What is capitalized interest?

Capitalized interest is the interest used to finance the construction of a long-term asset that an entity builds for itself (such as a building).

You add this interest 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 a fixed asset, and is included in the depreciation of the long-term asset. Thus, it is charged to expense over the useful life of the asset, and therefore appears on the income statement as depreciation expense, rather than interest expense.

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 specifically occurred 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.

Capitalization of borrowing costs terminates when the 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.

Capitalized Interest Example #1

ABC International is building a new world headquarters in Rockville, Maryland. ABC made payments of $25,000,000 on January 1 and $40,000,000 on July 1; the building was completed on December 31.

For the construction period, ABC can capitalize the full $25,000,000 of the first payment and half of the second payment, as noted in the following table:

Date	Payment	Capitalization Period*	Average Payment
1/1	$25,000,000	12/12	$25,000,000
7/1	40,000,000	6/12	20,000,000
			$45,000,000

* The number of months between the payment date and the date when interest capitalization ends.

During this time, ABC has a loan outstanding on which it pays 7.5% interest. The amount of interest cost it can capitalize as part of the construction project is $3,375,000 ($45,000,000 x 7.5% interest).

Capitalized Interest Example #2

Heavens Energy is constructing a wind farm off the coast of Cape Cod, Massachusetts. It can begin using each of the wind turbines as they are completed, so it stops capitalizing the borrowing costs related to each one as soon as it becomes usable.

Related Topics

Overview of depreciation
What does capitalize mean?
What is construction work in progress?
When do I stop assigning costs to a fixed asset?
Which costs can I assign to a fixed asset?