April 26, 2023
By Susanna Chon, Senior Manager
In the government contracting world, it is very common for two or more companies to create a joint venture for the purpose of bidding on federal government contracts. What many business owners may not consider are the accounting implications that entering into a joint venture agreement may bring. Typically, the method for how a company accounts for a joint venture is dictated by the degree of control that the company has over the arrangement, but getting this wrong may have some serious implications for your company.
Small, disadvantaged contractors in the SBA 8(a) program are required to submit financial statements. In the program, there are specific financial reporting requirements that are based off a company’s annual revenue. Participants with revenue between $2,000,000 and $10,000,000 must submit annual reviewed financial statements within 90 days after the close of the company’s fiscal year, and participants with revenue of more than $10,000,000 must submit annual audited financial statements within 120 days after the close of the company’s fiscal year. These financial statements must be prepared by a licensed independent public accountant. Unfortunately, companies forming a joint venture to pursue federal contracts are often caught off guard when the agreement pushes their consolidated revenue over the revenue thresholds. The consequences of failing to submit timely financial statements could include expulsion from the 8(a) program or financial penalties.
Degree of Control
The degree of control (i.e., if the company has “significant influence”) will typically establish the accounting treatment of the joint venture to each of the investors, either the cost method, equity method, or consolidation. Significant influence is defined as the power to participate in the operating and financial policies of an entity. This power includes representations on the board of directors, involvement in policy development, and the interchanging of managerial personnel. If a company must consolidate the activities of a joint venture, it will report the joint venture’s assets, liabilities, revenues, and expenses together with its own. This can have a significant impact on the consolidating company’s financial reporting. One impact this may have for a government contractor is on its financial statement reporting requirements if the company participates in the 8(a) program.
The cost method is used when the parent company has no significant influence in the activities of the joint venture, typically defined as when companies own less than 20% of the joint venture. If a company owns less than 20% of an investee company, but exercises significant influence, the equity method must be used. Under the cost method, the company will record its investment (at its original cost) in the joint venture as a non-current asset and will record dividends as income. The investment stays the same from the date of the acquisition unless shares are sold, additional shares are purchased, or if the joint venture incurs losses that substantially reduce net worth from the date of the acquisition.
The equity method is used when the parent Company has significant influence in the activities of the joint venture, typically defined as an ownership stake between 20% to a maximum of 50%. Like the cost method, the company will record its original investment at cost on the balance sheet. However, under the equity method, the investment account is then adjusted with the joint venture’s earning of income and payment of dividends. The investment account increases by the company’s share of the joint venture’s net income, with the same credit to the company’s income statement account, Equity in Subsidiary. Distributions by the joint venture to the company reduces the investment account and increases the company’s cash.
Consolidated financial statements are prepared when the parent company has more than 50% ownership of a subsidiary. There are many implications and the related guidance for consolidation can be found within FASB Topic 810 Consolidation. Consolidated financial statements are the financial reporting of a parent company and all its subsidiaries, i.e., the subsidiary company’s assets, liabilities, revenues, and expenses are combined into the parent company’s financial statements. While the subsidiary’s entire equity is eliminated (not reported), the parent company will also eliminate the “Investment in Subsidiary” account on their balance sheet. A noncontrolling (minority interest) account will also be created upon consolidation reporting. The fair value of any portion of a subsidiary that is not acquired (i.e., belongs to the other joint venture parent company) must be recorded to an account in the equity section of the consolidated financial statements.
Selecting the Correct Method of Reporting
Companies who decide to enter into joint venture agreements should keep the above general guidelines in mind as they decide under which method of reporting they must conduct. While this is a general guideline, consult a CPA to ensure that you are reporting correctly. There are specific audit reporting requirements for companies with (consolidated) revenue of over $10,000,000 in the SBA’s 8(a) program. It is particularly important for government contractors to ensure that the rules for financial reporting are considered when entering into a joint venture agreement.
Susanna Chon, CPA, CFE