The two most commonly proposed methods of reporting investments in Joint Ventures are the Proportionate Consolidation method and the Equity method. Currently accounting for Joint Ventures allows for a choice of either reporting method. On May 2011, International Accounting Standard Board (IASB) issued International Financial Reporting Standard (IFRS) 11 to clarify and streamline Joint Ventures accounting standard. This change will have an impact on accounting for Joint Ventures. The need for change to IFRS 11, arise from two perceived weaknesses in IAS 31. Firstly, the form of the arrangement under IAS 31 is the primary determinant of the accounting methodology that is accounting for interests in joint arrangements can differ depending on whether or not a legal entity is established. Secondly, the existing standard permits a choice of accounting treatment. Entities can opt to use the Equity method or Proportionate Consolidation, which means similar transactions, may be accounted for in different ways. Following two different accounting methods for Joint Ventures can lead to the recognition of assets that are not controlled and liabilities that are not obligations which is misleading. While it is hard to agree on what type of accounting treatment to use, effective January 2013, IASB requires the use of Equity method for Joint Ventures. Both the Equity and Proportionate Consolidation method have their own rationales.
Get your grade
or your money back
using our Essay Writing Service!
Reporting for financials may differ from the amounts that would have been reported under either Equity method or Proportionate Consolidation method. This is because the measurement rules for applying the Equity method differ from those that would have been applied to other assets and liabilities recognized. Equity method will broaden the focus for classifying Joint Ventures. Equity method of accounting is more appropriate method for accounting Joint Ventures since the investment is initially recorded at cost and subsequently adjusted thereafter for the post-acquisition change in the investor's share of net assets of the jointly controlled entity and this leads to more accurate reporting. IFRS 11 will bring significant and sustained improvements to the reporting of Joint Ventures. Clarifying the principles for classifying Joint Ventures will provide consistency in reporting. Mandatory use of Equity method for accounting will help to provide users with better information about an entity's involvement with Joint Ventures. Implementation of one accounting method for Joint Ventures that is Equity method of accounting, will lead to significant improvements in terms of comparability and transparency of financial information reported under Joint Ventures.
"A Joint Venture is a strategic alliance between two or more individuals or entities to engage in a specific project or undertaking" (RP Emery & Associates, 2009). Joint Ventures can be accounted for using Proportionate Consolidation method or Equity method. Joint Ventures are one type of intercorporate investment whose use is growing, though the underlying accounting issues are common to other investment types currently reported under the Proportionate Consolidation or Equity methods. On May 2011 International Accounting Standards Board (IASB) issued International Financial Reporting Standards (IFRS) 11, which overhauls the accounting for Joint Ventures. IFRS 11 provides amendments to the accounting models of the existing IAS 31, since the fundamental issue facing the IASB is how best to report investments in the financial statements.
New standard that is effective January 2013 has eliminated Proportionate Consolidation as a policy choice for jointly controlled entities. Equity method of accounting is required for accounting and reporting for investment activities of Joint Ventures. Due to this change, entities that have been accounting for their interest in a Joint Venture using Proportionate Consolidation will no longer be allowed to use this method; instead they will account for using the Equity method. It is important that management of entities that are part of Joint Ventures evaluate how the requirements of this change will affect the accounting and reporting for their existing or new Joint Ventures.
2. Proportionate Consolidation Method and Equity method:
The accounting treatment of two companies who are partners in a Joint Venture plays out in either the Equity or proportional consolidation reporting method. An essential element of the term Joint Venture is that the two partners enjoy joint control. How this control is reported on an organization income statements and balance sheets delineates the methods from one another. The Equity method of accounting is whereby an interest in a jointly controlled entity is initially recorded at cost and adjusted thereafter for the post-acquisition change in the investor's share of net assets of the jointly controlled entity. The profit or loss of the venturer includes the venturer's share of the profit or loss of the jointly controlled entity whereas Proportionate Consolidation is a method of accounting whereby a venturer's share of each of the assets, liabilities, income and expenses of a jointly controlled entity is combined line by line with similar items in the venturer's financial statements or reported as separate line items in the venturer's financial statements (Deloitte, 2009).
