When to capitalize interest
/What is Capitalized Interest?
Capitalized interest is the interest charge incurred by a business while an asset is being constructed, and which is then added to the cost of the asset. Interest is capitalized in order to obtain a more complete picture of the total acquisition cost associated with an asset, since an entity may incur a significant interest expense during the acquisition and start-up phases of the asset. The capitalized interest will then be depreciated over the useful life of the associated asset.
How Does Interest Capitalization Work?
Interest expense should be included in the cost of acquiring an asset during the period when an entity is carrying out those activities needed to bring the asset to its designated condition and location. The amount of interest capitalized should be the amount incurred during the period when expenditures are incurred for the asset. The accountant should capitalize the associated interest cost for the following assets:
Assets constructed for an entity’s own use.
Assets constructed for an entity by a supplier, with deposits or progress payments having been made.
Assets intended for sale or lease that are constructed as discrete projects (such as a cruise ship).
Investments that the investor accounts for under the equity method, where the investee has activities in progress to start up its principal operations, and is using funds to acquire assets for those operations. In this case, the interest cost to be capitalized is based on the investment in the investee, not the underlying assets of the investee.
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When Not to Capitalize Interest
It is not always necessary to capitalize interest cost. The most optimum situation for doing so is when an asset requires substantial expenditures and a substantial period to construct, thereby accumulating a significant amount of interest cost. However, if there is a significant additional accounting and administrative cost associated with capitalizing interest cost, and the benefit of the additional information is minimal, you do not have to capitalize it. The accountant should not capitalize the associated interest cost for the following assets:
Assets that are either in use already or ready for their intended use.
Assets that are not being prepared for use.
Assets that are not being used in an entity’s earnings activities.
Assets that are not included in the consolidated balance sheet of the parent entity.
Investments that the investor accounts for under the equity method, when the principal activities of the investee have already begun.
Investments in regulated investees that are capitalizing the cost of debt and equity capital.
Assets acquired with gifts or grants from donors, where the gift or grant is restricted to the acquisition of those assets.
Inventories that are routinely manufactured on a repetitive basis.
Capitalizing Interest Related to Land
You can only capitalize the interest cost associated with land if it is undergoing those activities necessary to prepare it for its intended use. If so, the expenditure to acquire the land qualifies for interest capitalization.
If an entity constructs a building on a newly-acquired land parcel, then the interest cost associated with the building should be capitalized as part of the building asset, rather than the land asset.