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On 12th May 2011, the International Accounting Standards Board (IASB) issued its new consolidation and related standards, replacing the existing accounting for subsidiaries and joint ventures (now joint arrangements), and making limited amendments in relation to accounting for associates.
In our previous article we had covered IFRS 10, the new standard on consolidated financial statements.
In this article we focus on IFRS 11, Joint Arrangements and IAS 28 (2011), Investments in Associates and Joint Ventures, giving our perspectives on the requirements that are modified and that are expected to have an impact on the preparers and users of IFRS financial statements.
The primary changes introduced under IFRS 11 are:
- It carves out from IAS 31 on jointly controlled entities, those cases in which although there is a separate vehicle, that separation is ineffective in certain ways. These arrangements are treated similar to jointly controlled assets/ operations and are now called joint operations; and
- Eliminates the free choice of equity accounting or proportionate consolidation for accounting for investments in joint ventures. These must now be accounted always using the equity method.
Identifying joint arrangements
A joint arrangement is an arrangement over which two or more parties have a joint control, being contractually agreed sharing of control i.e., unanimous consent is required for decisions about the relevant activities.
In order to identify a joint arrangement, IFRS 11 requires a two-step analysis to be performed: (1) assess whether collective control exists of an arrangement; and (2) then assess whether the contractual arrangement gives two or more parties joint control over the arrangement.
What is the meaning of control?
IFRS 11 does not define the term ‘control’. As such, reference may be had to the definition of ‘control’ under IFRS 10. As discussed in detail in our last article on IFRS 10, the assessment of control may undergo a change under IFRS 10 as compared to IAS 27 (2008). For instance, only substantive rights held by the investor and others are considered in assessing control. To be substantive, rights need to be exercisable when decisions about the relevant activities need to be made, and their holders need to have a practical ability to exercise the rights. It may be noted that the ‘rights that need to be exercisable when decisions about the relevant activities need to be made’ is different from the current requirement under IAS 27 (2008) of ‘rights that are currently exercisable’.
De facto control in case of joint arrangements
Joint control exists only when it is contractually agreed that decisions about relevant activities require the unanimous consent of the parties that control the arrangement collectively. When, for instance, the parties can demonstrate past experience of voting together in the absence of a contractual agreement to do so, this will not satisfy that requirement. However, it is possible to establish a joint de facto control i.e., control is based on de facto circumstances and the parties sharing control have contractually agreed to share that control.
For instance, A and B hold 24.5% each in Company C, while the remaining 51% shares are held by numerous shareholders, none of them holding more than 1% shares each and do not have any shareholder agreement amongst them. If A and B contractually agree that on decisions relating to the relevant activities of Company C, the casting of their combined voting power of 49% requires their unanimous consent; it may be concluded that A and B have joint control over Company C on a de facto basis.
Key differences from IAS 31
IFRS 11 does not modify the overall definition of an arrangement subject to joint control, although in a few cases, the joint control evaluation may undergo a change on account of application of control definition under IFRS 10.
Classifying joint arrangements
After determining that joint control exists, joint arrangements are divided into two types, each having its own accounting model, defined as follows:
- A joint operation is one whereby the jointly controlling parties, known as the joint operators, have rights to the assets and obligations for the liabilities, relating to the arrangement;
- A joint venture is one whereby the jointly controlling parties, known as the joint venturers, have rights to the net assets of the arrangement.
The key to determining the type of arrangement, and therefore the subsequent accounting, is the rights and obligations of the parties to the arrangement. For instance, two parties set up a separate entity, whereby the main feature of its legal form is that the parties (and not the entity) have rights to the assets and obligations for the liabilities of the entity, and the contractual arrangement between the parties establishes the parties’ rights to the assets, responsibility for all operational or financial obligations and the sharing of profit or loss. Though the arrangement is structured through a separate entity, as the legal form of the separate vehicle does not confer separation between the parties and the vehicle, the joint arrangement is a joint operation.
An entity determines the type of joint arrangement by considering the structure, the legal form, the contractual arrangement and other facts and circumstances.
Structure of joint arrangements
A joint arrangement not structured through a separate vehicle can be classified only as a joint operation. A separate vehicle is a separately identifiable financial structure, including separate legal entities or entities recognised by statutes, regardless of whether those entities have a legal personality.
A joint arrangement structured through a separate vehicle can be either a joint venture or a joint operation. As such, a separate vehicle is necessary but not a sufficient condition for a joint venture. If there is a separate vehicle, then the remaining tests are applied.
Legal form of the arrangement
If the legal form of the separate vehicle does not confer separation between the parties and the separate vehicle i.e., the assets and liabilities placed in the separate vehicle are the parties’ assets and liabilities, then the joint arrangement is a joint operation.
