Under the accrual basis of accounting, interest is capitalized in association with the financing of assets an organization constructs for internal use or for assets that are constructed with the intent to sell or lease upon completion. Interest is only capitalized during the period under which the asset is being prepared for its intended use. The purpose of this is to obtain a more accurate representation of the full costs incurred in acquiring or constructing the asset. The interest capitalized should be added to the cost of the asset on the balance sheet and, when the asset is used internally, amortized over the life of the asset.
Interest costs eligible for capitalization include interest costs recognized on borrowings that would otherwise not have been obtained if that asset had not been acquired. The interest rate used to determine the amount of interest capitalized should be equal to the rate on the outstanding debt instrument. Also, capitalized interest can include interest on other borrowings that would have been avoided if the company used the cash to pay down the debt rather than construct the asset. If multiple borrowings are in place and/or used to finance a constructed asset, a weighted average of rates can be used to determine the amount of interest capitalized.
Interest should not be capitalized on assets that are already in use or not being prepared for use. Also, capitalization of interests is not permitted on inventory that is routinely manufactured by an organization. Capitalization of interest is only required if the effect is material to the financial statements, otherwise, interest can be expensed as usual. Generally speaking, interest capitalization is most appropriate on projects with a large amount of expenditures and an extensive period of completion.
By Crystal Becerril, CPA