Understanding Capitalized Interest
When it comes to financing large projects, companies may choose to capitalize interest. This practice involves adding interest charges to the cost of the asset being constructed or acquired. While this can help businesses manage their cash flow during the construction phase, it also affects their financial statements in several ways.
In this article, we will delve into the details of capitalized interest, including the definition, calculation, and accounting treatment of this concept. We will also discuss the advantages and disadvantages of capitalizing interest, and provide examples to help illustrate how it works.
What is Capitalized Interest?
Capitalized interest refers to the interest expenses incurred during the construction or acquisition of a long-term asset, such as a building, machinery, or software. Instead of expensing these costs as incurred, companies can choose to add them to the cost of the asset, which increases its overall cost and, in turn, its depreciation expense.
The concept of capitalized interest is based on the time value of money, which states that money today is worth more than the same amount in the future. Therefore, by capitalizing interest, companies can recognize the time value of money by adding interest charges to the asset’s cost, which reflects the true cost of financing the project.
How is Capitalized Interest Calculated?
To calculate capitalized interest, companies need to follow specific guidelines established by accounting standards. According to the Generally Accepted Accounting Principles (GAAP) in the US, the capitalization period starts when:
- Activities that are necessary to prepare the asset for its intended use begin;
- Expenditures for the asset are being made;
- Interest costs are being incurred; and
- There are no substantial delays in the construction process.
Once the capitalization period starts, companies can capitalize interest expenses that are directly related to the asset’s construction or acquisition. The interest rate used for capitalization is typically the weighted-average interest rate of the debt used to finance the project.
Accounting Treatment of Capitalized Interest
When companies capitalize interest, they need to account for it in their financial statements. Specifically, they need to:
- Increase the asset’s cost by the amount of capitalized interest;
- Record the capitalized interest as a separate asset on the balance sheet; and
- Amortize the capitalized interest over the asset’s useful life, which reduces the interest expense over time.
Advantages and Disadvantages of Capitalized Interest
Capitalized interest can provide several benefits to companies, such as:
- Improving cash flow during the construction phase by reducing the amount of interest paid out-of-pocket;
- Increasing the value of the asset by reflecting the true cost of financing the project; and
- Lowering the interest expense in the early years of the asset’s life, which can improve profitability.
However, there are also some drawbacks to capitalizing interest, including:
- Higher initial costs, as the asset’s cost is increased by the amount of capitalized interest;
- Reduced earnings in the early years of the asset’s life, as the interest expense is lower due to amortization of capitalized interest; and
- Increased complexity in financial statements due to the need to account for capitalized interest as a separate asset.
Example of Capitalized Interest
To illustrate how capitalized interest works in practice, let’s consider an example. Suppose Company A is constructing a new building that will take two years to complete, and the total cost of the project is $10 million. Company A decides to finance the project with a $5 million loan with an interest rate of 5%.
During the first year, Company A incurs $100,000 in interest expenses related to the loan. Instead of expensing this amount, Company A chooses to capitalize it and add it to the cost of the building.
As a result, the building’s cost is now $10.1 million ($10 million + $100,000 in capitalized interest).
In the second year, Company A incurs an additional $100,000 in interest expenses related to the loan. This amount is also capitalized and added to the building’s cost, which is now $10.2 million ($10.1 million + $100,000 in capitalized interest).
Over the next 20 years, Company A amortizes the capitalized interest at a rate of $10,000 per year, which reduces the interest expense on the income statement. By the end of the 20-year period, the building’s cost will remain at $10.2 million, but the interest expense will have been reduced by a total of $200,000 ($10,000 per year for 20 years).
Capitalized interest is a useful accounting concept that allows companies to recognize the time value of money and reflect the true cost of financing a project. While it can provide several benefits, such as improving cash flow and increasing the value of the asset, it also comes with some drawbacks, such as higher initial costs and increased complexity in financial statements.
By understanding how capitalized interest works, companies can make informed decisions about whether to capitalize interest or expense it as incurred. As with any accounting concept, it’s essential to follow the specific guidelines established by accounting standards and consult with financial professionals as needed.