Question

Utilizing any of the search methods,determine whether capitalization of interest is required or optional when getting an asset ready for use.

Answer 1

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 an asset. 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.

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.

You 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.

You 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.

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.

Capitalized interest is the cost of the funds used to finance the construction of a long-term asset that an entity constructs for itself. The capitalization of interest is required under the accrual basis of accounting, and results in an increase in the total amount of fixed assetsappearing on the balance sheet. An example of such a situation is when an organization builds its own corporate headquarters, using a construction loan to do so.

This interest is added to the cost of the long-term asset, so that the interest is not recognized in the current period as interest expense. Instead, it is now a fixed asset, and is included in the depreciation of the long-term asset. Thus, it initially appears in the balance sheet, and is charged to expense over the useful life of the asset; the expenditure therefore appears on the income statement as depreciation expense, rather than interest expense.

The record keeping for the recordation of capitalized interest can be complicated, so it is generally recommended that the use of interest capitalization be confined to situations where there is a significant amount of related interest expense. Also, interest capitalization defers the recognition of interest expense, and so can make the results of a business look better than is indicated by its cash flows.

Generally, borrowing costs attributable to a fixed asset are those that would otherwise have been avoided if the asset had not been acquired. There are two ways to determine the borrowing cost to include in an asset:

• Directly attributable borrowing costs. If borrowings were specifically incurred to obtain the asset, then the borrowing cost to capitalize is the actual borrowing cost incurred, minus any investment income earned from the interim investment of those borrowings.
• Borrowing costs from a general fund. Borrowings may be handled centrally for general corporate needs, and may be obtained through a variety of debt instruments. In this case, derive an interest rate from the weighted average of the entity’s borrowing costs during the period applicable to the asset. The amount of allowable borrowing costs using this method are capped at the entity’s total borrowing costs during the applicable period.

Capitalization of borrowing costs terminates when an entity has substantially completed all activities needed to prepare the asset for its intended use. Substantial completion is assumed to have occurred when physical construction is complete; work on minor modifications will not extend the capitalization period. If the entity is constructing multiple parts of a project and it can use some parts while construction continues on other parts, then it should stop capitalization of borrowing costs on those parts that it completes.