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Interest and Construction




The process of capitalizing interest on construction projects is essential for accurate financial reporting. This blog post discusses the intricacies of interest capitalization during construction, in line with accounting principles. We’ll look into the concepts, methods, and examples to provide clarity.

1. Understanding Interest Capitalization

  • Purpose: Interest capitalization integrates the cost of borrowing directly into the asset being constructed, aligning with the idea that expenses should match revenue generation.
  • Key Objective: The goal is to allocate interest costs to the periods benefiting from the construction, rather than treating them as an immediate expense.

2. Interest Capitalization Options

The FASB outlines three primary methods to handle interest during construction:

  • No Interest Capitalization: Under this method, interest incurred during construction is expensed immediately. This approach aligns with treating borrowing costs as a financing activity rather than part of the asset’s cost.
  • Capitalizing All Interest: This method applies an interest cost to all funds used in construction, whether borrowed or not, and allocates interest to the asset’s cost.
  • Capitalizing Only Actual Borrowing Costs: Here, only the actual costs from debt specifically borrowed for the construction are capitalized, offering a conservative approach. It avoids estimating costs on funds not directly associated with the asset.

3. GAAP Guidelines on Interest Capitalization

  • Steps in Interest Capitalization:
    1. Identify Eligible Assets: Only assets under construction qualify.
    2. Calculate Capitalizable Interest: This involves interest from direct borrowings and, in some cases, a weighted average of general debt.
    3. Determine Capitalization Period: Interest is capitalized from the initiation of construction activities to completion or when the asset is ready for use.

4. Qualifying Assets and Capitalization Period

  • Qualifying Assets: These include buildings and long-term construction projects like ships. Ineligible assets include inventory or assets ready for use.
  • Capitalization Period: Begins when expenditures start, activities to ready the asset are in progress, and interest costs are incurred. It concludes when the asset is substantially ready for use.

5. Calculating Weighted-Average Interest

  • Interest Rate Determination: Companies often use a weighted-average interest rate when the debt exceeds specific borrowings for the project. This rate ensures an equitable distribution of interest costs.
  • Weighted-Average Calculation: Weighted-average accumulated expenditures are multiplied by the average interest rate to determine the interest to capitalize.

6. Illustrative Example

Let’s assume Company ABC has a project costing $2 million, with $1 million financed at a 10% rate and additional expenditures financed at an 8% weighted-average rate. Here’s how to calculate capitalized interest:

  • 2019 Interest: $1 million at 10% = $100,000; Remaining $1 million at 8% = $80,000.
  • Total Capitalized Interest: $180,000.

This example shows how blending specific and general debt affects the cost capitalized to the project.

7. GAAP Disclosures and Journal Entries

  • Disclosure Requirements: GAAP mandates that capitalized interest be disclosed in financial statements, showing both capitalized and expensed interest.
  • Typical Journal Entry:
    • For Capitalized Interest:
      • Debit Asset (e.g., Construction in Progress): $180,000
      • Credit Interest Expense: $180,000

This entry aligns with adding interest to the project’s carrying value, enhancing transparency in reporting.

8. Impact on Financial Statements

  • Balance Sheet: Capitalized interest increases the asset’s book value, affecting depreciation over its useful life.
  • Income Statement: By capitalizing rather than expensing, net income may initially appear higher. However, depreciation expense will spread this cost over future periods.

Conclusion

Capitalizing interest during construction requires careful calculation and adherence to GAAP principles. By treating interest as part of the asset cost, companies can more accurately match expenses with future revenues. Proper application of these principles ensures reliable financial reporting and reflects a true picture of the company’s financial health.

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