Accounting alert 2007/18 – Proposed changes to joint venture accounting

The AASB last week issued an exposure draft ED 157 Joint Arrangements, which is equivalent to IASB exposure draft, ED 9 Joint Arrangements. A copy of ED 157 can be downloaded from the AASB website (PDF 366 kb) and a copy of ED 9 can be downloaded from the IASB website. ED 157/ED 9 are intended to result in new Standards that would replace AASB 131 and IAS 31 Interests in Joint Ventures.

The proposals in ED 157/ED 9 may at first instance seem less than extraordinary, with the main change being the elimination of the option to proportionately consolidate interests in jointly controlled entities.

In this Accounting alert, we provide a high-level overview of the exposure draft and focus on some of the issues arising from them for Australian entities, covering the following topics:

a substantial de-emphasis on the legal form of joint venture arrangements - instead focussing on the substance of the arrangement
changing the manner in which the concept of ‘joint control’ is applied, particularly in relation to joint assets and operations
the draft Illustrative Guidance includes many examples that imply methods of accounting that may not necessarily be currently followed by Australian entities, particularly mining and oil and gas companies
expanded disclosure requirements around joint ventures, associates and subsidiaries.

De-emphasis of the legal form of joint venture arrangements

General principles

The exposure draft proposes that the form of an arrangement should not be the most significant factor in the determination of the appropriate accounting for the arrangement. This is unlike the approach taken under AASB 131/IAS 31 Interests in Joint Ventures which is closely aligned to the legal structure of joint venture arrangements, with only jointly controlled entities being singled out for equity accounting (or proportionate consolidation).

Substance over form approach

The EDs effectively adopt a ‘substance over form’ approach to the accounting for joint venture arrangements, focussing on the rights and obligations contractually agreed to by the parties. The EDs propose that:

a party to a joint arrangement should recognise its contractual rights and obligations (and the related income and expenses) in accordance with applicable IFRSs
a party should recognise an interest in a joint venture (i.e. an interest in a share of the outcome generated by the activities of group of assets and liabilities subject to joint control) using the equity method. Proportionate consolidation would not be permitted.

Types of joint arrangements

The following table summarises the three forms of joint arrangements contemplated by ED 157/ED 9:

Type	Characteristics	Ownership of assets	Summary of accounting required
Joint operation	Involves the use of the assets and other resources of the parties, often to manufacture and sell a joint product	Each party generally owns its own assets that it uses to create the joint product	Recognise controlled assets and incurred liabilities, expenses incurred and share of revenues and expenses from the sale of goods or services by the joint arrangement
Joint asset	Each party takes a share of the output from the asset and bears an agreed share of the costs incurred to operate the asset	Each party has rights, and often has joint ownership of the assets used to generate the output	Recognise share of joint assets, classified according the nature of the asset, liabilities incurred (including those jointly incurred), revenue from the sale of share of output and expenses incurred
Joint venture	Joint arrangement that is jointly controlled by the venturers. Each venturer is entitled to a share of the outcome of the activities of the joint venture	Venturers do not have rights to individual assets or obligations for expenses of the venture	Recognise the interest in the joint venture using the equity method unless an exemption applies (held for sale, exemption from equity accounting)

One arrangement can result in more than one category

The EDs effectively require an entity to take a holistic view of its joint venture arrangements. It also means that one arrangement can have multiple aspects and those aspects may be separately accounted for in some cases.

For instance, where joint arrangements are conducted through an entity, all associated agreements will need to be considered when assessing how to account for the arrangement – this could include leases granted or other rights afforded to one or more of the venturers, guarantees provided effectively making venturers liable for liabilities. These contractual rights and obligations considered in the context of the overall arrangement may bring some assets and liabilities directly onto the balance sheet of the venturers.

Example

This example is based on Illustrative Example 3 in ED 157/ED 9.

Three companies (venturers) jointly buy a 15-floor office building, with each floor having a separate legal title, allowing each floor to be sold separately. Each partner has ownership of five floors and can use one floor for whatever purpose it chooses. Ownership of the other four floors held by each venturer are transferred to a separate company and then rented to third parties. The venturers jointly control the company and are not liable for any costs of the company.

Under the proposals in the EDs, the venturers must recognise two separate items:

a direct interest in the floor, accounted for under applicable IFRSs
an interest in the company, equity accounted.

The same outcome would result if all 15 floors of the building were legally owned by the company, but with one floor leased to each venturer for the expected life of the building. This is because the rights afforded to each venturer through the lease produces an equivalent outcome in substance to direct ownership of the leased floor.

