IN BRIEF
FASB’s recent guidance on accounting joint ventures, ASU 2023-5, is intended to resolve diversity in practice and simplify the accounting for these entities. But classifying a newly created entity as a joint venture for accounting purposes is not as straightforward as the new standard might suggest. This article looks closer at other guidance in the Accounting Standards Codification (ASC), paying particular attention to the variable interest entity (VIE), voting interest entity (VOE), and purposes test literature to answer the question of whether certain joint ventures might be scoped out of the recent guidance.
***
Originally proposed in October, FASB affirmed its Accounting Standards Update (ASU) 2023-05, Business Combinations—Joint Venture Formations: Subtopic 805-60 Recognition and Initial Measurement, to take effect for all joint ventures with a formation date on or after January 1, 2025. Joint ventures (JV) formed before the effective date have the option to apply the rules retrospectively. While most of the exposure draft’s provisions were adopted by the board in the final standard, a provision that would have prohibited JVs from applying the measurement guidance contained in Accounting Standards Codification (ASC) 805-10-25 to its formation transaction was reversed during its deliberations; thus, JVs may apply measurement period guidance to JVs at formation date. This change was prompted by many stakeholders in their comment letters.
ASU 2023-05 requires contributions of assets and assumed liabilities to be valued at fair value upon formation. Under prior guidance, contributions to a JV could be valued at either fair value or the carrying values of the joint venturers on the formation date. This diversity in practice in turn undermined the usefulness of the financial statements provided to investors and other interested parties.
In their affirmation of the guidance, FASB decided to retain the ASC glossary’s definition of a JV’s formation date as the date an entity meets the definition of a JV, acknowledging that such a date might be different from the acquisition date on which the acquirer obtains control. The existing accounting guidance suggests that criteria constituting a JV for financial reporting purposes may not comport with the definition of either a JV or a corporate JV as defined in the glossary. To this end, this article analyzes the existing guidance relating to what constitutes a JV for accounting purposes. Such classification depends on the relevant guidance in ASC 323, ASC 805, and ASC 810. Accordingly, consideration will be directed toward the variable interest entity (VIE), and the voting interest entity (VOE) literature, as well as the purposes of a JV as defined in the existing guidance. In reflecting on this guidance, this article will focus on the following questions:
- May a JV be scoped out of the VIE literature under the business scope exception?
- Is the entity a VIE, and thus considered the equivalent of a subsidiary to be consolidated with its venturer, thereby precluding it from JV status?
- If an entity is not a VOE, it is not precluded from JV status under ASU 2023-05.
- But not being a VOE is necessary, not sufficient, for JV treatment.
- If an entity is neither a VIE nor a VOE, does it meet the purposes test? If not, it would not be considered a JV.
JV Scoped Out of VIE Literature Under the Business Scope Exception
ASC 810-10-15-17(d) states the following:
A legal entity that is deemed to be a business need not be evaluated by a reporting entity to determine if the legal entity is a VIE under the requirements of the Variable Interest Entities Subsections unless any of the following conditions exist (however, for legal entities that are excluded by this provision, other GAAP should be applied):
- The reporting entity, its related parties, or both participated significantly in the design or redesign of the legal entity. However, this condition does not apply if the legal entity is an operating joint venture under joint control of the reporting entity and one or more independent parties or a franchisee.
- The legal entity is designed so that substantially all of its activities either involve or are conducted on behalf of the reporting entity and its related parties.
- The reporting entity and its related parties provide more than half of the total of the equity, subordinated debt, and other forms of subordinated financial support to the legal entity based on an analysis of the fair values of the interests in the legal entity.
- The activities of the legal entity are primarily related to securitizations or other forms of asset-backed financings or single-lessee leasing arrangements. [Emphasis added]
Thus, a legal entity which meets the definition of a business under ASC 805-10-55-3(a)-55-6 and ASC 805-10-55-8-9 would not require evaluation under the VIE provisions of ASC 810-10. Because the exception to this paragraph would not apply to legal entities deemed either a JV or corporate JV under control of the reporting entity, only condition 1 applies. In most cases, a JV would not meet condition constraints 2, 3, and 4. It would be rare that a JV would meet the condition in constraints 2 and 4 and in most cases constraint 3 would also not apply. When testing condition 1 regarding whether the legal entity is an operating JV, the following characteristics apply:
- Degree of participation of venturers in making key decisions through substantive approval or veto rights
- If disputes develop, no venturer’s rights can be compromised
- Venturers are equally represented on the board of directors
- A lack of any major barriers inhibiting the rights of any one venturer.
The existing accounting guidance suggests that criteria constituting a JV for financial reporting purposes may not comport with the definition of either a JV or a corporate JV as defined in the glossary.
If any of the above characteristics are lacking, a candidate for JV classification must be evaluated under the VIE guidance.
