Key Changes in Joint Venture Formation Accounting: ASU 2023-05 Explained

ASU Overview

In August 2023, the Financial Accounting Standards Board (FASB) issued ASU No. 2023-05 to clarify how joint ventures should be accounted for under ASC 805-60. The update establishes that joint ventures are treated as newly created reporting entities, rather than acquisitions. As a result, no party is identified as the acquirer, and all contributed assets and businesses are consolidated into the joint venture as a single entity.

ASU No. 2023-05 also provides clearer guidance on the initial measurement of a joint venture’s net assets. Upon formation, a joint venture must measure its total net assets at the fair value of 100% of the joint venture’s equity. This includes the recognition of any noncontrolling interest in the net assets of the joint venture. The measurement of net assets at fair value is a significant update. The fair value approach ensures consistency in the treatment of joint venture formations, aligning the accounting treatment with other business combination transactions.

In addition to the measurement of net assets, the guidance specifies that the formation date of a joint venture is the date on which an entity initially meets the definition of a joint venture. At this point, goodwill, if applicable, must also be measured, and the formation of the joint venture is accounted for as a whole. No party is required to identify or recognize goodwill in isolation, as it is part of the overall joint venture structure. This approach simplifies the process and ensures that the formation is treated in a consistent manner across all participants in the venture.

Finally, ASU No. 2023-05 introduces new disclosure requirements for joint ventures at the formation date. These disclosures are distinct from those required for business combinations and are designed to help users of the joint venture’s financial statements understand the nature and financial effects of the formation. The disclosures are aimed at providing clarity on how the formation impacts the joint venture’s financial position and operations at the time of formation.

Joint ventures which were formed prior to January of 2025 when the ASU takes effect, will be able to retroactively apply the guidance in ASU 2023-05 if they have sufficient information to do so. Because ASU No. 2023-05 takes effect this year, we will examine its impact on various industries and provide examples of joint ventures applying the new accounting guidance.

Industry Analysis

The impact of this accounting update will vary based on industry-specific factors. The technology, pharmaceuticals, energy, and manufacturing industries will be impacted the most. JVs are commonly formed to share resources, mitigate risks, and accelerate innovation. The requirement to use the fair value approach upon formation of a JV will fundamentally alter how these ventures are initially recorded. The changes in fair value measurement from book value will influence financial reporting, investment decisions, and tax implications as described below.

Financial Reporting

ASU 2023-05 significantly impacts financial reporting by requiring JVs to recognize contributed assets and liabilities at fair value. In the technology sector, asset contributions in JVs will now reflect fair value, incorporating market expectations for future earnings, risk, and growth potential. This will provide a clearer valuation of intellectual property, software, and data assets. However, the ASU introduces challenges in assessing the fair value of AI models and proprietary algorithms due to their subjective nature. Industries with extensive amounts of intangibles will result in more complicated accounting treatment under this ASU. For example, tech company investments in server farms, R&D facilities, and manufacturing equipment will be measured at fair value rather than historical cost, making balance sheets more reflective of current market conditions. However, fair value may be difficult to reflect given the high volatility in the market due to rapid technological advancements. Other industries will likely encounter the same challenge.

The pharmaceutical industry will also experience more transparent financial reporting, particularly regarding patents and in-process R&D (IPR&D). The fair value of these assets, better reflecting a drug’s market potential and the impact of regulatory approvals. However, early-stage R&D projects pose a valuation challenge, as their fair value depends on clinical trial outcomes and FDA approvals. Similarly, inventory valuation will fluctuate based on market demand and exclusivity rights, leading to more dynamic but volatile financial statements. The same volatility will be experienced in the energy sector.

In the energy sector, assets such as oil and gas reserves, drilling rigs, and renewable energy infrastructure will now be recorded at fair value rather than historical extraction costs. Because fair value is influenced by commodity prices, geopolitical risks, and regulatory factors, energy firms may experience greater volatility in asset valuations. While this approach provides a more accurate snapshot of asset values, frequent fair value adjustments (particularly for energy infrastructure and reserves) could amplify earnings fluctuations.

The shift to the fair value approach impacts goodwill recognition. Goodwill is now calculated as the excess of the fair value of the JV over the net fair value of identifiable assets and liabilities contributed. The extent of this impact varies by industry, depending on the nature of contributed assets and the overall valuation of the JV.

In general, industries that rely on high-value intangible assets, such as technology and pharmaceuticals, will tend to see larger goodwill balances due to fair value increases. However, the requirement to test goodwill for impairment rather than amortizing it introduces potential earnings volatility, especially in sectors where asset values fluctuate significantly.

In the technology sector, goodwill is expected to be significant, as JVs often contribute software, AI models, and proprietary IP. Startups and AI-driven ventures, in particular, may see large goodwill balances due to high market expectations for future growth. However, rapid technological obsolescence poses a high risk of goodwill impairment, as the competitive landscape can shift quickly.

For pharmaceutical JVs, goodwill recognition is expected to be moderate to high, especially in cases where early-stage drug development and patents are contributed. If a JV is centered around promising drug candidates, much of its fair value may be recorded as goodwill rather than as identifiable assets. Additionally, regulatory approvals, such as FDA decisions, can significantly impact goodwill, either increasing its value or leading to impairments if clinical trials fail or patents expire.

Finally, in the energy industry, goodwill recognition is likely to be low to moderate. Most fair value adjustments involve tangible assets such as oil reserves, pipelines, and production infrastructure. However, renewable energy JVs may recognize goodwill if their regulatory incentives or market positioning contribute to value beyond physical assets. Despite this, commodity price volatility and regulatory shifts create a high impairment risk for energy JVs, particularly in fossil fuel ventures.

