (by achieving revenues in excess of related costs), it is reasoned that there has been no culmination

of an earnings process that warrants recognition of income or increase in asset value by a joint venture or the venturer investing in it. 3.8 The following discussion will consider the merits of each of the three methods identified abovethe equity, proportionate consolidation, and expanded equity methods. 3.9 As has been previously noted, there is much inconsistency between standards of the G4+1 members. In Canada, proportionate consolidation is required of all joint ventures, as defined. The IASC specifies proportionate consolidation for joint ventures to be its benchmark standard, but it permits the use of the equity method as an allowed alternative. IAS 31 might be interpreted to permit an enterprise to account for some of its joint ventures on a proportionate consolidation basis and some, under the allowed alternative, on an equity basis. The UK standard (FRS 9) requires what it describes as the gross equity method, a variation of the equity method, under which the venturers pro rata interest in the aggregate assets, liabilities, and revenues of a joint venture are disclosed as an amplification of the net equity amounts in the venturers financial statements. The New Zealand standard (SSAP-25) currently provides for proportionate consolidation of only certain types of unincorporated joint arrangements that would not meet the definition of a joint venture as proposed in this paper. The Australian standard (AASB 1006) requires equity basis accounting for joint entities. It provides that a joint venture should account for its share of the assets, liabilities, revenues, and expenses of other joint venture operations that are not joint venture entities. In the United States, an enterprise is permitted to include its proportionate interest of the assets and liabilities of an investee only for certain unincorporated joint arrangements where the investor owns an undivided interest in each asset and is proportionately liable for its share of each liability, if it is an established industry practice (such as in some oil and gas venture accounting) (AICPA Accounting Interpretation 2 of APB Opinion 18). In effect, U.S. generally accepted accounting principles require equity accounting for all joint ventures as defined in this paper.

The Equity Method in Comparison with Proportionate Consolidation 3.10 The equity method of accounting has been referred to as a one line consolidation. Under this method, an investment is presented in the investors balance sheet as a single amount, initially measured at cost and adjusted thereafter to include the investors pro rata share of postacquisition earnings and any increments (or decrements) arising from other changes in the investees equity, including distributions of earnings, capital contributions or withdrawals, and changes in the investors ownership interests. The investors share in the earnings of the investee is generally included as one line in the investors income statement, although there may be separate classification of some special components. 3.11 Under proportionate consolidation, the venturers pro rata share of each of the assets, liabilities, revenues, and expenses that are subject to joint control is combined on a line-by-line basis with the venturers other assets, liabilities, revenues, and expenses. The proportionate consolidation method would carry through to the statement of cash flows. It would reflect the venturers portion of the cash transactions of the venturer reflected as components of the venturers reported operating, investing, and financing categories of its cash flow statements. 3.12 It is useful to analyze the comparative attributes of each of these methods in terms of the concept of an asset. There is general recognition and acceptance among the conceptual frameworks of G4+1 members that an essential condition of an asset is that it be a resource controlled by the reporting enterprise. Proportionate consolidation is fundamentally inconsistent with

this basic economic concept because a venturer cannot control (that is, use or direct the use of) its pro rata share of individual assets in a joint venture. To report that the assets of an enterprise with, say, a 40 percent interest in a joint venture include 40 percent of the ventures cash balance, 40 percent of the ventures plant and equipment balance, and 40 percent of other accounts misrepresents the resources controlled by the venturer. The venturer does not command use of the ventures cash, plant, and other accounts. The investment in the joint venture gives the venturer only joint direction of the ventures assets and a collective return on the net assets of the joint venture. What the venturer does control is its joint venture rights, that is, it can determine how it will apply its rights of joint control over essential venture decisions (whether it will invoke its right of veto over decisions on essential matters, for example), its rights to share in the collective benefits of the joint venture, and any rights it has to sell its interests to another party or pledge its investment as collateral. All this is consistent with reporting the net equity interest as one line on the balance sheet. 3.13 Likewise, reasoning within the accepted concept of a liability, it is wrong in principle for a venturer enterprise to reflect a pro rata share of a joint ventures debt that is not a present obligation of the venturer enterprise. If a liability is the primary responsibility of the joint venture, then it should be recorded directly in the joint ventures balance sheet rather than in the venturers balance sheet. A joint venture enterprises debt would not be the primary responsibility of a venturer. At most, a venturer may be secondarily responsible, as a guarantor, if the venture enterprise should default.20 If it is a

