Researching Accounting for Joint Ventures: Opportunities for Behavioral Researchers

R. Davis Mautz, Jr.

Bryan School of Business and Economics, University of North Carolina at Greensboro

November 1995

As the comments of Cheri Reither and Ronald Lott indicate, the FASB will soon be considering the financial reporting of joint ventures in conjunction with its consolidations project. This commentary is intended to introduce some of the basic issues surrounding accounting for joint ventures, and to encourage behavioral researchers to identify and pursue research opportunities related to the financial reporting of joint ventures.

Joint venture accounting presents excellent research opportunities for behavioral researchers. Authoritative guidance on the topic is limited; several alternative accounting treatments have been proposed in the literature and/or adopted outside the U.S.; and, relatively little research has been published on the topic. Most importantly, the FASB has expressly indicated its interest in ex ante research exploring the usefulness of various methods of accounting for joint ventures, The following sections provides some basic background on joint venture accounting.

Joint Venture Basics-Definitions

One of the initial difficulties in researching joint venture accounting is the fact that the term "joint venture " is not well defined in U.S. authoritative literature. One of the best sources of information on U.S. accounting for joint ventures is an AICPA Issues Paper issued in 1979. This document (AICPA 1979, 3) notes that "...a generally accepted definition of what constitutes a joint venture has not been developed to delineate the class of entities and to identify the common characteristics significant for accounting purposes. " APB Opinion 18 prescribes the accounting methods for many corporate joint ventures. However, joint ventures may or may not be incorporated.

The definition of joint ventures provided in the Canadian Institute of Chartered Accountants (CICA) handbook is sufficiently broad to encompass both incorporated and unincorporated entities. The CICA definition notes that "joint control" is a distinctive feature of joint ventures. In other words, decisions concerning the operation of the venture require the consent of all venturers, and no individual venturer can assert unilateral control. International Accounting Standard (IAS) 31, Financial Reporting of Interests in Joint Ventures, also stresses the importance of joint control, IAS 3 1 defines a joint venture as "a contractual arrangement whereby two or more parties undertake an economic activity which is subject to joint control. " In its most nebulous form, a joint venture need not result in the creation of a separate entity at all. "Strategic alliances" in which companies agree to work together to promote each other's products or services may also be considered joint ventures.

Joint Venture Basics-Reporting Alternatives

Whatever the definition of joint ventures, the fundamental issue facing the FASB is how best to report investments in joint ventures in the venturer's (investor's) financial statements. A number of alternative accounting methods are currently used to account for investments of various types. For example, passive investments in equity securities are reported at either cost or fair value according to the provisions of FAS 115, while controlling interests are fully consolidated into parent company financial statements. However, investments in jointly controlled entities are neither passive, nor controlling interests. Accordingly, these methods are not generally considered appropriate alternatives.

The two most commonly proposed methods of reporting investments in joint ventures are the equity method and the proportionate consolidation method. The equity method is described in APB 18 and required by FAS 94 for investments in corporate joint ventures. Accounting Interpretation (AIN) 2 of APB 18 makes clear that, while the equity method may be appropriate for investments in partnerships and unincorporated joint ventures, the provisions of APB 18 do not necessarily apply to these types of interests.

AIN 2 recognizes that, in oil and gas ventures and in certain other industries, venturers commonly own an "undivided interest" in the assets of the jointly controlled entity and share a proportionate obligation for its liabilities. In these cases, recognition in the venturer's financial statements of proportionate shares of assets, liabilities, revenues and expenses (proportionate consolidation) may be appropriate. Proportionate consolidation is also the "benchmark" treatment prescribed in IAS 31.1

Illustration of Equity and Proportionate Consolidation Reporting

This section presents a brief illustration of equity reporting and proportionate consolidation of interests in jointly controlled, incorporated ventures. The example, while highly simplified, should facilitate understanding and comparison of these two basic

1 IAS 31 recognizes two methods of applying proportionate consolidation. Under the first method, proportionate interests in the assets, liabilities, revenues and expenses of the jointly controlled entity are combined with corresponding items in the venturer's financial statements, Under the second variation, those proportionate interests are recognized in the venturer's financial statements as separate line items. In other words, "plant assets" and "interest in plant assets of jointly-controlled-controlled entity" are separate line items. This latter method is most commonly known as the expanded (or extended) equity method.

reporting alternatives. In this example, the investor or parent company, Venturer Company, owns 50 percent of Jointly Controlled Company, the incorporated joint venture. Panel A presents separate company financial statements for Venturer and Jointly Controlled. Panel B illustrates the equity method and proportionate consolidation.

Panel A: Separate Company Financial Statements--Venturer

Panel B: Equity Method vs. Proportionate Consolidation

Review and analysis of examples like the one in panel B can help researchers isolate systematic differences that may have research implications. For example, proportionate consolidation results in systematically higher values in all balance sheet categories. Other differences may be dependent upon the specific facts used to generate the comparison. In the case of debt/assets or debt/equity comparisons, the equity method presents a more favorable picture only if the joint venture is highly leveraged. In still other analyses, the two methods yield the same results. For example, capitalizations of earnings should not differ depending on the method used to report investments in joint ventures.

Abundant Research Opportunities in Joint Venture Accounting

One implication of the preceding comments is that lenders and investors are likely to focus on different aspects of this issue and, perhaps, reach different conclusions about the relative desirability of the equity and proportionate consolidation methods. Preliminary research efforts in this area will need to explore the contexts in which investments in joint ventures are important and the processes into which this information is incorporated. Assuming these situations can be identified, the research possibilities are numerous.

At the most basic level, researchers may want to investigate the preferences of various constituent groups. Do lenders/investors prefer one accounting treatment over the other? Are there particular decisions for which one or the other method produces the most useful information?

At another level, financial statement users' decisions can be examined. Is a particular reporting method associated with lending decision outcomes? Such investigations might consider loan/no loan decisions, tasks which establish credit limits or interest rates, and analyses of judgment consensus, confidence, or efficiency. Many of these studies can be reproduced in an investment context. Reactions of preparers and auditors can also be considered. In short, the issue of accounting for joint ventures presents a rich set of researchable questions. The topic is timely; the FASB is receptive to input from the academic community; and, relatively little prior work has been done in the field. To echo the thoughts of Cheri Reither and Ronald Lott, the time is opportune for behavioral researchers to apply their varied skills to this complex issue.

SUGGESTED READINGS

International Accounting Standards Committee (reformat ted 1994). "Financial Reporting of Interests in Joint Ventures, " International Accounting Standard 31.

To obtain copies of IASC publications, contact:
International Accounting Standards Committee
167 Fleet Street
London EC4A 2ES
England
Phone: (44) 0171 353-0565
Fax: (44) 0171 353-0562

American Institute of Certified Public Accountants, (July 17, 1979). Issues Paper on Accounting and Reporting Investments in Joint Ventures (Prepared by the Accounting Standards Division).