A. Facts of the Case

1.A company (hereinafter referred as ‘the company’), is a public sector undertaking under the Ministry of Steel primarily engaged in the business of extraction of iron ore and diamonds. The querist has stated that during the financial year (F.Y.) 2011-12, the company in its financial statements, has categorised the investments in A Ltd. and B Ltd. as per Accounting Standard (AS) 23, ‘Accounting for Investments in Associates in Consolidated Financial Statements’, notified under the Companies (Accounting Standards) Rules, 2006 (hereinafter referred to as the 'Rules') as ‘Investments in Associates’ considering the ‘significant influence’ of the company in the financial and operating decisions of these companies and also considering representation of the company in the respective companies’ Board of Directors. An extract of long term investments as disclosed in the notes to accounts of the financial year 2011-12 has been supplied by the querist for the perusal of the Committee. However, the Government auditors pointed out that the above investments need to be classified under ‘Joint Ventures’ as per paragraphs 3.1 to 3.5 of Accounting Standard (AS) 27, 'Financial Reporting of Interests in Joint Ventures', notified under the 'Rules' and the disclosures need to be presented under that standard. The replies of the company for the audit enquiry, audit finding and provisional comment on the above issue have been supplied by the querist for the perusal of the Committee. The company has assured that the position of investments in A Ltd. and B Ltd. will be reviewed in the F.Y. 2012-13 accounts.

2. In this backdrop, the investment agreements of these companies as analysed by the querist are as under:

A Ltd.:

(i) A Ltd. is a special purpose vehicle incorporated by a Joint Venture agreement among S Ltd. (28.58%), C Ltd. (28.58%), R Ltd. (14.29%), the company (14.29%) and N Ltd. (14.29%) for acquisition of coal mines/blocks overseas. The copy of the Joint Venture agreement has been supplied by the querist for the perusal of the Committee.

(ii) Composition of the Board:

The Board has seven directors comprising 2 each from S Ltd. and C Ltd. and one each from the company, R Ltd. and N Ltd.

(iii). Chairman

There shall be a chairman of the Board of A Ltd. Each party holding 10% or more of the shareholding of the joint venture company (JVC) or A Ltd. shall be entitled to nominate Chairman by rotation. The Chairman shall have no second or casting vote.

(iv) Quorum for Board meetings :

Subject to the provision of the Act, the quorum for any meeting of the Board shall be one third of its total strength or four directors from four different parties, whichever is higher.

(v).Quorum for general meetings :

The quorum shall be not less than two shareholders and include at least one member from each party as long as its shareholding is not less than 10% of the paid up capital of the company.

(vi). Powers of the Board:

A. All decisions of the Board shall be taken by majority of all the directors present at the meeting of the Board.

B. There are some ‘reserved matters’ like:

(i) reconstruction, re-organisation, merger, amalgamation or consolidation of A Ltd. with another entity.

(ii) any amendment to Memorandum of Association and/or Articles of Association of A Ltd.

(iii) taking of long term loans for a term exceeding 12 months for an amount exceeding Rs.100 crore or altering any material term or
condition of any such loan etc.

The reserved matters requires affirmative vote of the majority of the Directors present in the meeting, and such majority shall include at least one director from each of the parties not holding less than 10% of the fully paid up share capital of the company.

3. B Ltd.:

(a) B Ltd. was initially incorporated as a joint venture between the Government of Andhra Pradesh and the Indian Railways with a share capital of Rs. 5 Lakh. Subsequently, share subscription agreement was entered with five parties as under:

RV Ltd.                                              30%
K Ltd.                                                30%
The company                                      15%
Government of Andhra Pradesh         13%
B I Ltd.                                              12% (Later joined).

The copy of the share subscription agreement has also been supplied by the querist for the perusal of the Committee.

(b) Composition of the Board:

There shall be a maximum of 12 directors on the Board. However, at present the board has eight directors as below:
RV Ltd. – 2, K Ltd. – 2, the company – 1, Government of Andhra Pradesh – 1, Ministry of Railways – 1 (as Chairman) and Appointment by Board – 1 (as Managing Director).

(c) Chairman:

B Ltd. shall have a part time non-executive Chairman who shall at all times be a nominee of the Ministry of Railways. The term of the Chairman shall be co-terminus with that of his term as director of the company.

