Capitalized interest is interest which has been included as part of the cost of acquiring an asset in the balance sheet instead of being treated as an interest expense in the income statement.
When a business acquires an asset it records the asset in its accounting records at the cost required to bring the asset to the condition and location necessary for its intended use. So for example if equipment is purchased the costs of shipping and installation are included in the cost.
If an asset requires a period of time to get it ready for its intended use, such as for example the construction of a new production facility, and the business uses debt finance, then an additional cost of getting it ready for use is the cost of interest on the debt finance. The additional cost added to the cost of the asset is referred to as capitalized interest, and the asset on which interest is capitalized is referred to as a qualifying asset.
By capitalizing the interest and depreciating it together with the other costs of acquiring the asset, the costs are matched against the future revenues generated by the asset, and the matching accounting concept is complied with.
Which Assets Qualify for Capitalization of Interest
To qualify the asset must take a period of time to bring it to the condition and location necessary for its intended use.
For example qualifying assets would include assets a business constructs for its own use, such as a new production facility, and assets the business constructs as discrete projects for others such as a real estate development.
Assets which are routinely manufactured such as inventory are not regarded as qualifying assets and interest on the acquisition of those assets is not capitalized.
Interest Cost to be Capitalized
The amount of interest to be capitalized is the lower of the avoidable interest and the actual interest on the loan facilities.
The avoidable interest is simply the interest which would have been avoided if the expenditure on the asset had not been made. The use of the term avoidable means that the capitalized interest does not necessarily have to be incurred on the qualifying asset itself.
For example, if a business has cash and decides to spend this on constructing a new manufacturing facility instead of using this to reduce its borrowings, then since the borrowings and the interest would have been avoidable had the cash not been spent on the qualifying asset, part of the interest can be attributed to the asset and capitalized.
The actual interest is the total amount of interest the business pays during the period on its borrowings. Since the amount capitalized can never be greater than the amount of interest actually incurred, this figure sets the maximum amount to be capitalized.
Calculation of Capitalized Interest
As with all interest calculations the amount of interest depends on three factors.
The interest cost is then given by the following formula.
Principal – Asset Expenditure
The amount of expenditure on the asset will vary over the accounting period. To simplify the calculation of capitalized interest the weighted average accumulated expenditure is used as principal in the interest calculations.
Rate – Capitalization Rate
The interest rate sometimes referred to as the capitalization rate, is the rate the business pays on its outstanding borrowings to finance the acquisition of the asset.
To compute the avoidable interest the rates used are firstly the rate on any specific borrowings used to acquire the asset and then a weighted average rate of any other general borrowings identified as being used to acquire the asset.
Time – Capitalization period
The time period is referred to as the capitalization period and is the time necessary to get the asset ready for its intended use.
The capitalization period starts when the following three criteria are met.
- Expenditure has been made on the asset.
- Activity is in progress to get the asset ready for its intended use.
- Interest costs are being incurred.
The capitalization period ends when any of the conditions fails to be satisfied for a significant period of time or when the asset is substantially complete and ready for its intended use.
Capitalized Interest Example
Suppose a business decides to build a new production facility at a cost of 500,000 starting on January 1. The expenditures on the construction are as follows.
The business takes out a new loan of 100,000 at 6.00% interest on January 1 specifically for the construction, and has two other general facilities outstanding during the year of 125,000 at 7.00% (Loan 1) and 375,000 at 8.00% (Loan 2).
Step 1: Calculate the Actual Interest
Since all the facilities are outstanding for the year the actual interest cost is calculated by multiplying the principal amount of the loan by the annual rate.
The interest cost actually incurred by the business during the year is 44,750, this determines the maximum amount which can be capitalized.
Step 2: Calculate the Weighted Average Interest Rate on General Borrowings
Since the general borrowings are a mixture of two facilities and it is not possible to determine which would have been avoidable had the construction not taken place, a weighted average rate is used.
Since the facilities have been outstanding throughout the year the weighted average rate is calculated as follows.
Weighted average rate = (Loan 1 x Rate 1 + Loan 2 x Rate 2) / (Loan 1 + Loan 2) Weighted average rate = (125,000 x 7% + 375,000 x 8%) / (125,000 + 375,000) Weighted average rate = 38,750 / 500,000 = 7.75%
Step 3: Calculate the Weighted Average Accumulated Expenditure
The expenditure on the construction occurs at various times during the year. To simplify the capitalized interest calculations a weighted average amount is calculated to represent the average amount funded throughout the year.
The table shows the date and actual expenditure in the first two columns, and then calculates the weighted amount column by multiplying the expenditure by the fraction of the year the expenditure was funded for.
So for example the expenditure on August 1 of 200,000 was funded for 5 months of the year (August to December), and the weighted average amount is calculated as follows.
Weighted average amount = Actual amount x Funding period / Total period Weighted average amount = 200,000 x 5 / 12 = 83,333
The total of the weighted amounts is 243,750 indicating that on average 243,750 was funded throughout the 12 months of the year. This amount is now used as the principal in the capitalized interest calculations.
Step 4: Calculate the Avoidable Interest
The avoidable interest is the interest cost of funding the weighted average expenditure (243,750) using the available loan facilities. In carrying out the calculation, specific facilities are used before general facilities.
In the example there is a specific 6.00% loan facility of 100,000 which leaves 143,750 (243,750-100,000) to be funded by the general loan facilities at the weighted rate of 7.75% (see Step #2).
Step 5: Calculate the Capitalized Interest
The capitalized interest is the lower of the avoidable interest (17,141) and the actual interest (44,750) incurred by the business during the year (see Step #1).
In this example the amount to be capitalized as part of the cost of the asset is therefore the avoidable interest of 17,141.
Capitalized Interest Journal Entry
In the example the total interest for the period was 44,750 and the amount to be capitalized calculated as 17,141.
The total interest cost of 44,750 is first posted as normal to the interest expense account.
Next the capitalized interest of 17,141 is transferred from the interest expense account to the appropriate qualifying asset account.
The capitalized interest now forms part of the total cost of the asset and will be depreciated in the normal manner over the useful life of the asset.