Financial Repor Ting Joint Venture

Financial Repor ting Joint Venture

J o i n t Ve n t u r e A c c o u n t i n g o n t h e M o v e Robert Kirk outlines the requirements of IAS 31.

Proportionate consolidation This is a method of accounting and reporting whereby a venturer’s share of each of the assets, liabilities, incomes and expenses of a jointly controlled entity are combined on a line-by-line basis with similar items in the venturer’s financial statements or reported as separate line items.

Equity method Initially the investment is carried at cost by a venturer and adjusted thereafter for the post acquisition change in the venturer’s share of net assets of the jointly controlled entity. The income statement reflects the venturer’s share of results of operations of the jointly controlled entity. IAS 31 at present favours proportionate consolidation but permits equity accounting as an acceptable second best solution when accounting for jointly controlled entities. IAS 31 identifies three broad types of joint venture activity: * jointly controlled operations * jointly controlled assets; and * jointly controlled entities They all have the common characteristics of having two or more joint venturers bound under contract and establishing joint control.

Background In this month’s issue I am going to cover the topic of joint venture accounting, a subject which is currently under review by the International Accounting Standards Board (IASB) and is likely to be altered in the next few months once the current exposure draft is implemented. IAS 31 was published in December 2003 and provides guidance on how to account for joint ventures. A joint venture is defined by IAS 31 as a contractual agreement whereby two or more parties undertake an economic activity which is subject to joint control. Joint control represents a contractually agreed sharing of control over an economic activity. A classic example of this arrangement is the Airbus operation in Toulouse which is jointly controlled by British Aeropace Plc and four other joint venturers, all of which have to consensually agree before any major operating decision is undertaken. There are two different accounting methods permitted by the standard:

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Jointly Controlled Operations Some joint ventures involve the use of assets and other resources rather than the establishment of a corporation, partnership or other entity. Each venturer uses its own assets and incurs its own expenses and raises its own finance. The joint venture agreement usually provides a means by which revenue from the sale of the joint product and any expenses are shared among the venturers. An example might be a joint venture to manufacture, market and distribute jointly a particular product such as an aircraft. Different parts of the manufacturing process are carried out by each of the venturers and each venturer takes a share of the revenue from the sale of the aircraft but bears its own costs. A venturer should recognise in its financial statements the following: (a) the assets it controls and the liabilities it incurs; and (b) the expenses it incurs and its share of the income it earns from the sale of goods or services by the joint venture.

Financial Repor ting Joint Venture

Effectively an entity is adopting proportionate consolidation for such relationships.

Jointly Controlled Assets Some joint ventures involve joint control by the venturers over one or more assets which are dedicated for the purposes of the joint venture. Each venturer may take a share of the output and bear an agreed share of the expenses incurred. No corporation, however, is established. Many activities in oil and gas and mineral extraction involve jointly controlled assets e.g. an oil pipeline. Another example is the joint control of property, each taking a share of the rents received and bearing a share of the expenses. Again, a venturer should recognise in its financial statements: (a) its share of jointly controlled assets, classified according to their nature; (b) any liabilities it has incurred; (c) its share of any liabilities jointly incurred with other venturers; (d) any income from the sale or use of the share of the output of the joint venture together with its share of any expenses incurred; (e) any expenses incurred re its interest in the joint venture. The treatment of jointly controlled assets should reflect their substance and economic reality and usually the legal form of the joint venture. Separate accounting records for the joint venture may be limited to those expenses incurred in common. Financial statements may not be prepared for the joint venture but management accounts may be needed to assess performance.

“Proportionate consolidation can only be adopted from the date the entity acquires joint control and it should be discontinued from the date on which it ceases to have joint control over a jointly controlled entity.” Jointly Controlled Entities The main type of joint venture is a jointly controlled entity. In this case a corporation is established and operates as per other legal entities except that there is a contractual arrangement between the venturers that establishes joint control over the economic activity of the entity. A jointly controlled entity controls the assets of the joint venture, incurs liabilities and expenses and earns income. It may enter contracts in its own name and raise finance for itself and each venturer is entitled to a share of the results of the jointly controlled entity. An example is when two entities combine their activities in a particular line of business by transferring relevant assets

and liabilities into a jointly controlled entity or it could be a joint venture by establishing a joint entity with a foreign government. In substance they are often similar to jointly controlled operations or jointly controlled assets. However, it does maintain its own accounting records and prepares its financial statements in the same way as other normal entities in conformity with appropriate national regulations. Each venturer usually contributes cash or other resources to the jointly controlled entity. These contributions are included in the accounting records of the venturer and recognised in its financial statements as an investment in the jointly controlled entity.

