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Chapter 1: Introduction
Joint arrangements are economic co-operations between two or more parties that are bound by a contractual agreement to share control. An entity might enter into a joint arrangement with another party for many reasons: for example, the investors might have complementary skills; it might be necessary to share the risk of a project; the project might benefit from economies of scale if two or more investors are involved; or the size of the project might be beyond a single entity’s capabilities. The purpose of the joint arrangement might be to share costs, or it might be motivated by profit.
There are two types of joint arrangements: joint operations and joint ventures. Classification in each of the categories depends on the investor’s rights and obligations. Joint operators have rights to assets and obligations for liabilities. Joint venturers have rights to net assets.
Classification of an arrangement determines its accounting treatment. Joint operations are accounted for by recognising the operator’s relevant share of assets, liabilities, revenues and expenses. Joint ventures are accounted for using equity accounting.
IFRS 11 refers to the rules in IAS 28 when requiring joint ventures to be equity accounted.
Scope
Joint arrangements are economic arrangements between two or more parties, where the investors sharing joint control make the decisions about the relevant activities.
Parties could participate in joint arrangements for other reasons, but they might not share joint control. The standard applies to all parties to a joint arrangement, whether they exercise joint control over the arrangement or not. The standard does not apply for accounting within the joint arrangement itself
Accounting by the joint arrangement itself: joint operations
IFRS 11 applies only to the accounting by joint operators, and not to the accounting by the separate vehicle that is the joint operation. So, the financial statements of the separate vehicle would be prepared in accordance with applicable standards.
Legal requirements in various countries might require the joint operation to prepare its own financial statements. Where management concludes that the joint arrangement is a joint operation in a separate vehicle, the question arises whether both the joint operators and the joint operation itself should recognise the same assets, liabilities, income and expense in their respective financial statements.
Assets and liabilities could meet the recognition criteria in the books of the legal entity, because the separate vehicle has the legal title to the assets and the legal obligations in respect of the liabilities. The economic benefit from the assets accrues to the legal entity in the form of revenue. It is not relevant whether those revenues are from third parties or from the joint operators.
The legal entity has an obligation for the liabilities when it enters into contracts in its own name. Although the joint operators might fund these obligations, this does not mean that the legal entity is no longer obligated for those liabilities.
The carrying amount of the assets should be appropriately reduced when some or all the economic benefits are transferred to the joint operators. This measurement should be based on the joint arrangement’s contractual terms.
A joint operation might have legal title to the assets, but it acts as an agent on behalf of the investors. The joint operation’s own financial statements would then reflect the accounting as an agent. Where, for example, a joint operation purchases inventory from a supplier, it raises a payable owed to the supplier and a corresponding receivable representing the amount to be received from the joint operators. It is the joint operators that recognise the actual inventory and the related expense in their financial statements, with a corresponding payable to the joint operation.
Scope: arrangements that do not involve joint control – examples
Two entities may agree to what they view as a joint arrangement but, of itself, this does not automatically bring them within the scope of IFRS 11. For example, if their two businesses are complementary (one manufactures and sells curtaining fabric and the other makes curtains to measure), each could simply agree to advertise the other’s website on its own website. This might be mutually beneficial for the businesses but the arrangement does not involve joint control and, accordingly, does not fall within the scope of IFRS 11.
Similarly, two entities sometimes use the term ‘joint venture’ in a general business sense to refer to an entity in which they both have interests but of which one of them has control (as defined in IFRS 10). Such an entity is a subsidiary of the controlling party, and the arrangement between the two entities is not within the scope of IFRS 11.
Not every party to a joint arrangement has to share control. For example, Entities A, B, C, D and E may all be parties to a joint arrangement, with control being shared by Entities A, B, C and D. In this scenario, all five parties should apply the requirements of IFRS 11, but the accounting specified for Entity E’s interest in the arrangement may be different from that specified for the interests of Entities A, B, C and D.
Scope: accounting in the financial statements of a joint operation that is a separate vehicle
When a joint operation that is a separate vehicle prepares financial statements, IFRS 11 does not apply to those financial statements. IFRS 11 applies only to the accounting by the parties to the joint operation and not to the accounting by the separate vehicle that is a joint operation. The financial statements of the separate vehicle should be prepared in accordance with applicable IFRS Standards.
