Capitalized interest

What Is Capitalized Interest?

Capitalized interest refers to the accounting treatment where interest costs incurred during the construction or development of a qualifying asset are added to the asset's cost on the balance sheet, rather than being recognized immediately as an interest expense on the income statement. This falls under the broader discipline of financial accounting, specifically concerning the proper valuation of long-term assets. The principle behind capitalizing interest is to reflect the full cost of getting an asset ready for its intended use. By including interest in the asset's cost, the expense is then recognized over the asset's useful life through depreciation or amortization.

History and Origin

Historically, the treatment of interest costs varied significantly among companies, with some expensing all interest immediately and others capitalizing it. This lack of uniformity led to inconsistencies in financial reporting. During the 1960s, as the acquisition and construction of productive assets accelerated, the debate over interest capitalization intensified. In 1974, the U.S. Securities and Exchange Commission (SEC) temporarily suspended interest capitalization for most companies due to the absence of clear authoritative guidance, aiming to prevent varied accounting approaches.³⁶,³⁵

This suspension prompted the Financial Accounting Standards Board (FASB) to address the issue. In October 1979, the FASB issued Statement of Financial Accounting Standards No. 34 (SFAS 34), "Capitalization of Interest Cost," which established definitive standards for capitalizing interest as part of the historical cost of certain assets.³⁴,³³ This standard aimed to provide a measure of cost that more accurately reflects an entity's total investment in an asset and to align the expense recognition with the periods that benefit from the asset.³² The accounting standards have since evolved, with the core principles of SFAS 34 now codified primarily within ASC 835-20.

Key Takeaways

• Capitalized interest adds borrowing costs to the book value of qualifying assets under construction.
• This accounting treatment applies to assets that require a significant period to be ready for their intended use or sale.
• The objective is to match the total cost of an asset with the revenue it generates over its useful life.
• It impacts both the balance sheet (increasing asset value) and the income statement (deferring interest expense).
• Both U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) have specific rules governing interest capitalization.

Formula and Calculation

The amount of interest to be capitalized is generally determined by applying a capitalization rate to the average accumulated expenditures for the qualifying asset during the construction period. The total amount of interest capitalized in an accounting period cannot exceed the total interest cost incurred by the entity during that period.³¹,³⁰

The formula can be expressed as:

Where:

• Average Accumulated Expenditures (AAE): The weighted-average amount of expenditures made on the qualifying asset during the capitalization period. These expenditures are typically calculated on a monthly or quarterly basis.²⁹
• Capitalization Rate: The interest rate used to determine the amount of interest to be capitalized. If specific debt is directly associated with the asset's construction, its interest rate can be used. Otherwise, a weighted-average interest rate of the entity's general outstanding borrowings is applied.²⁸,²⁷

The capitalization period 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 costs are being incurred.²⁶,²⁵ It ceases when the asset is substantially complete and ready for its intended use, or when construction activities are suspended for an extended period.²⁴

Interpreting the Capitalized Interest

Interpreting capitalized interest involves understanding its impact on an entity's financial statements and overall financial health. By capitalizing interest, a company defers the recognition of a current period expense into a future period. This means that during the construction phase, the company's reported net income may appear higher than if the interest had been expensed immediately, as the interest cost is added to the asset's carrying value on the balance sheet.²³

Once the asset is completed and placed into service, the capitalized interest becomes part of the asset's depreciable or amortizable cost. This cost is then systematically expensed over the asset's useful life through non-cash charges like depreciation or amortization. This accounting treatment aims to align the cost of obtaining the asset with the revenues it helps generate over its operational life, adhering to the matching principle of accounting. For investors and analysts, understanding capitalized interest is crucial for accurate financial modeling and assessing a company's true return on investment from its capital projects.

Hypothetical Example

Imagine "MegaCorp Inc." decides to build a new manufacturing facility. The construction begins on January 1, 2025, and is expected to take two years. MegaCorp takes out a specific construction loan of $10,000,000 at an annual interest rate of 6% to finance the project.

Let's assume the expenditures for the first year are as follows:

• January 1: $2,000,000
• April 1: $3,000,000
• August 1: $2,000,000
• November 1: $1,000,000

Total expenditures for the year: $8,000,000.

To calculate the average accumulated expenditures for the year, we can weight each expenditure by the portion of the year it was outstanding:

• $2,000,000 x (12/12) = $2,000,000
• $3,000,000 x (9/12) = $2,250,000
• $2,000,000 x (5/12) = $833,333
• $1,000,000 x (2/12) = $166,667

Sum of weighted expenditures = $5,250,000.
Average Accumulated Expenditures (AAE) = $5,250,000.

Using the loan's interest rate as the capitalization rate (6%):
Capitalized Interest for Year 1 = $5,250,000 x 0.06 = $315,000.

