Construction companies regularly pursue joint ventures to win larger contracts and manage bigger projects. In an economic downturn, they can be a useful option for companies that need additional resources and capital, want to share the risk, complement their workforce, or increase their bonding capacity.
But accounting for a joint venture can be tricky, as it involves the combined finances of two or more companies.
Accurate financial reporting can ensure the success of a joint venture, giving construction companies an advantage in a competitive industry.
What is a joint venture?
In a joint venture (JV), two or more companies agree to pool their resources to accomplish a specific task, such as a new project. As partners in a joint venture, the companies agree to share the project’s profits, losses, and costs. But the venture remains a separate entity from each company’s business operations.
Companies often pursue joint ventures as part of a strategy to pool resources, enter new markets, and as an alternative to a merger or acquisition. Firms also increasingly rely on JVs following major economic downturns, according to research by Deloitte.
Joint ventures in a tough economy
When manpower and other resources are stretched thin, joint ventures allow construction companies to band together to complete projects and other tasks they could not have managed on their own. Research shows joint ventures are more likely to remain active during economic hardship and uncertainty.
According to Harvard Business Review analysis, joint venture terminations fell sharply after the economic downturn of the early 1990s, the dot-com crash of the early eighties, and the global financial crisis at the start of 2010.
How joint ventures are taxed
Since any of a joint venture’s profits flow through to the individual companies that are part of it, each company records its share of the profits on its own corporate tax returns.
That means the JV itself would not submit its own tax filings, as the IRS does not recognize joint ventures as separate business enterprises.
Accounting for joint ventures
There is no one-size-fits-all accounting strategy for joint ventures. Since the individual members of a JV are the ones reporting, the accounting method depends on each company’s ownership in the venture. There are three methods:
- Cost Method
- When to use it: For companies with an investment of less than 20% or when the company cannot exert significant influence.
- How it works: The balance sheet records the company’s initial investment. If the JV pays dividends to the company, the company records them as dividend income.
- Equity Method
- When to use it: For companies with an investment of less than 50% but more than 20%, or when the company exerts significant influence over the JV’s operations or finances.
- How it works: The company reports its profits and losses from the JV on its own income statement records its profits and losses in the JV, and in an amount proportional to its share of the equity investment in the venture.
- Consolidation Method
- When to use it: For companies with an investment of 50% or more.
- How it works: The JV’s operations are consolidated into the company’s financial statements. The interests of the other companies in the JV are recorded as noncontrolling interests. Companies may consolidate only the proportional share of their interest in the JV’s assets, liabilities, revenues, and expenses, line by line.
Types of joint ventures
The type of joint venture contractors set up will depend on how they want to report it on their individual company’s financial statements.
There are three ways to set up a JV:
- LLC: An LLC has more flexibility on taxation, but generally taxable income is passed through to the owners.
- Partnership: The partners themselves are taxed, meaning each partner would report their own profits and losses from the partnership on their individual income tax returns.
- Corporation: These entities are taxed at both the corporate and shareholder levels.
JV setup dictates reporting strategy
Accounting for joint ventures is complex. So when establishing a joint venture, it’s important to work with professionals, such as accountants and attorneys with experience in construction joint ventures, to properly structure the entity.
It’s also important for partners to determine and clearly assign governance roles and responsibilities in the joint venture. Important roles include:
- Managing partner: the sponsor or operating party
- Accounting party: the party handling financial records
- Project specific assignments.
If you are setting up a joint venture or need assistance with financial reporting for an existing JV, our team of tax professionals can help guide you through the process of accounting for these entities.