This study examines bond risk premiums to determine the extent to which creditors of companies with investments in joint ventures interpret the joint venture debts as if they belong to the co-venturer. Creditors’ interpretation of joint venture liabilities provides standard setters guidance in determining the most relevant accounting treatment for financial statement users. United States generally accepted accounting principles (GAAP) require companies with investments in non-controlled joint ventures to recognize their portion of the joint venture net equity as a single line item in the investment section of the balance sheet. GAAP also requires co-venturers to recognize their portion of the joint venture income on one line of the income statement.

The current method of accounting, known as the equity method, fails to recognize the liabilities of the joint venture in the accounts of the venturer. Co-venturers, however, must disclose any debt guarantees as contingencies in the footnotes that accompany the financial statements. Companies with material investments in joint ventures must also disclose the financial position and the income of the joint venture in the notes. The capital structure of the joint venture determines the extent to which joint venture debts become an off-balance sheet item.

The interpretation of joint venture obligations depends on how creditors view the relationship between the joint venture and the co-venturers. One view employs a legal construct (legal model) where potential losses on joint venture investments are limited to the cost of the investment. The legal model appears to correctly represent the investment when the joint venture is organized as a corporation, limited liability company, or limited partnership and there are no purchase agreements, throughput agreements, or debt guarantees. The current equity method of accounting reflects the underlying economics of this model.

A second view of joint venture debt assumes that joint venture investments represent implicit extensions (implicit model) of the venturer. This view suggests that the operations of the venturer and the joint venture are so closely related that the liabilities of the joint venture implicitly are obligations of the venturer. The venturer has an interest in the operating success of the joint venture, regardless of any legal agreements or organizational form. Examples of joint ventures that support the implicit model include vertically integrated joint ventures that provide an important raw material, marketing function, or research and development services to the venturer.

Researchers have not empirically tested whether creditors of companies that invest in joint ventures interpret the joint venture debts using the legal model or the implicit model. If creditors view joint venture debts using the legal interpretation, bond risk measures should ignore the off-balance sheet joint venture debts because the company’s loss is limited to the original investment. On the other hand, if creditors view joint venture debt using the implicit model, bond risk measures should adjust for the off-balance sheet debts. Creditors’ interpretation of joint venture debts is inferred from the association of bond risk premiums to alternative accounting measures of debt.

The present study examines whether proportionate consolidation results in accounting measures that are more highly associated with bond risk premiums than the equity method of accounting. The study compares the explanatory power of a bond risk model using proportionate consolidation accounting (implicit model) to that of equity accounting (legal model) for bond risk measures.

A joint venture is an arrangement whereby two or more parties undertake an economic activity which by an unincorporated contractual arrangement is subject to joint control. Some ventures use the equity method (legal view), as described in International Accounting Standard 28, Accounting for Investments in Associate, to account for their interest in jointly controlled entities. They argue that interests in jointly controlled entities are similar to investments in associates, since the venturer has a measure of responsibility for the performance of the joint venture and its return on investment. Other venturers argue that in substance, the venturer has control over the flow of its share of the future economic benefits embedded in the assets of the venture (implicit view). Also, the venturer has responsibility for the outflow of economic benefits involved in the settlement of its share of the liabilities of the venture. Hence, this substance and economic reality view is achieved when the venturer uses proportionate consolidation to report its interest in jointly controlled entities. Thus, IAS 31, Financial Reporting of Interest in Joint Ventures, recommends the use of proportionate consolidation so long as the interest in the joint venture is not held for exclusive future subsequent disposal. IAS 31may be interpreted to permit an enterprise to account for some of its joint ventures on a proportionate consolidation basis and some, under the allowed alternative, on an equity basis.

In December 1998, the Australian Accounting Standards Board (AASB) issued a revised standard, AASB 1006, “Interest in Joint Ventures,” that distinguishes joint venture entities from joint venture operations. This standard requires the use of the equity method for joint venture entities. It provides that a joint venture should account for its share of the assets, liabilities, revenues, and expenses of joint venture operations that are not joint venture entities. However, pending standard AASB 131 reinforces the AASB preference for the equity method as it has eliminated the option of proporationate consolidation accounting for joint ventures.

In the United States, official accounting literature states that control of an investee company is the central issue determining whether an investor company reports consolidated financial information. Normally companies use the equity method of accounting for investments in 50% or less owned joint ventures. Using the equity method, venturers report their portion of the joint venture equity (assets less liabilities) as an investment on one line of the balance sheet and their share of joint venture income as other income on one line of the income statement.

Joint ventures, however, are jointly controlled and jointly operated. Kocan (1962), Nielsen (1965), and Reklau (1977) suggest that active participation of venturers in the joint venture operations indicate that companies share the control of the joint venture. They also suggest that proportionate consolidation would provide better information to financial statement users. Graham, King, and Morril (2003, Fig. 1) provide a detailed example of the differences in a hypothical investor’s financial statements using proportionate consolidation versus the equity method. Proponents of proportionate consolidation believe the equity method provides a distorted picture of an entity’s profitability and risk by the one-line balance reporting. Hence, the present study uses proportionate consolidation as a reporting alternative to the equity method.