Construction CPAs Offer Tips to Prepare for a Joint Venture
As the construction industry slowly recovers from its harsh economic slump, many companies have opted to collaborate for joint ventures. This short-term endeavor can open a window of lasting opportunities for the involved parties to better compete as well as emerge into new markets. Doeren Mayhew’s construction CPAs note the preparation that needs to take place and a list of joint venture accounting rules to follow in order to ensure your joint venture goals are accomplished with few headaches along the way.
Considering a Joint Venture
A joint venture is a collaborative effort between two or more persons or organizations for the purpose of adding business expertise for a specific project. From the involved parties arises a single subsidiary company developed for the project. This organization usually lasts a year or two and then diminishes. Some construction companies may lack sufficient capital, technical expertise or other resources needed to obtain the necessary contracts to thrive in today’s highly competitive environment. Joint ventures can help these companies compete with large construction conglomerates, venture into new markets and enjoy other benefits, such as:
- Large pool of resources: Let’s assume your construction company has the capabilities to successfully erect an office building for a well-known customer, however, does not have the financial backing to obtain such as major project. Temporarily joining with an organization that offers more financial stability can provide a gamut of opportunities that you may have never had access to otherwise.
- Shared risks: No need to worry about shouldering all of the load if a project goes awry. Having two companies versus one can help relieve some of the stress and other issues that commonly arise on a project. In addition, it can alleviate a variety of risks in tackling construction projects of larger magnitude, including:
- Cash shortfalls: No contractor wants to lack the funds needed to successfully support a project. Joint ventures can help reduce this risk, as the newly combined entity has a stronger capital base from which to draw.
- Inaccurate bidding and estimating: In a joint venture, there is usually one company that is savvier in its approach to handling finances, a strength that can help the parties avoid over- or under-estimating funds.
- Financial commitment: Monetary investment is shared in a joint venture, so in the event that a profit is not gained from the project, the parties leave with less money lost than they would have on their own.
- Equal control and management: Managing a large project can be challenging for smaller construction operations, but with a set of extra hands, the burden is minimized. In addition, control and power issues can be reduced through a preliminary joint agreement, usually developed by a consulting attorney.
Doing Your Homework
While many construction companies that begin a joint venture have established a relationship prior to working together, it is still critical to do thorough research. In the midst of all of the changes and adjustments that come in joining with another firm, it is easy to overlook the small, yet pertinent information you should be assessing. A few key factors to evaluate include:
- Financial strength – Know the ins and outs of the partnering company’s financial metrics, including equity, cash flow and projected revenues.
- Past joint venture experience – The best way to predict the effectiveness of a joint venture with a company is to know how they have worked with others. If possible, contact past joint venture partners to find out the advantages and disadvantages of working with this company, how the venture operated and if the past partner would consider entering a joint venture agreement with them again.
- Bonding capacity – Financial gain is a major benefit of a joint venture. A partner with a large bonding capacity can help you attract bigger projects and successfully compete with larger companies.
- Legal claims and history – Go as far as 10 years into the legal history of the companies you are considering. Even though it is unrealistic to assume a company will have a perfect legal record, it helps to know any legal issues companies have endured.
Joint Venture Accounting
Most management and operational issues will be resolved with an attorney before the joint venture agreement. Roles and responsibilities should be clearly defined and concise so that any concerns arising during and after the project can be resolved. Within this agreement, the company with a larger and/or more sophisticated accounting department typically oversees the accounting for the engagement. However, relying on one company is not enough to ensure accounting records are being kept effectively. There are several joint venture accounting rules and guidelines that each party should know in order to accurately record their part in the venture as time progresses. Recording Your Investment Wisely In a joint venture, each company puts in capital, whether it’s funds or equipment. This capital is usually divided percentage wise (50 percent for each company or 70 percent and 30 percent, 40 percent and 60 percent, etc.) Once the joint venture begins, profits and losses come into play. It is critical that each party not just rely on the designated accounting company to facilitate and record all accounting information appropriately, but makes sure it records the investments on the individual balance sheets appropriately. There are a few accounting consolidation methods that can be applied to a joint venture depending on the structure of the company and the capital each puts into the venture. This ensures that each company is appropriately recording its half of the joint venture on its consolidated financial statements for the subsidiary as a single entity. The three most commonly used methods are the equity, cost and proportionate consolidation methods:
- In joint ventures, all interests are typically accounted for under the equity method. This method is applicable to companies that invest 20 percent to 50 percent into the ventures. Each company that invests a specific percentage records it on the “Investment In” joint venture line item on the financial balance sheet, taking into account shared profits and losses since the initiation of the venture. This will reflect as a single amount on the balance sheet in the specified line item. Shares of earnings and deficits must also appear as a single amount on each company’s financial income statement as the “Equity Earnings (Losses) From Joint Venture.”
- Unlike the equity method, under the cost method, the original cost of the investment is added to a single line item on the balance sheet, but does not require any adjustments based on profits and losses. The only plausible way in which adjustments are made is if the fair market value of the investment increases. Essentially, what has been invested is what appears on the balance sheet. This method is typically used for investments under 20 percent or those with constraints due to bankruptcy, legal reorganization or government-imposed restrictions. Dividends received in excess of earnings after the beginning of the investment are considered a “return on investment,” thus recorded as a reduction of the investment carrying value.
- The proportionate consolidation method, as the name suggests, is an accounting method used to include income, expense, assets and liabilities in proportion to the percentage of the company’s involvement in the joint venture. Here, the equity method is applied to the balance sheet, then the gross amount based on the percentage of the company’s investment in the joint venture is added for the income statement. For example, a company invests 50 percent into a joint venture that produces $10 million in revenue. On the company’s income statement, a $5 million gross from the $10 million in revenue would appear, bringing the total revenue reported on the income statement to $15 million.
Preparing Taxes Appropriately Certain tax laws are applicable as well. Most joint ventures are structured as a limited liability company (LLC) and must abide by tax rules catering to those entities, including:
- One partner in the joint venture is designated to handle tax matters, receive IRS tax notices and communicate regularly with the IRS regarding any examinations.
- A joint venture’s tax year-end must match with that of the majority partner. In the case that no companies involved own more than 50 percent of the subsidiary, they must use the percentage-of-completion tax method. The percentage-of-completion tax method recognizes revenues and gross profits in applicable periods of construction and not only when the construction project has been completed. This tax method is projected by total cost of construction incurred to the date of tax filing by the estimated cost of the project.
- All tax accounting methods should be made clear in the initial tax return to establish a foundation for subsequent returns. Regardless of the accounting method selected, the joint venture must accurately estimate taxable income for its members for tax planning purposes.
- Tax requirements and obligations should be specified in the joint venture agreement.
Preparation is key to success before, during and after a joint venture. To learn more about the above tips or other advice to help your joint venture run smoothly, contact our dedicated construction CPAs in Michigan or Houston.