Mergers and acquisitions (M&A) are among the quickest paths to business growth. However, not all businesses are keen to face the complexity of M&As or take on the risks of a deal. In recent years, more companies have looked to other investment models to grow, such as forming joint ventures and strategic business alliances.
Investors enter into arrangements with another party for many reasons. For example, the investors may 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.
In the 15th PwC-MAP Philippine CEO Survey, 36 percent of the CEOs say that during the time prior to entering possible partnerships, their planning for the preparations needed for such partnerships has not been completed by then. Of the 64 percent of CEOs who say that they have completed or are planning to undertake preparations before entering into partnerships, 33 percent say that improving the financial and accounting reporting process was part of such preparations.
Partnerships offer an opportunity for two or more people to form a single business, and another form of investment is a joint arrangement. Joint arrangements enable investors, or even different businesses, to form a new entity. The purpose of the joint arrangement might be to share costs (e.g. shared distribution network or use of an asset), or might be motivated by profit (e.g. property development, management or investment, or pharmaceutical companies sharing research).
Joint arrangements could be set up in different structures and forms. It can be established in writing in the form of a contract between parties, a documented discussion, or local legislation. What is important is for contractual arrangements to be established by the parties – to bind the parties and provide shared control. Joint arrangements, after all, will not exist if control is unilateral.
For financial reporting purposes, the accounting for joint arrangements will depend upon the rights and obligations that arise from such arrangements. Philippine Financial Reporting Standards 11, Joint Arrangements, provides entities an underlying principle for reporting joint arrangements in whatever form they take. The principle is that parties should recognize their rights and obligations arising from the joint arrangement. Let’s take a look at some scenarios:
• Cesar, Edzel, Chris and Cyril own a 25 percent stake each in KC Corp.; decisions need to be approved by a 75 percent vote. In this scenario, KC Corp. is not jointly controlled, so each investor will account for its interest in KC Corp. as an investment in associate. The presumption is that each investor would have significant influence but not joint control over KC Corp.
• Suppose Liezl owns 51 percent, and Carlos owns 30 percent, in CalLuc Ltd., and the rest of the 19 percent interest is widely held by other investors. Decisions need to be approved by a 75 percent vote. In this scenario, CalLuc Ltd. is jointly controlled by shareholders Liezl and Carlos. Why? Because based on their ownership interest (collectively at 81 percent), they must act together to make decisions affecting the investee-company. None of the investors can unilaterally make decisions because 75 percent majority is required.
• An investment property is equally held by three parties. The joint owners’ agreement requires all parties to unanimously agree on certain decisions relating to the investment property. All property expenses are shared by the parties based on their ownership interests. The parties are also jointly and severally liable for claims upon the investment property. Rental income is also distributed to the owners based on their relative ownership interest. This arrangement would be classified as a joint operation.
These illustrations demonstrate a contractual arrangement, which gives parties rights to a share of the net outcome generated by an economic activity (i.e. joint venture), and contractual arrangements that give parties an interest in individual assets and liabilities (i.e. joint operation). The determination of the type of joint arrangement will result in different accounting for financial reporting purposes.
In a joint operation, the investor recognizes its assets, liabilities, revenue from sale of its share of the output, and expense, including its share of assets held jointly, and liabilities incurred jointly. Any gains or losses resulting from the transaction should only be recognized to the extent of the other parties’ interest in that joint operation. The accounting method treats the operations as if the investor conducted them directly, thus it is booked in the investor’s own financial statements.
In a joint venture, the investor initially recognizes an investment at cost. Subsequently, the investor adjusts its investment by the investors’ share in profit or loss and other comprehensive income.
There are a number of advantages to enter into joint arrangements. Since investors do not have to give up its business or acquire new business when entering into joint arrangements, investors can work together with other businesses in a joint arrangement and still maintain their other businesses separate from the joint arrangement. Working with the right party will allow businesses to tap into markets, gain access to resources, grow their capacity and expertise, and build market presence.
Joint arrangements are not a quicker path to growing a business, nor are they entered into without risks. The 15th PwC-MAP CEO Survey reveals that 55 percent of CEOs have walked away or terminated a partnership.
Reasons cited were not sharing the same vision, mismatch in the personalities of the management team members, not delivering on what was promised, and demand for too much control. Understanding your business strategy and finding the right partner will help unlock the value of any arrangement.
Carlos Federico C. de Guzman is an Assurance director at Isla Lipana & Co., the Philippine member firm of the PwC network. For more information, please email email@example.com. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.