The recorded amount of an asset includes all of the costs necessary to get the asset set up and functioning properly for its intended use, including interest. All assets that require a time period to get ready for their intended use should include a capitalized amount of interest. However, accomplishing this level of capitalization would usually violate a reasonable cost/benefit test because of the added accounting and administrative costs that would be incurred. In many such situations, the effect of interest capitalization would be immaterial.
In this post, I am going to discuss about interest cost and its capitalization on an asset acquisitions. With case example provided here, you may get a better understanding in interest capitalization. If you are in hurry, you may want to jump to diagram presented at the end of this article which summarizes the accounting for interest capitalization. Enjoy!
The principal purposes accomplished by the capitalization of interest costs are:
- To obtain a more accurate measurement of the costs associated with the investment in the asset
- To achieve a better matching of costs related to the acquisition, construction, and development of productive assets to the future periods that will benefit from the revenues that the assets generate.
Accordingly, interest cost is only capitalized as a part of the historical cost of the following qualifying assets when such interest is considered to be material, which normally implies that construction or creation occurs over extended periods of time.
Common examples include:
- Assets constructed for an entity’s own use or for which deposit or progress payments are made
- Assets produced as discrete projects that are intended for lease or sale
- Equity-method investments when the investee is using funds to acquire qualifying assets for principal operations that have not yet begun
Generally, inventories and land that are not undergoing preparation for intended use are not qualifying assets. When land is being developed, it is a qualifying asset. If land is developed for lots, the capitalized interest cost is added to the cost of the land. The capitalized interest will then be properly matched against revenues when the lots are sold. If, however, the land is developed for a building, then the capitalized interest cost is added to the cost of the building, in which case the capitalized interest will be matched against related revenues as the building is depreciated.
Situations Where Capitalization of Interest Is Not Applicable
The capitalization of interest costs DOES NOT apply to the following situations:
- When routine inventories are produced in large quantities on a repetitive basis
- When the effects of capitalization would not be material, compared to the effect of expensing interest
- When qualifying assets are already in use or ready for use
- When qualifying assets are not being used and are not awaiting activities to get them ready for use
- When qualifying assets are not included in a consolidated balance sheet
- When principal operations of an investee accounted for under the equity method have already begun
- When regulated investees capitalize both the cost of debt and equity capital
- When assets are acquired with grants and gifts restricted by the donor to the extent that funds are available from those grants and gifts.
The Amount Of Interest To Be Capitalized
Interest cost includes the following:
- Interest on debt having explicit interest rates (fixed or floating)
- Interest related to capital leases
- Interest required to be imputed on payables (i.e., those due in over one year)
The most appropriate rate to use as the capitalization rate is the rate applicable to specific new debt resulting from the need to finance the acquired assets. If there is no specific new debt, the capitalization rate is a “weighted-average of the rates” of the other borrowings of the entity. This latter case reflects the fact that the previously incurred debt of the entity could be repaid if not for the acquisition of the qualifying asset. Thus, indirectly, the previous debt is financing the acquisition of the new asset and its interest is part of the cost of the new asset.
The selection of borrowings to be used in the calculation of the weighted-average of rates requires judgment. The amount of interest to be capitalized is that portion which could have been avoided if the qualifying asset had not been acquired. Thus, the capitalized amount is the incremental amount of interest cost incurred by the entity to finance the acquired asset.
If the reporting entity uses derivative financial instruments as fair value hedges to affect its borrowing costs, ASC 815-25-35 specifies that the interest rate to use in capitalizing interest is to be the effective yield that takes into account gains and losses on the effective portion of a derivative instrument that qualifies as a fair value hedge of fixed interest rate debt.
The amount of interest subject to capitalization could include amortization of the adjustments of the carrying amount of the hedged liability under ASC 815, if the entity elects to begin amortization of those adjustments during the period in which interest is eligible for capitalization. Any ineffective portion of the fair value hedge is not reflected in the capitalization rate.
During the deliberations with respect to ASC 815-25-35, the FASB staff expressed a belief that when variable-rate interest on a specific borrowing is associated with an asset under construction and capitalized as part of the cost of that asset, the amounts in accumulated other comprehensive income related to a cash flow hedge of the variability of that interest are to be reclassified into earnings over the depreciable life of the constructed asset, since that depreciable life coincides with the amortization period for the capitalized interest cost on the debt.
Once the appropriate rate has been established, the base to which that rate is to be applied is the average amount of accumulated net capital expenditures incurred for qualifying assets during the relevant time frame.
Capitalized costs and expenditures are not the same terms. Theoretically, a capitalized cost financed by a trade payable for which no interest is recognized is not a capital expenditure to which the capitalization rate is applied. Reasonable approximations of net capital expenditures are acceptable, however, and capitalized costs are generally used in place of capital expenditures unless there is expected to be a material difference. If the average capitalized expenditures exceed the specific new borrowings for the time frame involved, then the excess expenditures are multiplied by the weighted-average of rates and not by the rate associated with the specific debt. This requirement more accurately reflects the interest cost incurred by the entity to acquire the fixed asset.
