Capitalized Interest

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 statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more, 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 –

Steps to Calculate Capitalized Interest

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For eg:
Source: Capitalized Interest (wallstreetmojo.com)

Below are the steps for calculation of capitalized interest –

  1. Find the Capitalization Period.

    The first step is to understand the time period until when the construction of the fixed assetFixed AssetFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples.read more 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.

  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)

  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 incomeInvestment IncomeInvestment income is the earnings made from allocating funds in financial instruments or assets like securities, mutual funds, bonds, property, etc. It includes dividends on bonds and interest received on bank deposits, profits and capital gain from the sale of real estate and securities. read moreInvestment income is the earnings made from allocating funds in financial instruments or assets like securities, mutual funds, bonds, property, etc. It includes dividends on bonds and interest received on bank deposits, profits and capital gain from the sale of real estate and securities. read moreInvestment income is the earnings made from allocating funds in financial instruments or assets like securities, mutual funds, bonds, property, etc. It includes dividends on bonds and interest received on bank deposits, profits and capital gain from the sale of real estate and securities. read more 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.

  4. Calculate Avoidable Interest


    Capitalized Interest Calculation

  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.

  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

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 sheetsBalance SheetsA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more 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

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