Under both scenarios, the joint venture company itself would not recognise the rights to use the floor which rest with the individual venturers.

Summary flowchart

The following flowchart (a simplified version of Application Guidance included in ED 157/ED 9) illustrates how a party to a joint arrangement recognises its interests in the arrangement.

The proposals in ED 157/ED 9 are part of the IASB’s short-term convergence project with the FASB, although ED 157/ED 9 does not include industry specific guidance that exists under US-GAAP.

Although the proportionate consolidation approach has only recently been introduced in the Australian context, it has had a long history of support and use in some parts of the world (particularly Europe) and its proposed elimination under ED 157/ED 9 may see some staunch resistance as a result. The IASB’s proposals around a ‘substance over form’ approach to accounting for joint venture arrangements may in some cases address concerns about the elimination of the proportionate consolidation approach to recognising interests in jointly controlled entities.

The approach under ED 157/ED 9 requires legal structures to be ignored, in some cases bringing assets and liabilities held in separate legal entities directly onto the balance sheets of the venturers. This may provide entities with the opportunity to structure arrangements to achieve accounting outcomes that resemble proportionate consolidation for some existing incorporated joint ventures. However, entities wishing to bring such assets and liabilities onto the balance sheet may need to accept a higher level of exposure to the underlying risks and rewards associated with those arrangements to achieve a ‘substance over form’ outcome. In other words, the new approach will not be a complete remedy for those that oppose the abolition of proportionate consolidation from IFRS as the substance and legal form of the arrangement will dictate an equity accounting approach in some cases.

The possible dividing of one arrangement into many component parts will potentially introduce a lot more judgement into accounting for these types of arrangements. This substance over form approach, whilst perhaps a pragmatic solution to convergence with US-GAAP so strongly pursued by the IASB and FASB, is in some respects premature when considered in light of the wider projects being undertaken by the IASB. This project is heavily dependent on the notion of ‘unit of account’ which is currently being debated by the IASB in its overall conceptual framework project – the Framework for the Preparation and Presentation of Financial Statements currently lacks guidance on how to account for ‘parts’ of assets or rights to particular aspects of assets.

Changes to the application of the concept of ‘joint control’

The proposals in ED 157/ED 9 are focussed on ‘joint arrangements’ rather than ‘joint ventures’ that were within the scope of IAS 31.

A ‘joint arrangement’ is defined as follows:

A contractual arrangement whereby two or more parties undertake an economic activity together and share decision-making relating to that activity.

The new definition requires shared decision making by all parties to the arrangement, rather than joint control, although this concept is retained for joint ventures. The IASB decided to change the approach because the concept of ‘control’ does not translate well to an asset or operation and furthermore, it was acknowledged that venturers do not often establish financial and operating policies for a joint operation or joint asset arrangement.

However, the current wording of ED 157/ED 9 means that there remains uncertainty around entities that participate in joint arrangements but who do not participate in shared decision-making. Under ED 157/ED 9, ‘shared decisions’ are defined as “decisions that require the consent of all of the parties to a joint arrangement” (emphasis added).

The definitions and workings of ED 157/ED 9 is somewhat circular, so it is difficult to determine whether ED 157/ED 9 is intended to contemplate joint arrangements where only some parties participate in joint control.

Accordingly, it is unclear whether minority participants in joint arrangements where decisions are made by a contractually agreed majority will be within the scope of any standard resulting from ED 157/ED 9.

It may be that the intention of the IASB was that these arrangements are within the scope of ED 157/ED 9 and so parties that don’t participate in shared decision-making will be able to ‘account for what they own’ and recognise their share of assets and liabilities where the arrangement affords them an undivided interest. Under AASB 131/IAS 31, this is outcome is not supported by all accounting professionals, with some preferring equity accounting under AASB 128/IAS 28 (due to ‘significant influence’) or the recognition of an intangible asset under AASB 138/IAS 38 (a form of right).

Example

Company D, Company E and Company F hold ownership interests of 45%, 30% and 25% respectively in an unincorporated ‘joint venture’ which is involved in the extraction of minerals from a particular area. Each party to the ‘joint venture’ has an undivided interest in the assets and liabilities of the joint venture in proportion to its ownership interest. The ‘joint venture agreement’ provides that each party has voting rights in proportion to its ownership interest and that all significant decisions require at least 75% approval. There are no ‘casting vote’ in the event that the 75% threshold is not reached, but instead a contractual arbitration process is followed.

Due to the contractual requirement for 75% approval for decisions to be made, Company D and Company E must agree before decisions can be made (as they together have a 75% interest). Accordingly, Company F does not participate in shared decision-making.