The financial statements of the joint operation should include the assets, liabilities, revenues and expenses of the legal entity/separate vehicle. However, when identifying the assets and liabilities of the separate vehicle, it is necessary to understand the joint operators’ rights and obligations relating to those assets and liabilities and how those rights and obligations affect those assets and liabilities.
This conclusion was confirmed by the IFRS Interpretations Committee in March 2015.
Accounting by the joint arrangement itself: transfer of business on formation of joint venture
Question:
How should a joint arrangement account for businesses contributed to it by its investors, on formation or otherwise?
Answer:
Joint venturers might contribute assets or groups of assets on formation of a joint venture. An entity should assess whether a contribution of assets from its investor meets the definition of a business combination under IFRS 3.
The IFRSs are silent on how a joint arrangement should account for businesses contributed to it by its investors on formation.
The only relevant guidance is that formation of a joint venture is outside the scope of IFRS 2 and IFRS 3. IFRS 3 excludes the formation of a joint arrangement from its scope. The contribution of a business on the formation of a joint venture is also outside the scope of IFRS 2.
A joint venture has an accounting policy choice on how to account for a business contributed to it on formation. The joint venture could:
a. record the business contributed at fair value, including goodwill; or
b. record the business at the previous carrying amount in the venturer’s financial statements. Any subsequent contribution of assets in exchange for shares is likely to be within IFRS 2’s scope. IFRS 2 requires goods acquired by issuing equity instruments to be recognised at fair value.
Joint control and control are mutually exclusive. It is implicit in the definition of joint control that there have to be at least two parties that share control over the arrangement. If one party can control the arrangement, the arrangement is not a joint arrangement, and it is outside the scope of IFRS 11. “An investor controls an investee when the investor is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee”. Management should first assess whether it controls the arrangement on its own before concluding on the existence of joint control.
Chairman with casting vote
Entities A and B set up a joint venture company, entity J, by signing a joint operating agreement. Both investors delegate three directors each to entity J’s board of directors. Decisions are made by simple majority. In the event of a deadlock, the chairman (a director of entity B) has the casting vote.
It is, therefore, likely that entity B has control over entity J, because decisions made on behalf of entity B cannot be prevented by entity A.
The flow chart below illustrates the decision-making process and the interaction between IFRS 10, IFRS 11 and IAS 28 and IFRS 9 (IAS 39):
Joint control
“Joint control is the contractually agreed sharing of control of an arrangement, which exists only when the decisions about the relevant activities require the unanimous consent of the parties sharing control”. Joint operators and joint venturers need not hold equal shareholdings in an entity for joint control to exist.
Characteristics of a joint arrangement
A joint arrangement is defined as an arrangement of which two or more parties have joint control.
Two characteristics are necessary to fulfil the definition of a joint arrangement:
- the parties to the joint arrangement are bound by a contractual arrangement; and
- the contractual arrangement gives two or more of those parties joint control of the arrangement.
Unequal interests
Joint control can exist where the interests of the parties are unequal. However, a very uneven split of interests between parties − for example, 90:10 − might undermine the joint control assertion.
Management should be particularly careful in this situation to understand the commercial rationale for joint control and why the majority shareholder would accept sharing control. This could occur if, for example, the majority shareholder sets up an arrangement in a foreign location, and local regulation requires government or local investor involvement to the extent of joint control.
Management might need to apply judgement to conclude whether joint control exists. A contractual agreement with explicit articulation of joint control within the agreement makes the conclusion straightforward. In some cases, however entities need to look at other facts to conclude whether joint control exists. Consider the following example:
Shareholders A and B form a new entity J, which will invest in several investment properties. Shareholders A and B each own 35% and 65% equity interest in entity J respectively. Under the terms of the shareholders agreement, major decisions about all the relevant activities of entity J require unanimous consent of the shareholders. For entity J, examples of some of the major decisions include, approval of the budget and business plan, entering into significant leases and, decisions to buy or sell properties.
In this case, the requirement for unanimous consent on major decisions concerning all relevant activities means that Entity J is subject to joint control.