Always on Time
Marked to Standard
The application of Proportionate Consolidation means that the statement of financial position of the venturer includes its share of the assets that it controls jointly and its share of the liabilities for which it is jointly responsible. The statement of comprehensive income of the venturer includes its share of the income and expenses of the jointly controlled entity. Different reporting formats may be used to give effect to Proportionate Consolidation. The venturer may combine its share of each of the assets, liabilities, income and expenses of the jointly controlled entity with the similar items, line by line, in its financial statements. For example, it may combine share of the jointly controlled entity's inventory with its inventory and its share of the jointly controlled entity's property, plant and equipment with its property, plant and equipment. Alternatively, the venturer may include separate line items for its share of the assets, liabilities, income and expenses of the jointly controlled entity in its financial statements. For example, showing share of a current asset of the jointly controlled entity separately as part of its current assets; it may show share of the property, plant and equipment of the jointly controlled entity separately as part of its property, plant and equipment. Both these reporting formats result in the reporting of identical amounts of profit or loss and of each major classification of assets, liabilities, income and expenses.
Also it is important that a venturer discontinues the use of Proportionate Consolidation from the date on which it ceases to share in the control of a jointly controlled entity (Spector, 2012). For example, this may happen when the venturer disposes of its interest or when such external restrictions are placed on the jointly controlled entity that the venturer no longer has joint control.
As an alternative to Proportionate Consolidation, a venturer shall recognize its interest in a jointly controlled entity using the Equity method. Equity method recognizes interest in a jointly controlled entity irrespective of whether it also has investments in subsidiaries or whether it describes its financial statements as consolidated financial statements. The use of the Equity method is supported by the argument that it is inappropriate to combine controlled items with jointly controlled items and by those who believe that venturers have significant influence, rather than joint control, in a jointly controlled entity.
3. Accounting Standards and Assessing Risk:
Taking an insight into standards, existing accounting standard is replaced by IFRS 11 which does two things below:
Firstly, it carves out from IAS 31 jointly controlled entities meaning those cases in which although there is a separate entity, that separation is ineffective in certain ways,
Secondly, it emphases on using the Equity method of accounting.
Classification of the Joint Venture effective January 2013 depends on whether parties have rights to and obligations for underlying assets and liabilities. The need for IFRS 11 arises from two perceived weaknesses in existing standard. The first is that the form of the arrangement under existing standard is the primary determinant of the accounting methodology which is accounting for interests in Joint Venture, can differ depending on whether or not a legal entity is established. Secondly, it permits a choice of accounting treatment. Entities can opt to use the Equity method or Proportionate Consolidation, which means similar transactions, may be accounted for in different ways. Following existing standard can lead to the recognition of assets that are not controlled and liabilities that are not obligations. For example: When a party has joint control of an entity, it shares control of the activities of the entity. Individual parties do not control each asset, nor have an obligation for each liability; rather, each party has control over its investment.
While it is hard to agree on what type of accounting treatment to use, IASB requires the use of Equity method for Joint Ventures. Both the Equity method and Proportionate Consolidation have their own rationales. For example, the Proportionate Consolidation method is better for explaining price volatility, while the Equity method is better at explaining bond ratings. Nevertheless, regardless of what treatment is used, failing to disclose all Joint Ventures investment activities prevents market participants from adequately assessing risks (KPMG, 2011).
4. Equity Method of Accounting Mandatory - Why?
This Essay is
a Student's Work
This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.Examples of our work
Equity method of accounting will become mandatory requirement for Joint Ventures. When looking at reasons for this decision, it seems this method provides a parent company with a more accurate Income Balance. It shows the investment income from all its sources and not just the parent company. Parent companies and subsidiaries do not share consolidated statements so this method of accounting brings their numbers together. For Example, this can strengthen a company's numbers to show a higher profit then could be seen from the parent company's numbers alone. Another thing to consider is that a parent company can use the Equity method to hide unfavorable numbers from investors. If a parent company has numbers showing a low profit, then adding the numbers from its subsidiaries can reflect a higher profit for the company. These higher numbers can encourage shareholders and the public to keep investing in the parent company and to see it as being of a higher value. The parent company can also fail to disclose subsidiary numbers if that would bring down the value of the parent company.