20

A joint venture was defined in Chapter 2 as a separate enterprise, with its own assets and operating activities.

guarantor, then it should disclose this and provide for it as a liability to the extent that it has an expected obligation value to the venturer. 3.14 It may be concluded, then, that portrayal of the net assets of a joint venture by the equity method is consistent with the accepted concepts of assets and liabilities, while the proportionate consolidation method is not. 3.15 However, proponents of proportionate consolidation believe that the equity method approach takes too narrow an interpretation of the definitions of assets and liabilities and that the substance and economic reality of an interest in a jointly controlled enterprise is best reflected when the venturer reports its interests in the assets, liabilities, income and expenses of the jointly controlled entity . . . (IAS 31, paragraph 26). Proponents of proportionate consolidation argue that the power of joint direction of a venture operation is significantly greater, and should be distinguished from, equity accounting for investees on the basis of significant influence. 3.16 In replying to the conceptual case against proportionate consolidation, some challenge the conceptual validity of the equity method of accounting for significantly influenced, but not controlled, investees. They reason that the investors pro rata share of the earnings of a noncontrolled investee does not meet the definition of an asset of the investor. This is because the investor does not control the investee and, thus, does not have the power to have assets equal to its share of the investees earnings remitted to it or,

alternatively, to direct their use in the investees enterprise. 21 Equity accounting may then be considered just a pragmatic rule that may be useful from an information value perspective, but which, in the final analysis, has no better conceptual credentials than proportionate consolidation. 3.17 Proponents of the equity method of accounting may respond to the above conceptual argument that the equity method of accounting by a joint venture is not an asset recognition issue, but rather a question of how to measure the value to the venturer of its investment in a joint venture. Nevertheless, even if one accepts that there is a conceptual problem with the equity method of accounting, one may still prefer it over proportionate consolidation, because the latter is a more flagrant infraction of conceptual framework concepts in representing that a venturers pro rata share of jointly controlled assets and liabilities are assets and liabilities of the venturer. 3.18 At the heart of the case of those arguing for proportionate consolidation is their strongly held belief that it is more useful accounting. They argue that portraying the venturers share of the activities of the joint venture as part of the venturers operations provides a broader and more comprehensive representation of the extent of venturer operations and assets and liabilities. Further, they claim that proportionate consolidation provides a better representation of the performance of enterprise management, and an improved basis for predicting the ability of the venturer to generate cash and cash equivalents in the future, particularly where a significant portion of business is conducted using joint ventures. 3.19 Those beliefs are open to challenge. In assessing practical usefulness, it is not obvious that external users want, or benefit from, a portion of the operations of a jointly controlled activity being commingled with the unilaterally controlled operations of the venturer or that it is appropriate to expand the domain for which management is held accountable to include the assets and liabilities of enterprises over which it has only joint control and responsibility. 3.20 It may be that an external users understanding of a venturers operations is not enhanced, but is potentially confused, by adding together pro rata portions of jointly controlled assets and liabilities with the assets and liabilities of the reporting enterprise. It may be argued that the extent of operations carried out by joint ventures is much better portrayed through the types of supplementary disclosure discussed in Chapter 4. 3.21 Proponents of proportionate consolidation express particular concern that joint ventures may be utilized to hide debt, that is, to achieve off-balance-sheet debt financing. To illustrate, suppose that two independent enterprises, C and D, each agree to contribute substantial operating plant and equipment to a joint venture and then have the joint venture finance a significant portion of these assets by issuing debt. C and D may enter into take-or-pay contracts with the joint venture to purchase sufficient product from the joint venture to provide it with sufficient cash flows to repay the debt. Under the equity method, C and D will each show a relatively small investment in the joint venture, since it is significantly leveraged by the joint ventures debt financing. The proportionate consolidation method will result in each venturer including in its balance sheet a portion of the joint venture debt equal to its pro rata interest in the joint venture. 3.22 Proponents of proportionate consolidation believe this to be a fairer representation of the venturers financial position than the equity method. But is this really the case? A joint venture is a separate enterprise with its own operating cash flows, under the conditions for being a joint venture enterprise proposed in Chapter 2. In this case, the debt is that of the joint venture to be paid with its

