Capitalized Interest
Capitalized interest is the cost of borrowing to acquire or construct a long-term asset. In the next year, when the production facility is used, the company books a straight-line depreciation expense of $275,000 ($5.5 million of the facility's book value divided by 20 years of useful life) of which $25,000 ($500,000 of capitalized interest divided by 20 years) is attributable to the capitalized interest. Because many companies finance the construction of long-term assets with debt, Generally Accepted Accounting Principles (GAAP) allow firms to avoid expensing interest on such debt and include it on their balance sheets as part of the historical cost of long-term assets. Capitalized interest shows up in installments on a company's income statement through periodic depreciation expense recorded on the associated long-term asset over its useful life. Unlike an interest expense incurred for any other purpose, capitalized interest is not expensed immediately on the income statement of a company's financial statements.
What Is Capitalized Interest?
Capitalized interest is the cost of borrowing to acquire or construct a long-term asset. Unlike an interest expense incurred for any other purpose, capitalized interest is not expensed immediately on the income statement of a company's financial statements. Instead, firms capitalize it, meaning the interest paid increases the cost basis of the related long-term asset on the balance sheet. Capitalized interest shows up in installments on a company's income statement through periodic depreciation expense recorded on the associated long-term asset over its useful life.
Understanding Capitalized Interest
Capitalized interest is part of the historical cost of acquiring assets that will benefit a company over many years. Because many companies finance the construction of long-term assets with debt, Generally Accepted Accounting Principles (GAAP) allow firms to avoid expensing interest on such debt and include it on their balance sheets as part of the historical cost of long-term assets.
Typical examples of long-term assets for which capitalizing interest is allowed include various production facilities, real estate, and ships. Capitalizing interest is not permitted for inventories that are manufactured repetitively in large quantities. U.S. tax laws also allow the capitalization of interest, which provides a tax deduction in future years through a periodic depreciation expense.
From the perspective of accrual accounting, capitalizing interest helps tie the costs of using a long-term asset to earnings generated by the asset in the same periods of use. Capitalized interest can only be booked if its impact on a company's financial statements is material. Otherwise, interest capitalization is not required, and it should be expensed immediately. When booked, capitalized interest has no immediate effect on a company's income statement, and instead, it appears on the income statement in subsequent periods through depreciation expense.
Important
In accordance with the matching principle, capitalizing interest ties the costs of a long-term asset to the earnings generated by the same asset over its useful life.
Example of Capitalized Interest
Consider a company that builds a small production facility worth $5 million with a useful life of 20 years. It borrows the amount to finance this project at an interest rate of 10%. The project will take a year to complete to put the building to its intended use, and the company is allowed to capitalize its annual interest expense on this project, which amounts to $500,000.
The company capitalizes interest by recording a debit entry of $500,000 to a fixed asset account and an offsetting credit entry to cash. At the end of construction, the company's production facility has a book value of $5.5 million, consisting of $5 million in construction costs and $500,000 in capitalized interest.
In the next year, when the production facility is used, the company books a straight-line depreciation expense of $275,000 ($5.5 million of the facility's book value divided by 20 years of useful life) of which $25,000 ($500,000 of capitalized interest divided by 20 years) is attributable to the capitalized interest.
Related terms:
Accrual Accounting
Accrual accounting is an accounting method that measures the performance of a company by recognizing economic events regardless of when the cash transaction occurs. read more
Balance Sheet : Formula & Examples
A balance sheet is a financial statement that reports a company's assets, liabilities and shareholder equity at a specific point in time. read more
Capitalization
Capitalization is an accounting method in which a cost is included in the value of an asset and expensed over the useful life of that asset. read more
Capitalize
To capitalize is to record a cost/expense on the balance sheet for the purposes of delaying full recognition of the expense. In general, capitalizing expenses is beneficial as companies acquiring new assets with long-term lifespans can amortize the costs. read more
Capitalized Cost
A capitalized cost is an expense that is added to the cost basis of a fixed asset on a company's balance sheet. read more
Cost Basis
Cost basis is the original value of an asset for tax purposes, adjusted for stock splits, dividends and return of capital distributions. read more
Depreciation
Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life and is used to account for declines in value over time. read more
Earnings
A company's earnings are its after-tax net income, meaning its profits. Earnings are the main determinant of a public company's share price. read more
Fixed Asset
A fixed asset is a long-term tangible asset that a firm owns and uses to produce income and is not expected to be used or sold within a year. read more
Generally Accepted Accounting Principles (GAAP)
GAAP is a common set of generally accepted accounting principles, standards, and procedures that public companies in the U.S. must follow when they compile their financial statements. read more