However, it is important to understand the commercial rationale for joint control where there is a notably uneven split of interests between parties. In this example, Shareholder A is an entity with extensive experience of the real estate industry in the area in which entity J operates whereas shareholder B has very limited experience but is able to provide the majority of the capital investment entity J requires.
Contractual agreement
Joint control cannot exist without an enforceable contractual agreement. The agreement proves that one party alone cannot control the joint arrangement.
Minutes of meetings and documentation of discussions can also be evidence of an enforceable contractual agreement. The agreement does not have to be in writing. However, where the joint arrangement is included within a separate vehicle, legally binding documents would usually be available in some written form. These could include articles of associations, charters or by-laws.
Contractual arrangements required to be enforceable
Although IFRS 11 does not state explicitly that the contractual arrangement should be enforceable, this appears to be implicit in IFRS 11, which requires that the parties are bound by it.
When a separate legal entity or other vehicle is used, its articles, charter or by-laws may set out some or all of the terms of the contractual arrangement. Usually, the contractual arrangement will deal with matters such as:
- the purpose, activity and duration of the joint arrangement;
- how the members of the joint arrangement’s governing body (the board of directors, or equivalent) are appointed;
- the decision-making process: the matters that require decisions from the parties, the voting rights of the parties and the required level of support for those matters (this process is key in establishing joint control);
- the required capital or other contributions to be provided by the parties; and
- how the assets, liabilities, revenue, expenses or profit or loss of the joint arrangement are to be shared between the parties.
The purpose of the agreement is not only to establish joint control over the arrangement but also to set out the terms and conditions under which the joint arrangement operates. Some common terms present in contractual arrangements establishing joint control are:
- The purpose, activity and duration of the joint arrangement.
- How the members of the board of directors (or equivalent governing body of the joint arrangement) are appointed.
- The decision-making process.
- The capital or other contributions required of the parties.
- How the parties share assets, liabilities, revenues and expenses or profits or losses arising from the joint arrangement.
Common terms in contractual arrangements
Common terms included in contractual arrangements are the following:
· The purpose, activity and duration of the joint arrangement.
The agreement might explain, for example, why the parties created the joint arrangement and how long they intend to operate it. It would establish who the parties creating the joint arrangement are, which parties exercise joint control and which parties do not.
· How the members of the board of directors, or equivalent governing body of the joint arrangement, are appointed.
The agreement could establish how the parties nominate members onto the board, what their responsibilities are and how the board of directors can be removed. It would also establish the voting rights of each board member.
· The decision-making process.
This establishes the existence of joint control via decision-making processes. It could include details on what activities would qualify as ‘relevant activities. These activities require unanimous consent by the parties exercising joint control.
· The capital or other contributions required of the parties.
· How the parties share assets, liabilities, revenues and expenses or profits or losses arising from the joint arrangement.
This is a key factor in determining whether the arrangement is classified as a joint operation or a joint venture.
· The delegation of the entity’s day-to-day operation to one of the parties to the joint arrangement.
· Transfer of interests to new parties or among existing parties.
· Arbitration procedures, which become particularly important when the parties cannot reach unanimous agreement.
Resolution of disputes
Sometimes it may not be possible for the parties that have joint control of an arrangement to reach unanimous consent. The contractual arrangement may include clauses on the resolution of such disputes; for example, it may require that, in such circumstances, the parties seek arbitration. The existence of such provisions does not prevent an arrangement from being jointly controlled.
Arrangements for resolution of disputes
Some arrangements for dispute resolution can lead to a conclusion that the parties do not have joint control, even if the other elements for joint control are in place. When the contractual terms include a mechanism which, in the event of a dispute, gives one party (Entity A) a substantive right to overrule the other party (Entity B), this may indicate that Entity A is in a controlling position.
Conversely, when the contractual arrangement requires the parties to seek independent arbitration and, in the event that agreement still cannot be reached, to abide by the decision of the independent arbitrator, it may be appropriate to conclude that the parties have joint control of the arrangement.
Changes in facts and circumstances
If there is a change in facts and circumstances, an entity should reassess whether it still has joint control of the arrangement.
Changes in facts and circumstances leading to reassessment of joint control – example (1)
Entities A and B each have 50 per cent of the ordinary shares, and 50 per cent of the voting rights, in Company X. The Memorandum and Articles of Company X are such that decisions about the relevant activities require a majority of the votes.
