Overview

What you’ll learn:

• Why profit in property joint ventures is often not split by ownership percentage
• How fees, preferred returns, and promotes affect who gets paid first
• What a waterfall is and why cash flows in a strict order
• Why accounting profit and cash distributions can look very different
• When and why profit allocations may shift during a project’s life

This episode explains the commercial economics behind the numbers, not detailed calculations.

Best for:

• Offshore finance teams reviewing JV profit and loss allocations
• Team members confused by profit shares that don’t match ownership
• Finance staff supporting JV reporting, forecasting, or reviews
• Anyone asking, “Why did we earn more (or less) than 50% this month?”

Completion of Episodes 2–4 is recommended.

• Estimated time: 6 mins

Listen

Read (Reference Notes)

Chapter 5 Fees, waterfalls & uneven returns

Context: This note addresses the accounting complexities arising from property joint ventures where economic returns do not align with static ownership percentages. This includes the treatment of development fees, preferred returns, and promote structures under the equity method.

1. Development Fees vs. Equity Returns

In property joint ventures, a developer often acts as both an investor (equity partner) and a service provider (Development Manager). Accounting standards require distinguishing between returns on capital and revenue from services.

• Service Revenue (AASB 15/Topic 606): Development Management (DM) fees, construction management fees, and leasing fees are typically accounted for as revenue from contracts with customers.
• Intra-Entity Profit Elimination: When a developer charges a fee to a JV in which it holds an equity interest, the developer cannot recognize the profit portion of that fee to the extent of its own interest in the JV. The "internal" portion of the profit must be eliminated until realized by a sale to a third party,.

◦ Example: If a developer owns 50% of a JV and charges a $1m fee (with 100k) against the investment carrying value.

• Capitalisation Risk: If the JV capitalises the fee into Inventory (Work in Progress), the developer must track the eliminated profit and recognize it only as the underlying asset is sold or depreciated.

1. Uneven Economic Interests (The "Waterfall")

Standard equity accounting applies the investor's ownership percentage to the investee's net income. However, property JV agreements often designate different allocations for profits, losses, and cash distributions (a "waterfall") that change over time or upon the occurrence of specified events.

• Substance Over Form: Where specified profit and loss allocation ratios (e.g., 50/50) differ from the allocation of cash distributions and liquidating distributions (e.g., 10% preferred return to one partner), the specified ratios should not be used. The investor must determine their share of earnings by analyzing how changes in the investee's net assets affect their cash rights,.
• Preferred Returns: If an investee has outstanding cumulative preference shares/units held by other parties, the investor must compute its share of profit or loss after adjusting for the dividends/returns on those shares, whether or not they have been declared,.

1. Promote Structures (Carried Interest)

A "promote" is a performance incentive where a developer receives a disproportionate share of profits after the capital partner achieves a specified hurdle rate (e.g., Internal Rate of Return).

• Classification (Revenue vs. Equity): There is judgement in determining whether a promote is a performance fee for services (accounted for under revenue standards) or a disproportionate allocation of equity (accounted for under the equity method).
• Accounting Implications: If treated as an equity allocation, the promote results in a mismatch between the legal ownership percentage and the economic share of profits. The investor must account for this by recognizing earnings based on the substantive economic rights rather than legal shares,.

1. Hypothetical Liquidation at Book Value (HLBV)

When capital structures are complex (e.g., flips, waterfalls, or non-pro rata allocations), the standard "percentage of ownership" method may fail to reflect the investor's true economic interest. The Hypothetical Liquidation at Book Value (HLBV) method is an approach used to estimate the investor's share of earnings in these scenarios,.

• Methodology: The investor calculates its claim on the investee's net assets at the beginning and end of the reporting period, assuming the investee were liquidated at its book value (US GAAP/IFRS carrying amounts) at those dates.
• Calculation:

1. Calculate claim on net assets at period end (via the waterfall).
2. Add back cash distributions received during the period.
3. Subtract contributions made during the period.
4. Subtract claim on net assets at the beginning of the period.
5. The result is the investor's share of earnings (or loss).

• Application: This method ensures that the recognition of equity earnings reflects the actual contractual rights to cash flows under the JV agreement, rather than a static ownership percentage.

1. Accounting Judgement Areas

• Substantive Profit Sharing: Determining whether a profit-sharing arrangement is "substantive" requires judgement. The arrangement must retain its economic outcome over time and not be susceptible to unwinding by subsequent events.
• Debt vs. Equity Classification: In scenarios involving preference shares or fixed returns, judgement is required to determine if the instrument represents an equity interest (AASB 128) or a financial liability/asset (AASB 9). If the instrument has mandatory redemption or fixed returns unrelated to residual profits, it may not be "in-substance common stock",.
• Control Assessment: Complex fee and promote structures must be assessed to ensure they do not convey control (requiring consolidation) rather than just significant influence or joint control.

Key Takeaways

• Ownership percentage does not guarantee the same profit percentage
• Cash flows through a waterfall, not a straight-line split
• Development fees are paid for work done and reduce residual profit
• Preferred returns pay some partners before profits are shared
• Promotes reward performance but can reverse if projects underperform

Common Mistakes / Watch-outs

• Assuming profit must always follow ownership
• Ignoring preferred return or promote clauses in the agreement
• Treating development fees as “extra profit” without considering eliminations
• Comparing accounting profit directly to cash without reviewing the waterfall
• Escalating “errors” before checking the commercial deal structure

🧠 Practical reminder

When profit numbers look strange, don’t ask first:

“Is the accounting wrong?”

Ask instead:

“What does the agreement and waterfall say?”

That question usually explains the result.

Quick Links

• Next episode →Episode 4 – Booking Mechanics & Eliminations
• Back to hub →Episode 6 – Impairment & Losses