Contractual arrangement
When the contractual arrangement specifies that the parties have rights to the assets and obligations for the liabilities relating to the arrangement, then the arrangement is a joint operation.
It may be noted that in relation to ‘obligations for the liabilities’, it seems that the contractual obligation for liabilities is something that needs to reflect a primary obligation, rather than a secondary one; and something that represents a non-contingent, ongoing obligation, rather than an obligation that will be settled if and when a certain event occurs (say, a default in case of guarantees issued or calling of uncalled capital).
Other facts and circumstances
The test at this step of the analysis is to identify whether, despite the legal form and contractual arrangements indicating that the arrangement is a joint venture, other facts and circumstances give the parties rights to substantially all of the economic benefits relating to the arrangement and cause the arrangement to depend on the parties on a continuous basis for settling its liabilities, and therefore the arrangement is a joint operation.
In practice, most joint arrangements in India, which are structured as separate companies, may meet the separation criteria and hence qualify as a joint venture and not as a joint operation.
Financial statements of joint venturers
IFRS 11 prescribes accounting treatment for joint operators, whereas IAS 28 (2011) prescribes the accounting treatment for joint venturers.
In its consolidated financial statements, a joint venturer accounts for its interest in the joint venture using the equity method in accordance with IAS 28 (2011), unless under IAS 28 (2011), the entity is exempted from applying the equity method.
Under the equity method, the investment in a joint venture is recognised initially at cost, and subsequently adjusted for the post- acquisition changes in the share of the joint venture’s net assets. The joint venturer’s share of profit or loss and other comprehensive income of the joint venture are included in its profit or loss and other comprehensive income, respectively.
In its separate financial statements, a joint venturer accounts for its interest in the joint venture in accordance with IAS 27 (2011) Separate financial statements i.e., at cost or in accordance with IFRS 9/IAS 39. Such a choice is available even if the joint venturer is exempted from preparing consolidated financial statements. This requirement is in line with the existing requirements.
Key differences from IAS 31
IAS 31 provides an accounting policy choice for a joint controller’s interest in a jointly controlled entity, whereby either the equity method or pro-portionate consolidation can be used. In future, only the equity method shall be permitted. As such, the joint co ntroller’s share of net income and net assets that are adjusted against the individual items of income/expenses/assets/liabilities shall now be presented as a single line item in the statement of financial position and statement of comprehensive income. In other words, a single line ‘Investment in Joint Venture’ and a single line ‘equity profit pick-up’ adjustment on such investments will be recorded.
Financial statements of joint operators
In both its consolidated and separate financial statements, a joint operator recognises its assets, liabilities and transactions, including its share of those incurred jointly. These assets, liabilities and transactions are accounted for in accordance with the relevant IFRS.
Transactions between a joint operator and a joint operation
When a joint operator sells or contributes assets to a joint operation, such transactions are in effect transactions with other parties to the joint operation. The joint operator recognises gains and losses from such transactions only to the extent of the other parties’ interests in the joint operation. The full amount of any loss is recognised immediately by the joint operator, to the extent that these transactions provide evidence of impairment of any assets to be sold or contributed.
When a joint operator purchases assets from a joint operation, it does not recognise its share of the gains or losses until those assets have been sold to a third party. The joint operator’s share of any losses is recognised immediately, to the extent that these transactions provide evidence of impairment of those assets.
Other parties to the joint arrangement
Other parties to the joint venture
For the purpose of consolidated financial statements, the other parties to the joint venture first determine whether they exercise significant influence. If significant influence exists, then the interest is recognised in accordance with IAS 28 (2011); else it is recognised in accordance with IAS 39/IFRS 9.
For separate financial statements, other parties to a joint venture account for their interest in the joint venture in accordance with IAS 39/IFRS 9. If significant influence exists, then the interest may also be recognised at cost.
Other parties a joint operation
The other party to a joint operation accounts for its investment in the same way as a joint operator if it has rights to the assets and obligations for the liabilities. If such a party does not have such rights and obligations, then it accounts for its interest in accordance with the IFRS applicable to that interest for instance IAS 28 (2011) or IAS 39/IFRS 9 as the case may be.
Summary
Overall, the implementation of IFRS 11 will require significant judgment in several respects, while the requirement to apply equity method of accounting to account for interests in joint ventures may have a significant impact on the entity’s financial statements. While the standard is not mandatorily effective until periods beginning on or after 1 January 2013, it is expected that preparers will want to begin evaluating their involvement with joint arrangements sooner than that, as the changes under the new standard generally will call for retrospective application.
At this moment, it is unclear by when the corresponding changes will be introduced under the Ind-AS framework. However, it is advisable for Indian companies to evaluate the impact of this new standard, as it is inevitable that Ind-AS will ultimately incorporate the changes due to the new standard.
