Interest capitalization during fixed asset construction
January 17, 2015
Most costs capitalized to manufactured or constructed assets are easy to differentiate from costs that should be immediately expensed. In this article, however, we’ll cover a more obscure cost that should be allocated to constructed fixed assets – interest on the debt used to finance the construction project.
Certain costs associated with a company’s operations should not be recorded as immediate expenses. Instead, the costs are added to the carrying value of an asset to be expensed later. For example, the costs of materials, labor, and overhead are added to inventory assets, and those costs are transferred to expense when the inventory is sold. Likewise, if a company builds its own fixed asset, those same costs are added to the initial cost of the asset, and those costs are eventually expensed via the depreciation process.
This concept is called capitalization. Most costs that are supposed to be capitalized are obviously associated with the long-term value of an asset, such as the materials used to produce the asset. But if all costs necessary to bring the asset to useful condition should be capitalized, how do we account for something as indirect as interest on loans related to asset production?
As a general rule, interest should not be capitalized to ordinary inventory. However, if the asset is a fixed asset that will be sold or used by the company – such as when a company builds its own factory or equipment – interest should be added to the cost of the asset during the construction period.
If there is an unexpected delay during construction, interest should still be capitalized. However, if the company intentionally delays the project, interest should not be capitalized until production resumes. It is important to remember that only loans related to fixed asset construction should be capitalized. If a cash inflow from a loan isn’t used to fund construction of an asset, then no interest should be capitalized.
There are two pieces to the capitalization calculation. First, the company must determine which interest rate to use. This part is simple if the company takes out a loan specifically for the project – the interest rate on that loan is used for the calculation. If the company uses general funds for the project or if the construction loan is not sufficient to cover all the costs of the project, a weighted average interest rate based on all outstanding interest-bearing debt is used.
The second part of the calculation is to determine how much of the company’s total interest cost should be capitalized. US GAAP utilizes a concept called avoidable interest. In other words, how much interest could have been avoided if the company didn’t spend any funds on the project? In the absence of the project, the company could have avoided the specific construction loan altogether, or it could have paid off some of its outstanding debt.
The costs associated with the project should be weighted by the amount of time outstanding, because an interest rate is annualized. A $50,000 payment in January results in more interest than a $50,000 payment in December.
As a final rule, the company can’t capitalize more interest that it actually incurred for the period. If the amount of interest calculated using the two-step process above is more than the total amount of interest incurred, the total amount calculated should be capitalized to the asset(s) under construction.
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