The Report of Its Death is Out of Proportion
Construction Joint Ventures
What is a construction joint venture (JV) anyway? And why do construction companies enter into such JVs? And, does US GAAP still permit the investing company the choice to use proportional consolidation, instead of the equity method, to present a construction JVs in its financial statements? This article will attempt to shed some light on these questions.
What is a Construction Joint Venture?
A construction JV is generally a legal entity of limited duration, usually between two construction companies, to join forces to bid, obtain, perform, and complete a single construction project.
Why Does a Construction Company Enter Into Such Arrangements?
These projects are often much larger than those that either construction company customarily performs. Thus, they may mutually agree to join together for the following reasons:
- The potential contract owner considers the project too significant a risk for just one contractor
- Each contractor’s aggregate bonding program is too small for the size of the project
- For each contractor, the size and demands of the project exceed their individual liquidity, working capital, and equity necessary to perform and complete the project timely and successfully
- One contractor may find a gap in their expertise in a particular project phase and therefore wishes to enlist the second contractor’s resources to supplement his capabilities
- It permits a contractor who has not performed a project in a particular geographical territory to join forces with a local contractor, and
- It improves backlog (and hopefully, profitable backlog.)
The JV partners will need the up-front expertise of a lawyer who specializes in construction law. A lawyer who has experience with construction JVs. Here are some of the areas the partners should seek advice:
- JV Structure. Consideration should be given as to how the JV is structured. There are several ways to structure a construction JV. For example, will it be a line-item JV where each JV partner performs identified line-items of the project, or will it be a more traditional JV where resources (employees, working capital, financing, and equipment) are made available or contributed to the JV to perform the project?
- Legal Form. What legal form should the JV take? This decision may impact the JV partner’s method of reporting JV assets, liabilities, and activity in their financial statements. (The methods of financial reporting are discussed in the next section.)
- Governance. What will be the form of the JV governance?
- Ownership Considerations. What will be the percentage ownership of the JV? If a line-item JV, how will ownership be structured?
- Profit Allocation. How will the contract profit be split? Will one JV partner have a greater than 50% allocation?
- Variable Consideration. How will early completion bonuses and shared savings be split? What about project delays and liquidated damages? Who will bear the brunt of this?
- Subcontractors. Will the JV pay the subcontractors directly, or will it be the JV partners’ responsibility?
- And the list and the clauses go on and on. Other matters to be discussed and decided include the disposition and handling of contingency funds, bonding, employee non-encroachment agreements, dispute resolutions, and non-compete agreements.
Is Proportional Consolidation Permitted?
In general, US GAAP provides the following methods of accounting for an investment in joint ventures:
- Cost method. The cost method must be used if the investor cannot exercise significant influence over the financial or operating decisions of the investee unless such ability can be demonstrated. An investment of less than 20% of the voting stock creates the presumption that the investor does not have significant influence.
- Equity method. The equity method should be used if the investor has significant influence. FASB ASC 323-10-15-8 clarifies that “(a)n investment (direct or indirect) of 20 percent or more of the voting stock of an investee shall lead to a presumption that in the absence of predominant evidence to the contrary an investor can exercise significant influence over an investee.” An investor with 20% to 50% of the voting stock of the investee is considered to have significant influence.
- Full Consolidation. If it exercises control over the JV, an investor will add 100% of the joint venture’s assets, liabilities, revenue, and expenses to each applicable line of its financial statements. Any non-controlling interest will be backed-out of consolidated equity and net income. This control can take the form of financial investment in the JV greater than 50% or a variable interest structure in which the investor is the primary beneficiary.
- Proportional Consolidation. If certain conditions under US GAAP are present, proportional consolidation may be used instead of the equity method. However, proportion consolidation cannot be used in place of the cost method or full consolidation. So what is proportional consolidation? Proportional consolidation is where the investor’s proportional share of the JV’s assets and liabilities are added to each applicable line of its own balance sheet. And the investor’s proportional share of the JV’s operations is included in each appropriate line in its income statement. There is a variation of this which we will describe in the last section.
Proportional Consolidation Criteria
Under what situations or criteria is proportional consolidated permitted in place of the one-line equity method?
Generally, proportional consolidation may be used under US GAAP in two situations:
- Undivided interest. FASB ASC 810-10-45-14 states, “If the investor-venturer owns an undivided interest in each asset and is proportionately liable for its share of each liability, the provisions of paragraph 323-10-45-1 may not apply in some industries.” (ASC 323-10-45-1 describes the applicability of the equity method.) Therefore, the equity method may not apply when the construction JV is an undivided interest and not a legal entity. In such cases, the venturer may use the proportional consolidation method.
- Construction and extractive industries subject to the equity method. FASB ASC 810-10-45-14 further states, “Specifically, a proportionate gross financial statement presentation is not appropriate for an investment in an unincorporated legal entity accounted for by the equity method of accounting unless the investee is in either the construction industry…or an extractive industry.” (Emphasis added.)Therefore, if an investor has a non-controlling interest in a construction unincorporated legal entity that may be accounted for under the equity method, it may elect to use proportional consolidation instead.
It should be noted that a limited liability company (“LLC”) is a separate legal entity. However, it is not incorporated. Therefore, it is subject to proportional consolidation in lieu of the equity method of presentation.
Therefore, an investor in a construction JV may use proportional consolidation if the JV is formed as:
- An undivided interest
- General partnership
- An LLC or limited liability partnership, provided it has governance and economic characteristics more like a partnership than a corporation.
However, if the construction JV is incorporated or an unincorporated entity, such as an LLC, with the governance and economic characteristics like a corporation, then the equity method must be used instead of proportional consolidation. Additionally, all majority-owned subsidiaries in which the parent has a controlling interest must be fully consolidated. Therefore, it is not subject to proportional consolidation.
As can be seen, proportional consolidation is very restrictive under US GAAP. However, its use is established in the construction industry and therefore permitted to continue subject to the restrictions outlined above. (FASB ASC 810-10-45-14.)
Financial Reporting Under Proportional Consolidation
There are two basic approaches to proportional consolidation in practice. Each is acceptable.
- The investor company combines its proportional amount of the construction JV’s assets, liabilities, and operations on its balance sheet and income statement on a line-by-line basis. The JV’s construction contract is presented on the contract schedule at 100% on one line, with a reduction on the line below for the amounts that represent the other JV partner’s percentage ownership. The third line will be the net amount representing the reporting JV partner’s percentage ownership.
- A hybrid method is also used in practice. The investor company reports its proportional amount of the construction JV’s assets and liabilities using the one-line equity method on the balance sheet and its gross proportional amount of operations on the income statement on a line-by-line basis. Public construction company investors often use this hybrid method.
The contract schedule presentation will be the same as number 1 above, except the over and underbillings will need adjustment since they are netted into the one-line presentation on the balance sheet.