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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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