5.8 Interest Costs
Investors may incur interest expense as a result of loans from third parties to finance the funding of their investments in equity method investees. In addition, equity method investees may incur interest expense as a result of loans from equity method investors or other third parties. The accounting for interest incurred by the investors and the investees principally depends on the use of the funds and the activities of the investees.
5.8.1 Capitalization of Interest Costs
ASC 835-20
15-5
Interest shall be capitalized for the following types of
assets (qualifying assets): . . .
c. Investments (equity, loans, and advances)
accounted for by the equity method while the
investee has activities in progress necessary to
commence its planned principal operations provided
that the investee’s activities include the use of
funds to acquire qualifying assets for its
operations. The investor’s investment in the
investee, not the individual assets or projects of
the investee, is the qualifying asset for purposes
of interest capitalization.
15-6
Interest shall not be capitalized for the following
types of assets: . . .
d. Investments accounted for by the equity
method after the planned principal operations of
the investee begin (see paragraph 835-20-55-2 for
clarification of the phrase after planned
principal operations begin) . . . .
30-6 The
total amount of interest cost capitalized in an
accounting period shall not exceed the total amount of
interest cost incurred by the entity in that period. In
consolidated financial statements, that limitation shall
be applied by reference to the total amount of interest
cost incurred by the parent entity and consolidated
subsidiaries on a consolidated basis. In any separately
issued financial statements of a parent entity or a
consolidated subsidiary and in the financial statements
(whether separately issued or not) of unconsolidated
subsidiaries and other investees accounted for by the
equity method, the limitation shall be applied by
reference to the total amount of interest cost
(including interest on intra-entity borrowings) incurred
by the separate entity.
35-2
This Subtopic requires capitalization of interest cost on an investment
accounted for by the equity method that has not begun its planned principal
operations while the investee has activities in progress necessary to commence
its planned principal operations provided that the investee’s activities
include the use of funds to acquire qualifying assets for its operations.
Under those circumstances, capitalized interest cost may be associated with
the estimated useful lives of the investee’s assets and amortized over the
same period as those assets. Interest capitalized on the investments accounted
for by the equity method is amortized consistent with paragraph 323-10-35-13.
ASC 835-20 allows an investor to capitalize interest costs it incurs in certain
situations. ASC 835-20-35-2 states, in part, that investments (e.g., equity, loans,
advances) accounted for under the equity method are qualifying assets of the investor
provided that the investee “has activities in progress necessary to commence its planned
principal operations” and the investee is using its funds “to acquire qualifying assets
for its operations.”
Once the investee commences its planned principal operations, the investor must cease capitalization of interest costs. If the investee is already operating, the investor’s entire equity method investment does not qualify for interest capitalization, even if certain projects are still under way (e.g., several plants are under construction and one plant begins operations).
In addition, if an investee meets the criteria in ASC 835-20-15-5 through 15-8,
it would qualify for interest capitalization on construction projects within its own
financial statements regardless of whether the investor is precluded from capitalizing the
interest it incurs, as described in the preceding paragraph. The investor would apply the
equity method of accounting to recognize interest capitalized by the investee (i.e., the
interest would be recognized as a pickup of the investor’s portion of the depreciation
expense associated with the capitalized interest recorded by the investee) unless the
capitalized interest is associated with a borrowing from the investor. In those instances,
the investor should deduct its proportionate share of the capitalized interest recorded by
the investee for the investor loan from its equity method investment and make a
corresponding adjustment to equity method earnings.
Under ASC 835-20-30-6, the total interest cost permitted to be capitalized by a
consolidated group is limited to the interest incurred by the parent and its consolidated
subsidiaries. Given that an investee is inherently not included in the investor’s
consolidated group, interest incurred by the investee is not eligible for capitalization
by the consolidated group and interest incurred by the investor is not eligible for
capitalization by the investee.
Any basis differences resulting from application of this guidance should be adjusted by the investor over the same period as the associated underlying assets of the investee when recording equity method earnings (i.e., depreciation).
Example 5-48
On January 1, 20X8, Investor B obtains a loan for $5 million from a third-party bank and correspondingly (1) lends Investee M $4 million and (2) acquires a 30 percent interest in M’s voting common stock for $1 million. Investee M will use the proceeds to construct a new building.
- The loan between B and the third-party bank is for 10 years and has a 10 percent annual interest rate.
- The loan between B and M is for 10 years and has a 10 percent annual interest rate.
Investor B has the ability to exercise significant influence over M and applies
the equity method of accounting. For simplicity, other intra-entity
transactions and the effect of income taxes have been ignored.
As of January 1, 20X8, M’s planned principal operations have not yet commenced.
