Undertaking real estate projects requires significant capital, and financing cost is a major cost factor. If real estate is acquired that is not ready for its intended use, interest expense incurred during the development and construction period is part of a project’s costs that is capitalized. You may want to ask: (1) what amount of interest should I Capitalized? (2) What steps to take to capitalize interest? This post provides step-by-step determination of the amount of interest to be capitalized in a real estate project.
FASB believes that through “interest capitalization“, a measure of acquisition cost is obtained that reflects the company’s investment in the real estate asset. Accordingly, interest capitalization is not discontinued when a real estate project is impaired; any write-down is increased by interest expected to be capitalized in future accounting periods.
There may be a period of time in which a company generates interest income from the investment of unused funds on project financing obtained. Generally, such interest income is recognized as income when earned. It is not offset against interest cost when determining the amount of interest cost to be capitalized, except in the case of certain tax – exempt borrowings.
The determination of the amount of interest to be capitalized in a real estate project is a four – step process:
STEP-1: Determine Whether The Asset Qualifies For Interest Capitalization
The following assets qualify for interest capitalization:
- Assets that are constructed or otherwise produced for a company’s own use
- Assets intended for sale or lease that are constructed or otherwise produced as discrete projects, such as real estate developments
Additionally, investments in equity method, investees may be qualifying assets. FASB Statement No. 34, Capitalization of Interest Cost , precludes interest capitalization for certain types of assets, including (1) assets that are in use or ready for their intended use, and (2) assets that, although not in use, are not undergoing activities to get them ready for their use.
Land that is not undergoing activities necessary to get it ready for its intended use is not an asset qualifying for interest capitalization. Once activities are undertaken for the purpose of developing land for a particular use, the acquisition and development expenditures qualify for interest capitalization while those activities are in progress. If a structure is built on the land, such as a plant or an office building, interest capitalized on the land expenditures is part of the cost of the structure. If a tract of land is developed and subdivided to be sold as developed lots, interest capitalized on the land expenditures becomes part of the cost of the land.
STEP-2: Determine The Types Of Expenditures That Qualify For Interest Capitalization
After it has been determined that a project qualifies for interest capitalization, the expenditures incurred for that project have to be evaluated to determine whether they qualify for interest capitalization.
As a general rule, expenditures that do not require the transfer of cash or other assets or the incurrence of liabilities on which interest is accrued do not qualify for interest capitalization. As such, capitalized amounts financed through trade payables, retainages, or progress payment collections from customers may lead to differences between capitalized project costs and the amount of expenditures that qualify for interest capitalization. Paragraph 16 of FASB Statement No. 34 provides, however, that capitalized expenditures for an asset may be used as a reasonable approximation of expenditures on which interest is capitalized, unless the difference is material.
STEP-3: Determine The Capitalization Period
Interest is capitalized when the following three conditions are present: Expenditures for the asset (that qualify for interest capitalization) have been made. Activities that are necessary to get the asset ready for its intended use are in progress.
Interest cost is being incurred. The term “activities that are necessary to get the asset ready for its intended use” is interpreted broadly in practice. Such activities include administrative and technical activities before ground is broken, such as the development of plans or the process of obtaining permits from governmental authorities. If a company suspends substantially all activities related to the development of the property, the company has to evaluate the reason and duration of the suspension and determine whether interest capitalization during such period of suspension is appropriate.
An interruption that is brief or inherent in the asset development process, such as labor strikes or weather conditions, would not lead to a cessation of interest capitalization, whereas a company – induced suspension in construction activities due to a decline in the real estate market would preclude interest capitalization. The capitalization period ends when the asset is substantially complete and ready for its intended use. By requiring that the capitalization period end when the asset is “substantially complete”, the FASB intended to prohibit the continuation of interest capitalization in situations in which the final completion of assets is intentionally delayed. For example, a developer may choose to defer installing fixtures and fittings until condominium units are being sold to give buyers a choice of styles and colors.
Paragraph 22 of FASB Statement No. 67 allows for a maximum period of one year after cessation of major construction activities, over which a developer may assert that the project is not substantially completed, by requiring that “a real estate project shall be considered substantially completed and held available for occupancy upon completion of tenant improvements by the developer but no later than one year from cessation of major construction activity . . .”
Real estate projects may need to be divided into separate assets or parts for purposes of determining whether they are ready for their intended use. For example: a condominium building is comprised of individual condominiums, which can be used independently from each other. Each such condominium constitutes a separate asset, and interest ceases to be capitalized on condominiums that have been completed and are ready for use. Other real estate assets must be completed in their entirety before any part of the asset can be used, such as the construction of a manufacturing facility.
Judgment must be exercised when determining whether a real estate project should be divided into separate parts for purposes of interest capitalization.
STEP-4: Determine The Amount Of Interest Cost To Be Capitalized
The amount of interest cost to be capitalized is intended to be that portion of the interest cost incurred during the asset’s acquisition and construction period that theoretically could have been avoided if expenditures for the asset had not been made. The total amount of interest cost that may be capitalized in an accounting period is limited to the total amount of interest cost incurred by the company in that period. For purposes of FASB Statement No. 34, interest cost incurred by a company includes:
- Interest recognized on obligations with explicitly stated interest rates (including the amortization of discount or premium and debt issue costs)
- Interest imputed on certain types of payables, in accordance with Accounting
Principles Board (APB) Opinion No. 21, Interest on Receivables and Payables Interest on capital leases determined in accordance with FASB Statement No. 13, Accounting for Leases.
The amount of interest cost to be capitalized in an accounting period is determined by applying an interest rate to the average amount of accumulated expenditures for the asset during the period. In determining what interest rate to use, the objective is to determine a reasonable measure of the cost of financing the acquisition and development of the asset. The interest rate or interest rates used should be based on the rates applicable to borrowings outstanding during the period. If a company has obtained a specific loan for a qualifying asset, the company may use the rate on that borrowing as the capitalization rate for the expenditures for the asset. If the average accumulated expenditures for the asset exceed the amounts of that loan, the capitalization rate applied to any excess is a weighted average of the rates applicable to other borrowings of the company.
Paragraph 14 of Statement provides with respect to the weighted average interest rate to be used:
In identifying the borrowings to be included in the weighted average rate, the objective is a reasonable measure of the cost of financing the acquisition of the asset in terms of the interest cost incurred that otherwise could have been avoided.
Accordingly, judgment will be required to make a selection of borrowings that best accomplishes that objective in the circumstances.
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