(d) Quorum for Board meetings :

The quorum for a meeting of the Board shall be reckoned in accordance with the Act, provided that quorum shall be complete only when at least one of the representative Director nominated by RV Ltd./K Ltd. is present in the meeting.

All resolutions of the Board of Directors shall be adopted by simple majority. In case of equality of votes, the Chairman shall have a second or casting vote.

(e) Super Majority Resolution at General Meetings :

In connection with certain ‘fundamental issues’, a super majority resolution is required at general meeting of shareholders. Some of such issues are as under:

(i). Merger with or acquisition of any company by B Ltd.

(ii).Any change in the capital structure of B Ltd. including any fresh issue of capital.

(iii). Finalisation of the terms of any debt raised by B Ltd.

(iv) Amendment to Memorandum of Association and Articles of Association of B Ltd., etc.

4. As per AS 23, notified under the 'Rules', the definitions of 'Associate', 'Significant Influence' and 'Control' are as under:

“3.1 An associate is an enterprise in which the investor has significant influence and which is neither a subsidiary nor a joint venture of the investor.

3.2 Significant influence is the power to participate in the financial and/or operating policy decisions of the investee but not control over those policies.

33. Control:

(a) the ownership, directly or indirectly through subsidiary(ies), of more than one-half of the voting power of an enterprise; or

(b) control of the composition of the board of directors in the case of a company or of the composition of the corresponding governing body in case of any other enterprise so as to obtain economic benefits from its activities.”

Paragraph 5 of AS 23 reads as under:

“5. The existence of significant influence by an investor is usually evidenced in one or more of the following ways:

(a) Representation on the board of directors or corresponding governing body of the investee;

(b) participation in policy making processes;

(c) material transactions between the investor and the investee;

(d) interchange of managerial personnel; or

(e) provision of essential technical information.”

5. As per AS 27, notified under the 'Rules', the definitions of 'Joint Venture', 'Joint Control', 'Control', 'Venturer' and 'Investor' are as under:

“3.1 A joint venture is a contractual arrangement whereby two or more parties undertake an economic activity, which is subject to joint control.

3.2 Joint control is the contractually agreed sharing of control over an economic activity.

3.3 Control is the power to govern the financial and operating policies of an economic activity so as to obtain benefits from it.

3.4 A venturer is a party to a joint venture and has joint control over that joint venture.

3.5 An investor in a joint venture is a party to a joint venture and does not have joint control over that joint venture.”

Further, paragraph 5 of AS 27 reads as under:

“The existence of a contractual arrangement distinguishes interests which involve joint control from investments in associates in which the investor has significant influence (…). Activities which have no contractual arrangement to establish joint control are not joint ventures for the purposes of this Standard.”

In addition, paragraph 21 of AS 27, inter alia, states that the jointly controlled entity operates in the same way as other enterprises, except that a contractual agreement between the venturers establishes joint control over the economic activity of the entity.

6. The company’s views on the classification of above investments in the light of provisions of AS 23 and AS 27 are as follows:

As per AS 27

(a) A venturer has been defined as a party to a joint venture and has joint control over that joint venture. An investor has been defined as a party to a joint venture and does not have joint control over that joint venture.

(b) The company has no power to govern the financial and operating policies of the above companies.

(c)The company has only protective rights but not participative rights in both the companies. Hence, the above investments do not qualify for categorising as investments in joint venture.

(d) As defined in the Standard, the company is an investor in both the companies but not a venturer.

As per AS 23

(a) Even though the company has no control over the financial and operating policies of the above companies, it has ‘significant influence’ in view of representation on the Board of Directors.

(b) Further, as per paragraph 5 of AS 23, significant influence is evident from the representation on the Board.

Considering the above, the company is of the view that the investments need to be classified as ‘Investments in Associates’.

B. Query

7. In view of the facts mentioned above, the opinion of the Expert Advisory Committee is sought by the querist on the following issues:

(i) Whether the classification of the above investments by the company as ‘Investment in Associates’ is in order.

(ii) If not, how the investments need to be classified?

C. Points considered by the Committee

8. The Committee notes that the basic issue raised in the query relates to propriety of classification of investments by the company as 'Investments in Associates' in A Ltd. and B Ltd. The Committee has, therefore, considered only this issue and has not touched upon any other issue arising from the Facts of the Case, such as, accounting for investments in the separate and consolidated financial statements of the company, disclosure requirements as per AS 23 and AS 27, etc.

