The accounting treatment of two companies who are partners in a joint venture plays out in either the equity or proportional consolidation reporting method. While the American Institute of CPAs doesn't clearly define the meaning of "joint venture," an essential element of the term is that the two partners enjoy joint control. How company income statements and balance sheets report this control delineates the methods from one another.
The Joint Venture
Both equity method and proportionate consolidation accounting treatments pertain to joint ventures. Simply stated, a joint venture is a short-term partnership for a limited time and purpose, according to Cornell University's School of Law. Each party in the venture contributes assets to the partnership -- and also shares the risk. Parties can be people or companies. Partners commonly use joint ventures to enter foreign markets, and international trade laws as well as federal income taxes apply to .partnerships.
Definition of the Equity Method
The equity method calculates net income from a joint venture partnership, proportional to the size of its investment. The key to understanding the method is "net." In the equity method, you first record the investment is recorded at cost, and then adjust it up or down, depending on the current value and expenses. Should the company no longer have a "significant influence" in control over the investment, then the equity method treatment must stop and you record a new value at the current cost basis.
Definition of Proportionate Consolidation
Proportionate consolidation "consolidates the accounts of joint ventures," according to the website Vernimmen. The venture puts both assets and liabilities onto the investor's balance sheet in direct proportion to the amount of the investment. The income statement records income and expenses in the same way. Partners prepare the consolidated financial statements using the same reporting date. In the U.S., proportionate consolidation focuses on controlling financial interests.
While nations may not agree on what type of accounting treatment to use -- the U.S. requires the equity method for joint ventures -- both the equity method and proportionate consolidation have their own rationales. For example, according to the website Science Direct, the proportionate consolidation method is better for explaining price volatility, while the equity method is better at explaining bond ratings. Nevertheless, Science Direct notes that regardless of what treatment you use, failing to disclose all joint venture investment activity prevents "market participants" from adequately assessing risk.
- Social Science Research Network: Proportionate Consolidation Vs. the Equity Method
- AAAHQ: Researching Accounting for Joint Ventures; R. Davis Mautz
- Science Direct: Proportional Consolidation Versus the Equity Method; K. Kothavala
- Vernimmen: Proportionate Consolidation
- Cornell University Law School: Joint Venture