Investments in Associates and Joint Ventures: Equity Method

In 1991, General Mills, a US-based cereal company, and Nestle, a Swiss food manufacturer, entered into a 50-50 joint venture to help both companies market and promote products. How do these companies benefit from this joint venture?

Along with these and other benefits of a 50-50 partnership, both Nestle and General Mills also have significant influence over each other. And when one company has significant influence over another, the accounting standards require that the __equity method__ be used. This means that the joint venture's financial statements are aggregated into _one_ line on the income statement and balance sheet of each investor. It's also called "one-line consolidation" for this reason.

More specifically, under the equity method, the initial investment by Nestle and General Mills is recorded on each company's balance sheet at cost under non-current assets. Each period after, the balance sheet amount is adjusted for the proportionate share of the joint venture's earnings or losses, and the earnings and losses for each period are also reported on the income statement (profit and loss). If the joint venture pays any dividends, that amount reduces the carrying amount on the balance sheet and isn't reported on the income statement. What type of accounting treatment does that sound like?

Dividends are treated as a partial return of the investment made in the joint venture, and since cash is received, the single line item in shareholders' equity is also increased to keep the balance sheet equal. For example, say the General Mills/Nestle 50-50 joint venture was funded with EUR 450,000,000 from each company. If in Year 1, the entity earns EUR 87,500,000 and pays dividends of EUR 12,500,000, both General Mills and Nestle would record EUR 487,500,000 on its balance sheet after that first year. $$\displaystyle 450{,}000{,}000 + (87{,}500{,}000 \times 50 \%) - (12{,}500{,}000 \times 50 \%) = 487{,}500{,}000$$

But say the General Mills and Nestle joint venture tanks. In that case, under both US GAAP and IFRS, Nestle and General Mills would typically stop using the equity method and carry the value at zero on the balance sheet. Why do you suppose IFRS and US GAAP would suspend the equity method at zero?

Yes! In fact, all three are benefits of the joint venture: both companies will be expanding their business presence globally, they'll be able to market and distribute to more customers, and they'll have a firmer financial standing, which allows them to undertake riskier—and potentially more rewarding—investments.

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Exactly. There wouldn't be an excess profit. All profits are either retained by the joint venture or paid out to Nestle and General Mills.

No. There wouldn't be an excess profit. All profits are either retained by the joint venture or paid out to Nestle and General Mills.

Not quite. Both companies may choose to refund the joint venture, but that's not a requirement of IFRS and US GAAP.

Yes! It's pretty simple: General Mills and Nestle can't write down a negative value because it would lower the value below the investment amount. Then any losses deferred by not applying the equity method are carried forward. If joint-venture profitability resumes, the zero balance will remain until the income earned exceeds the net unrealized losses.

No, actually. Dividends are treated as a return of capital and aren't owed back to the joint venture.

Now, for General Mills and Nestle, the equity method nicely captures the joint venture that was established. But in some rare cases, companies can elect to use the __proportionate consolidation method__, which is really just like it sounds: _Each_ line item is consolidated onto Nestle's and General Mills's income statements and balance sheets in the proportion of ownership (in this case, it's 50-50). While net income and total net assets will be the same under the equity and proportionate consolidation methods, ratio analysis between firms using the different methods will vary because of the single line versus every line consolidated approaches.

Global expansion

Opportunity for riskier investments

Increased marketing and distribution

An excess profit made by the joint venture

A return of part of the investment made in the joint venture

Because both companies need to refund the joint venture

Because both companies owe back any dividends received

Because both companies can't lose more than the amount invested

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