9. The Committee notes the definitions of 'Joint Venture', 'Joint Control', 'Control', 'Venturer' and 'Investor', as defined in AS 27, which are reproduced by the querist in paragraph 5 above. The Committee further notes paragraph 8 of AS 27 as follows:

“8.The contractual arrangement establishes joint control over the joint venture. Such an arrangement ensures that no single venturer is in a position to unilaterally control the activity. The arrangement identifies those decisions in areas essential to the goals of the joint venture which require the consent of all the venturers and those decisions which may require the consent of a specified majority of the venturers.”

The Committee notes from the above that a joint venture is an arrangement over which two or more parties have joint control, i.e., power to govern the financial and operating policies of the joint venture. Thus, in order to demonstrate joint control, it should be examined whether the company in question shares the power to govern the financial and operating policies of A Ltd. and B Ltd. with other venturers. The Committee is of the view that generally the financial and operating policies are understood to include areas such as budgeting, capital expenditures, treasury management, dividend policy, production, marketing, sales and human resources. Accordingly, the Committee is of the view that the exercise of joint control is a matter of fact, which has to be determined in the facts and circumstances of each case separately considering the manner in which decisions are taken, for example, in the Board meetings, etc. In this context, on a perusal of the contractual agreements as supplied by the querist, the Committee is of the view that although these agreements stipulate the right of the company to participate in certain significant decisions relating to matters such as, amalgamation, merger, amendment of Memorandum or Articles of Association, mortgaging the venture’s property, issuance/transfer of additional/existing shares, etc., the company has no control over the financial and operating policies of A Ltd. and B Ltd. although it has the right to participate in those policies through representation on the Board of Directors of A Ltd. and B Ltd. Accordingly, the Committee is of the view that the investments in A Ltd. and B Ltd. cannot be considered as investments in joint ventures.

10.With regard to classification of investments as ‘investments in associates’ as per AS 23, the Committee notes the definitions of ‘Associate’, ‘Significant Influence’, and ‘Control’ and paragraph 5 of AS 23, which are reproduced by the querist in paragraph 4 above. Further, the Committee notes paragraph 4 of AS 23, which is reproduced below:

“4. For the purpose of this Standard, significant influence does not extend to power to govern the financial and/or operating policies of an enterprise. Significant influence may be gained by share ownership, statute or agreement. As regards share ownership, if an investor holds, directly or indirectly through subsidiary(ies), 20% or more of the voting power of the investee, it is presumed that the investor has significant influence, unless it can be clearly demonstrated that this is not the case. Conversely, if the investor holds, directly or indirectly through subsidiary(ies), less than 20% of the voting power of the investee, it is presumed that the investor does not have significant influence, unless such influence can be clearly demonstrated. A substantial or majority ownership by another investor does not necessarily preclude an investor from having significant influence.

Explanation:

In considering the share ownership, the potential equity shares of the investee held by the investor are not taken into account for determining the voting power of the investor.”

From the above, the Committee notes that for recognising an investment as ‘investment in associate’, the investor should have significant influence on investee, e.g., 20% or more of the share ownership giving rise to voting power or in the absence of such voting power, the power to participate in and not to govern the financial and/or operating policy decisions of the investee. The Committee notes that in the extant case, the company does not have 20% voting power by virtue of share ownership in A Ltd. and B Ltd. Accordingly, the power to participate in the financial and/or operating policy decisions of the investee will have to be examined in the light of facts and circumstances of each case, considering various factors, such as, participation in the policy making process as may be evidenced from the minutes of the board meetings and general meeting of the entities, interchange of managerial personnel between the company and the entities, if any, or by virtue of any agreement between the parties, etc. The Committee notes that in the extant case, the company has representation on the board of directors of A Ltd. and B Ltd. From this, it appears that the company has significant influence over A Ltd. and B Ltd. and classification of investment in A Ltd. and B Ltd. as 'investment in associates' is in order unless it can be demonstrated, as evidenced from the internal records, such as minutes etc., that such representation on the board does not lead to significant influence in actual practice.

D. Opinion

11. On the basis of the above facts as available and understood by the Committee, the Committee is of the opinion that the classification of investments in A Ltd. and B Ltd. as 'Investment in Associate' is in order unless it can be demonstrated that the company does not exercise significant influence over these companies as discussed in paragraph 10 above.

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¹Opinion finalised by the Committee on 7.2.2013.