Capitalized Interest

What is Capitalized Interest?

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 5 percent interest rate the $100,000 loan which is borrowed to construct windmills. It takes one year to complete the construction. This implies that the cost of the windmill will not only include the initial cost of asset 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.
• Capitalized Interest becomes a part of the long-term asset and is depreciated over the useful life.

Steps to Calculate Capitalized Interest

Capitalized Interest Cash 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 on 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

For calculating the capitalized interest cost, we need to calculate Avoidable Interest.

Step 5 – Calculate Actual Interest on Loans

Actual interest on the overall loan is also straightforward. You can calculate this directly multiplying the corresponding interest rate to the debt raised.

Step 6 – Select the lower of Actual Interest and Avoidable Interest as Capitalized Interest

Capitalized Interest = Lower (Actual Interest, Avoidable Interest)

Capitalized 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 10% interest rate (taken for the specific purpose of constructing the builidng)
• $75,000 at 8% interest rate (general loan)

The following payments were made for the 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 Jan, 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 on the specific borrowings and from the general funds.

• $60,000 at 10% interest rate (taken for the specific purpose of constructing the builidng)
• $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 of Capitalized Interest

• 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 of Capitalized Interest.
• Capitalized interest has no immediate effect on a company’s income statement when booked and it appears on the income statement through a depreciation expense instead.
• When a company or an organization capitalizes the accrued interest, 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 allow 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.

Recommended Articles

This has been a guide to what is Capitalized Interest Accounting. Here we discuss a step by step approach to calculate capitalized interest along with practical examples. You can learn more about accounting basics from the following articles –

• Depreciation Expense Formula – Examples
• Accrued Interest Meaning
• Formula of Capital Expenditure (CAPEX)
• Loan Amortization
• Capital Expenditure
• What are Accounting Policies?
• Bonds Payable on Balance Sheet