What Is Capitalized Interest?
Capitalised interest is the interest cost incurred to obtain or construct a long-lived asset. Contrary to the case of interest expense related to any other purpose, capitalised interest is not expensed immediately on the income statement of a company’s financial statements. Instead, firms capitalise it: the interest paid increases the asset’s cost basis on the balance sheet. Capitalised interest hits the income statement of a company through periodic depreciation expense recorded on the related long-lived asset over the asset’s useful life.
Capitalized interest is the cost of borrowing to obtain a long-term asset.
Unlike ordinary interest expense, capitalised interest doesn’t show up as an expense in a company’s income statement.
Since many companies finance such long-term assets through debt, firms are permitted to amortise the assets over the long-term.
In this way, firms capitalise (thus the name capitalising the interest expense) the interest cost, effectively creating a revenue-generating source that will be used to pay for the asset.
Capital interest is thus treated as ‘expensed’ over the depreciable life of the asset.
Understanding Capitalized Interest
Capitalised interest is of obtaining long-lived assets that will benefit a company over the long term. This is important because many companies use debt to fund the construction of long-term assets, and Generally Accepted Accounting Principles (GAAP) permit firms to not expense interest on debt associated with long-lived assets and instead include it on their balance sheet as part of the historical cost of long-lived assets.
Standard illustrations of such long-term assets where capitalisation of interest is permitted are production plants, buildings, ships, etc. Interest capitalisation is not allowed for those inventories that are mass-produced in small denominations.US tax law also permits a valuation where interest capitalisation is allowed. The tax deduction is available through a periodic depreciation.
Important
So interest capitalisation can be said to match the costs of a long-term asset with the economic benefits generated by the asset during its useful life.
Capitalized Interest vs. Expensed Interest
In accrual accounting terms, capitalisation of interest ensures that the costs of using the long-term asset are ‘matched’ to earnings of the asset in the same periods of use. Interest capitalised only if it affects the financial statements with ‘materiality’. This means that, if the effect of the capitalised interest is immaterial, interest capitalisation is not necessary and, therefore, must be immediately expensed.
When the capitalised interest is booked, it has no immediate impact on a company’s income statement. Instead, it shows up on the income statement in the following periods in the form of depreciation expense. The journal entry to book capitalised interest is a debit to a capitalised asset account and a credit to cash (if the interest is paid; otherwise the credit is to the liability open until the interest is paid).
Whether or not the interest is capitalised or expensed, in the long term both methods will get a company to the same place on its financial statements. If a company has its blinkers on about the realities of financial accounting, the short term cash outlay could also be identical; there is a cash outflow due within the period, regardless of how interest is capitalised or expensed. The only difference between capitalised interest and expensed interest is when the expense shows up on the income statement.
Capitalized Interest vs. Accrued Interest
Accrued interest is the amount of interest that has accrued on a loan since it’s last payment. For example, if a borrower has a monthly payment on a loan, and they don’t make that payment, interest will still accrue on the loan until they make their next monthly payment. The interest they were suppose to pay but decided not to pay during that time is referred to as accrued interest.
When this happens, accrued and capitalised interest are equal. For example, when an unpaid accrued sum of interest is added to the amount outstanding – called the principal – then the amount of accrued is the amount of capitalised.
Nevertheless, the nature of accrued interest is not always such as to force its capitalisation. If the missed payment of interest constitutes an expense to be incurred immediately, the accrued interest to be paid is not capitalised, it is considered an immediate expense on the income statement.
Rates of interest are capitalised on assets under construction, transferable or significant separate accounting units, or investments that are accounted for under the equity method and subject to specific investee activities.
Capitalized Interest and Student Loans
Capitalised interest also exists in many student loans. The term ‘capitalised interest’ in the context of student loans refers to interest that accrues on a loan and is included in the principal amount of the loan. This happens when the borrower is not making payments on the loan and interest continues to accrue (such as when the student is in school).
For instance, a borrower of a student loan may be in a repayment status, but he or she can still be in a deferment of some kind. And even when the status is a deferment, interest can continue to compound on the loan. Sometimes, the accrued interest is added to the loan’s principal balance, and interest is paid on a higher principal balance (interest on interest).
Of course, not all student loans capitalise interest in deferment, and some loans, including government loans, can have interest subsidies that eliminate or cover interest that accrues during deferment. But student borrowers should take account of capitalised interest (which could go up) and respect capitalisation because it matters to how much you pay off on your loan and how quickly you do it.
Example of Capitalized Interest
The company purchases a small production facility at a cost of $5 million, depreciates it with a 20-year useful life, and borrows the funds to pay for the facility at an interest rate of 10 per cent. The company will be allowed to use its project-by-project capitalisation rules to capitalise the interest expense this project generates in year one, changing it from an expense that needs to be gutted and adjusted to the current year’s figures, to non-expense: $500,000. The interest expense must be accrual (recorded) every year for 20 years of the building’s life, but the company can keep it off its GAAP income statement for at least the first year.
Interest capitalised: the company records interest capitalisation by making a $500,000 debit entry into a fixed asset account and a $500,000 offsetting credit entry into cash. Production facility at end of construction with beginning land and building cost, and interest capitalised The total cost of the company’s production facility is now $5.5 million, with $5 million for the actual construction costs and $500,000 for the interest capitalisation.
In the next year, when the facility is used to produce the goods, a straight-line expense of $275,000 (of the facility’s $5.5 million book value divided by 20 years of useful life) is recognised, of which $25,000 (the $500,000 of capitalised interest divided by 20 years) relates to the capitalised interest.
How Does Capitalized Interest Work?
Capitalised interest is a true-up of interest that is currently charged against an outstanding principal balance (similar to an interest assessment charged on a loan balance) but, rather than being expensed immediately, is added – or capitalised – to the cost of a long-lived asset being produced. That interest is instead recognised in the profit and loss account by capitalising the interest within the cost basis of the asset being manufactured and by depreciating that asset over time.
When Should Interest Be Capitalized?
The precise timing of interest capitalisation will vary depending on the nature of the interest, but for student loans, interest capitalises as part of the terms and conditions of the loan contract and the type of loan, and this may also be influenced by the type of education (undergraduate versus graduate education) a student is pursuing. Interest may often capitalise during construction when an asset is “under construction’.
Why Would You Want to Capitalize Interest?
Interest can be capitalised if companies wish to defer interest expense deduction to later periods, which may be desirable because, in the periods to which they are capitalised, the company will probably have rent income being generated from the asset being developed in the same time period when the interest expense could be taken. Taking all that interest upfront would result in not redeeming all the benefits of the expense if the firm does not make the best use of interest which can be used to reduce taxes.
How Do You Calculate Capitalized Interest?
Capitalised interest is calculated the same way as regular interest: the effective interest rate is multiplied by the effective principal balance of debt over a given period of time, plus days consideration, and is added to the principal balance amount. It might be good periodically to track original principal balance and balance of interest that has accumulated.
The Bottom Line
Capitalised interest is interest that accrues but is not paid. In this case, it is added to the principal balance of the loan. This is what’s called capital interest. You’re not paying interest on the loan, so interest continues to grow and is added to the principal balance. When interest is added onto principal, the borrower pays interest on a higher principal balance for future periods because that’s the basis for the calculation of interest – a higher starting balance. For the purposes of student loans, students could experience capitalised interest during periods of deferment when they’re in school.