What is Capitalized Interest?
Capitalized Interest is the cost of borrowing incurred by the company in order to acquire or construct the long term asset to be used in the business and is added in the value of the asset to be shown in the balance sheet of the company instead of showing it as an interest expense in the company’s income statement.
In simple words, Capitalized Interest is interest accrued during the construction of long-term assets, and is included as the initial cost of assets on the balance sheet instead of being charged off as interest expense on the income statement.
For example: At a 5 percent interest rate, the $100,000 loan is borrowed to construct windmills. It takes one year to complete the construction. This implies that the cost of the windmill will include not only the initial cost of assets but also the interest expense required to be paid off for the load. The total cost will be $100,000 + $5000 = $105,000. Here please note that interest expense is not reported in the income statement, whereas the capitalized interest is added to the cost of the long-term asset.
- Under the accrual basis of accounting, it is reported in the balance sheet as the total amount of fixed assets. An organization using a construction loan to build its own corporate headquarters is another example of such a situation.
- It becomes a part of the long-term asset and is depreciated over the useful life.
Steps to Calculate Capitalized Interest
It can be calculated using the following steps –
Step 1 – Find the Capitalization Period.
The first step is to understand the time period until when the construction of the fixed asset will take place, and by when the asset will be ready for use. Capitalization of borrowing costs terminates when the asset has been prepared its intended use and has substantially completed all activities needed. The capitalization period will not be extended by work on minor modifications. If the entity can use some parts while construction continues on other parts, then it should discontinue capitalization of borrowing costs on the parts that it completes.
Step 2 – Calculate Weighted Average Accumulated Expenditure.
It is the product of the expenditure for the construction of a fixed asset and is time-weighted for the accounting year.
Weighted Average Accumulated Expenditure = Expenditure x (months in capitalization/12)
Step 3 – Determine the interest in the specific borrowings and from the general funds.
- If the loan was specifically taken for the construction of fixed assets, then the actual borrowing cost incurred is the borrowing cost to capitalize minus any kind of investment income earned from the interim investment of those borrowings.
- For general corporate needs, borrowings may be handled centrally and could be obtained via a variety of debt instruments. During the period applicable to the asset, in this case, gain an interest rate from the weighted average of the entity’s borrowing costs. Using this method, the number of allowable borrowing costs at the entity’s total borrowing costs during the applicable period.
Step 4 – Calculate Avoidable Interest
Step 5 – Calculate Actual Interest on Loans
The actual interest on the overall loan is also straightforward. You can calculate this directly, multiplying the corresponding interest rate to the debt raised.
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Step 6 – Select the lower of Actual Interest and Avoidable Interest.
Capitalized Interest = Lower (Actual Interest, Avoidable Interest)
Example
RKDF construction started construction of a building that is to be used for production. The construction of the building will end by 31st December, and the building will be ready to use.
The following Debt was outstanding from 1st January 2017.
- $60,000 at a 10% interest rate (taken for the specific purpose of constructing the building)
- $75,000 at 8% interest rate (general loan)
The following payments were made for the construction of the building –
- 1st Feb, 2017 – $50,000
- 1st August, 2017 – $75,000
Calculate Capitalized Interest?
Step 1 – Capitalizion Period
As given in the information above, the capitalization period will be from 1st January 2017 to 31st December 2017.
Step 2 – Calculate Weighted Average Accumulated Expenditure.
Weighted Average Accumulated Expenditure = 50,000 x (11/12) + $75,000 x (5/12) = $45,833 + $31,250 = $77,083
Step 3 – Determine the interest in the specific borrowings and from the general funds.
- $60,000 at 10% interest rate (taken for the specific purpose of constructing the building)
- $75,000 at 8% interest rate (general loan)
Step 4 – Calculate Avoidable Interest
Avoidable Interest = = $60,000 x 10% + (77,083 – $60,000) x 8% = $6000 + $1,367 = $7,367
Step 5 – Calculate Actual Interest on the Loans
Actual Interest on the Loans = $60,000 x 10% + $75,000 x 8% = $6,000 + $6,000 = $12,000
Step 6 – Lower of Actual Interest and Avoidable Interest
Capitalized Interest = ($7,367, $12,000) = $7,367
Features
- Capitalizing interest helps a user of financial statements, from the perspective of accrual accounting, to have a better allocation of costs to earnings in the periods when an acquired asset is being used and obtain an accurate measure of the acquisition cost of an asset.
- If an impact on a company’s financial statements is material, capitalized interest can then be booked; else, there is no need.
- It has no immediate effect on a company’s income statement when booked, and it appears on the income statement through a depreciation expense instead.
- Since the last payment, it considers the total amount of interest it owes on a loan balance or long-term asset and by adding the total interest owed to the total cost of the loan balance or long-term asset capitalizes it.
- For students to defer the loan, Capitalized Interest is the most common way where interest is added to the principle of the loan, which increases the interest owed monthly.
Conclusion
To set the acquiring assets up for their intended use for a period of time, capitalized interest is part of the historical cost. The GAAP allows firms to avoid expensing interest on the debt as many companies finance the construction of long-term assets with debt and include it on their balance sheets as a component of a historical cost of long-term assets. Various production facilities, ships, and real estate involve the long-term assets for which Capitalized Interest is allowed. Inventories that are manufactured over and over again in large quantities, capitalizing interest is not permitted for them.
Capitalized Interest Video
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