The interest being paid on the debt may be simple or compound. Simple interest is computed on the principal alone, whereas compound interest is computed on the principal and on any interest that has not been paid. Most fixed assets will be acquired with debt subject to compound interest. Compound interest can be computed using compound interest tables or computer software.
The total amount of interest actually incurred by the entity is the ceiling for the amount of interest cost capitalized. The amount capitalized cannot exceed the amount actually incurred during the period involved. On a consolidated basis, the ceiling is defined as the total of the parent’s interest cost plus that of the consolidated subsidiaries. If financial statements are issued separately, the interest cost capitalized is limited to the amount that the separate entity has incurred, and that amount includes interest on intercompany borrowings. The interest incurred is a gross amount and is not netted against interest earned except in cases involving externally restricted tax-exempt borrowings.
Example Of Accounting For Capitalized Interest Costs
. On January 1, 2009, Putra Corp. contracted with Dharma Company to construct a building for $2,000,000 on land that Putra had purchased years earlier.
. Putra Corp. was to make five payments in 2009 with the last payment scheduled for the date of completion, December 31, 2009.
. Putra Corp. made the following payments during 2009:
January 1, 2009 $200,000
March 31, 2009 400,000
June 30, 2009 610,000
September 30, 2009 440,000
December 31, 2009 350,000
. Putra Corp. had the following debt outstanding at December 31, 2009:
- A 12%, three-year note dated 1/1/09 with interest compounded quarterly. Both principal and interest due 12/31/12 (relates specifically to building project). $850,000
- A 10%, ten-year note dated 12/31/03 with simple interest payable annually on December 31. $600,000
- A 12%, five-year note dated 12/31/05 with simple interest payable annually on December 31. $700,000
The amount of interest to be capitalized during 2009 is computed as follows:
Average Accumulated Expenditures
Date Expenditure Capitalization Average
period *) accumulated
1/1/09 $200,000 12/12 $200,000
3/31/09 400,000 9/12 300,000
6/30/09 610,000 6/12 305,000
9/30/09 440,000 3/12 110,000
12/31/09 350,000 0/12 —
Note: *) The number of months between the date expenditures were made and the date interest capitalization stops (December 31, 2009).
Potential Interest Cost to Be Capitalized
($850,000 × 1.12551) * – $850,000 = $106,684
65,000 × 0.1108** = 7,202
* The principal, $850,000, is multiplied by the factor for the future amount of $1 for four periods (quarterly compounding) at 3% to determine the amount of principal and interest due in 2009.
** Weighted-average interest rate:
10%, ten-year note $ 600,000 $60,000
12%, five-year 700,000 84,000
= Total interest / Total principal
= $144,000 / $1,300,000
= 11.08% weighted-average interest rate
The actual interest is calculated as follows:
12%, three-year note [($850,000 × 1.12551) – $850,000] = $106,684
10%, ten-year note ($600,000 × 10%) = 60,000
12%, five-year note ($700,000 × 12%) = 84,000
Total interest = $250,684
The interest cost to be capitalized is the lesser of $113,886 (avoidable interest) or $250,684 (actual interest), which is $113,886. The remaining $136,798 ( =$250,684 – $113,886) is expensed during 2009.
Determining The Time Period For Interest Capitalization
Three conditions must be met before capitalization commences:
- Necessary activities are in progress to get the asset ready to function as intended
- Qualifying asset expenditures have been made
- Interest costs are being incurred
As long as these conditions continue, interest costs are capitalized.
Necessary activities are interpreted in a very broad manner. They start with the planning process and continue until the qualifying asset is substantially complete and ready to function. Brief, normal interruptions do not stop the capitalization of interest costs. However, if the entity intentionally suspends or delays the activities for some reason, interest costs are not capitalized from the point of suspension or delay until substantial activities regarding the asset resume.
If the asset is completed in parts, the capitalization of interest costs stops for each part as it becomes ready. An asset that must be entirely complete before the parts can be used capitalizes interest costs until the total asset becomes ready.
Interest costs continue to be capitalized until the asset is ready to function as intended, even in cases where lower of cost or market rules are applicable and market is lower than cost. The required write-down is increased accordingly.
Capitalization Of Interest Costs Incurred On Tax-Exempt Borrowings
If qualifying assets have been financed with the proceeds from tax-exempt, externally restricted borrowings, and if temporary investments have been purchased with those proceeds, a modification is required. The interest costs incurred from the date of borrowing must be reduced by the interest earned on the temporary investment in order to calculate the ceiling for the capitalization of interest costs. This procedure is followed until the assets financed in this manner are ready. When the specified assets are functioning as intended, the interest cost of the tax-exempt borrowing becomes available to be capitalized by other qualifying assets of the entity. Portions of the tax-exempt borrowings that are not restricted are eligible for capitalization in the normal manner.
Assets Acquired With Gifts Or Grants
Qualifying assets that are acquired with externally restricted gifts or grants ARE NOT subject to capitalization of interest. The principal reason for this treatment is the concept that there is no economic cost of financing when a gift or grant is used in the acquisition.
Summary Of Interest Capitalization Requirements
Below diagram summarizes the accounting for interest capitalization: