The equity method and the proportional consolidation method are two types of accounting methods used when two companies are part of a joint venture. Which one is used depends on the way the companies' balance sheets and income statements report these partnerships.
Note that today, for the most part, only the equity method is still in use.
- The equity method of corporate accounting is used to value a company's investment in a joint venture when it holds significant influence over the company it is investing in.
- The proportional consolidation method of accounting looks at income, expenses, assets, and liabilities in proportion to a firm's percentage of participation in a joint venture.
- As of 2013, the International Accounting Standards Board (IASB) abolished the use of proportional consolidation and it is no longer recognized by IFRS.
A joint venture is a type of business agreement involving two or more parties that group their available resources in a common undertaking. Each party in a joint venture has a certain amount of control and responsibility for the costs associated with the venture, as well as sharing profits or losses. Joint ventures are commonly used to invest in foreign and emerging market economies.
Joint ventures offer an expedient way for companies and individuals to pool knowledge, expertise, and resources to accomplish a potentially lucrative deal while decreasing each party's exposure to risk. The joint venture is an enterprise in and of itself, separated and set apart from any other business deals or interests in which the partnered companies are involved.
The Equity Method
The equity method of accounting is used to assess the profits earned by their investments in other companies. The firm reports the income earned on the investment of its income statement. Under the equity method, the reported value is based on the size of the equity investment.
If a company holds more than 20% of another company's stock, the company has significant control where it can exert influence over the other company. The initial investment is recorded at cost and each quarter adjustments are made depending on the value at the end of the period.
For example, Company A buys 10,000 shares of Company B at $10 per share; Company A would record the investment cost of $100,000 for the initial period. Any profit or income on the investment in the coming years would also reflect changes in the value of the investment.
The value reported by each company represents only that firm's relative share of the costs and assets. This equity method of accounting is more commonly used when one company in a joint venture has a recognizably greater level of influence or control over the venture than the other.
If a firm comes to a point where it is no longer maintaining any significant level of control over the investment, the equity method can no longer be used. At that point, a new value is recorded in the company's profit and loss records, determined on the basis of the current cost.
The Proportional Consolidation Method
The proportional consolidation method of accounting records the assets and liabilities of a joint venture on a company’s balance sheet in proportion to the percentage of participation a company maintains in the venture. In calculating those assets and liabilities, the company would list all income and expenses from the joint venture and includes them on its balance sheet and income statement.
For example, if Company A has 50% controlling interest over Company X, Company A would record the investment at 50% of the assets, liabilities, revenues, and expenses of Company X. So if Company A has revenues of $100 million and Company X has revenues of $40 million, Company A would have in total $120 million.
Those favoring the proportional consolidation method argue that it provides a more accurate and detailed record because it breaks down how well a joint venture performs. This method allows each company to see the operational effectiveness of various steps in the joint venture process including production costs, shipping costs, and the profit margin.
Under the U.S. generally accepted accounting principles (GAAP), a firm's interest in a joint venture is accounted for using the equity method.
Moreover, since 2013 the proportional method has largely been abandoned. In addressing accounting for joint ventures, the International Financial Reporting Standards (IFRS) sought to eliminate inconsistencies in the reporting of "joint arrangements," which the IFRS classifies as either "joint operations" or "joint ventures," in accordance with IFRS 11. International Accounting Standards (IAS) 31 merged joint operations and joint ventures, and IFRS 11 requires the use of the equity method and the abolition of the proportional consolidation method.
Though the proportional consolidation method was previously accepted by the IFRS, it also allowed the use of the equity method.
The Bottom Line
There are proponents for the use of each of these accounting methods, and different accounting standards organizations are split as to which is the more appropriate practice. Companies generally use the method that fits best with their overall operations and existing accounting practices.
On Jan. 1, 2013, the International Accounting Standards Board (IASB) decided it was no longer appropriate to use proportional consolidation.