An investor should consider interest costs related to equity method investments. ASC 835-20 requires an investor to capitalize interest costs while the investee has activities in progress to begin planned principal operations and the investee is using funds to acquire assets for its operations. Interest cannot be capitalized after the planned principal operations have commenced, for example, when an investee has several factories under construction but one begins operations.

Separately, an investee may qualify to capitalize interest on allowable projects in its own financial statements, even if the investor is not permitted to capitalize the interest it incurs. The investor would recognize interest capitalized by the investee through its equity method earnings (i.e., its proportionate share of the depreciation expense related to the investee’s capitalized interest). However, if the investee’s capitalized interest is related to a loan from the investor, the investor should adjust equity method earnings for its proportionate share of capitalized interest from its equity method investment with a related deduction from its equity method investment. Example EM 4-8 illustrates this concept.

EXAMPLE EM 4-8
Investee capitalizes interest costs for loan from investor

Investor has a 25% investment in Investee common stock that is accounted for under the equity method of accounting. On 1/1/20X1, Investor loans $1 million with a 6% annual interest rate to Investee to build a factory. Investee does not have any other loans outstanding. Investee’s planned principal operations have not yet commenced, and so the related interest qualifies for capitalization per ASC 835-20. Investee has net income for the year ending 12/31/20X1 of $300,000.

How should Investor record its share of Investee’s earnings?

Investor would record its 25% share of Investee’s earnings for the year ending 12/31/20X1 as follows.

Investor would also record $60,000 of interest income for the year ending 12/31/20X1 ($1,000,000 loan balance multiplied by 6% annual interest rate).

Investee has capitalized the interest associated with the loan provided by Investor. Therefore, Investor needs to adjust equity method earnings to deduct Investor’s proportionate share of the interest capitalized by Investee (25% of $60,000 total Investee interest).

Investors should evaluate if loans to the investee are considered in-substance capital contributions, such as a scenario when all investors are required to make loans or advances in proportion to their equity interests. If an in-substance capital contribution, interest received by the investor would be accounted for as a distribution from the investee, with a reduction to the investor’s equity method investment instead of interest income.

ASC 835-20-30-6 limits the total interest cost to be capitalized by a consolidated group to the interest incurred by the parent and its consolidated subsidiaries. An equity method investee is not a part of the investor’s (parent’s) consolidated group. Therefore, interest incurred by the investee is not eligible for capitalization by the investor. Similarly, interest incurred by the investor is not capitalizable by the investee.