# Capitalization of Interest

Companies finance construction of their capital-intensive assets either by raising new equity capital or arranging loans from banks or issue of bonds to bondholders. The interest expense (also called borrowing cost) incurred on the debt is effectively a cost of the asset and matching principle of accounting requires such costs to be capitalized and depreciated over the useful life of the asset.

## Borrowing costs

In US GAAP, ‘capitalized interest’ is the part of interest expense that is capitalized as part of the cost of asset. IFRS on the other hand, uses the term ‘borrowing costs’ to refer to the costs incurred in relation to a debt used for construction of the asset. This may include (effective) interest expense on debt, finance cost of a finance lease, etc.

Not all interest costs are capitalized. Instead, only such costs are capitalized that are incurred on qualifying assets during the eligible capitalization period and that too only to a certain maximum limit.

## Qualifying assets

In the context of capitalization of interest, a qualifying asset is an asset for which capitalization of borrowing cost is allowed. It is an asset that takes substantial time is its construction, whether for internal use, sale or as an investment property. Typical examples of qualifying assets include plant, buildings, intangible assets, customized inventory, etc. However, normal production of inventories doesn’t qualify for capitalization of interest even if it takes substantial amount of time.

## Calculation of capitalized interest

The calculation of capitalized interest depends on the actual financing arrangement. An asset may be financed by a loan raised specifically for the asset or by funds withdrawn from the general pool of funds available or a combination of both. In general, calculation of capitalized interest involves the following steps:

1. Preparation of a schedule of expenditures incurred on the asset, differentiating between the asset-specific borrowing and general funds.
2. Calculation of capitalization period.
3. Calculation of weighted-average accumulated expenditures.
4. Determination of interest rate on the specific borrowing and the weighted-average interest rate on funds drawn from general pool.
5. Calculation of avoidable interest.

## Capitalization period

Capitalization period is the time period during which interest expense incurred on a qualifying asset is eligible for capitalization. Interest is eligible for capitalization when (a) the expenditures have been made, (b) activities related to construction of asset are ongoing, AND (c) interest cost is being incurred. Capitalization period begins when all the conditions are met and ceases when the asset is ready. Capitalization also ceases when all the activities related to the project are suspended except where such delay is normal.

## Weighted-average accumulated expenditures

Weighted-average accumulated expenditure is the product of expenditures incurred on a qualifying asset and a fraction representing the capitalization period in terms of years.

Weighted-average accumulated expenditures = expenditure incurred * months in capitalization period of the relevant year/12

## Specific borrowings and weighted-average interest rate

Interest rate on the loan specifically raised for the construction of asset is straightforward. It is the negotiated contract rate on the loan. Interest rate on funds withdrawn from general pool of debts is called the weighted-average interest rate and is calculated by dividing the annual interest expense on loans other than the specific loan by the total principal balance of the loans.

## Calculation of avoidable interest

The final step in calculation of capitalized interest involves calculating avoidable interest, using the following formula:

Capitalized interest = weighted-average accumulated expenditures up to the principal balance of specific borrowing * interest rate on that specific borrowing + weighted-average accumulated expenditures in excess of specific borrowing * weighted-average interest rate.

## Journal entries

Capitalized interest is included in the cost of the qualifying assets using the following journal entry:

 Qualifying Asset XXXXX Interest Expense XXXXX

## Example

KPK Infrastructures, Inc. (KPKI) is a company set up to build, own and operate all key public infrastructure projects in KPK. On 1 January 2013, it contracted Gandahara Inc. (GI) to build a bridge over Indus at a total cost of \$8,000,000. Following is the schedule of payments made by KPKI to GI over the year:

Payment Date Expenditure
01-Jan-13 3,000,000
01-May-13 1,000,000
01-Sep-13 2,000,000
01-Dec-13 2,000,000

Half of the project cost is financed by a specific loan carrying annual interest rate of 8% and the rest is financed out of two general loans: a loan from MCB of \$10,000,000 carrying 10% annual interest rate and another loan from UBL of \$5,000,000 carrying 11% annual interest rate. GI ceases work on the project in the monsoon season i.e. July and August.

Calculate the interest expense that KPKI can capitalize.

Solution

Following schedule calculates the weighted-average accumulated expenditures:

Payment Date Expenditures
(A)
Capitalization Period
(B)
Weight
(C=B/12)
Weighted Expenditures
(A×C)
01-Jan-13 3,000,000 12 months 1.00 3,000,000
01-May-13 1,000,000 8 months 0.67 666,667
01-Sep-13 2,000,000 4 months 0.33 666,667
01-Dec-13 2,000,000 1 month 0.08 166,667
4,500,000

Out of this \$4.5 million, \$4 million is financed by specific loan. The rest i.e. \$500,000 is financed out of the general loans. The interest rate on specific loan is 8% while the weighted interest rate on the general loans is calculated below.

Loan Principal Rate Annual Interest
MCB 10,000,000 10% 1,000,000
UBL 5,000,000 11% 550,000
15,000,000 1,550,000
 Weighted-average Interest Rate = \$1,550,000 = 10.33% \$15,000,0000

The above calculations furnish us with all the data needed to arrive at an estimate of avoidable interest.

Funding Amount Rate Avoidable Interest
Specific Loan 4,000,000 8% 320,000
General pool 500,000 10.33% 51,667
371,667

This \$371,667 is the amount of interest that could have been avoided. This much interest can be capitalized provided it doesn’t exceed the actual interest expense for the period.

KPKI should pass the following journal entry while recording the capitalized interest.

 Bridges-Indus \$371,667 Interest expense \$371,667

This would form part of the total cost of the bridge and will be amortized over the useful life of the bridge.
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