Whether the Legal Entity is a VIE
ASC 810-10-15-14 states the following:
A legal entity shall be subject to consolidation under the guidance in the Variable Interest Entities Subsections if, by design, any of the following conditions exist …
- The total equity investment (equity investments in a legal entity are interests that are required to be reported as equity in that entity’s financial statements) at risk is not sufficient to permit the legal entity to finance its activities without additional subordinated financial support provided by any parties, including equity holders.
- As a group the holders of the equity investment at risk lack any one of the following three characteristics:
- The power, through voting rights or similar rights, to direct the activities of a legal entity that most significantly impact the entity’s economic performance. …
- The obligation to absorb the expected losses.
- The right to receive the expected residual returns of the legal entity. The investors do not have that right if their return is capped by the legal entity’s governing documents or arrangements with other variable interest holders or the legal entity. For this purpose, the return to equity investors is not considered to be capped by the existence of outstanding stock options, convertible debt, or similar interests because if the options in those instruments are exercised, the holders will become additional equity investors. …
If interests other than the equity investment at risk provide the holders of that investment with these characteristics or if interests other than the equity investment at risk prevent the equity holders from having these characteristics, the entity is a VIE.
- The equity investors as a group also are considered to lack the characteristic in (b)(1) if both of the following conditions are present:
- The voting rights of some investors are not proportional to their obligations to absorb the expected losses of the legal entity, their right to receive the expected residual returns of the legal entity, or both.
- Substantially all of the legal entity’s activities (for example, providing financing or buying assets) either involve or are conducted on behalf of an investor that has disproportionately few voting rights. … For purposes of applying this requirement, reporting entities shall consider each party’s obligations to absorb expected losses and rights to receive expected residual returns related to all of that party’s interests in the legal entity and not only to its equity investment at risk.
If the entity falls under the above subparagraphs, it would not be considered a JV, but rather it would be deemed a subsidiary of the investor entity, requiring the latter to consolidate the financial statements of the former with its own.
If the entity falls under subparagraphs ASC 810-10-15-14(a) or (b), it is considered a VIE. If the entity does not fall within the VIE subparagraphs, it must also then not meet any of the provisions of the Voting Interests Model (VOE) in order to avoid consolidation. If the entity is not a VIE, consolidation must then be evaluated under the voting interest model, as discussed in the following section.
Classifying a newly created entity as a joint venture for accounting purposes is not as straightforward as the definitions of both joint venture and corporate joint venture might suggest.
Whether the Entity is Considered a VOE
In the event an entity based on the above analysis is not a VIE, a determination must be made regarding whether consolidation is necessary under the VOE model. In general, a controlling financial interest is ownership of over 50% of the outstanding voting shares. Per ASC 810-10-15-10(a), all majority-owned subsidiaries, either direct or indirect, that provide the parent entity with over 50% interest must be consolidated. It is possible in some instances, however, for an entity to have a greater than 50% economic interest in an entity but not have control over that entity. In other instances, an entity may have less than a 50% economic interest in an entity but have control over it. These situations arise in an evaluation of whether an indirect relationship with an entity establishes a subsidiary relationship.
To illustrate the greater than 50% economic interest scenario: Assume Company X has a 40% interest in Company Y. In turn, Company Y has a 60% interest in Company Z. Further assume that Company X has a 30% direct interest in Company Z. Company X’s economic interest in Company Z is its direct interest of 30% plus its indirect interest in Z via its 40% of Y’s 60% in Z, for a combined economic interest in Z of 54%. But because Company X’s interest in Company Y is 40%, Z cannot be treated as a subsidiary for consolidation purposes.
To illustrate the lesser than 50% economic interest scenario: Assume that Company A has a 70% interest in Company B, which has a 31% interest in Company C. Company A has a 20% direct interest in Company C. Here, Company A’s interest in Company C consists of its direct interest of 20%, plus its indirect interest in Company C of 70% of B’s 31% interest in C, or 42% economic interest. But by virtue of its 70% interest in Company B, it controls the voting shares of Company C. Thus, Company A under the VOE model would be required to consolidate its accounts with those of Company B and C. Given that many parent-subsidiary relationships involve a myriad of indirect affiliated relationships, application of the VOE model can be difficult to evaluate.
In other cases, even though an entity may have a less-than-50% interest in the voting shares of another entity, it may nonetheless be required to consolidate the latter entity’s accounts with its own, if by agreement it can appoint a majority of its representatives to the board of directors.