Financial Statements of a Venturer Under IAS 31, a venturer should report its interest in a jointly controlled entity using one of two reporting formats for proportionate consolidation or using the equity method. It is essential that a venturer reflects the substance and economic reality of the arrangement. The application of proportionate consolidation means that the consolidated balance sheet of the venturer includes its share of the assets it controls jointly and its share of the liabilities for which it is jointly responsible. The consolidated income statement includes the venturer’s share of the income and expenses of the jointly controlled entity. Many of the procedures are similar to consolidation procedures set out in IAS 27. There are different reporting formats to give effect to proportionate consolidation but the most popular is to combine a venturer’s share of each of the assets, liabilities, income and expenses of the jointly controlled entity with similar items in the consolidated statements on a line by line basis. e.g. its share of inventory with inventory of the consolidated group. Proportionate consolidation can only be adopted from the date the entity acquires joint control and it should be discontinued from the date on which it ceases to have joint control over a jointly controlled entity. This could happen when the venturer disposes of its interest or when external restrictions mean that it can no longer achieve its goals. As an alternative, a venturer may report its interest in a jointly controlled entity using the equity method as per IAS 28 Accounting for associates. The equity method is supported by those who argue that it is inappropriate to combine controlled items with jointly controlled items. Originally, the standard took the view that it should not recommend the use of the equity method because proportional consolidation better reflects the substance and economic reality of a venturer’s interest in a jointly controlled entity. However, the latest exposure draft (October 2007) has now decided to recommend the demise of proportionate consolidation and has opted for equity accounting only. As with proportionate consolidation a venturer should discontinue the use of the equity method from the date it ceases to have joint control. An example of both approaches is provided on the following page:

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Financial Repor ting Joint Venture

Example – Castlerock Plc The following financial statements relate to Castlerock, a public limited company. Income Statement for year ended 31 December 2007 £m Turnover Cost of sales Gross profit Distribution costs 17 Administration expenses 8 Other operating income Exceptional item Finance costs Profit on ordinary activities before tax Income tax Balance Sheet at 31 December 2007 Non current assets Property, plant and equipment Goodwill

£m

Suggested solution – Castlerock Plc How should the investment in Castlerock plc be treated in the consolidated balance sheet and income statement? £m 212 (170) 42

Calculation of goodwill (25) 17 12 29 (10) (4) 15 (3) 12 £m

30 7

Equity and reserves Called up share capital Ordinary share capital Share premium account Retained profits (36 – 4 dividend paid)

31 (12) 19 56 (10) 46

10 4 32 46

(i) Castlederg, a public limited company, acquired 30 per cent of the ordinary share capital of Castlerock Plc at a cost of £14 million on 1 January 2006. The share capital of Castlerock has not changed since acquisition when the retained profit of Castlerock was £9 million. Two other venturers each own 35% of the entity and all three have joint control over the operating activities of the investee. (ii) At 1 January 2006 the following fair values were attributed to the net assets of Castlerock Plc but not incorporated in its accounting records. £m Property, plant and equipment 30 (carrying value £20m) 10 Goodwill (estimate) Current assets 31 Current liabilities 20 Non current liabilities 8 (iii)During the year to 31 December 2007, Castlerock sold goods to Castlederg to the value of £35 million. The inventory of Castlederg Plc at 31 December 2007 included goods purchased from Castlerock Plc on which the company made a profit of £10 million. (v) The policy of all companies in the Castlederg group is to depreciate tangible fixed assets at 20 per cent per annum on the straight-line basis.

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At 1 January 2007 – fair value of assets £m Property, plant and equipment Current assets Current liabilities Non current liabilities Shareholding 30% x £33m Fair value of investment Goodwill (bal fig.)

30 31 (20) (8) 33 9.9 14 4.1 £m

37 Current assets Current liabilities Net current assets Total assets less current labilities Non current liabilities

Equity Accounting The investment should be disclosed as a single line under IAS 31, if adopting equity accounting, as follows:

Disclosure in balance sheet (Extract) Cost of investment Post-acquisition profits 30% x (£32m–£10m share capital - £9m retained reserves) Additional depreciation charge (2 years x 20% x (£30m fair value – £20m cost)) x 30% Investment in joint venture Alternative disclosure Share of net assets (£46m–£10m share of inventory profits) Revaluation of property, plant and equipment Additional depreciation (£10m x 20% x 2 years)

