Capitalization of interest

What Is Capitalization of Interest?

Capitalization of interest is an accounting principle within Financial Accounting that requires certain interest costs incurred during the acquisition or construction of a qualifying asset to be added to the asset's cost, rather than being expensed immediately. This practice ensures that the historical cost of an asset accurately reflects all costs necessary to bring it to its intended use. It impacts how expenditures are reported on a company's Balance Sheet and subsequently recognized as an expense over the asset's useful life through Depreciation or Amortization. The core idea behind capitalization of interest is that interest costs, like other direct costs, are a necessary component of the overall investment in a self-constructed or specially produced Qualifying Asset.

History and Origin

The concept of capitalizing interest has evolved through various accounting standards. In the United States, the Financial Accounting Standards Board (FASB) formalized the practice with the issuance of Statement No. 34, "Capitalization of Interest Cost," in October 1979. This standard established the criteria for when interest cost should be capitalized as part of the historical cost of acquiring certain assets, particularly those requiring a substantial period to get ready for their intended use.³⁸ Internationally, the International Accounting Standards Board (IASB) addresses this through International Accounting Standard 23 (IAS 23), "Borrowing Costs." First issued by the International Accounting Standards Committee in December 1993 and subsequently revised by the IASB in March 2007, IAS 23 mandates that borrowing costs directly attributable to the acquisition, construction, or production of a qualifying asset must be capitalized.³⁷,³⁶ Prior to the 2007 revision, IAS 23 permitted both capitalization or immediate expensing, but the option for immediate expensing was eliminated to enhance comparability.³⁵

Key Takeaways

• Capitalization of interest adds certain borrowing costs to the asset's cost rather than recognizing them as immediate Interest Expense.
• This practice applies to "qualifying assets," typically those requiring a significant Construction Period to prepare for use or sale.
• The objective is to present a more accurate total investment in the asset and match costs with the revenues the asset helps generate over its useful life.
• Capitalized interest is subsequently expensed through depreciation or amortization over the asset's life.
• The decision to capitalize or expense affects a company's Income Statement, balance sheet, and Cash Flow Statement, influencing reported profitability and cash flow from operations.

Formula and Calculation

The amount of interest to be capitalized is determined by applying a capitalization rate to the weighted-average accumulated expenditures for the qualifying asset during the capitalization period. This approach is often referred to as the "avoided cost method," meaning the interest that theoretically could have been avoided if expenditures for the qualifying asset had not been made is capitalized.³⁴,³³

The calculation generally involves:

1. Determining the weighted-average accumulated expenditures: This considers the average amount of expenditures on the asset over the capitalization period.
2. Identifying the capitalization rate:
   • For specific borrowings used to finance the asset, the interest rate on that specific loan is used.
   • For expenditures exceeding specific borrowings, or when no specific borrowing exists, a weighted-average interest rate of the entity's other outstanding borrowings is applied.³²,³¹
3. Calculating the capitalizable interest: This is the result of applying the capitalization rate to the weighted-average accumulated expenditures.

The total amount of interest cost capitalized in an accounting period cannot exceed the total amount of actual interest cost incurred by the entity in that period.³⁰,²⁹,²⁸

The calculation can be illustrated as:

Where:

• Weighted-Average Accumulated Expenditures: Represents the average amount of funds tied up in the asset's construction during the period.
• Capitalization Rate: The interest rate used to determine the amount of interest to capitalize, derived from specific or general borrowings.

Interpreting the Capitalization of Interest

Capitalization of interest provides a clearer picture of the true cost of creating a Long-term Asset. By including interest costs in the asset's carrying value, the accounting aims to match the expenses associated with generating future revenues. If a company expenses interest immediately, the asset's initial cost on the Balance Sheet would be lower, and current period Income Statement would show higher Interest Expense.

Conversely, capitalizing interest leads to a higher asset value and defers the recognition of these costs to future periods through Depreciation or Amortization. This deferral can make reported profitability appear smoother over time.²⁷,²⁶ For external users of financial statements, understanding whether a company capitalizes interest is crucial for accurate financial analysis, as it directly impacts metrics like Return on Assets and other Financial Ratios.

Hypothetical Example

Suppose XYZ Corp is constructing a new manufacturing plant for its own use, which will take two years to complete. To finance the construction, XYZ Corp takes out a construction loan of $10 million at an annual interest rate of 6%.

In the first year, XYZ Corp incurs $4 million in construction expenditures evenly throughout the year. The weighted-average accumulated expenditures for the year would be approximately half of the total expenditures, or $2 million (assuming expenditures occurred mid-year on average for simplicity).

The capitalizable interest for the first year would be:

This $120,000 is added to the cost of the new manufacturing plant on the balance sheet, rather than being reported as an Interest Expense on the Income Statement for the current year. The total cost of the plant at the end of the first year for accounting purposes would include the $4 million in direct expenditures plus the $120,000 in capitalized interest. This total capitalized cost will then be depreciated over the plant's useful life once it is placed in service.