Under the proposals in ED 157/ED 9, it is unclear how Company F should account for its 25% interest in the arrangement.

Draft Illustrative Guidance may cause issues

The Draft Illustrative Examples accompanying ED 157/ED 9 contains a number of comprehensive examples that are very useful in understanding and applying its requirements, particularly as some of the concepts in the main body of the EDs can be quite esoteric.

However, there are a number of examples in the Draft Illustrative Examples that may cause concern for some Australian entities where the method of accounting for transactions and assets and liabilities associated with the joint arrangement being illustrated in the examples may not align with their current accounting policy.

The analysis below highlights some of the more troublesome examples in the EDs. These relate mainly to the extractive industries where past and current practice tends to be diverse. Whilst the clarification in the EDs is in some regards welcome, we are concerned that many of the issues illustrated cut across the IASB’s project on extractive activities and so believe a note of caution is warranted in the way that the examples are worded and presented.

Example 5 – Mining unitisation arrangement

Example 5 illustrates a mining unitisation arrangement whereby entities which each have rights to extract minerals from adjacent areas enter into a contract to combine their operations into one combined area for the purpose of sharing costs. Each party retains legal ownership of the extractive rights for their respective areas and the participation percentages are adjusted on the basis of the findings of an independent study of reserves (sometimes called a ‘redetermination’).

In this instance, the joint arrangement is considered to involve joint assets, meaning that each party recognises its respective interest in the mineral rights, production equipment, minerals extracted, liabilities incurred, decommissioning liabilities and financing of the operations.

In the event that there is no redetermination process, the example states that whilst the arrangement involves joint assets, the initial setup of the unitisation arrangement is considered the exchange by each party of its interest in its original mineral rights for a percentage of the mineral rights in the combined area.

Under this view of unitisation arrangements, it would be expected that a sale transaction would be recognised, leading to the recognition of a gain or loss on the initial set up of the unitisation arrangement.

Our experience is that this approach is not always followed by entities in relation to unitisation arrangements, particularly where they involve the exploration and evaluation or early development phases, where the fair values of the various assets involved in the unitisation can be difficult to determine.

The simplistic example also does not deal with the common situation whereby the unitisation arrangement undergoes a number of redeterminations before the final percentages in the overall field are locked in by way of a final determination. The implied guidance in this Illustrative Example could lead to the recognition of a gain or loss at the time of final redetermination, as this could be considered the sale of the underlying interest in exchange for a new interest in the combined field at that time.

Example 6 – Oil and gas ‘farm-in’ arrangement

Example 6 deals with a typical ‘farm-in’ arrangement whereby two parties each earn a 25% working interest in an exploration field by spending CU2 million. The arrangement is considered to involve joint assets with each entity recognising their interest in the exploration assets and operating costs, and any financing of the operations.

More importantly, the arrangement is also characterised as a cost-sharing and risk-sharing arrangement whereby the entity farming-out is selling an interest in exploration assets and the entities farming-in are buying an interest in the exploration assets. Explicit guidance is provided that at the time of the agreement, the entity farming-out recognises a gain or loss on disposal of exploration assets in accordance with applicable IFRSs.

Again, the issue of how to account for farm-ins and farm-outs under IFRS is an area of considerable conjecture under IFRS. As a large number of these types of arrangements commonly arise during the exploration and evaluation phase of the extractive activity operations, the predominant applicable standard is IFRS 6 Exploration for and Evaluation of Mineral Resources (AASB 6 is the equivalent Australian Standard).

In Australia, following the Australian-specific requirements introduced in AASB 6 by the AASB, it is common practice to adopt a capitalisation approach for exploration and evaluation expenditures. Under this approach, so long as the other requirements of AASB 6 are met, an asset is created in relation to each area of interest where activities in the area of interest have not at reporting date reached a stage which permits a reasonable assessment of the existence or otherwise of economically recoverable reserves.

Because of this ‘capitalise if unsure’ approach, the exploration and evaluation asset is viewed as a cost accumulation of all expenditure in relation to the area of interest. If the entity then farms-out an interest in the overall area of interest, the following approaches are commonly adopted:

if cash is received as a result of the farm-out arrangement, the amounts received are used to reduce the asset as it can be seen as a ‘recovery of cost’
if cash is not received (such as a ‘free carry’ arrangement for a period of time or for an agreed amount), often no entries are made and the accumulated costs are carried forward as the cost of the entity’s interest
in some cases, the carrying amount of the asset may be tested for impairment if the carrying amount of the asset is higher than the implied value of the farm-out arrangement, i.e. the arrangement is considered to trigger the modified impairment indicator approach dictated by AASB 6 – although under a pure ‘cost accumulation’ approach this is not always followed so long as the other requirements of AASB 6 are met (mainly that exploration and evaluation activities are continuing and that the existence or otherwise of economically recoverable reserves is unknown).