14 3.9 (1.2) 16.7

36 10 (4) 42

Shareholding (30% x £42m) Share of goodwill Investment in joint venture

12.6 4.1 16.7

The alternative disclosure is more correct since it does not disclose any element of profit as part of the investment. Disclosure in the income statement (Extract) Share of operating profit in joint venture (30% x £29m – £3m inter-co. profit - £0.6.m depreciation) Exceptional item – joint venture (30% x £10m) Finance costs–joint venture (30% x £4m) Tax on profit on ordinary activities of Joint venture (30% x £3m)

£m 5.1 (3.0) (1.2) (0.9)

Financial Repor ting Joint Venture

X: Denotes Castlederg Plc results for the year Proportionate consolidation If Castlederg adopted proportionate consolidation the following would be recorded: Consolidated income statement £m Consolidated income statement (Extract) Turnover: Group and share of joint ventures (£212m gross less inter-company turnover £35m x 30%) Cost of sales (£170m less inter company turnover £35m plus inter co profit £10m x 30% + depreciation 0.6m) Distribution costs (£17m x 30%) Administration expenses (£8m x 30%) Other operating income (£12m x 30%) Exceptional items (£10m x 30%) Finance costs (£4m x 30%) Taxation (£3m x 30%)

X + 53.1

Disclosure Under IAS 31, a venturer should disclose the aggregate amount of the following contingent liabilities, unless the probability of loss is remote, each separately: (a) any contingent liabilities incurred in relation to its interest in joint ventures and its share in each contingent liability incurred jointly with other venturers; (b) its share of contingent liabilities of the joint ventures for which it is contingently liable; and

X + ( 44.1) X + ( 5.1)

(c) those contingent liabilities that arise because the venturer is contingently liable for the liabilities of the other venturers of a joint venture.

X + ( 2.4)

Items (a) to (c) should be disclosed separately.

X + 3.6

A venturer should also disclose the aggregate amount of the following commitments regarding interests in joint ventures separately from other commitments:

X + (3.0) X + (1.2) X + (0.9)

Consolidated balance sheet (Extract) Property etc (£37m + £10m revaluation–£4m additional depreciation= £43m x 30%)

X + 12.9

Current assets (£31m – £10m inter-company profit on stocks = £21m x 30%)

X + 6.3

Goodwill

X + 4.1

Current liabilities (£12m x 30%)

X + (3.6)

Non current liabilities (£10m x 30%)

X + (3.0)

Net assets

X + 16.7

Transactions between a Venturer and a Joint Venture When a venturer contributes or sells assets to a joint venture, recognition of any portion of a gain or loss should reflect the substance of the transaction. While the assets are retained by the joint venture and provided the venturer has transferred the significant risks and rewards of ownership, the venturer should recognise only that portion of the gain or loss which is attributable to the interests of the other venturers. The venturer should recognise the full amount of any loss when the sale provides evidence of a reduction in the NRV of current assets or an impairment loss. When a venturer purchases assets from a joint venture the venturer should not recognise its share of the profits of the joint venture until it resells the assets to an independent party. A venturer should recognise its share of the losses in the same way as profits except the losses should be recognised immediately when they represent a reduction in the NRV of current assets or an impairment loss under IAS 36.

(a) any capital commitments re joint ventures and its share in capital commitments incurred jointly with other venturers; and (b) its share of capital commitments of the joint ventures themselves. A venturer should disclose a listing and description of interests in significant joint ventures and the proportion of ownership interest held in jointly controlled entities. An entity that adopts line by line reporting for proportionate consolidation or the equity method should disclose the aggregate amounts of each of its current assets, long-term assets, current liabilities, long-term liabilities, income and expenses related to interests in joint ventures. A venturer that does not publish consolidated accounts, because it has no subsidiaries, should disclose the above information as well. Two excellent examples of good disclosure in Ireland are provided by McInerney Property Holdings Plc and UTV Plc, the former adopting equity accounting and the latter proportionate consolidation.

McInerney Property Holdings Plc Year ended 31st December 2006 Interests in Joint Ventures A joint venture is a contractual arrangement whereby the Group and other parties undertake an economic activity that is subject to joint control and the strategic financial and operating policy decisions relating to the activities of the joint venture require the unanimous consent of the parties sharing control. Joint venture arrangements that involve the establishment of a separate entity which each venturer has an interest are referred to as jointly controlled entities. The Group reports its interests in jointly controlled entities using the equity method. The net amount of the Group’s share of the assets and liabilities of jointly controlled entities is disclosed in the consolidated balance sheet as Interests in Joint Ventures.