Construction on the building begins immediately and is expected to continue
for two years, with principal operations commencing at the end of the second
year. Construction of the building qualifies for interest capitalization in
accordance with ASC 835-20 for the year ended December 31, 20X8.
During the year ended December 31, 20X8, B records the following:
In addition, because M has capitalized $400,000 of interest associated with the loan provided by B, B should deduct its proportionate share of such capitalized interest from its equity method investment. Investor B should consider which presentation is most meaningful in the circumstances. Potential acceptable alternatives are:
- Alternative 1:
- Alternative 2:
Investor B will need to consider the effects of potential basis differences resulting from the $500,000 capitalized interest on the third-party loan and the $120,000 reversal of B’s share of capitalized interest by M. Both basis differences should be amortized in a manner consistent with ASC 323-10-35-13.
In addition, in accordance with ASC 970-835-35-1, we believe that an investor should consider the following before recording interest income on a loan or an advance to an investee:
- Collectibility of the principal or interest.
- Whether other investors can bear their share of losses (see Section 5.2).
5.8.2 Interest on In-Substance Capital Contributions
ASC 970-323
35-22
Interest on loans and advances that are in substance capital contributions
(for example, if all the investors are required to make loans and advances
proportionate to their equity interests) shall be accounted for as
distributions rather than as interest income by the investors.
Although the guidance above was written to address an investor’s accounting for
loans and advances to an investee that is a real estate venture, we believe that it should
apply to lending transactions involving any equity method investment.
An investor should evaluate whether loans or advances to an investee are
in-substance capital contributions (e.g., whether all the investors are required to make
loans and advances proportionate to their equity interests). If it is concluded that the
loans or advances are, in effect, in-substance capital contributions, the investor should
(1) account for interest received as a distribution from the investee, (2) reduce its
equity method investment accordingly rather than recognize the amount as interest income,
and (3) account for the loan as part of the equity method investment.
The above scenario may be common in certain industries. For example, in
the U.S. insurance industry, U.S. insurers may invest in private funds by using a “rated
feeder fund” structure to maximize regulatory capital. Capital commitments to the rated
feeder fund are split between equity commitments and loan commitments. In some cases, the
contractual terms of the rated feeder fund (1) require all limited partners to make loans
and advances proportionate to their equity interests and (2) do not allow the debt and
equity investments to be separately transferred without the general partner’s consent
(i.e., the debt and limited partnership interest are not legally detachable20). We believe that, in such a scenario, the debt and equity investments in the rated
feeder fund, while separate in legal form, would be considered a single unit of account21 within the scope of ASC 323, including the subsequent-measurement guidance in ASC
970-323-35-22 related to the recognition of interest income.
Example 5-49
Investor A has a 30 percent equity interest in Investee H’s common stock.
Investor A has the ability to exercise significant influence over H and
applies the equity method of accounting.
On January 1, 20X8, H obtains $10 million in loans from all
equity investors (including A) in proportion to their equity interest. As a
result, H receives a $3 million loan from A. Investor A accounts for the loan
to H as in-substance common stock and as part of the equity method investment,
since the attributes of the loan qualify for this treatment by aligning with
those discussed in Section 2.5.
Investee H accounts for the loans as debt with a 5 percent interest rate. For
simplicity, other intra-entity transactions and the effect of income taxes
have been ignored.
Investor A and Investee H record the following entries to
reflect the initiation of the loan:
Investor A — Records Loan as
In-Substance Common Stock
Investee H — Records Loans From All
Investors
During the year ending on December 31, 20X8, H records a $1.2 million net
loss. Included in this net loss is $500,000 of interest expense ($10 million ×
5%) related to the loans from investors that were originated on January 1,
20X8.
Investee H — Records Interest Expense
Related to Loans
Since A accounts for the loan to H as in-substance common
stock, A would (1) account for interest received as a distribution from the
investee and (2) reduce its equity method investment accordingly rather than
recognize the amount as interest income. However, because this interest is
included in H’s calculation of net loss for the year, A should ensure that it
does not double count this interest expense when determining its share of H’s
earnings for the year ending on December 31, 20X8. Accordingly, Investor A
would record the following entries:
Investor A — Records Distribution From
H
Investor A — Records Share of H's Loss
Investor A — Eliminates Distribution
Received, Which Was Accounted for as Interest Expense by H and Included in
the Calculation of H's Net Loss
Footnotes
20
See additional discussion of legal detachability and unit-of-account
considerations in Section
3.3.1 of Deloitte’s Roadmap Distinguishing Liabilities From Equity.
21
Provided that the investor does not consolidate the rated feeder
fund in accordance with ASC 810.