Though there is a shortfall in the method as it fails to show dividends as revenue and instead shows these as deductions. With Equity method of accounting, dividends reduce the amount of the investment and are not reported as dividend income (EC Staff, 2011). This results in the investor's equity showing up as only being reflected by underlying net assets. It is also important to know that using this accounting method, dividends from a subsidiary company are never transferred to the parenting company.
5. Impact on Financial Statements:
Accounting for Joint Venture varies, as many companies require the Equity method, at least in some circumstances. Under the Equity method, the venturer's net investment in the Joint Venture is shown as a single line item on the venturer's balance sheet. Similarly, the venturer's share of the Joint Venture's net income or loss appears as a single line item on the venturer's income statement. Under Proportionate Consolidation, the venturer's share of each of the Joint Venture's financial statement items is combined on a line-by-line basis with its counterpart in the venturer's financial statements, thereby eliminating the need for the Equity method's single line items.
Figure 2 provides a numerical illustration of the differences between Equity method and Proportionate Consolidation. In the illustration, XYZ Partner Ltd. is assumed to be a partner in the Joint Venture Inc. XYZ Partner's financial statements are prepared first under Proportionate Consolidation and then under the Equity method. Partner's assets and liabilities are both higher under Proportionate Consolidation than under the Equity method, but shareholders' equity is the same under both methods. Similarly, Partner's revenues and expenses are higher under Proportionate Consolidation, but both methods produce the same net income.
It seems Equity method is the more appropriate method for accounting Joint Ventures, primarily because jointly controlled assets and liabilities do not meet the control criterion required for full consolidation with the venturer. Note that a single venturer in a Joint Venture cannot control, that is use or direct the use of its pro rata share of Joint Venture assets. Because financial statements prepared under Proportionate Consolidation report the pro rata shares of Joint Venture assets and liabilities as the venturer's assets and liabilities thus can be argued that such reporting is inappropriate. Similarly, it can also be argued that it is wrong in principle for a venturer to reflect a pro rata share of a Joint Venture's debt that is not a present obligation of the venturer, although Joint Venture debt for which the venturer is contingently liable is an exception. As with any other contingent liability, the venturer should disclose the contingency and/or record a provision, depending on the probability that the venturer will have to assume this debt.
6. Strengths and Weaknesses of the Two Accounting Treatments:
When using Proportionate Consolidation method, the venture combines share of assets, liabilities, income and expenses line by line in financial statements thus similar to procedures of consolidations of investments i.e.: proportion of its share of inventory recorded line-by-line. The consolidation accounting system for a Joint Venture takes the Joint Venture's balance sheet and puts the proportion a company owns on its books. For example, if a company owns 50% of a Joint Venture, it would have 50% of all the Joint Venture accounts on the owner's books. That would mean that 50% of the assets would be added onto the owner's books as well as 50% of all the liabilities and shareholders' equity.
Whilst with Equity method of accounting the investment is initially recorded at cost. The investment in the venture is subsequently adjusted for its share of the change in the net assets of the venture. The venturer includes its share of the venture's profit or loss in its own profit or loss. For example, assume a company invested $1 million in a 50% stake of the Joint Venture. The entry on the balance sheet would be a $1 million increase to long-term investments and a $1 million decrease to cash. In the first year, the Joint Venture had a net income of $100,000 and paid no dividends. The portion of the company's net income is just 50% of the $100,000, or $50,000, and that is added to its investment carrying value. The investment is now carried at $1,050,000. In year two, the Joint Venture breaks even but pays out $200,000 in dividends. The company receives 50% of the $200,000, or $100,000. That increases cash by $100,000, but decreases the carrying value of the investment by $100,000 to $950,000. It seems companies generally prefer to use the Equity method because they do not need to have the Joint Venture's books on its books. Especially for Joint Ventures that have a lot of debt, an owner might not want that debt on its books, because it would make the owner's balance sheet look less attractive.
