What is Capitalized Interest?

In simple words, Capitalized Interest is interest accrued during the construction of long-term assets. Therefore, it is included as the initial cost of assets on the balance sheet instead of being charged as interest expense on the income statement.

For example: At a 5 percent interest rate, the $100,000 loan is borrowed to construct windmills. It takes one year to complete the construction. This implies that the cost of the windmill will include not only the initial cost of assets but also the interest expenseInterest ExpenseInterest expense is the amount of interest payable on any borrowings, such as loans, bonds, or other lines of credit, and the costs associated with it are shown on the income statement as interest expense.read more  required to be paid off for the load. The total cost will be $100,000 + $5000 = $105,000. Here please note that interest expense is not reported in the income statementIncome StatementThe income statement is one of the company’s financial reports that summarizes all of the company’s revenues and expenses over time in order to determine the company’s profit or loss and measure its business activity over time based on user requirements.read more, whereas the capitalized interest is added to the cost of the long-term asset.

  • Under the accrual basis of accounting, it is reported in the balance sheet as the total amount of fixed assets. An organization using a construction loan to build its corporate headquarters is another example of such a situation.It becomes a part of the long-term asset and is depreciated over the useful life.

Steps to Calculate Capitalized Interest

It can be calculated using the following steps –

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Example

RKDF construction started the construction of a building that is to be used for production. The construction of the building will end by 31st December, and the building will be ready to use.

  • Find the Capitalization Period. The first step is to understand the time period until when the construction of the fixed assetFixed AssetFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples.read more will take place and when the asset will be ready for use. Capitalization of borrowing costs terminates when the asset has been prepared for its intended use and has substantially completed all activities needed. The capitalization period will not be extended by work on minor modifications. If the entity can use some parts while construction continues on other parts, it should discontinue capitalization of borrowing costs on the parts it completes. Calculate Weighted Average Accumulated Expenditure. It is the product of the expenditure for constructing a fixed asset and is time-weighted for the accounting year.  Weighted Average Accumulated Expenditure = Expenditure x (months in capitalization/12) Determine the interest in the specific borrowings and from the general funds. Suppose the loan was specifically taken for the construction of fixed assets. In that case, the actual borrowing cost incurred is the borrowing cost to capitalize minus any investment incomeInvestment IncomeInvestment income is the earnings made from allocating funds in financial instruments or assets like securities, mutual funds, bonds, property, etc. It includes dividends on bonds and interest received on bank deposits, profits and capital gain from the sale of real estate and securities. read more Investment income is the earnings made from allocating funds in financial instruments or assets like securities, mutual funds, bonds, property, etc. It includes dividends on bonds and interest received on bank deposits, profits and capital gain from the sale of real estate and securities. read moreInvestment income is the earnings made from allocating funds in financial instruments or assets like securities, mutual funds, bonds, property, etc. It includes dividends on bonds and interest received on bank deposits, profits and capital gain from the sale of real estate and securities. read moreearned from the interim investment of those borrowings. For general corporate needs, borrowings may be handled centrally and could be obtained via a variety of debt instruments.During the period applicable to the asset, in this case, gain an interest rate from the weighted average of the entity’s borrowing costs. Using this method, the number of allowable borrowing costs at the entity’s total borrowing costs during the applicable period. Calculate Avoidable Interest Calculate Actual Interest on Loans The actual interest on the overall loan is also straightforward. You can calculate this directly, multiplying the corresponding interest rate by the debt raised. Select the lower of Actual Interest and Avoidable Interest. Capitalized Interest = Lower (Actual Interest, Avoidable Interest)

The first step is to understand the time period until when the construction of the fixed assetFixed AssetFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples.read more will take place and when the asset will be ready for use. Capitalization of borrowing costs terminates when the asset has been prepared for its intended use and has substantially completed all activities needed. The capitalization period will not be extended by work on minor modifications. If the entity can use some parts while construction continues on other parts, it should discontinue capitalization of borrowing costs on the parts it completes.