21

See, for example, W. J. McGregor, Directions for Australian Standard-SettersA Personal View (paper presented at the AARF Forum on Off-Balance Sheet Structures, November 1989); and Christopher W. Nobes, An International Analysis of the Development of the Equity Method (discussion paper in accounting finance and banking, no. 59, University of Reading, May 1998).

assets and cash flows and is not a present obligation of the venturers. The obligations of the venturers relate to the take-or-pay contracts and any additional guarantees that they may have provided. Any discomfort with the joint venture debt being off the balance sheets of the venturers may be primarily a discomfort with the accounting for take-or-pay commitments and guarantees. The pragmatic solution of proportionate consolidation does not seem to be a well-targeted cure for the apparent ills caused by the assumption of indebtedness by a joint venture. The problems of accounting for and disclosure of take-or-pay contracts and guarantees are not matters that are exclusively related to joint ventures. Summary Observations 3.23 The conceptual basis for the proportionate consolidation of joint ventures is weak. Recognizing portions of assets and liabilities that are not under the control or primary responsibility of the venturer is inconsistent with established concepts of assets and liabilities. In pragmatic terms, proportionate consolidation may provide information about off-balance-sheet financing activities, but only by introducing other noise into the financial reporting system in terms of commingling a portion of jointly controlled assets and liabilities with the controlled assets and liabilities of the reporting enterprise. Proportionate consolidation cannot rectify the fact that a joint venture arrangement provides the venturer with, at best, a right of veto over the collective activities of the venture. While there are some practical concerns with respect to, for example, the possibility for achieving off-balance-sheet debt financing, the proportionate consolidation method is not a conceptually or pragmatically sound response to them. Disclosure, as discussed in Chapter 4, is a better solution. The Expanded Equity Method 3.24 The expanded equity method represents a joint venture interest by including major groupings of the pro rata portion of venture assets, liabilities, revenues, and expenses in the appropriate parts of the venturers financial statements, but with separate disclosure and without combining these amounts directly with its own assets and liabilities.22 The venturers pro rata portion of cash flows will also be separately presented in some form in the venturers cash flow statement. 3.25 The expanded equity method is in essence a compromise proposal. Its primary benefits are that, in comparison with the equity method, it offers recognition of the major groupings of the venturers pro rata share of a joint ventures assets and liabilities and revenues and expenses in the venturers financial statements without commingling them with the venturers balances. This method may be most accurately described as a modified proportionate consolidation approach.

22

Richard Dieter and Arthur R. Wyatt, The Expanded Equity MethodAn Alternative in Accounting for Investments in Joint Ventures, The Journal of Accountancy (June 1978), p. 89.

3.26 While it may have some display advantages, the expanded equity method is subject to the same basic conceptual shortcomings as proportionate consolidation, because it includes as assets and liabilities of the venturer enterprise a portion of jointly controlled assets and liabilities.23 As has been noted, in the United Kingdom, FRS 9 requires the gross equity method, which is distinguished from the expanded equity method in that it requires that the net equity in a venturer be recorded in a venturers financial statements and then presents the venturers proportionate interests in the assets, liabilities, revenues, and expenses of a joint venture on the face of the financial statements as a supplementary amplification of the net equity figures. This display approach is further discussed in Chapter 4. Conclusion 3.27 The equity method of accounting is the most appropriate method for presenting an interest in a joint venture enterprise in the financial statements of a venturer.