Also it is important to understand that no direct comparisons can be made between methods used for accounting, because each is used under different circumstances. Furthermore, their specific qualities can be good or bad, depending on outside factors. For example, investors using Equity method do not need to fear unrealized losses due to market price changes but likewise cannot benefit from unrealized gains. A similar problem extends to the investor's obligation to record a portion of the corporation's income, which can be good or bad depending on that corporation's profitability. For example, when looking at the Equity method, dividends are the sole constant disadvantage because they are a deduction to its investment rather than revenue.
On the other hand Proportional consolidation is a normal method of accounting, though the reason for rejection of this method by the IASB is a believe that it can be misleading to represent each venturer's joint control of a Joint Venture which allows it to direct the operating and financial policies of the Joint Venture only with the consent of the other venturers as being in substance equivalent to its having sole control of its share of that entity's assets, liabilities and cash flows. The key features of control are that the controlling party has the ability to direct or deploy what it controls or deploys without question of entitlement. The use of the Equity method goes some way towards giving the additional information that would be available under Proportional Consolidation. However it does not imply control over the share of net assets or turnover that is included in the consolidated financial statements. Therefore Equity method could be said to be an attempt by the IASB to compensate those who view Proportional Consolidation as potentially useful.
All Joint Ventures will need to be re-assessed on transition to IFRS 11. As the classification of a Joint Venture requires assessment of the substance of an investor's interest including consideration of related contractual arrangements, and other facts and circumstances, this is expected to be an area of judgment requiring careful consideration. Furthermore, the transition from Proportionate Consolidation, where previously applied, to the Equity method will affect a number of financial statement line items, notably decreasing revenue, gross assets and gross liabilities. Thus careful understanding of the new requirements will help avoid confusion and enable smooth transition of accounting methodology for Joint Venture companies.
It seems the issue of accounting for Joint Ventures has been a matter of ongoing discussion in the movement to resolve significant differences. Users of proportionate consolidation argue that this method provides more detailed information, since it breaks out the performance of the Joint Venture interest into its component parts whilst the Equity method is favored by others, who feel that it is a simpler and more straightforward approach of accounting.
Companies that account for Joint Venture's using Proportionate Consolidation method will need to change their accounting policies. However, rather than automatically switching to the Equity method of accounting, management needs to determine whether, based on the legal form, the terms of contractual arrangements, and other facts and circumstances, each party has rights to assets and obligations for liabilities and account accordingly. Even though the mandatory effective date for change is not until January 2013, the frequency of strategic alliances is growing, including Joint Ventures particularly when an acquisition is not an option due to cash limitations or risk management reasons.
To conclude, Joint Ventures are continuously increasing in a number of industries as entities expand their distribution channels. Companies should consider the impact of using Equity method of accounting when negotiating Joint Ventures or modifying existing ones. An early analysis will help avoid surprises and ease transition. Equity method of accounting provides better comparability, consistency and more accurate reporting for Joint Ventures.
Figure 1 - Separate Company Financial Statements:
Figure 2 - Equity Method vs. Proportionate Consolidation Method:
Figure 3 - Definitions:
An arrangement of which two or more parties have joint control
The contractually agreed sharing of control of an arrangement, which exists only when decisions about the relevant activities require the unanimous consent of the parties sharing control
A joint arrangement whereby the parties that have joint control of the arrangement have rights to the assets, and obligations for the liabilities, relating to the arrangement
A joint arrangement whereby the parties that have joint control of the arrangement have rights to the net assets of the arrangement
A party to a Joint Venture that has joint control of that Joint Venture
Party to a joint arrangement:
An entity that participates in a joint arrangement, regardless of whether that entity has joint control of the arrangement
A separately identifiable financial structure, including separate legal entities or entities recognized by statute, regardless of whether those entities have a legal personality
Source: Definitions retrieved from Deloitte Website: Deloitte. (May 2011). IFRS 11. In Key Definitions. Retrieved October 2012, from http://www.iasplus.com/en/standards/standard51#link7.