As discussed in IFRS 11, the arrangement has implicitly established joint control, because decisions about the relevant activities cannot be made without both parties agreeing. Accordingly, Entities A and B have joint control and the arrangement is a joint arrangement.
Subsequently, Entity B sells half of its shareholding in Company X to Entity C. As a result, the arrangement ceases to be a joint arrangement. Even though Entity A can block any decision, it does not control the arrangement because it needs the agreement of either Entity B or Entity C. Entities A, B and C collectively control the arrangement. However, there is now more than one combination of parties that can agree to reach a majority of the voting rights (i.e. either Entities A and B or Entities A and C).
Accordingly, Entities A and B both cease to have joint control of Company X.
Joint control should be in place over the decisions on ‘relevant activities. Relevant activities are defined as “activities of the investee that significantly affect the investee’s returns”. Some examples of these activities are:
- approval of the arrangement’s business plans and overall strategy;
- issuing new (or reducing the current level of) share capital;
- major capital expenditure and significant asset disposals;
- funding decisions; and
- nomination and removal of board members.
It is important to understand at what level the decisions about relevant activities are made.
Unanimous consent
The contractual agreement must require unanimity for decisions over the relevant activities, but this does not mean that all parties need to agree all decisions. It would be impractical for all investors who share joint control to participate in every decision required in carrying out the arrangement’s economic activity. The nature of the decisions that are subject to unanimous consent should be considered when assessing joint control.
Nature of joint control: requirement for unanimous consent of parties that control the arrangement collectively
For joint control to be present, three conditions must be met:
- no single party to the arrangement has control; but
- two or more parties can be identified who, collectively, are able to control the arrangement; and
- decisions about relevant activities cannot be taken if any of the identified parties withholds consent (i.e. each of the identified parties has an explicit or implicit right of veto).
This last element is particularly important. Many arrangements without a controlling party will not meet the definition of a joint arrangement because none of the parties to the arrangement has an explicit or implicit right of veto. Therefore, when assessing whether an arrangement is a joint arrangement, it may sometimes be helpful to focus on whether any of the parties to the arrangement has an explicit or implicit right of veto. If not, then it will be possible for all of the parties to the arrangement individually to be outvoted or overruled by the others, and the arrangement is not a joint arrangement.
Accordingly, in practice, when assessing whether an arrangement is a joint arrangement, it is sensible to focus on those parties (if any) whose consent is required in respect of decisions over relevant activities because those are the parties who are likely to exercise joint control over the arrangement. Such parties may either have an explicit right of veto in respect of decisions about relevant activities, or may have an implicit right of veto (e.g. because the voting rights of the other parties are together insufficient to enable such decisions to be passed).
Other factors to consider when assessing an investor’s rights
Potential voting rights
An investor might own instruments that, if exercised or converted, give the entity voting power over the relevant activities of another entity; these are termed ‘potential voting rights. Potential voting rights are “rights to obtain voting rights of an investee, such as those arising from convertible instruments or options, including forward contracts”. Potential voting rights might take various forms, including share warrants, share call options, forward contracts, and debt or equity instruments that are convertible into ordinary shares.
The existence of potential voting rights can reverse the effect of a contractual arrangement that establishes joint control between the investors. For example, a shareholders’ agreement between two parties provides for joint decision-making over relevant activities. In the same agreement, one investor has a substantive option to purchase the interest held by the other investor. The option reverses the effect of the joint decision-making over relevant activities, and joint control is not established.
Potential voting rights
Entities A and B decide to manufacture products jointly in a new territory. Entity C will undertake the manufacturing process in this territory, using components supplied by entities A and B. Entities A and B each own 50% of the voting rights in entity C; they are entitled to 50% of any dividends and 50% of the assets in liquidation. Entity C’s articles of association state that its operations should be conducted in accordance with an annual business plan approved unanimously by the shareholders. The shareholders appoint six directors in proportion to their shareholdings, to manage entity C’s activities. Entities A and B, therefore, each have three directors on the board. The chairman of the board rotates between entity A and entity B and has no casting vote. The articles set out the types of relevant activity that require the directors’ unanimous consent, which include approval of the arrangement’s business plan. Entity A has an option to buy entity B’s shares in entity C. The option can be exercised by entity A at any time if entities A and B do not agree on a strategic decision. The option is deemed to be substantive.
