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December 2009

GAPs in GAAP – Accounting for joint ventures Proportionate consolidation v. equity method

By Dolphy D’Souza, Chartered Accountant
Reading Time 5 mins

Accounting Standards

Under Indian GAAP (AS-27 Financial Reporting of Interests
in Joint Ventures
), an interest in a joint venture (jointly controlled
entity — JCE) is accounted for using the proportionate consolidation method.
Under this method the venturers report their respective proportion of the JCE’s
assets, liabilities, income and expenses in its consolidated financial

Under IFRS, IAS-31 requires the application of proportionate
consolidation method for joint ventures but also allows the application of
equity method as an alternative method. Under the equity method an interest in a
JCE is initially recorded at cost and adjusted thereafter for the
post-acquisition change in the venturer’s share of net assets of the JCE. The
profit or loss of the venturer includes the venturer’s share of the profit or
loss of the JCE.

The International Accounting Standards Board (IASB) issued an
Exposure Draft (ED) 9 Joint Arrangements which is intended to replace
current IAS-31. Unlike IAS-31, the ED proposes that a joint venture shall be
accounted using the equity method only. In other words, proportionate
consolidation method which is the preferred method under current IAS-31 will no
longer be available and the alternative method, i.e., equity method in
current IAS-31 becomes the only method to be followed.

The IASB is of the view that the removal of options from IFRS
will reduce the possibility of similar transactions being accounted for in
different ways. Further, the IASB believes that the proportionate consolidation
method has certain technical flaws and is not consistent with the Framework
for the Preparation and Presentation of Financial Statements
. When a party
to an arrangement has joint control of an entity, it shares control of the
activities of the entity. It does not, however, control each asset, nor does it
have a present obligation for each liability of the JCE. Rather, each party has
control over its investment in the entity. If the party uses proportionate
consolidation to account for its interest in a JCE, it recognises as assets and
liabilities a proportion of items that it does not control or for which it has
no obligation. These supposed assets and liabilities do not meet the definition
of assets and liabilities in the Framework.

A number of respondents to the ED have questioned the IASB’s
decision to require only equity method for joint ventures. At the time of
issuance of current IAS-31, the same Framework was applicable. At that
time, the IASB has clearly recognised that proportionate consolidation better
reflects the substance and economic reality of a venturer’s interest in a JCE.
Against this background, the ED does not offer any compelling arguments for
removal of proportionate consolidation method.

While the IASB has indicated that proportionate consolidation
has technical flaws and is not consistent with the Framework, it does not
explain as to why the equity method is considered more appropriate to account
for interests in a JCE ? How does the application of the equity method enhance
the faithful representation of joint ventures in the financial statements of the
venturer ? Further, the removal of proportionate consolidation will lead to the
same accounting treatment for ‘joint control’ and ‘significant influence,’ which
is inappropriate.

Significant impact on Indian entities :

In India, a number of entities in sectors such as real
estate, infrastructure development, oil and gas, etc. carry out significant
activities through joint ventures. For example, KSK Power or GMR Infrastructure
carry out significant activities through joint ventures. If such entities need
to apply equity method to their interests in joint ventures, it is possible that
their financial statements will not reflect any significant economic activity.
If equity accounting is to be used, the infrastructure holding company will not
be able to present proportionately the activities and revenues of its various
joint ventures. This may have several consequential implications on matters such
as borrowing capacity, satisfaction of debt covenants, performance evaluation of
key executives, key ratios, explaining performance to investors and analysts,
etc. In certain cases, these entities may even have to reconsider their overall
business strategy and significant contracts.

IASB’s view is that the enhanced disclosure requirements of
the proposed IFRS would provide better information about the assets and
liabilities of a joint venture than is provided by using proportionate
consolidation. The exposure draft proposes the disclosure of summarised
financial information for all individually material joint ventures to help meet
the needs of users of financial statements. In the author’s view, this line of
argument is inappropriate and disclosures cannot justify equity accounting of
joint venture. Besides in many cases, disclosures on their own may not provide
any solution, for example, in the case of project bidding where qualification
requirements are linked to the revenues recorded in the financial statements of
the bidding entity.

As IFRS would eventually apply to Indian entities, it is high
time that Indian companies and local standard-setters started paying more
attention to IFRS exposure drafts. Companies that would be significantly
impacted should make suitable representations to the IASB along with the local

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