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Determinants of the Accounting Choice between Alternative Reporting Methods for Interests in Jointly Controlled Entities

2010; Routledge; Volume: 19; Issue: 4 Linguagem: Inglês

10.1080/09638181003687844

1468-4497

Isabel Lourenço, José Dias Curto,

Corporate Finance and Governance

Abstract This paper examines whether the type of jointly controlled entity influences the management choice to report interests in this kind of joint venture using the equity method or proportionate consolidation. We address this gap in the accounting choice literature by exploiting the UK setting where, due to the transition to IFRS, firms had to change their reporting method for interests in jointly controlled entities from the gross equity method to a similar approach (equity method) or to proportionate consolidation. We support our analysis on the classification of jointly controlled entities proposed by Hennart Citation(1988). We hypothesize that venturers are more likely to change their reporting method to proportionate consolidation when the majority of their jointly controlled entities are cases of Link instead of Scale cooperation. After controlling for several variables, our results are consistent with the predictions and thus suggest that the type of jointly controlled entity plays an important role in the management decision to report interests in jointly controlled entities using the equity method or proportionate consolidation. However, the results also provide empirical evidence supporting the importance of debt covenant costs and monitoring costs in the choice between alternative reporting methods. Acknowledgements We are grateful to the participants at the 2006 European Accounting Association Congress (Dublin) and at the 2009 Mid-Year Conference of the American Accounting Association (International Section, Florida), and to two anonymous referees for their helpful comments and suggestions. We are also grateful to Professor Salvador Carmona and to our colleagues Ana Isabel Morais from ISCTE – IUL Business School, José António Moreira from Oporto University and Sebahattin Demirkan from Binghampton University for their help and useful suggestions to improve this paper. Notes Whittred Citation(1987) documents a relationship between the adoption of consolidated reporting in Australia and the number and type of subsidiaries, as well as the management's share of a firm's equity and the presence of inter-company guarantees. Mian and Smith Citation(1990) analyze the incentives to report the performance of financial subsidiaries on a consolidated or unconsolidated basis prior to the Financial Accounting Standards Board Statement 94. This study provides evidence that the greater the operating, financial and informational interdependencies between parent and subsidiary, the more US parents are likely to choose to report the operations of a financial subsidiary on a consolidated basis. Whittred and Zimmer Citation(1994) use the case of accounting for unincorporated joint ventures in the Australian extractive industries to demonstrate how accounting methods can be determined by the firm's type of assets (assets in the exploration sector versus assets in the development/production sector) and the manner in which they are financed (on a 'non-recourse' basis versus on a 'with-recourse' basis). The venturer's share of JCEs' assets, liabilities, revenue and expenses can be reported in the venturer's financial statements as separate line items (Format 1) or they can be combined line by line with the similar items from the venturer (Format 2). This is true in the absence of inter-company transactions. This is usually a negative impact. In the Balance Sheet, interests in JCEs presented as an asset should be desegregated in two items: the venturer's share of JCEs' assets less the venturer's share of JCEs' liabilities. In the Income Statement, the venturer's share of JCEs' revenue from sales should be presented as an amount deducted from total revenue from sales in order to present just the venturer's revenue from sales. According to IAS 31, Interests in Joint Ventures (IASB, 2003), those ventures applying the line-by-line reporting format for proportionate consolidation or the equity method shall disclose the aggregate amount of each of current assets, long-term assets, current liabilities, long-term liabilities, income and expenses related to its interests in joint ventures. For example, the market for crude is a failing market. Oil refining is a capital-intensive flow process, requiring constant throughput. As storing crude oil is costly, refineries are custom-built to handle a particular type of crude. The market for this raw material tends therefore to be thin, exposing parties to opportunistic behaviour. For this reason, oil refiners have found it necessary to integrate backward into crude exploration and production instead of writing long-term contracts with independent crude producers (Hennart, Citation1988). These Comment Letters are available at www.iasb.org/current+projects/IASB+projects/joint+ventures.htm Where debt is secured, the scope for debt holder and shareholder conflict is reduced since the lender's claim over specific assets limits the likelihood of asset substitution and claim dissolution. Mather and Peirson Citation(2006) found similar results in relation to most covenants used in Australian private debt. Dichev and Skinner Citation(2002) demonstrate empirically that firms that violate debt covenants enclosed in private debt agreements tend to be more highly levered and less profitable (lower ROA and lower coverage ratio) than firms that do not violate such covenants. The IAS 31, Interests in Joint Ventures (IASB, 2003), requires venturers to disclose in the Notes the aggregate amount of each of current assets, long-term assets, current liabilities, long-term liabilities, income and expenses related to its interests in JCEs. However, this information does not allow users to compute some ratios, like the return on assets, as if the venturer would report interests in JCEs by the alternative method. Almost all the firms listed in the London Stock Exchange belonging to the FTSE All Shares applied IFRS for the first time in the year of compulsory adoption. We found two early adopter firms with interests in JCEs. They are both foreign firms and their interests in JCEs are reported by proportionate consolidation. The inclusion of these firms would not be relevant for the purpose of our study. In the exceptional cases where the information is not available in the Thomson Worldscope Database, we use information hand-collected from the venturers' annual consolidated financial statements presented in their website. A Scale and a Link Venturer are ventures where the majority of JCEs are, respectively, Scale and Link. The UK GAAP require venturers to report interests in JCEs as an asset (equity method) and to provide additional information about the venturer's share of JCEs' assets and liabilities. This information is always presented by the venturers and enables the computation of pro forma total assets and total liabilities as if JCEs were reported by proportionate consolidation instead of the equity method. Ali and Kumar Citation(1994) suggest the inclusion of interactions in order to enhance the ability to explain accounting choice decisions.