Private Companies Should Think Ahead on Joint Venture Changes

The Financial Account Standards Board’s recently adopted accounting standard update will require newly formed joint ventures to disclose their formation date starting on Jan. 1, 2025.

They must also measure their identifiable assets as the fair value of the joint venture as of the formation date, and recognize goodwill as of the formation date as the difference between the joint venture’s total net assets and its identifiable net assets, when applicable.

There are no generally accepted accounting principles for how joint ventures measure, if at all, assets contributed and liabilities assumed at the time of formation of a joint venture. Practices have been inconsistent among business owners, investors, and accounting professionals, forcing them to rely on guidance on how to manage such transactions from the various statements provided by the Securities and Exchange Commission.

The latest update requires companies forming a joint venture to disclose their contributed assets and liabilities. By requiring each entity to provide certain disclosure information and measure its fair value at formation, the FASB aims to encourage uniformity and provide investors with valuable and accurate information.

While joint ventures formed before the effective date won’t have to follow the update, the FASB encourages them to elect it before its effective date.

So where do private companies fit in?

Though not required, many private companies follow GAAP. Standard commercial lending documents often require financial reporting to be consistent with GAAP. In addition, representations and warranties made in the context of mergers and acquisitions often reference GAAP.

Private companies should act now to comply with the ASU; not doing so could create a trap for the unwary. This could trigger a default under applicable loans or a post-closing indemnification claim, leading to unintended yet preventable consequences.

If a company anticipates, or recently completed, a sales process, representations and warranties and related indemnification obligations are implicated by the change. Post-closing covenants and earn-outs are also likely to involve financial reporting under GAAP. In each instance, understanding the implication of the change on your balance sheet is essential for avoiding an inadvertent default.

Commercial loan documents often contain covenants that are balance-sheet related. Anticipating the way this change could impact those covenants, including any adjustment relating to the change, is necessary to ensure covenant compliance.

Thoughtful financial professionals should review covenants today for each financial instrument that includes covenants and model the implication of this change. The transition period is designed specially to facilitate this exercise.

When negotiating a new loan agreement, care should also be given to ensuring the implementation of this rule is anticipated. Loan agreements should accommodate the transition in a way that should facilitate the intention of the parties.

Companies should also review existing purchase and sale agreements in the context of private company sales. Such documents frequently include post-closing covenants.

Earn-outs, which have been particularly popular in recent years, are triggered by financial performance. In the context of those earn outs, there’s a need for financial reporting under GAAP. Understanding whether the definition of GAAP used in those documents evolves with the changing standards is important. Modeling the way post-closing financial reporting will be affected is essential to ensuring parties’ intentions.

In deals that are being negotiated during this transition, care should also be given to how the latest update affects the transaction. Whenever there are changes to GAAP, definitions in deal documents relating to financial reporting that are often not controversial, become more important and nuanced.

As with the analysis around deals that have already closed, modeling is necessary to ensure the accuracy of representations and warranties and the impact on earn-outs.

Finally, consider whether any potential adjustment required to comply with the new ASU may trigger a tax implication. Depending on the magnitude and nature of the adjustments, companies may need to amend the information they previously filed with tax authorities, and failure to do so can lead to a slew of unintended consequences.

Because there’s time for an orderly transition, responsible finance professionals can embrace the changes and ensure there are no surprises. This is certainly an area where awareness and attention will pay dividends.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Charles J. Morton Jr., managing partner of Venable’s Baltimore office, counsels clients on corporate matters—assisting lenders, investors, entrepreneurs, private equity groups, and banks.

Jordan D. Jean is an associate in Venable’s Baltimore office, where he focuses on corporate matters such as M&A, fund formation, commercial contracts, REITs, and general business transactions.

We’d love to hear your smart, original take: Write for us.