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Steven Brice

IASB Chooses More Faithful Representation Over Convergence With U.S. GAAP

Here’s why.

March 26, 2012
by Steven Brice

The International Accounting Standards Board (IASB) issued International Financial Reporting Standards (IFRS) 11 Joint Arrangements (IFRS 11) on May 2011 and, subject to European Union approval, it is effective for accounting periods beginning on or after January 1 (with early adoption permitted). The joint arrangements project was proposed as a memorandum-of-understanding (MoU) project between the Financial Accounting Standards Board (FASB) and the IASB, the goal of which was to make existing accounting standards fully compatible as soon as is practicable.

However, in issuing IFRS 11, the IASB concluded that convergence with U.S. GAAP would not result in the improvements to financial reporting that it desired. According to the IASB, IFRS 11, which adopts a more “principle-based” approach, will bring “greater improvements to financial reporting than would be achieved by simply adopting U.S. GAAP.”

A More ‘Principle-Based’ Approach

The focus of IFRS 11 is to account for joint arrangements according to the rights and obligations of each party to the arrangement. By contrast, according to the IASB, the U.S. GAAP requirements are “very dependent on the legal form … and, in some cases, are industry specific.” As such, the IASB concluded that IFRS 11 would provide a more faithful representation of those arrangements and would provide better information to the users of the financial statements.

Under IFRS 11, a joint arrangement exists in which there is joint control between parties of an incorporated or unincorporated vehicle. Joint arrangements are further divided between joint operations and joint ventures.

Where parties to a joint arrangement have rights to the assets and obligations for the liabilities relating to the arrangement, the arrangement is classified as a joint operation under IFRS 11. Joint operators are required to recognize in relation to their interest in the assets and liabilities of the arrangement, their share of joint assets or jointly incurred liabilities in accordance with the contractual arrangement.

By contrast, where parties have rights to the net assets of the arrangement, IFRS 11 defines the arrangement as a joint venture, and requires the equity method of accounting to be applied. The equity method of accounting is where the investment is initially recognized at cost and adjusted thereafter for investor’s share in the post-acquisition change of the net assets of the investee.

When an arrangement is classified as a joint venture, IFRS 11 does not permit the use of proportionate consolidation. Previously, the use of proportionate consolidation or equity accounting was an accounting policy choice for those entities applying IFRS.  Proportionate consolidation occurs when the venture’s share of each of the assets, liabilities, income and expense of a jointly controlled entity are combined line by line with similar items in the venturer’s financial statements.

The U.S. GAAP Approach

Under U.S. GAAP, ASC 323 generally requires investors to report for both unincorporated and incorporated joint arrangements using the equity method. However, ASC 323 and ASC 810 do allow for proportionate consolidation in the extraction and construction industries, where there is a long-standing practice of using it. This is not permitted reporting for joint ventures in any other industry.

The U.S. and IFRS approach could therefore result in a significantly different treatment by an investor of the assets and liabilities of a joint arrangement under two sets of circumstances:

  1. Under IFRS it has been determined that an investor — acting in an industry outside of the extraction or construction industries, or working within these industries and investing in an incorporated entity — has a right to the individual assets and an obligation for the individual liabilities of the joint venture. Under these circumstances, IFRS 11 requires that an investor must record its interest in the assets and its obligation for the liabilities on its balance sheet, in accordance with the contractual arrangement. By contrast, U.S. GAAP ASC 323 requires the investor to record an investment for its interest using the equity method of accounting.
  2. An investor in an unincorporated entity working in the extraction and construction industries has accounted under U.S. GAAP for its interest in a joint arrangement using the proportionate consolidation method but is judged, under IFRS, to have a right to the net assets of the arrangement. Under these circumstances, IFRS 11 requires that an investor must record its interest as an investment using the equity method.

More a Matter of Principle Than Form

In practice, the IASB believes it is unlikely that a joint arrangement in an unincorporated legal entity will not specify which parties have rights to the assets and obligations to the liabilities.

As a result, the IASB does not envision any significant differences between the approach adopted by investors working in the extraction and construction industries when they use the proportionate consolidation method under U.S. GAAP. However, the IASB accepts that when, under U.S. GAAP, an interest in joint arrangement is accounted for under the equity method, a judgment is required under IFRS as to the rights and obligations arising from the arrangement and, as a result, there may be significant differences under IFRS regarding the investor’s reported assets and liabilities.

Conclusion

While the differences between IFRS 11 and the U.S. GAAP standards surrounding joint ventures will be of interest to investors in jointly controlled operations, there is a wider significance of the divergence resulting from IFRS 11.

Despite the project forming part of the agenda for convergence, it is clear that the IASB will not work towards convergence where it believes that it can achieve ‘greater improvements’ to reporting by going its own way.

Where U.S. GAAP standards are based on legal form and are industry specific, it is likely that the IASB will not accept a change to IFRS to make the accounting standards fully compatible. It is therefore interpreted that while the IASB is working towards convergence with the FASB, if a converged proposal does not meet the aims of the IASB, then the IASB is willing, in these instances, to deviate from the concept of convergence.

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Steven Brice is a technical partner in the financial reporting advisory group for Mazars LLP UK and provides his views on IFRS developments and the proposed creation of the PCSIC. For U.S. IFRS, you can contact Remi Forgeas, CPA, who is an audit and assurance partner for WeiserMazars LLP U.S. and provides his views on international convergence of GAAP and whether progress is really being made in light of recent developments.

* The views expressed in this article are the author’s own and do not necessarily reflect the views of the AICPA or AICPA Corporate Finance Insider.