Question:
Is joint control present?
Answer:
No. Joint control does not exist, because entity A can purchase entity B’s shares in entity C and, therefore, it can cancel the joint venture agreement. Entity A has control. Potential voting rights assessed under IFRS 10 can reverse the effect of a contractual arrangement that establishes joint control.
Do the parties collectively control the arrangement?
Management might conclude that a group of parties, or all of the investors, collectively control the arrangement. Management should establish whether any of those parties that have collective control exercise joint control. Collective control exists when all of the parties, or a group of the parties, when considered collectively, can direct the relevant activities. Joint control only exists when these parties are bound by a contractual agreement, whether established formally or informally, to agree unanimously on all decisions affecting the relevant activities. Existence of collective control does not, by itself, give rise to joint control.
The contractual arrangement might require a minimum proportion of voting rights to make decisions. The arrangement is not a joint arrangement if the proportion can be achieved by more than one combination, unless the contract specifies which participants should agree. For example, where shareholders A, B and C have 50%, 25% and 25% holdings respectively and a 75% approval is needed for decisions, A and B or A and C would need to agree. No joint control exists.
Joint de facto control
When considering control for the purposes of identifying whether another entity is a subsidiary of the reporting entity, the reporting entity may conclude that it has de facto control. IFRS 11 does not include any discussion of de facto control or joint de facto control, but IFRS 11 requires IFRS 10 to be used for the purposes of applying the definition of joint control. Therefore, it is apparently possible to conclude that two or more parties to an arrangement have joint de facto control of the arrangement.
For example, assume that Entity A and Entity B own 25 per cent and 24 per cent, respectively, of the ordinary shares of a listed entity, Entity C. Entity A and Entity B enter into a contractual arrangement under which they agree that they will vote together on all matters relating to Entity C. If decisions are based on majority vote and Entity C has an otherwise widely dispersed group of shareholders with no individually significant shareholders, then it may be appropriate to conclude that Entity A and Entity B have joint control of Entity C.
Conversely, if Entity C has a small number of shareholders overall, and each has significant voting rights, it is unlikely that joint de facto control could exist.
Implicit joint control
Where a group of parties establishes a joint arrangement, such as a strategic alliance to combine their operations, the decision-making process might be explicitly included in the contract, requiring unanimous consent. Joint control can also be achieved implicitly. For example, A has 60% and B has 40%, and a 75% approval is needed for decision making. Although unanimous consent is not explicitly required, joint control is implied, since both A and B need to agree for a decision to be made.
Implicit joint control with two shareholders: shareholders are the decision-making body
Entities A and B operate in the telecommunications industry and entered into a joint arrangement in order to combine their 3G access networks. The purpose of this arrangement is to reduce operating costs for both parties, to make capital infrastructure savings and to obtain economies of scale from jointly managing and maintaining a consolidated network. All significant decisions about strategic investing and financing activities are decided by a simple majority of the voting rights. Entities A and B each have one vote in the decision-making process.
Is this arrangement a joint arrangement?
Yes. All decisions about the relevant activities require consent of both parties, so the arrangement is a joint arrangement. The contractual arrangement does not explicitly require unanimous consent, but the fact that all decisions must be made by majority leads to implicit joint control.
Arbitration
The parties to the joint arrangement might also set out arbitration procedures in case they cannot agree on decisions related to relevant activities. The existence of arbitration procedures to resolve disputes can be strong evidence of joint control; and the absence of these provisions might suggest that unanimous consent is not required for all key decisions, and so joint control does not exist.
Right of veto versus protective rights
An investor exercising joint control has veto over relevant decisions where joint control exists. An investor cannot, on its own, decide on the relevant activities, but it can prevent the other investors from doing so. Management should consider whether the rights arising from the arrangement are substantive rights or protective rights. A veto over a decision on relevant activities determines the existence of joint control, but a veto over protective rights does not. Protective rights, such as veto over closing the entity, are rights that can be in place for other investors as well, such as minority shareholders.
Continual assessment of joint control
Decisions on whether joint control exists might require significant judgement from the parties. An entity should re-assess whether it still has joint control if the facts and circumstances change.