Similarly, the entity farming-in to the area of interest might also adopt a ‘cost accumulation’ approach and recognise an exploration and evaluation asset as the amounts are spent, rather than as an upfront purchase transaction with a liability. This approach is often justified by reference to the requirements of AASB 6 and the optionality implied in the farm-in arrangement, i.e. most of these arrangements permit the entity farming-in to choose not to expend the full committed amount and thereby relinquish its interest in the tenement.

Many directors involved in the extractive industries would feel quite uncomfortable taking a ‘sale and purchase’ rather than ‘cost recovery/accumulation’ approach with farm-ins and farm-outs over exploration and evaluation interests. They argue that the asset is uncertain and that under the ‘cost accumulation’ approach it would be misleading to show a gain or loss as a result of a farm-out arrangement when the arrangement is in substance a means of sharing costs and spreading risk.

Expanded disclosure requirements

ED 157/ED 9 propose a number of enhanced disclosure requirements around joint arrangements, particularly in relation to joint ventures (which must be equity accounted under the EDs). Consequential amendments are also proposed to AASB 128/IAS 28 and AASB 127/IAS 27 to align disclosure requirements between the various Standards.

General requirements

A description of the nature and extent of operations conducted through each of the three types of joint arrangement (joint operations, joint assets and joint ventures) must be disclosed. The requirement to disclose details of capital commitments and contingent liabilities in relation to joint arrangements remains.

Disclosures for joint ventures

AASB 128/IAS 28 and the proposals in the EDs require the use of the equity method to account for interests in associates and joint ventures respectively. Accordingly, the IASB took the view that the disclosure requirements for interests in joint ventures should be aligned with those required by IAS 28 for investments in associates in order to meet the needs of users of financial statements.

New disclosures specifically in relation to joint ventures include:

a requirement to disclose several financial measures for each individually material joint venture – including, but not limited to, current and non-current assets and liabilities, revenues and profit and loss
where the financial report of the joint venture used for the purposes of equity accounting has a different reporting date or period from the venturer, reasons for using that different reporting date or period
the nature and extent of any significant restrictions (e.g. resulting from borrowing arrangements or regulatory requirements) on the ability of joint ventures to transfer funds to the venturer in the form of cash dividends, or repayments of loans or advances
the unrecognised share of losses of a joint venture, both for the period and cumulatively, if a venturer has discontinued recognition of its share of losses of a joint venture
separate disclosure of the share of the profit or loss of joint ventures accounted for using the equity method, and the share of any discontinued operations of joint ventures
an explicit requirement to recognise in other comprehensive income a venturer’s share of changes recognised in other comprehensive income by joint ventures.

Consequential amendments

Consequential amendments are also proposed to AASB 128/IAS 28 to reflect decisions made in relation to the disclosure requirements in the EDs, including the following:

requiring disclosure of a list and description of investments in significant associates and the proportion of ownership held
requiring the summarised financial information about associates to be disaggregated into current and non-current components
removing the requirement to explicitly state when associates have not been accounted for using the equity method, along with summarised financial position of any such entities.

A further consequential amendment is proposed to the disclosure requirements in AASB 127/IAS 27 to include an explicit requirement to disclose the identity and details of significant subsidiaries.

Australian impact

From the Australian perspective, the revised disclosures proposed by ED 157/ED 9 are not as extensive as those required by the Australian-specific paragraphs in AASB 131, AASB 127 and AASB 128 which were removed by AASB 2007-4 Amendments to Australian Accounting Standards arising from ED 151 and Other Amendments with effect for annual reporting periods beginning on or after 1 July 2007. Accordingly, this aspect of ED 157/ED 9 will not have a great impact on Australian entities, although there will be a number of reporting periods where there disclosures are not required.

More information

For more information, see the following:

IAS Plus Newsletter Proposed Changes to Accounting for Joint Ventures (PDF 116 kb)
IAS Plus project page on the IASB joint ventures convergence project
IASB Exposure Draft ED 9 Joint Arrangements – comments close on 11 January 2008
IASB press release 'IASB proposes improvements to the accounting for joint arrangements'
IASB project page on joint ventures convergence project
AASB ED 157 Joint Arrangements (PDF 366 kb) – comments close on 30 November 2007
AASB Media Release 'Comments invited on AASB 157 Joint Arrangements' (PDF 67kb)