Public benefits entities: Classification of joint arrangements - some examples

In the March 2019 edition of Accounting Alert we noted that PBE IPSAS 37 Joint Arrangements (“PBE IPSAS 37”), which is in effect for Tier 1 and Tier 2 public benefit entities (“PBEs”) for annual financial reporting periods beginning on or after 1 January 2019, does three primary things:

  1. Defines what constitutes a joint arrangement
  2. Defines the two different types of joint arrangement
  3. Provides the accounting requirements for each of the two types of joint arrangement.

In the March 2019 edition of Accounting Alert we examined how to determine whether joint control exists. 

In the May 2019 edition of Accounting Alert we examined the classification of joint arrangements as either joint operations or joint ventures and noted that classification depends on the rights and obligations of the parties to the arrangement:

  • When an entity has rights to the assets, and obligations for the liabilities, relating to the arrangement, the arrangement is a joint operation
  • When an entity has rights to the net assets of the arrangement, the arrangement is a joint venture.

In this article we look at two examples that demonstrate the factors that require consideration when classifying joint arrangements.  

Example one

Question

Entity A and Entity B are in the process of structuring a joint arrangement as an incorporated entity (Entity C), which Entity A and Entity B will each have a 50% ownership interest in.  Entity A and Entity B are considering two possible alternatives for the structure of Entity C:

  • Alternative A: Set up Entity C so that the assets and liabilities held in Entity C are the assets and liabilities of Entity C
  • Alternative B: Set up Entity C so that Entity A and Entity B each have an interest in the assets of Entity C, and are each liable for the liabilities of Entity C, in a specified proportion.

How would Entity A and Entity B classify their interest in Entity C under each of the alternative structures?

Comments

Each of the two alternatives would be classified as indicated in the table below:

Alternative

Classification of the arrangement

Alterative A:

Set up Entity C so that the assets and liabilities held in Entity C are the assets and liabilities of Entity C.

This structure will mean that Entity A and Entity B will have rights to the net assets from the arrangement; as a result, the arrangement will be classified as a joint venture.

Alternative B:

Set up Entity C so that Entity A and Entity B each have an interest in the assets of Entity C, and are each liable for the liabilities of Entity C, in a specified proportion.

This structure will mean that Entity A and Entity B will have rights to the assets, and obligations for the liabilities, relating to the arrangement; as a result, the arrangement will be classified as a joint operation.

Example two

Question

Entity D and Entity E each have a 50% ownership interest in a joint arrangement that is structured as a company (Company A). The purpose of Company A is to manufacture materials that are required by Entities D and E for their individual manufacturing processes. The materials manufactured by Company A are manufactured to the quantity and quality specifications of Entities D and E.  Entities D and E purchase all of the output of Company A (with each purchasing 50%).  The price charged by Company A for its materials has been set so that Company A will break even.  If Company A produces any additional output (which will only occur infrequently, as Company A manufacturers to the quantity specifications of Entities D and E), Company A is only permitted to sell that output to third parties if both Entity D and Entity E approve the sale

Is Company A a joint operation or a joint venture?  If Entities D and E did not specify Company A’s output, would the classification change? 

Comments

The legal form of Company A (a company) indicates that the assets and liabilities held in Company A are the assets and liabilities of Company A and there is nothing to suggest that Entities D and E have rights to the assets, or obligations for the liabilities, of Company A.  This suggests that Company A is a joint venture.

However: 

  • Entities D and E purchase all the output produced by Company A (with each purchasing 50% of the total output)
  • The quantity of materials manufactured by Company A is based on Entity D’s and Entity E’s specifications 
  • In the rare event that Company A has excess output, it may only sell it to a third party with the approval of Entities D and E
  • The price charged by Company A is set to enable Company A to meet its expenses, but not make a profit.

The obligation of Entities D and E to purchase all the output of Company A reflects the dependence of Company A on Entities D and E for the generation of its cash flows, which suggests that Entities D and E have an obligation to fund the settlement of the liabilities of Company A.  In addition, the fact that Entities D and E have rights to all of the output of Company A suggests that Entities D and E are consuming, and therefore have rights to, all the service potential or economic benefits of the assets of Company A. 

These facts and circumstances indicate that the arrangement is a joint operation. 

If Entities D and E changed the terms of the arrangement so that Company A was able to sell output to third parties, this would result in Company A assuming demand, inventory and credit risks. In that scenario, Company A would likely be classified as a joint venture.

 

For more on the above, please contact your local BDO representative.