If interest is capitalized, it is included in the cost of carry. Capitalizing interest is common in construction projects. The interest cost is included as an asset versus being expensed on the income statement for the period it occurred.

In the U.S., SFAS 34 governs the capitalization of interest cost during an accounting period. SFAS 34 requires that the interest cost incurred during a construction period is accounted for as a long-lived asset. To be capitalized, the interest must be from borrowed money. If no specific borrowing is identified, interest can be estimated by means of a weighted average interest rate on outstanding debt for the amount invested.

Example:
A company built a building for $1m. It borrowed $500,000 at 5% to build the building. In this case the interest capitalized will amount to $25,000.

Another company built a building for $1m. It borrowed $500,000 at 5% to build the building; it also had an outstanding debenture of $3m at 10% and a $1M mortgage at 15%. In this case, the interest capitalized will amount to:

500,000 * 5% = 25,000
500,000 * 10% = 50,000
Total 75,000

Interest to be expensed = total interest paid - capitalized interest

= 25,000+300,000+150,000-75,000
= 400,000

The total capitalized interest is $75,000 because we assume the $500,000 balance was financed through the debenture. The reason we do not consider the mortgage is that it is already assigned to another identifiable asset.

Some argue that the capitalization costs of self-financed assets should not be included.

The decision to capitalize interest will have an effect on a company's:

  • Net income - In the current period earnings will be higher (overstated).
  • CFO - In the current period, CFO will be higher (overstated) because the interest expense will be included in CFI.
  • CFI - In the current period, CFI will be lower (understated).
  • Assets - Total assets will be overstated because they include the capitalized interest.
  • Solvency ratios - Since assets, EBIT and stockholders' equity will be higher, all solvency ratios will be overstated.


Capitalizing Intangible Assets

Related Articles
  1. Investing

    Understanding Capitalized Interest

    Capitalized interest is associated with debt used to make or construct a depreciable asset.
  2. Small Business

    Explaining Cost Of Capital

    Cost of capital is the cost of funds used to finance a business.
  3. Personal Finance

    Calculating Interest Expense

    Interest expense is the cost of borrowing money.
  4. Investing

    Explaining Capitalized Cost

    A capitalized cost is an expense associated with a fixed asset that is added to the basis of that asset and expensed over its depreciable life.
  5. Small Business

    Understanding Capital

    Capital has a variety of meanings, but it generally refers to financial resources.
  6. Investing

    Understanding Capital Assets

    A capital asset is one that a company plans on owning for more than one year, and uses in the production of revenue.
  7. Investing

    Explaining Capital Employed

    Generally, capital employed refers to all of the assets used in a business that contribute to the company’s ability to earn revenue.
  8. Small Business

    What's Capitalization?

    Capitalization has different meanings depending on the context.
  9. Investing

    Ares Capital (ARCC) to Buy Rival for $3.4 bln (ARCC, ACAS)

    Private equity firm Ares Capital inks deal to acquire smaller rival American Capital for $3.4 bln in stock and cash.
  10. Small Business

    Understanding Capital Investment

    Capital investment is a term that describes a company’s expenditures for long-term assets used in the operation of its business.
Trading Center