What is Capitalized Interest?
Capitalized interest is the cost of borrowing to acquire or construct a long-term asset. Unlike an interest expense incurred for any other purpose, capitalized interest is not expensed immediately on the income statement of a company's financial statements. Instead, firms capitalize it, meaning the interest paid increases the cost basis of the related long-term asset on the balance sheet. Capitalized interest shows up in installments on a company's income statement through periodic depreciation expense recorded on the associated long-term asset over its useful life.
Understanding Capitalized Interest
Capitalized interest is part of the historical cost of acquiring assets that will benefit a company over many years. Because many companies finance the construction of long-term assets with debt, Generally Accepted Accounting Principles (GAAP) allow firms to avoid expensing interest on such debt, and include it on their balance sheets as part of the historical cost of long-term assets.
Typical examples of long-term assets for which capitalizing interest is allowed include various production facilities, real estate, and ships. Capitalizing interest is not permitted for inventories that are manufactured repetitively in large quantities. U.S. tax laws also allow the capitalization of interest, which provides a tax deduction in future years through periodic depreciation expense.
In accordance with the matching principle, capitalizing interest ties the costs of a long-term asset to the earnings generated by the same asset over its useful life.
From the perspective of accrual accounting, capitalizing interest helps tie the costs of using a long-term asset to earnings generated by the asset in the same periods of use. Capitalized interest can only be booked if its impact on a company's financial statements is material. Otherwise, interest capitalization is not required, and it should be expensed immediately. When booked, capitalized interest has no immediate effect on a company's income statement, and instead, it appears on the income statement in following periods through depreciation expense.
Example of Capitalized Interest
Consider a company that builds a small production facility worth $5 million with a useful life of 20 years. It borrows the amount to finance this project at an interest rate of 10%. The project will take a year to complete to put the building to its intended use, and the company is allowed to capitalize its annual interest expense on this project, which amounts to $500,000.
The company capitalizes interest by recording a debit entry of $500,000 to a fixed asset account and an offsetting credit entry to cash. At the end of construction, the company's production facility has a book value of $5.5 million, consisting of $5 million in construction costs and $500,000 in capitalized interest.
In the next year, when the production facility is used, the company books a straight-line depreciation expense of $275,000 ($5.5 million of the facility's book value divided by 20 years of useful life) of which $25,000, ($500,000 of capitalized interest divided by 20 years), is attributable to the capitalized interest.