23

IAS 31, paragraph 28, treats the expanded equity approach simply as an alternative reporting format that may be adopted to give effect to proportionate consolidation.

CHAPTER 4!DISCLOSURE OF INTERESTS IN A JOINT VENTURE 4.1 Cooperative arrangements between business enterprises can have unique characteristics relating to the jointness of their activities, sharing of risks, common control, and the collective determination of outcomes. Such arrangements may involve complex contractual conditions and relationships between the venturers. These may include cross-commitments, contingent liabilities, and trading and financing transactions. As a result, it is important to consider the nature and extent of disclosures necessary to provide users with an adequate understanding of these arrangements, their financial effects, and potential implications for future cash flows. 4.2 It is well accepted that interests in joint ventures should be separately classified in the venturers financial statements from other intercorporate investments recognized using the equity method of accounting and that some additional information on joint venture arrangements is needed. Joint Venture 4.3 It is proposed that the following information should be provided where there is significant involvement in joint ventures.24 A listing and description of significant interests in joint ventures, including the nature of their trade or business activities, and the proportion of common control interests held in each significant venture.

4.4 It is proposed that the following should be provided for significant individual joint ventures, groups of similar ventures, and in aggregate (significance may be assessed in terms of the size of joint venture operations relative to those of applicable reportable venturers business segments). Summarized financial statements of the joint venture operations, including at least the investors share of the following amounts: Current assets and long-term assets Current liabilities and long-term liabilities (with a maturity profile of material amounts of longterm debt) Revenues and expenses by major components, and net income before and after taxes Cash flow from operating, investing activities, and financing. Descriptions and amounts of significant contingencies and commitments in respect of joint ventures separately from other contingencies and commitments, including: Capital commitments of the venturer in respect of joint ventures, its share of the capital commitments incurred jointly with other venturers, and its share of the capital commitments of the joint ventures themselves Contingencies related to interests in joint ventures, including those incurred jointly with other venturers, those liabilities of other venturers for which the reporting enterprise is contingently liable, and its share of the contingent liabilities of the joint ventures themselves. Amounts owed to or by a venturer and joint ventures and other venturers, and related party transactions. (Existing standards already generally require that the nature and extent of relatedparty transactions be disclosed.) Particular attention may be needed to provide meaningful

24

In the United Kingdom, FRS 9 sets out specific thresholds based on the percentage of an investors share of joint venture assets, liabilities, revenues, or operating results to the corresponding amounts of the investor group as a whole. It requires certain disclosures of the investors share in aggregate joint venture sales, fixed assets, and current and long-term liabilities where one or more of the thresholds exceed 15 percent, and certain additional information on individual ventures that exceed 25 percent.

information on potentially complex transactions arising out of joint venture relationships, including material gains and losses recognized as a result of such transactions. 4.5 Existing accounting requirements in many jurisdictions already require at least some of the above information. Joint Arrangements Other Than a Joint Venture 4.6 General standards of fair presentation should be considered to require sufficient information about other joint arrangements to enable financial statement users to understand their impact and potential implications for the ability of the enterprise to generate cash flows in future periods. In particular, much of the information outlined above on joint venture arrangements may be relevant to material joint activities, especially those involving jointly owned assets and joint and several liabilities. See also Chapter 2, paragraphs 2.24 and 2.27. Display Issues 4.7 The disclosures outlined above may be appropriately set out in the notes or in supplementary schedules to the investors financial statements. In the United Kingdom, FRS 9 requires what it describes as the gross equity method for the presentation of the reporting enterprises share of the aggregate assets and liabilities of joint ventures on the face of its balance sheet and the reporting enterprises share of joint venture revenues in the statement of income. These are displayed as an amplification of the net equity amounts clearly distinguished on the reporting enterprises balance sheet and income statement.25 Such display may be helpful in giving an indication of the size of the combined business of the investor and its share of jointly controlled operations as long as it is set out in a way that does not give a misleading implication that the combined amounts are the result of controlled activities of the investor enterprise.

25

Examples of these disclosures are provided in FRS 9, Appendix IV, pages 7681.