It is the product of the expenditure for constructing a fixed asset and is time-weighted for the accounting year.  Weighted Average Accumulated Expenditure = Expenditure x (months in capitalization/12)

Suppose the loan was specifically taken for the construction of fixed assets. In that case, the actual borrowing cost incurred is the borrowing cost to capitalize minus any investment incomeInvestment IncomeInvestment income is the earnings made from allocating funds in financial instruments or assets like securities, mutual funds, bonds, property, etc. It includes dividends on bonds and interest received on bank deposits, profits and capital gain from the sale of real estate and securities. read more Investment income is the earnings made from allocating funds in financial instruments or assets like securities, mutual funds, bonds, property, etc. It includes dividends on bonds and interest received on bank deposits, profits and capital gain from the sale of real estate and securities. read moreInvestment income is the earnings made from allocating funds in financial instruments or assets like securities, mutual funds, bonds, property, etc. It includes dividends on bonds and interest received on bank deposits, profits and capital gain from the sale of real estate and securities. read moreearned from the interim investment of those borrowings. For general corporate needs, borrowings may be handled centrally and could be obtained via a variety of debt instruments.During the period applicable to the asset, in this case, gain an interest rate from the weighted average of the entity’s borrowing costs. Using this method, the number of allowable borrowing costs at the entity’s total borrowing costs during the applicable period.

The actual interest on the overall loan is also straightforward. You can calculate this directly, multiplying the corresponding interest rate by the debt raised.

Capitalized Interest = Lower (Actual Interest, Avoidable Interest)

The following Debt was outstanding from 1st January 2017.

  • $60,000 at a 10% interest rate (taken for the specific purpose of constructing the building)$75,000 at 8% interest rate (general loan)

The following payments were made for the construction of the building –

  • 1st Feb, 2017 – $50,0001st August, 2017 – $75,000

Calculate Capitalized Interest?

Step 1 – Capitalizion Period

As given in the information above, the capitalization period will be from 1st January 2017 to 31st December 2017.

Step 2 – Calculate Weighted Average Accumulated Expenditure.

Weighted Average Accumulated Expenditure = 50,000 x (11/12) + $75,000 x (5/12) = $45,833 + $31,250 = $77,083

Step 3 – Determine the interest in the specific borrowings and from the general funds.

  • $60,000 at 10% interest rate (taken for the specific purpose of constructing the building)$75,000 at 8% interest rate (general loan)

Step 4 – Calculate Avoidable Interest

Avoidable Interest = = $60,000 x 10% + (77,083 – $60,000) x 8% = $6000 + $1,367 = $7,367

Step 5 – Calculate Actual Interest on the Loans

Actual Interest on the Loans = $60,000 x 10% + $75,000 x 8% = $6,000 + $6,000 = $12,000

Step 6 – Lower of Actual Interest and Avoidable Interest

Capitalized Interest = ($7,367, $12,000) = $7,367

Features

  • Capitalizing interest helps a user of financial statementsUser Of Financial StatementsFinancial statements prepared by the Companies are used by different categories of individuals and corporates on the basis of their relevancy to the respective parties. The most common users to the financial statements are Management of the Company, Investors, Customers, Competitors, Government and Government Agencies, Employees, Investment Analysts, Lenders, Rating Agency and Suppliers.read more, from the perspective of accrual accounting, to better allocate costs to earnings in the periods when an acquired asset is being used and obtain an accurate measure of the acquisition cost of an asset.Capitalized interest can then be booked if an impact on a company’s financial statements is material; otherwise, there is no need.It has no immediate effect on a company’s income statement when booked, and it appears on the income statement through a depreciation expense instead.Since the last payment, it considers the total interest it owes on a loan balance or long-term asset. Adding the total interest owed to the total cost of the loan balance or long-term asset capitalizes it.For students to defer the loan, Capitalized Interest is the most common way where interest is added to the principle of the loan, which increases the interest owed monthly.

Conclusion

Capitalized interest is part of the historical cost of setting the acquiring assets up for their intended use. The GAAP allows firms to avoid expensing interest on the debt. Many companies finance the construction of long-term assets with debt and include it on their balance sheetsBalance SheetsA balance sheet is one of the financial statements of a company that presents the shareholders’ equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner’s capital equals the total assets of the company.read more as a component of the historical cost of long-term assets. Various production facilities, ships, and real estate involve the long-term assets for which Capitalized Interest is allowed. In inventories that are manufactured repeatedly in large quantities, capitalizing interest is not permitted for them.

Capitalized Interest Video

This has been a guide to what capitalized interest accounting is. Here we discuss a step-by-step approach to calculating capitalized interest and practical examples. You can learn more about accounting basics from the following articles –

  • Accrued Interest MeaningCapexWhat are Accounting Policies?Bonds Payable On Balance Sheet