Question

“According to SFAS No. 34, interest on self-constructed assets should be capitalized."

Team 2: Criticize the provisions of SFAS No. 34. Present arguments against capitalizing interest. Tie your arguments to the concepts and definitions found in the conceptual framework. (Finance theory would say that interest is a return to the capital provider, the lender. Finance theory might assist you in your argument).”

Answer 1

Team 2           Argue against the capitalization of interest

Interest is the cost of debt, not the cost of an asset. Interest is a function of time. As such it is a period cost, i.e., an expense of the accounting period. Debt is incurred to acquire assets which will be employed to generate future cash inflows, or revenues. The assets generate the revenue, not the debt. Hence, the assets constitute the physical plant, the operating assets of the business enterprise. When operating assets are used up their cost expiration is considered an expense of operations. Alternatively, because debt is not a part of the physical plant, the cost of debt (interest) is not considered an operating expense. Rather, it is a nonoperating cost, or expense, of doing business.

According to SFAC No. 6, expenses are outflows or other using up of assets or incurrences of liabilities from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations. Debt provides moneys to acquire assets. The assets are used to deliver or produce goods, etc. Interest is incurred to provide debt. Thus, indirectly, the interest is an outflow of assets, incurred in the process of delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations. It is incurred during the accounting period in which those activities take place and is a cost, or expense, of the period. It should not be capitalized as a part of the historical cost of the constructed asset.

Finance theory is consistent with the argument that interest incurred during construction should not be capitalized. Modern capital structure theory views creditors as capital providers. The corporation determines how much debt versus common stock it wants in its capital structure. In other words, moneys can be supplied to acquire assets with debt or by issuing common stock. According to finance theory, the interest on the debt, like dividends to common stockholders, is a payment to capital providers, a return on their investment in the business. As such it represents a distribution of income, not a cost incurred to acquire an asset. Under this theory, interest would not only not be a part of the historical cost of the asset, it would not even be considered an expense.