Assets - Computing the Effects of Capitalizing vs. Expensing

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. Career Education & Resources

    How Hard are the CFA Exams?

    Learn about the difficulty of the CFA exams with a description of the tests, some statistics on pass rates and suggestions that can help you pass the exams.
  2. Professionals

    What it Takes to be a Financial Analyst

    A financial analyst researches companies and economic conditions to make business, sector and industry recommendations.
  3. Career Education & Resources

    Financial Analyst: Career Path & Qualifications

    Read about what it takes to become a financial analyst in a corporation or securities firm, and learn how far you can rise in the profession.
  4. Career Education & Resources

    Financial Planner: Career Path & Qualifications

    Learn what education and certifications you need to become a financial planner, as well as the future prospects and earnings potential for financial planners.
  5. Career Education & Resources

    Where to Find Non-Profit Finance Jobs

    The non-profit sector offers a stable selection of jobs for those who seek other types of fulfillment from their jobs than just purely financial.
  6. Career Education & Resources

    Portfolio Manager: Career Path & Qualifications

    Learn about the basic requirements for getting hired as a portfolio manager, and discover how most professionals in the field rise into the position.
  7. Your Practice

    4 Professional Associations Advisors Should Join

    These four professional organizations are among the most respected and well known in the industry.
  8. Professionals

    Equity Research: Career Path and Qualifications

    Find out what equity research analysts do on a day-to-day basis, and learn more about the typical career progression for these securities professionals.
  9. Professionals

    What's on the CFA Level II Exam?

    The Chartered Financial Analyst Level II exam is the second of three tests that CFA candidates must pass.
  10. Professionals

    Financial Data Analyst: Career Path & Qualifications

    Learn more about the career options available to financial data analysts, and determine whether the profession is a good match for you.
RELATED TERMS
  1. Personal Financial Advisor

    Professionals who help individuals manage their finances by providing ...
  2. CFA Institute

    Formerly known as the Association for Investment Management and ...
  3. Security Analyst

    A financial professional who studies various industries and companies, ...
  4. Chartered Financial Analyst - CFA

    A professional designation given by the CFA Institute (formerly ...
RELATED FAQS
  1. What are the differences between a Chartered Financial Analyst (CFA) and a Certified ...

    The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >>
  2. How do I become a Chartered Financial Analyst (CFA)?

    According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >>
  3. What types of positions might a Chartered Financial Analyst (CFA) hold?

    The types of positions that a Chartered Financial Analyst (CFA) is likely to hold include any position that deals with large ... Read Full Answer >>
  4. Who benefits the most from prepaid expenses?

    Prepaid expenses benefit both businesses and individuals. Prepaid expenses are the types of expenses that are bought or paid ... Read Full Answer >>
  5. If I am looking to get an Investment Banking job. What education do employers prefer? ...

    If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Full Answer >>
  6. Can I still pass the CFA Level I if I do poorly in the ethics section?

    You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Full Answer >>
Hot Definitions
  1. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  2. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  3. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  4. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  5. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  6. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
Trading Center