In addition, even though control based on an entity’s greater than 50% interest or a lack of control by a less than 50% interest over another entity may be indicated, a careful consideration of the extent of noncontrolling shareholder, protective, and participative rights is often required in determining the applicability of the VOE model. The guidance regarding such rights is contained in ASC 810-10-25-2-ASC 810-10-25-14. When analyzing whether JV status is achieved relative to the VOE model, the following warrant consideration:
- Participation of venturers in significant decisions through substantive veto or approval rights
- The lack of significant barriers that would inhibit the decision-rights of any one investor
- Dispute resolution without any venturer’s rights compromised
- Existence of kick-out or carve-out rights
- Equal representation on the board of directors.
Even if, after a deliberate and detailed analysis, it is determined that a JV does not fall under any of the various VOE subparagraphs, a final test is required before a JV designation for financial reporting purposes can be made. Namely, the JV must meet the purposes test.
Whether a Proposed JV Meets the Purposes Test
ASC 805-60-25-2 states the following:
An entity shall determine whether a transaction or an event is a joint venture formation by applying the definition of joint venture (or corporate joint venture) and the guidance in paragraph 805-60-25-3 on its formation date. If the transaction is not a joint venture formation, the reporting entity shall account for the transaction in accordance with other generally accepted accounting principles.
It is not enough for accounting purposes to rely upon the legal definition of a joint venture.
The definition of JV or corporate JV can be found in ASC 323-10-20:
A corporation owned and operated by a small group of entities (the joint venturers) as a separate and specific business or project for the mutual benefit of the members of the group. A government may also be a member of the group. The purpose of a corporate joint venture frequently is to share risks and rewards in developing a new market, product, or technology; to combine complementary technological knowledge; or to pool resources in developing production or other facilities. A corporate joint venture also usually provides an arrangement under which each joint venturer may participate, directly or indirectly, in the overall management of the joint venture. Joint venturers thus have an interest or relationship other than as passive investors. An entity that is a subsidiary of one of the joint venturers is not a corporate joint venture. The ownership of a corporate joint venture seldom changes, and its stock is usually not traded publicly. A noncontrolling interest held by public ownership, however, does not preclude a corporation from being a corporate joint venture.
Based upon this definition, for an entity to be classified as a JV, it must have a purpose—which might be a new product, market, technology—under which each venturer participates in the management, directly or indirectly. Thus, even if a JV can avoid treatment as a subsidiary under either the VIE or VOE models, it must meet the purposes test, which ASC 805-60 incorporated into the new guidance.
Example. To illustrate this test, assume the following fact pattern:
- Two entities, Able and Cain, form a new entity XYZ, for which both contribute businesses.
- Able wishes to contribute one of its subsidiaries with a fair value of $2,000 million.
- Cain wishes to contribute one of its branches for $1,800 million.
- In exchange for its contribution, Able receives a 60% interest in XYZ.
- In exchange for its contribution, Cain receives a 40% interest in XYZ.
- Able and Cain have representation on the Board of Directors proportional to their respective interests in XYZ.
Based upon this fact pattern, have Able and Cain successfully formed a JV for financial reporting purposes? The answer is no. There is no defined purpose underlying the formation of this entity. The parties have merely executed a merger. Able would be required to consolidate its 60% interest in XYZ net assets with its net assets under ASC Topic 805. Under ASC 323-10-15-7, Cain would account for its 40% interest as a significant influence investment using the equity method of accounting.
If instead, the parties’ contributions were made for the purpose of developing a new product line for their mutual benefit, a JV for accounting purposes will have been formed, assuming that neither party has control of the entity. In effect, each party would be considered a noncontrolling interest in the JV.
Not as Straightforward as It Seems
Classifying a newly created entity as a joint venture for accounting purposes is not as straightforward as the definitions of both joint venture and corporate joint venture might suggest. As discussed above, evaluating whether a JV can be classified as such requires a detailed analysis and interpretation of the guidance contained in ASC Topics 323, 805, and 810. Given the complexity of various transactions aimed at forming a JV, a determination regarding whether a particular transaction meets the business scope waiver, any of the criteria under the VIE model, or control criteria under the VOE models, and finally, the purposes test will continue to challenge accounting practice in this area of financial reporting.
The above analysis suggests that it is not enough for accounting purposes to rely upon the legal definition of a joint venture. Rather, a deliberative determination of whether two or more entities have formed a joint venture will require:
- A determination of the date at which the legal entity meets the definition of a joint venture;
- In cases where formations of joint ventures comprise multiple contributions over a period, the ability of companies to analyze factors provided in the literature which enable it to distinguish between contributions that comprise the formation and those that do not;
- A close examination of whether the arrangement is organized within a separate legal entity;
- A determination of whether multiple arrangements should be accounted for as a single formation transaction;
- A close evaluation of the entity’s purpose, design, and other characteristics consistent with a joint venture as defined in the guidance;
- An analysis of whether the contributors can exercise joint control over the entity.
FASB should be encouraged to provide greater implementation guidance addressing the above points regarding the classification of joint ventures.
