by 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 assets appearing 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.
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.
Capitalization is the addition of unpaid interest to the principal balance of your loan. The principal balance of a loan increases when payments are postponed during periods of deferment or forbearance and unpaid interest is capitalized. As a result, more interest may accrue over the life of the loan, the monthly payment amount may be higher, or more payments may be required.
Accounting for Capitalized Interest
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.
Which Borrowing Costs to Capitalize
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.
When to Capitalize Interest
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.
When to Stop Capitalizing Interest
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.
How Much It Will interest Cost
The cost of a loan, ignoring any one-time fees, is the interest you pay. In other words, you repay what they gave you, plus a little extra. Total cost is driven by:
- The amount you borrow: The higher your loan balance, the more interest you’ll pay
- The interest rate: The higher the rate, the more expensive it is to borrow
- The amount of time you take to repay the loan: If you take longer to pay, there’s more time for your lender to charge interest.
Reasons for Interest on Drawn
Drawings are opposite to capital invested i.e. these are the funds drawn by partners from the business. Therefore, in order to keep the distribution of profit fair, a clause may be inserted in the agreement, where an interest is charged on the drawings of the partners. Again, this can be on the total amount or on an amount exceeding a specific limit. Both of the above things depend upon the agreement between partners.
Accounting Treatment
One may think that as Interest on Capital is paid to the partners, so it should be treated as business expense and Interest on Drawings is charged from the partners, therefore, it should be treated as income. But this is not the case. Just like partners salaries, both these items will be included in the Profit and Loss Appropriation Account. Partners’ salaries, interests etc. are never treated as expense or income of the business. They are a part of DISTRIBUTION OF PROFIT.
