Introduction
In August 2023, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2023-05: Business Combinations—Joint Venture Formations (Subtopic 805-60). This ASU addresses a long-standing deficiency in U.S. GAAP regarding how newly formed joint ventures should recognize and initially measure their assets and liabilities.
The energy sector, in particular, stands to be significantly impacted by these changes given the prevalence of joint venture structures for large, capital-intensive projects like renewable energy developments, oil and gas exploration, and infrastructure construction.
This article explores the scope of ASU 2023-05, its major provisions, practical implications for the energy sector, and steps companies should be taking now to prepare for compliance.
Background: Why the New Guidance Was Needed
Prior to ASU 2023-05, U.S. GAAP lacked explicit guidance on how joint ventures should recognize and measure the assets and liabilities contributed by the venturers at formation. This void resulted in inconsistent practices:
- Some joint ventures recognized contributed assets at the venturers’ carrying amounts.
- Others recognized assets at fair value, based on the nature of the contributions or by analogy to business combinations.
This diversity in practice made comparability difficult for investors and users of financial statements. The FASB’s objective with ASU 2023-05 is to enhance consistency, transparency, and relevance in financial reporting for newly formed joint ventures.
Overview of ASU 2023-05 Requirements
The ASU provides that a joint venture, upon formation, apply a new basis of accounting.
1. Recognition and Initial Measurement
- Fair Value at Formation: Upon formation, a joint venture must recognize and initially measure all identifiable assets and liabilities contributed at fair value (with exceptions to fair value measurement that are consistent with the business combinations guidance).
- Goodwill Recognition: If the fair value of the joint venture as a whole exceeds the fair value of identifiable net assets contributed, the difference is recognized as goodwill.
2. Scope Clarifications
- Applies only to the initial formation of a joint venture.
- Does not apply to:
- Subsequent contributions by venturers after formation.
- The accounting by the venturers (investors) under the equity method.
3. Disclosure
The ASU requires a joint venture to disclose the following in the period of formation:
- The formation date
- A description of the purpose for which the joint venture was formed (for example, to share risks and rewards in developing a new market, product, or technology; to combine complementary technological knowledge; or to pool resources in developing production or other facilities)
- The formation-date fair value of the joint venture as a whole
- A description of the assets and liabilities recognized by the joint venture at the formation date
- The amounts recognized by the joint venture for each major class of assets and liabilities as a result of accounting for its formation, either presented on the face of financial statements or disclosed in the notes to financial statements
- A qualitative description of the factors that make up any goodwill recognized, such as expected synergies from combining operations of the contributed assets or businesses, intangible assets that do not qualify for separate recognition, or other factors.
If the initial accounting for the joint venture is incomplete, the following information should be disclosed:
- The reasons why the initial accounting is incomplete
- The assets, liabilities, noncontrolling interests, or the formation-date fair value of the joint venture as a whole for which the initial accounting is incomplete
- The nature and amount of any measurement period adjustments recognized during the reporting period, including separately the amount of adjustment to current-period income statement line items relating to the income effects that would have been recognized in previous periods if the adjustment to provisional amounts was recognized as of the formation date.
4. Effective Dates
- Prospective Application: The ASU is effective prospectively for all joint venture formations with a formation date on or after January 1, 2025.
- Early Adoption: Permitted in any interim or annual period in which financial statements have not yet been issued.
Relevance to the Energy Sector
Joint ventures are a cornerstone structure in the energy sector, driven by the need to:
- Pool significant financial resources.
- Share risks across multiple parties.
- Facilitate access to technical expertise.
Examples of energy joint ventures include:
- Wind and solar farm developments.
- LNG (liquefied natural gas) facilities.
- Oil field exploration and drilling partnerships.
- Infrastructure projects like pipelines and transmission systems.
Practical Implications
- Increased Upfront Valuation Work: At formation, energy joint ventures must perform fair value assessments for a wide range of contributed assets and liabilities, including:
- Land rights
- Mineral interests
- Property, plant, and equipment
- Leases and contract assets
- Goodwill Recognition: For the first time, energy JVs may recognize goodwill on their balance sheets, impacting key financial metrics.
- Changes in Deal Structuring: Transaction structuring decisions (e.g., contributions of assets vs. cash) could be influenced by the accounting treatment under the new guidance.
- Investor Communications: Entities must be prepared to explain the impact of fair value measurements and goodwill recognition to stakeholders.
Challenges and Considerations
While the ASU improves consistency, it introduces new complexities:
- Fair Value Challenges: Determining fair value for specialized or regulated energy assets (e.g., offshore wind rights, oil reserves) may require specialized valuation expertise.
- Audit Readiness: Valuation assumptions and methodologies will face heightened auditor scrutiny.
- Systems and Controls: Companies must ensure their accounting systems and internal controls can capture the necessary valuation data at formation.
Practical Steps to Prepare
To ensure readiness for ASU 2023-05, energy companies involved in or contemplating joint ventures should:
- Identify Upcoming JV Formations: Assess which upcoming transactions will fall under the new standard.
- Engage Valuation Experts Early: Begin valuation workstreams as part of deal planning.
- Educate Finance and Deal Teams: Ensure internal stakeholders understand the accounting implications.
- Review Templates and Policies: Update internal accounting policies and financial reporting templates to align with the new guidance.
- Coordinate with External Auditors: Seek early input on valuation methodologies and documentation expectations.
Conclusion: A New Era for Joint Venture Accounting
ASU 2023-05 brings significant change to how joint ventures, especially in the energy sector, recognize and measure their financial position at formation. While the fair value requirement increases initial complexity and cost, the resulting transparency and comparability benefits will better inform investors and stakeholders.
Given the January 1, 2025, effective date, energy companies should act now to incorporate these new accounting requirements into their deal planning and financial reporting processes. Those who proactively prepare will be better positioned to execute joint venture transactions smoothly and minimize reporting surprises.
