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Have you ever considered participating in a joint venture© It may not be a bad idea - these arrangements allow participants to share expertise and resources as well as mitigate the inevitable risks of a construction contract.
But along with properly structuring the relationship legally and operationally, you need to determine the most appropriate financial reporting method. Most joint venture partners conduct the arrangement within a separate legal entity, such as a corporation or partnership, in which each member has a proportionate interest.
By creating this new entity, however, you and your partners must decide how you'll handle the financial reporting. Let's look at some common methods for doing so.
The consolidation method. Consolidated financial statements involve adding your company's assets, liabilities, equity and income statement activity to those of the joint venture entity.
Eliminating adjustments are made for any intercompany transactions and investments your company's balance sheet reports for its interest in the project. Additionally, the ownership of your joint venture partners is removed, so the statement reports only your share of the arrangement's net income and equity.
Generally accepted accounting principles (GAAP) require consolidated financial statements when one company directly or indirectly has a "controlling financial interest" in another company (in this case, the joint venture entity). The usual condition for establishing a controlling financial interest is ownership by one enterprise of more than 50 percent of the outstanding voting shares of the other enterprise.
But with the issuance of the Financial Accounting Standards Board Interpretation No. 46(R) (FIN 46(R)), you must particularly consider whether consolidation is required by GAAP. FIN 46(R) defines many other conditions under which the "primary beneficiary" of a joint venture must consolidate its financial statements.
Which party is the primary beneficiary depends on factors such as who has the ability to make decisions and how profits and losses are shared. This determination can be complex, so be sure to consult your financial advisor. FIN 46(R) applies to new joint ventures of privately held companies created after Dec. 31, 2003, and applies to previously existing joint ventures in calendar year 2005.
The equity method. Under the equity method, the amount you originally invest in the joint venture is initially recorded on your balance sheet. This investment is then increased or decreased by the proportionate share of the project's earnings or losses and decreased by all dividends or distributions you receive from the venture.
The equity method is often used when an investment in a joint venture represents less than a majority interest, but the participant still has the ability to exercise significant influence over the project. In fact, many contractors refer to this approach as the "one-line method." This is because you report the joint venture interest on one balance sheet line item rather than recording the individual assets, liabilities, equity components and income statement activity throughout your financial statement as you would when consolidating.
The cost method. Under the cost method, the original cost of your investment in the joint venture is recorded on your balance sheet, just as it would be using the equity method. The difference is that with the cost method no adjustment to this investment amount is made until the joint venture entity is dissolved.
All distributions from the joint venture are recorded as income when you receive them. A participant typically uses the cost method when it has little or no influence over the job.
The most appropriate method. Joint ventures are primarily associated with large, specialized long-term projects. Thus, they're complicated endeavors to begin with. In your effort to manage the complexities, however, don't neglect to evaluate which GAAP-compliant financial reporting method is most appropriate.
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