Equity method vs. proportional consolidation

The accounting treatment of two companies who are partners in a joint venture plays out in either the equity or proportional consolidation reporting method. While the meaning of "joint venture" is not clearly defined, an essential element of the term is that the two partners enjoy joint control.

How this control is reported on company income statements and balance sheets delineates the methods from one another.

The Joint Venture

Both equity method and proportionate consolidation accounting treatments pertain to joint ventures. Simply stated, a joint venture is a short-term partnership for a limited time and purpose, according to Cornell University's School of Law. Each party in the venture contributes assets to the partnership -- and also shares the risk. Parties can be people or companies. They're commonly used to enter foreign markets, and partnerships are subject to international trade laws as well as federal income taxes. In practical use, the definition of "joint venture" is not clearly defined, according to the American Institute of CPAs.

Definition of the Equity Method

The equity method calculates net income from a joint venture partnership, proportional to the size of its investment. The key to understanding the method is "net." In the equity method, the investment is recorded at cost at first, and is then adjusted up or down, depending on the current value and expenses. Should the company no longer have a "significant influence" in control over the investment, then the equity method treatment must stop and the new value is recorded at the current cost basis.

Definition of Proportionate Consolidation

Proportionate consolidation is used to "consolidate the accounts of joint ventures," according to the website Vernimmen. Both assets and liabilities are put onto the investor's balance sheet in direct proportion to the amount of the investment; they're also added to the income statement in the same way. The consolidated financial statements of the partners are prepared using the same reporting date. In the U.S., proportionate consolidation focuses on controlling financial interests.

Assessing Risk

While nations may not agree on what type of accounting treatment to use -- the U.S. requires the equity method for joint ventures -- both the equity method and proportionate consolidation have their own rationales. For example, according to the website Science Direct, the proportionate consolidation method is better for explaining price volatility, while the equity method is better at explaining bond ratings. Nevertheless, Science Direct notes that regardless of what treatment is used, failing to disclose all joint venture investment activity prevents "market participants" from adequately assessing risk.