What Is Capital Interest?
Capital interest, in the realm of accounting, refers to the cost of borrowing funds specifically incurred during the construction or development of a long-term asset. Instead of being recognized immediately as an interest expense on the income statement, this interest is added to the historical cost of the asset on the balance sheet. This process, known as capitalization, ensures that all costs necessary to bring an asset to its intended use are included in its value, aligning with the Generally Accepted Accounting Principles (GAAP) matching principle. Once the asset is ready for its intended use, the capitalized interest is then expensed over the asset's useful life through depreciation.18, 19, 20
History and Origin
The concept of capitalizing interest costs developed to provide a more accurate representation of an asset's total investment cost. Historically, there was varied practice regarding which interest costs should be included in the cost of an asset. To standardize this, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 34, "Capitalization of Interest Cost," in October 1979. This authoritative guidance, now largely codified under ASC 835-20, established the standards for capitalizing interest as part of the historical cost of acquiring certain assets.15, 16, 17 The core principle is that if an asset requires a period of time for activities necessary to bring it to its intended condition and location, the interest cost incurred during that period from expenditures for the asset is considered part of its historical cost.13, 14
Key Takeaways
- Capital interest is the cost of financing incurred during the construction of a self-built fixed asset.
- It is added to the asset's cost on the balance sheet rather than expensed immediately.
- This capitalization aligns with accounting principles by matching expenses to the period in which the asset generates revenue.
- Once the asset is ready for use, the capitalized interest is expensed through depreciation over the asset's useful life.
- Specific rules for capitalization are outlined in accounting standards and tax regulations.
Formula and Calculation
The amount of capital interest to be capitalized is determined by applying a capitalization rate to the weighted-average accumulated expenditures for the asset during the period of construction. The total interest capitalized in an accounting period cannot exceed the total interest cost incurred by the entity in that period.12
The general approach involves:
- Identify Qualifying Assets: Assets that are constructed for an entity's own use or discrete projects built for lease or sale (not routine inventory) generally qualify.
- Determine Capitalization Period: This begins when expenditures for the asset have been made, activities to prepare the asset are in progress, and interest costs are being incurred. It ends when the asset is substantially complete and ready for its intended use.11
- Calculate Weighted-Average Accumulated Expenditures: This considers the amount and timing of cash outflows for the construction project.
- Determine Capitalization Rate:
- For debt specifically incurred to finance the asset, use the interest rate on that specific debt.
- For expenditures exceeding specific borrowings, use the weighted-average interest rate of other general borrowings of the entity.
The formula for capitalized interest typically involves:
Where:
- Weighted-Average Accumulated Expenditures: The average amount of funds spent on the asset during the capitalization period.
- Capitalization Rate: The applicable interest rate(s) on specific or general borrowings.
The principal balance of the underlying loans directly influences the interest costs that may be capitalized.
Interpreting the Capital Interest
Interpreting capital interest involves understanding its impact on a company's financial reporting. By capitalizing interest, a company avoids immediate recognition of these costs as expenses, which can result in higher reported net income in the short term. Instead, these costs are spread out over the asset's useful life through depreciation. This treatment provides a more accurate reflection of the true cost of bringing a large-scale project, such as a new manufacturing plant or corporate headquarters, to its operational state. It allows for a better matching of costs with the revenues that the asset is expected to generate over its economic life.
Hypothetical Example
Imagine TechCorp is building a new data center. The construction period is 12 months, and the company takes out a construction loan of $10 million at an annual interest rate of 6%. Over the 12 months, the company incurs expenditures for building materials, labor, and other construction costs.
Let's assume the weighted-average accumulated expenditures for the data center during the year is $8 million.
To calculate the capital interest for the year:
Instead of recording $480,000 as an interest expense on its income statement for the year, TechCorp adds this amount to the total cost of the data center on its balance sheet. So, if the direct construction costs were $9 million, the total cost of the asset recorded would be $9 million + $480,000 = $9,480,000. This $9,480,000 would then be depreciated over the data center's estimated useful life, affecting the income statement in future periods.