This $315,000 would be added to the cost of the new facility on MegaCorp's balance sheet, increasing the asset's carrying value. Instead of being recorded as an interest expense in 2025, it becomes part of the capital expenditures for the new plant. Once the facility is complete and operational, this capitalized interest will be expensed over the asset's useful life through depreciation.

Practical Applications

Capitalized interest is primarily applied in industries with significant long-term construction projects or where assets take a substantial period to prepare for their intended use. This includes real estate development, utilities, manufacturing (for new plant construction), and large-scale infrastructure projects.

For instance, a utility company building a new power plant will capitalize the interest on debt incurred to finance its construction. Similarly, a real estate developer will capitalize interest on loans used to fund a multi-year residential or commercial property development.²²

The Internal Revenue Service (IRS) also has rules regarding capitalized interest, particularly under the uniform capitalization (UNICAP) rules. IRS Publication 535, "Business Expenses," provides guidance on when interest must be capitalized for tax purposes, often differing from GAAP requirements due to their distinct objectives.²¹,²⁰,¹⁹ For example, tax rules may require capitalization for a broader range of production expenditures, including pre-production activities.¹⁸,¹⁷

When an entity accounts for an investment using the equity method, interest may also be capitalized on advances or loans to the equity affiliate if the investee is still in the development phase and using funds to acquire qualifying assets.¹⁶,¹⁵ This ensures that the investor's total investment in the project, including the cost of financing, is appropriately recorded. This accounting practice impacts a company's financial statements and the calculation of key metrics like cost of goods sold for certain produced assets.

Limitations and Criticisms

While capitalized interest aims to provide a more accurate depiction of an asset's total cost, it has faced certain criticisms and presents limitations. One primary concern is that it can inflate reported earnings and return on investment during the construction phase, as interest expenses are deferred rather than immediately recognized.¹⁴ This can obscure a company's true debt servicing costs and current profitability, potentially presenting a rosier financial picture than is warranted by its underlying cash flow.

Critics also argue that capitalizing interest can complicate financial analysis, making it more challenging to compare companies that have ongoing construction projects with those that do not, or with companies that follow different accounting treatments (where allowed).¹³ Determining the "average accumulated expenditures" and the appropriate "capitalization rate" can involve judgment, which introduces a degree of subjectivity into the accounting process.¹²,¹¹

Furthermore, the differences between GAAP rules for financial reporting and IRS rules for tax purposes (such as those outlined in IRS Publication 535) can create complexities for businesses, requiring separate calculations and potentially leading to deferred tax implications.¹⁰ Although the IASB revised its guidance in IAS 23, "Borrowing Costs," to align more closely with U.S. GAAP's mandatory capitalization approach, some historical debate existed about whether expensing or capitalizing was superior.⁹ Despite its weaknesses, when applied consistently and transparently, capitalized interest can provide valuable information about an entity's investment in productive assets.⁸

Capitalized Interest vs. Interest Expense

The key distinction between capitalized interest and interest expense lies in their accounting treatment and impact on financial statements.

Confusion often arises because both involve borrowing costs. However, capitalized interest specifically ties these costs to the creation of a future productive asset, treating them as part of the asset's "all-in" cost. Conversely, interest expense is treated as a period cost, reflecting the routine cost of financing operations.⁷ Understanding this difference is crucial for accurately assessing a company's asset base and profitability.

FAQs

What types of assets qualify for interest capitalization?

Generally, assets that require a substantial period to get ready for their intended use or sale qualify for interest capitalization. This primarily includes assets that are constructed or produced for an entity's own use (like buildings, machinery, or facilities), or assets intended for sale or lease that are constructed as discrete projects (such as real estate developments or ships).⁶,⁵

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 costs are being incurred. Capitalization typically ends when the asset is substantially complete and ready for its intended use or sale, even if it has not yet been placed in service.⁴,³

Does capitalizing interest improve a company's financial performance?

Capitalizing interest can initially make a company's reported net income appear higher during the construction phase because the interest cost is deferred rather than expensed immediately. However, it does not inherently improve a company's underlying operational profitability or cash flow. The capitalized interest will eventually be expensed through depreciation or amortization over the asset's life, impacting future periods.

Is capitalized interest a cash expense?

No, capitalized interest is not a cash expense in the period it is capitalized. The actual cash payment for interest occurs when the debt payment is made. Capitalizing interest is an accounting entry that reclassifies the interest cost from an immediate expense to an asset's cost. The cash outlay for the interest already occurred when the company made its loan payments.

Are all borrowing costs eligible for capitalization?

No, only borrowing costs directly attributable to the acquisition, construction, or production of a qualifying asset are eligible for capitalization. General interest expenses incurred for other purposes, such as financing regular operations or purchasing non-qualifying assets, are not capitalized and are expensed as incurred.²,¹