Joint Ventures
Accounting treatment of investments in less-than-wholly-owned operations differs based on the level of ownership or control. For majority ownership positions, results of operations are consolidated into the results of the parent company, with investment and income associated with third party investors shown as minority interest and minority interest expense, respectively. For minority ownership positions greater than 20 percent, the "equity method" is generally used whereby the investment is recorded at cost plus retained earnings and the share of net income from the operation is recorded on a single line in business unit income. For investments of less than 20 percent where the company exercises no significant influence over the operations, the "cost method" is used whereby the investment is shown at lower of cost or market with income reflecting dividend or interest income from the venture.
Economics of Joint Ventures
Joint investments imply operating involvement falling somewhere on the spectrum from no influence to total control. At one extreme, the business tosses cash over the transom and simply awaits returns to be tossed back over time. At the other extreme, the business receives money over the transom from outside investors and is responsible for the day-to-day operations of the venture and for providing those outside investors their returns. In the middle are ventures where each party provides capital and management in varying degrees.
In every case, investment in a portion of a business and a proportionate return from the business are evaluated the same as with any other kind of investment. From a "stock" perspective, the discounted income from the investment must exceed the amount invested. From a period-to-period "flow" perspective, the proportionate returns from the investment must exceed the charge on the invested capital. From either perspective, the cost of capital becomes important in evaluating the value created in a partnership.
Behavioral Impact
Since financial accounting ignores the cost of capital, it provides no insight as to whether actual returns from a joint investment are sufficient to create value. An earnings or income focus will automatically create a propensity toward over-investment in partnerships, as it does for any kind of investment. More particularly, it may provide a propensity toward risky investments where returns can be very high. This danger is particularly high with risky ventures such as entertainment productions or highly leveraged ventures like real estate development.
Baseline EP helps overcome that gross propensity toward investment, but not necessarily the bias toward higher risk with regards to unconsolidated ventures. For significant, unconsolidated investments, material distortions can be introduced into Baseline EP reflecting equity method accounting. For example, an unconsolidated investment may be carrying substantial debt on the books of the venture. With no adjustment, we would be charging the businesss weighted average cost of debt and equity capital against what is essentially an equity investment that, due to leverage, carries considerably higher risk. To illustrate this, consider a case where the business owns 25% of the following operation:
Income Statement______Balance Sheet________
Revenue $100 Assets 140 Debt 100
COGS 82 Equity 40
Interest 6
Profit Before Tax 12
Tax (@33%) 4
Income 8
If we used the equity method in calculating EP, NOPAT would be $2.0 million and Capital would be $10.0 million. At a 10 percent cost of capital, EP would be $1.0 million:
NOPAT $2.0 (25% of $8.0 income)
Capital 10.0 (25% of $40 equity)
x Cost of Capital 10%
Capital Charge 1.0
EP 1.0
This example looks positive, but the calculation ignores the significant leverage inside the joint venture and the resulting high risk of the equity investment. It turns out that returns from this operation do not cover the cost of capital.
NOPAT $12.0 ($8.0 income plus $4 interest after tax)
Capital 140.0
x Cost of Capital 10%
Capital Charge 14.0
EP (2.0)
The above EP calculation of the entire venture shows it to be EP negative. But the equity method misleads us into thinking this operation creates value for the investors.
Alternative Treatments
Significant ownership in unconsolidated units can be treated one of several ways for EP purposes. The choice of treatments can affect whether or not to invest in a joint venture and how that venture is managed. Generally, the ideal treatment is a separate calculation of EP related to the investment, and attribution of a proportionate level of the EP to the parent company. This is consistent with the accounting treatment of investments whose results are consolidated and somewhat consistent with the equity method. For small investments, e.g., representing less than two or three percent of division capital, allowing the cost method to affect Baseline EP is generally adequate, avoiding the work of an adjustment with little risk of distorted decision making.
One solution would be to step up the cost of capital of the business unit to account for the risk of a joint venture investment, but this would require constant adjustment for varying levels of leverage and risk, which makes such a solution impractical.
