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June 2011

GapS in GAAP — Accounting for Jointly Controlled Entities that have Minority Interest

By Dolphy D’Souza | Chartered Accountant
Reading Time 3 mins

Entities A, B and C have equal ownership (33.33%) in Entity D, which they all account for as an interest in an associate (commonly known as equity method). Now A and B, enter into an arrangement under which they will form a Newco (a newly formed shell company), in which they will each have a 50% interest in return for contributing their shares in Entity D. Consequently, after completion of the transaction, Newco has a 66.7% controlling interest in Entity D and, in its consolidated financial statements (CFS), will record minority interest for investor C’s interest in Entity D.

Entities A and B when exchanging their shares in Entity D for shares in Newco, also enter into a contract which results in them having joint control (as defined in AS-27 ‘Financial Reporting of Interests in Joint Ventures’) over Newco. A and B both apply proportionate consolidation for Jointly Controlled Entities (JCE) in the CFS.

In the CFS of A and B, should the proportionate consolidation be restricted to the effective interests (33.33%) that Entities A and B each have in Entity D, or to 50% of all line items in Newco’s financial statements (including the minority interest) ?

View 1:
Entities A and B will recognise only their effective interests (33.33%) in Entity D. Proponents of this view use the definition of proportionate consolidation to support the argument. As per AS-27 Proportionate consolidation “is a method of accounting and reporting whereby a venturer’s share of each of the assets, liabilities, income and expenses of a jointly controlled entity is reported as separate line items in the venturer’s financial statements.” This definition refers only to the venturer’s share of each of the assets, liabilities, income and expenses of a JCE, and that minority interest does not meet the definition of any of these items. Further, paragraph 30 of AS-27 may also support this view, “When reporting an interest in a jointly controlled entity in consolidated financial statements, it is essential that a venturer reflects the substance and economic reality of the arrangement, rather than the joint venture’s particular structure or form. In a jointly controlled entity, a venturer has control over its share of future economic benefits through its share of the assets and liabilities of the venture. This substance and economic reality is reflected in the consolidated financial statements of the venturer when the venturer reports its interests in the assets, liabilities, income and expenses of the jointly controlled entity by using proportionate consolidation.”

View 2:
Proponents of view 2 (50% proportionate consolidation) point out to paragraph 31 of AS-27 ‘. . . . Many of the procedures appropriate for the application of proportionate consolidation are similar to the procedures for the consolidation of investments in subsidiaries, which are set out in AS-21 Consolidated Financial Statements’. Therefore, it is considered that this results in a requirement for the inclusion of all line items, including those relating to minority interest, for the purposes of proportionate consolidation.

View 3:
Entities A and B have an accounting policy choice, as the accounting guidance is not definitive.

Author’s view:
If the formation of Newco has no substance other than to house the JV and to achieve a gross-up presentation in the CFS of Entity A and B that includes minority interest, then view 1 (33% consolidation) may be a more appropriate accounting treatment. If however, the Newco did have substance (for example, it may be planned to raise funds or list NewCo) then view 2 (50% consolidation) could be favorably argued. In other words, substance over form should prevail.

Nevertheless, this is an issue that ultimately the standard-setters should resolve.

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