Overall, ASU 2023-05’s fair value requirement makes goodwill more prominent and emphasizes the need for robust valuation practices and impairment testing in affected JVs.

Investment Decisions

The transition to fair value accounting under ASU 2023-05 enhances the ability of investors to make informed decisions. In technology and pharmaceutical industries, where intangible assets drive value, investors will gain greater insight into the potential of proprietary software, AI models, and drug development pipelines. These types of JVs will benefit from fair value adjustments that reflect market potential rather than outdated book values, making it easier for investors to assess growth opportunities. However, investment decisions will rely heavily on accurate modeling and fair value assessments. Additionally, for research-based pharmaceutical JVs or companies in industries with significant regulatory oversight, investment risks may rise due to valuation fluctuations tied to approvals, clinical trials, and supply chain disruptions.

In energy, investors will benefit from a clearer valuation of oil reserves, renewable energy projects, and long-term supply contracts. Previously, these assets were measured at cost, making it difficult to compare JVs with different historical investments. Now, fair value accounting will enable better comparability. However, the volatility of commodity prices and regulatory risks may lead to fluctuations in reported asset values, especially in JVs located in different geopolitical regions. This will create uncertainty in investment assessments.

Pharmaceutical JVs that develop long-term strategic partnerships will now be easier to evaluate for investors. With fair value recognition, investors can more accurately assess the worth of blockbuster drug patents, aerospace tooling, and supply chain agreements, leading to stronger balance sheets for companies with high-value assets. However, for research-based pharmaceutical JVs or companies in industries with significant regulatory oversight, investment risks may rise due to valuation fluctuations tied to approvals, clinical trials, and supply chain disruptions.

Tax implications

Under ASU 2023-05, forming a corporate JV results in the recognition of deferred tax liabilities (DTLs) and deferred tax assets (DTAs). While these deferred taxes are recognized at formation, the first reporting period will only reflect changes in deferred tax positions since the formation date. This means the JV's income tax expense in the first period will only capture subsequent adjustments due to changes in fair value or tax laws. Industries with assets that often have a higher fair value than their tax basis, such as technology, pharmaceuticals, and energy are likely to see an increase in deferred tax liabilities upon formation. This initial increase in reported tax liabilities can affect cash flow planning and may require additional tax provisions. Furthermore, in industries where asset values are volatile or depreciate quickly, fair value fluctuations could result in further tax-related volatility. The ASU implies the need for careful tax planning and extensive valuation assessments to manage the effects of these deferred tax changes.

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Example A – Fair Value Assessment and Goodwill Calculation

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Example B – Comprehensive Overview

Background

Safe and Green Corporation (the Company) entered into an agreement with Milk & Honey to form a new legal entity, under the name Sugar Phase I LLC, with the goal of developing single, eco-friendly family homes in Texas.

On September 30, 2024, the Company transferred land valued at $317,500 and contributed capital of $100,000 to Sugar Phase I LLC. This date represents the formation date under ASU 2023-05 as it's the date the Company meets the definition of a joint venture. In this case it would be a corporate joint venture because no accounting acquirer was identified, a separate entity was formed, and the arrangement was established for the mutual benefit of the companies.

ASU Update Application

ASU No. 2023-05 was effective January 1, 2025, the joint venture was formed prior to this effective date. Thus, the Company has the option to apply the standard retrospectively. To demonstrate the application of the update, we will assume the Company decides to retrospectively adjust their statements to the standard.

As outlined in the update the FASB released, cumulative adjustments are made to the opening balance of retained earnings, and fair value measurements of assets and liabilities are reflected in the balance sheet. The Company has disclosed that PPE and project development costs were not originally valued at fair value. Accounts payable and accrued expenses are considered to approximate their fair value. This is illustrated below with the following facts.

The Company does not purchase or sell any assets during the first quarter of the year
Liability amounts on the balance sheet reflect their fair value measurements.
Prepaid assets are valued at $852,600
Land and equipment valued at $2,103,890 and $2,067 respectively
Project development costs are valued at $123,737
Intangible assets have a fair value of $545,340
The total fair value of the JV is $30,000,000 and FV of net identifiable assets is $17,500,000

Thus, the Company needs to adjust asset and goodwill balances. Goodwill was revalued at $12.5 million, calculated from FV of NIA at 17.5 million subtracted from FV of JV at 30 million. These are shown below.

The journal entry below demonstrates the adjusting entry to be recorded in order to write assets to their fair value measurements. The total effect on retained earnings is about 11 million.

Conclusion

In conclusion, the issuance of ASU No. 2023-05 marks a significant step forward for the FASB in clarifying the accounting treatment of joint ventures under ASC 805-60. By treating joint ventures as the formation of a new reporting entity without an accounting acquirer, the ASU simplifies the process of accounting for joint ventures and ensures a more consistent and transparent approach across all transactions. This guidance, which includes the fair value measurement of net assets and clearer disclosures, aligns joint venture accounting more closely with other business combinations. Certain sectors, particularly those with a high volume of joint venture activity or complex entity structures, may experience a more pronounced shift in accounting practices. Industries such as energy, technology, and pharmaceuticals will likely face significant changes in how they measure and report the formation of these ventures due to the nature of their balance sheets. Ultimately, ASU No 2023-05 furthers the FASB’s goal of clarifying financial reporting. The ASU allows for more informed decision-making by investors, analysts, and other stakeholders.

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