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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, 2011.
      a. Company A borrowed $2 million on January 1, 2011 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:
              2011: $6,000,000
              2012: $12,000,000
              2013: $3,000,000

      e. The plant became ready for use on April 30, 2013.
      f.   The plant began actual production on July 1, 2013.

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

2011 2012 2013

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

2011 $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

2012 $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

2013 $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

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