Practical Applications

Capitalization of interest is primarily seen in industries with significant long-term construction projects or the production of qualifying Assets.

• Real Estate Development: Developers often capitalize interest costs incurred on loans used to finance the construction of properties intended for sale or lease. This ensures that the full cost of the property, including financing costs during the Construction Period, is reflected in the inventory or fixed assets.
• Utilities: Companies in the utility sector frequently undertake large infrastructure projects, such as power plants or transmission lines. Interest costs during the construction of these substantial Long-term Assets are capitalized. For municipal utilities, while Governmental Accounting Standards Board (GASB) Statement No. 89 generally requires expensing construction period interest, an exception allows for recording it as a "regulatory asset" when such costs are recovered in utility rates.²⁵,²⁴ Some large utilities carry significant debt loads, and managing their capitalization situation is a key focus.²³
• Manufacturing: A manufacturing company building a new factory or a specialized machine for its own operations would capitalize the interest incurred on debt financing these projects.
• Tax Compliance: From a tax perspective, the Internal Revenue Service (IRS) also has rules requiring interest capitalization under IRC Section 263A(f) for certain "designated property" produced by a taxpayer, especially real property and tangible personal property with a depreciable class life of 20 years or more.²²,²¹ These rules are distinct from financial accounting standards but also require interest costs to be added to the basis of an asset.
• Financial Institutions: For financial institutions, "capitalized interest on loans" generally refers to uncollected interest added to the unpaid principal, often in cases of loan workouts or modifications. The Office of the Comptroller of the Currency (OCC) has provided guidelines on the accounting treatment for such capitalization, emphasizing that it should be based on the borrower's ability to repay the debt.²⁰

Limitations and Criticisms

While capitalization of interest aims to improve financial reporting accuracy, it has limitations and can sometimes be a point of criticism:

• Impact on Financial Statements: Capitalizing interest can initially present a more favorable picture of current profitability because the interest is not immediately recognized as an Interest Expense on the Income Statement. Instead, it increases Assets on the Balance Sheet, and the expense is deferred over the asset's useful life through Depreciation or Amortization. This can make a company's financial results appear "smoother" but may not fully reflect the immediate cash burden of debt servicing.¹⁹,¹⁸
• Comparability Issues: Different accounting standards (e.g., U.S. Generally Accepted Accounting Principles (GAAP) vs. International Financial Reporting Standards (IFRS) in certain historical contexts, or GASB for governmental entities) and interpretations can lead to variations in how interest is capitalized, potentially hindering comparability across entities.¹⁷ For example, while IFRS IAS 23 largely aligns with U.S. GAAP on mandatory capitalization, governmental accounting standards (GASB 89) now generally require expensing construction period interest for municipal utilities unless specific regulatory asset criteria are met.¹⁶
• Subjectivity: Determining the "capitalization rate" and identifying expenditures that qualify can involve management judgment, which might introduce some subjectivity into the accounting process. However, accounting standards like FASB ASC 835-20 provide specific criteria for when the capitalization period begins and ends, and which assets qualify.¹⁵,¹⁴
• Complexity: The record-keeping and calculations for capitalization of interest can be complex, especially for large, ongoing projects with various funding sources.¹³
• Cash Flow Presentation: While capitalizing interest increases reported cash flow from operations (as the cash outlay is classified as an investing activity), the actual cash outflow for interest payments remains the same. This can sometimes be misconstrued by less informed users.¹²,¹¹

Capitalization of Interest vs. Expensing of Interest

The primary difference between capitalization of interest and Expensing of Interest lies in the timing and classification of the cost on a company's financial statements.

Confusion often arises because both methods involve interest payments. However, capitalization applies specifically when interest is incurred to finance the acquisition, construction, or production of an asset that will provide future economic benefits, whereas expensing applies to routine interest costs associated with general operations or short-term borrowings.

FAQs

What types of assets qualify for capitalization of interest?

Generally, assets that require a substantial period of time to get ready for their intended use or sale qualify for capitalization of interest. This includes assets constructed for a company's own use (like buildings or equipment), or discrete projects intended for sale or lease (such as ships or real estate developments).⁸,⁷ Assets that are routinely manufactured in large quantities or are ready for use when acquired typically do not qualify.

When does interest capitalization begin and end?

Interest capitalization begins when three conditions are met: expenditures for the asset have been made, activities necessary to get the asset ready for its intended use are in progress, and interest cost is being incurred.⁶,⁵ Capitalization ceases when the asset is substantially complete and ready for its intended use.⁴ Capitalization is suspended during extended periods where active development of the asset is halted.³,

How does capitalization of interest affect a company's financial statements?

Capitalization of interest increases the recorded value of Assets on the Balance Sheet in the period of construction. On the Income Statement, it delays the recognition of interest costs as an expense, instead spreading them out over the asset's useful life through Depreciation or Amortization. On the Cash Flow Statement, the cash outflow related to capitalized interest is reported under investing activities, which typically results in higher reported cash flow from operating activities compared to immediate expensing.²,¹