Practical Applications
Capital interest appears in various real-world scenarios, primarily in industries with significant capital expenditures and long construction periods. It is commonly applied in:
- Real Estate Development: Companies building large commercial properties, residential complexes, or industrial facilities capitalize interest on loans taken to finance these projects during the construction phase.
- Utilities and Infrastructure: Power plants, pipelines, and transportation networks often involve multi-year construction, making interest capitalization a key aspect of their asset accounting.
- Manufacturing: Businesses constructing new factories or significant expansions capitalize interest incurred during the build-out.
From a regulatory perspective, both accounting standards bodies like FASB and tax authorities like the Internal Revenue Service (IRS) have specific rules governing capital interest. The IRS, for instance, details accounting methods and periods in IRS Publication 538, which informs taxpayers on how to properly report income and expenses, including interest capitalization.9, 10 Recent changes in new IRS regulations for property improvements also highlight the ongoing relevance and evolving nature of these rules.8 Understanding the prevailing Federal Funds Effective Rate and broader interest rate environment is crucial when estimating the potential impact of interest capitalization on project costs and financial statements.7
Limitations and Criticisms
While capital interest aims to provide a more accurate asset cost, it does have limitations and faces some criticisms. One primary concern is that it can obscure a company's true borrowing costs in the period they are incurred. By moving interest expense from the current period's income statement to the balance sheet as part of an asset, a company's immediate profitability might appear stronger than if the interest were expensed. This deferral of expenses can affect financial ratios and profitability analysis.
Another criticism relates to the complexity in determining the "weighted-average accumulated expenditures" and the appropriate capitalization rate, especially when a company has multiple projects and various sources of debt. Judgments are required, which can introduce subjectivity into the financial statements. Furthermore, if a project experiences significant delays, the capitalized interest continues to accrue, increasing the asset's cost without a corresponding increase in its operational readiness, potentially distorting its initial valuation. The rules for interest capitalization on investments accounted for by the equity method also present complexities, as detailed in accounting standards.6
Capital Interest vs. Expensed Interest
The key distinction between capital interest and expensed interest lies in their treatment on a company's financial statements and their impact on profitability and asset valuation.
| Feature | Capital Interest | Expensed Interest |
|---|---|---|
| Timing | Incurred during asset construction/development | Incurred on general borrowings or after asset is operational |
| Financial Statement Impact | Added to the cost of the asset on the balance sheet; expensed later through depreciation | Recognized immediately as an expense on the income statement |
| Purpose | To include all costs necessary to bring an asset to its intended use | To reflect the cost of borrowing funds for general operations |
| Effect on Net Income | Defers expense, potentially resulting in higher current net income | Reduces current net income |
The confusion between the two often arises because both relate to the cost of borrowing. However, capital interest is a specific application within accrual accounting for self-constructed assets, while expensed interest represents the more common treatment for most other debt-related costs.
FAQs
What types of assets qualify for interest capitalization?
Assets that qualify for capital interest are typically those that require a significant period of time to get ready for their intended use. This includes assets constructed for a company's own use (like a new building or machinery) or assets built through discrete projects for subsequent sale or lease (excluding routine inventory).5
How does capitalizing interest affect a company's taxes?
When interest is capitalized, it increases the basis of the asset rather than being immediately deductible as an expense. This means the tax deduction for this interest is recovered over the asset's useful life through depreciation or amortization, or when the asset is sold. This can defer tax deductions compared to immediately expensing the interest, impacting a company's taxable income in the short and long term.2, 3, 4
Can a company choose whether to capitalize interest or expense it?
No, the decision to capitalize interest is not optional for qualifying assets under GAAP. If the conditions for capitalization are met (expenditures made, activities in progress, interest being incurred), a company is generally required to capitalize the interest costs. This ensures consistency and comparability in financial reporting across different entities.1