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Capitalization of Interest Cost

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Summary of SFAS No. 34

FASB Statement of Financial Accounting Standards (SFAS) No. 34
Capitalization of Interest Cost , October 1979

Cost of an asset acquired
--> includes all costs necessary
(to make the asset ready for intended use)

Interest cost incurred
          --> during the period
                    (to make the asset ready for intended use)
          --> is a part of acquisition cost of the asset.

Assets qualified for interest capitalization
      Assets constructed
          a. for the entity's own use
          b. for sale or lease "as discrete projects"

          --> Examples: Ships, Real estate developments

Assets not qualified for interest capitalization
          a. Inventories
          b. Assets that are
                  --> in use
                  --> ready for intended use
                  --> not used in the earning activities

Amount to be capitalized

          a. In general,

            --> Average amount of accumulated expenditures
                       (for the period)
                  x interest rate (capitalization rate)

          b. Specific borrowing for certain assets

            --> Average accumulated expenditures
                        (up to the amount of specific borrowing)
                  x interest rate of specific borrowing

          c. Amount exceeding specific borrowing

            --> Average accumulated expenditures
                        (over the amount of specific borrowing)
                  x weighted average interest rate of other borrowings

An Example of Interest Capitalization

Example 1

Company A began a construction on January 1, 2006.
      a. Company A borrowed $2 million on January 1, 2006 to finance this construction project.
      b. Annual interest rate for $2 million is 8%.
      c. Other borrowings of Company A:
              $15 million at 10% annual interest rate
              $25 million at 12% annual interest rate

      d. Expenditures that incurred evenly during the year:
              2006: $6,000,000
              2007: $12,000,000
              2008: $3,000,000

      e. The plant became ready for use on April 30, 2008.
      f.   The plant began actual production on July 1, 2008.

Step 1: Weighted average interest rate

     Interest rate for specific borrowing: 8%
     Weighted average interest rate for other borrowings:

Amount Interest Rate Interest Cost

$15,000,000 10% $1,500,000

$25,000,000 12% $3,000,000

Total $40,000,000 $4,500,000

Weighted average interest rate = $4,500,000 / $40,000,000 = 11.25%

Step 2: Average cumulative expenditures

2006 2007 2008

A Beginning accumulated expenditures $3,272,250 $10,250,656

B Expenditures incurred during the year $6,000,000 $12,000,000 $3,000,000

C=A+B Ending accumulated expenditures $6,000,000 $15,272,500 $13,250,656

D=(A+C)/2 Average accumulated expenditures $3,000,000 $9,272,500 $11,750,656

E Interest cost to be capitalized $272,250 $978,156 $418,983

F=C+E Accumulated expenditures after interest capitalization $3,272,250 $10,250,656 $12,169,639

Interest cost to be capitalized

Borrowing Interest rate Interest cost No. of Months Interest to be capitalized

$2,000,000 8% $160,000

$1,000,000 11.25% $112,500

2006 $3,000,000 $272,500 12 $272,500

Borrowing Interest rate Interest cost No. of Months Interest to be capitalized

$2,000,000 8% $160,000

$7,272,000 11.25% $818,156

2007 $9,272,000 $978,156 12 $978,156

Borrowing Interest rate Interest cost No. of Months Interest to be capitalized

$2,000,000 8% $160,000

$9,750,000 11.25% $1,096,949

2008 $11,750,656 $1,256,949 4 $418,983

Interest Capitalization Example 1 in pdf

Interest Capitalization Example 2 in pdf

Interest Capitalization Example 3 in pdf

Other Accounting Topics

Inventory Valuation Methods

Depreciation Methods

Revenue Recognition Principle

Accrual Basis vs. Cash Basis Accounting

Basics of Journal Entries

Ratios for Financial Statement Analysis

U.S. GAAP by Topic

Statements of Financial Accounting Standards (SFAS)

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