What is the Equity Method for Joint Ventures?
Which accounting method should you use in a joint venture? Why and when can the equity method be used? Read more to find out.
Joint ventures are increasingly popular. Parties who are trying to expand to a foreign market often enter into a joint agreement with a domestic party. However, how do you account for the profits or losses incurred in the joint venture? Which accounting method do you use? Although there are two methods, this article discusses the equity method of accounting.
A joint venture is a business arrangement between two or more parties where they combine their resources to perform a specific task or achieve a business objective.
As a party to a joint venture, you will pool your resources and efforts together to accomplish a common goal. You do this whilst still remaining independent. To learn more about joint ventures, you can visit this link.
It is important to note that there are two accounting methods to use when parties participate in a joint venture. They are the equity method and the proportional consolidation method. Which accounting method to use depends on one party’s significant influence on the joint venture.
Before deciding on what method of accounting to use on a joint venture, it is important to consider the degree of influence a venturer has on a joint venture. If there is a significant influence, then the equity method must be used.
Generally, a venturer has significant influence if it directly or indirectly has over 20% of voting power. Other factors include whether the venturer actively participates in the decision-making process or whether they are in the joint venture’s board of directors.
If there is significant influence, the venturer must account for their investment in the joint venture under the equity method.
Under the equity method, the initial investment of the venturer towards the joint venture is recorded at cost. This means that the recorded value of the initial investment will be based off the value of the equity stake. For example, Company X buys 10,000 shares of Company Y for $5 per share. Then the initial investment at cost will be $50,000. Subsequent profits or losses incurred by the joint venture will be allocated depending on the amount of equity invested by the venturer. For example, Company X’s investment comprises of 50% of the equity stake in a joint venture with Company Y. The profit is $100,000. Then company X will only record $50,000 of profit in their income statement.
AASB 128 governs investments in joint ventures. It is a set of rules created by the Australian Accounting Standards Board to regulate accounting practices so that they adhere to a certain standard. It provides the details as to employing the equity method and its considerations. You can view the rules from this link.
To conclude, equity method is used if the venturer has a significant control over the joint venture. This means that the venturer must directly or indirectly have 20% or more voting power or equity stake in the joint venture.
As a result, initial cost of the investment and subsequent profits or losses incurred will be reported according to the venturer’s equity stake. However, to minimise your risk, you should consult a business lawyer.
Ryan currently works in the content team as a Legal Intern for Lawpath. He is in his third year of a Bachelor of Law and Business degree at UTS.