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. Personal Finance

    Calculating Interest Expense

    Interest expense is the cost of borrowing money.
  2. 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.
  3. Small Business

    Understanding Capital

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

    Target Corp: WACC Analysis (TGT)

    Learn about the importance of capital structure when making investment decisions, and how Target's capital structure compares against the rest of the industry.
  5. Investing

    Analyzing Investments With Solvency Ratios

    Solvency ratios are extremely useful in helping analyze a firm’s ability to meet its long-term obligations; but like most financial ratios, they must be used in the context of an overall company ...
  6. 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.
  7. Investing

    American Capital Sells Itself to 2 Companies

    Prominent business development company American Capital (NASDAQ: ACAS) is soon to be no more. The company has agreed to sell its assets to a pair of peers, fellow BDC Ares Capital (NASDAQ: ARCC) ...
  8. Insights

    What's Economic Capital?

    While regulatory and economic capital use some of the same measurements of risk to determine how much capital a firm should hold in reserve, economic capital uses more realistic measures.
  9. Small Business

    What's Capitalization?

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

    Breaking Down Optimal Capital Structure

    An optimal capital structure shows the best balance of debt to equity a company can have in order to minimize its cost of capital.
Frequently Asked Questions
  1. What's considered to be a good debt-to-income (DTI) ratio?

    Your debt-to-income ratio helps lenders determine your credit worthiness. Find out how to calculate your score and how to ...
  2. What is the difference between a loan and a line of credit?

    Learn to differentiate between lines of credit and standard loans, and determine when you are likely to use each method of ...
  3. What does a Chief Financial Officer (CFO) do?

    A CFO is responsible for accurate reporting of a company's financial information, investing the company's money and identifying ...
  4. How did George Soros break the Bank of England?

    George Soros pocketed $1 billion by betting against the British pound, cementing his reputation as the premier currency speculator ...
Trading Center