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Financial Repor ting Joint Venture The Group’s share of the profits and losses after interest and tax of jointly controlled entities is disclosed as Share of Results from Joint Ventures in the consolidated income statement.

Investments (continued)

Any goodwill arising on the acquisition of the Group’s interest in a jointly controlled entity is accounted for in accordance with the Group’s accounting policy for goodwill (see below). Where the Group transacts with its jointly controlled entities, unrealised profits and losses are eliminated to the extent of the Group’s interest in the joint venture.

During the year ended 31 December 2006 there were two joint venture companies, First Radio Sales Limited and Digital Space Limited (2005: Absolute Radio (UK) Limited, Digital Space Limited and First Radio Sales Limited). The revenue, expenditure, asset and liability information relating to those joint ventures proportionately consolidated in the Group accounts is disclosed below.

Aggregate amounts relating to Joint Ventures included in noncurrent assets:

Total Assets Total Liabilities

2006 €’000

2005 €’000

99,125

74,153

(91,693)

(62,867)

Total Net Assets

7,432

11,286

Net Interest in Joint Ventures

3,877

4,660

Aggregate amounts relating to Joint Ventures included in Income Statement: 2006 €’000

2005 €’000

Revenue

15,895

2,864

Expenses

(14,098)

(2,940)

Profit / (Loss)

1,747

(76)

Group’s Share of Profit / (Loss)

1,064

(21)

Interests in Joint Ventures

(c) Joint Ventures

The latest developments - ED 9 Joint Arrangements (September 2007) In September 2007 the IASB issued an exposure draft ED 9 Joint Arrangements in which it proposes to eliminate the proportionate consolidation option. ED 9 sets out requirements for recognition and disclosure of interests in joint arrangements. Its objective is to enhance the faithful representation of joint arrangement and it achieves this by requiring an entity: (a) to recognise its contractual rights and obligations arising from its joint arrangement. The precise form of arrangement is no longer the most significant factor in determining the appropriate accounting treatment; and (b) to provide enhanced disclosures about its interest in joint arrangements. It forms part of the short term convergence project currently being undertaken by the IASB and American Financial Accounting Standards Board (FASB) and will lead to current IAS 31 being superceded.

The Group has a number of joint venture entities which are used to finance specific projects. A list of all significant joint ventures, including the name, country of incorporation, proportion of ownership and nature of operations, is provided in note 46 on page 77.

Main features of ED 9

Details of land commitments held in joint ventures are provided in note 41.

The definitions are similar to IAS 31 in that a joint arrangement is a contractual arrangement whereby two or more parties undertake an economic activity together and share decision making relating to the activity. There are still three types – joint operations, joint assets and joint ventures.

UTV Plc Year ended 31st December 2006 Investment in joint venture A joint venture is an entity in which the Group holds an interest under a contractual arrangement where the Group and one or more other parties undertake an economic activity that is subject to joint control. The Group’s interest in its joint ventures is accounted for by proportionate consolidation, which involves recognising a proportionate share of the joint venture’s assets, liabilities, income and expenses with similar items in the consolidated financial statements on a line-by-line basis. The reporting dates of the joint venture and the Group are identical and both use consistent accounting policies.

The core principle of ED 9 is that all parties to a joint arrangement should recognise their contractual rights and obligations arising from the joint arrangement.

ED 9 requires a party to recognise its contractual rights and obligations as assets and liabilities. Contractual rights to individual assets and contractual obligations for expenses represent interests in joint operations or joint assets. The major recommendation is that an interest in a joint venture must use the equity method. ED 9 also requires disclosure of a description of the nature of operations it conducts through joint arrangements as well as a description of and summarised financial information relating to its interests in joint ventures.

Attributable to Joint Ventures:

Revenue Operating costs Finance income Profit / (loss) before tax Taxation Profit / (loss) for the year Current assets Current liabilities Non-current liabilities 12

2006 €’000

2005 €’000

1,268 (988) 15 295 (6) 289 546 156 -

978 (1,011) 3 (30) (1) (31) 365 106 -

Conclusion The latest exposure draft will certainly force many listed Irish companies to readdress the subject of joint venture accounting. A large number of companies such as UTV Plc have switched over from adopting equity accounting to proportionate consolidation on first adoption of international financial reporting standards but this process will inevitably have to be reversed in the next two years. At this stage we are not sure when the revised standard will be published but is unlikely it would be adopted for any entities reporting before the end of 2009.

Robert Kirk is a Professor of Financial Reporting at the University of Ulster.