Loading the player...

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 must not be expensed on the income statement of a company's financial statements, and instead, firms capitalize it, meaning such interest increases the cost basis of a long-term asset on a balance sheet. Capitalized interest shows up on a company's income statement through a periodic depreciation expense recorded on the associated long-term asset throughout its useful life.

BREAKING DOWN 'Capitalized Interest'

Capitalized interest is part of the historical cost of acquiring assets that require a period of time to set them up for their intended use. Because many companies finance the construction of long-term assets with debt, the Generally Accepted Accounting Principles (GAAP) allow firms to avoid expensing interest on such debt, and include it on their balance sheets as part of a 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. As far as tax books, U.S. tax laws also allow the capitalization of interest, which provides a tax deduction in future years through a depreciation expense.

Accounting for Capitalized Interest

From the perspective of accrual accounting, capitalizing interest helps a user of financial statements obtain an accurate measure of the acquisition cost of an asset and have a better allocation of costs to earnings in the periods when an acquired asset is being used. Capitalized interest can only be booked if its impact on a company's financial statements is material. Otherwise, interest capitalization is not required. When booked, capitalized interest has no immediate effect on a company's income statement, and instead, it appears on the income statement through a depreciation expense.

An Example of Capitalized Interest

Consider a company that builds a small production facility worth $5 million with a useful life of 20 years, and it borrows the same amount to finance this project at an interest rate of 10%. The project will take a year to complete to put the asset 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 issuing a debit entry of $500,000 to a fixed asset account and a credit entry to cash, and the cash equivalent for the same amount when an interest payment is made to a lender. After 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.

RELATED TERMS
  1. Capitalization

    Capitalization, in accounting, is when the costs to acquire an ...
  2. Capitalize

    To capitalize is to list a cost/expense on the balance sheet ...
  3. Capital Asset

    A capital asset is a type of asset with a useful life longer ...
  4. Income Statement

    An income statement is one of the three major financial statements ...
  5. Depreciated Cost

    Depreciated cost is the original cost of a fixed asset less accumulated ...
  6. Interest Rate

    Interest rate is the amount charged, expressed as a percentage ...
Related Articles
  1. Investing

    Depreciation: Straight-Line Vs. Double-Declining Methods

    Appreciate the different methods used to describe how book value is "used up".
  2. Investing

    12 things you need to know about financial statements

    Before investing, discover 12 characteristics of financial statements that can help you evaluate companies and increase your chances of choosing a winner.
  3. 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.
  4. Investing

    Understanding the Income Statement

    The best way to analyze a company - and figure out if it's worth investing in - is to know how to dissect its income statement. Here's how to do it.
  5. Small Business

    Capital Expenditure Versus Revenue Expenditure

    Capital expenditures and revenue expenses have significant differences. Here's the difference between the two.
  6. Investing

    Book Value: How Reliable Is It For Investors?

    In theory, a low P/B ratio means you have a cushion against poor performance. In practice, it is much less certain.
  7. Investing

    Cash flow statement: Analyzing cash flow from financing activities

    The financing activity in the cash flow statement measures the flow of cash between a firm and its owners and creditors.
  8. 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.
RELATED FAQS
  1. What are typical examples of capitalized costs within a company?

    Learn examples of capitalized costs such as expenses incurred to put fixed assets to use as well as software development ... Read Answer >>
  2. How do current assets and fixed assets differ?

    Current assets are short-term assets that are used up within one year. Fixed assets are physical assets and have a life of ... Read Answer >>
  3. What is the difference between CAPEX and OPEX?

    In this article, we'll teach you the differences between a company's capital expenditures and its operational expenses. Read Answer >>
  4. Difference Between an Operating Expense and Capital Expense

    Learn more about the differences between an operating expense (OPEX) and a capital expense (CAPEX), and see how they are ... Read Answer >>
  5. What is the relationship between accumulated depreciation and depreciation expense?

    Understand the relationship between accumulated depreciation and depreciation expense. Learn how each one is accounted for ... Read Answer >>
Hot Definitions
  1. Business Cycle

    The business cycle describes the rise and fall in production output of goods and services in an economy. Business cycles ...
  2. Futures Contract

    An agreement to buy or sell the underlying commodity or asset at a specific price at a future date.
  3. Yield Curve

    A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but ...
  4. Portfolio

    A portfolio is a grouping of financial assets such as stocks, bonds and cash equivalents, also their mutual, exchange-traded ...
  5. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
  6. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
Trading Center