Capitalized interest is interest cost added to the carrying amount of an asset instead of being charged to interest expense in the period it is incurred. Carrying amount is the figure the asset is reported at on the balance sheet, so the interest reaches income later, when the rest of the asset’s cost does, through depreciation, amortization or cost of sales.
The reasoning is cost attachment, not presentation. The historical cost of acquiring an asset includes the costs necessarily incurred to bring it to the condition and location necessary for its intended use, so when an asset needs a period of time for those activities, the interest incurred during that period as a result of expenditures for the asset is part of the acquisition cost (FASB Statement No. 34, Capitalization of Interest Cost, paragraph 6). Interest capitalization is required today under Subtopic 835-20, Capitalization of Interest, of the FASB Accounting Standards Codification (FASB Accounting Standards Update 2017-07, paragraph BC25).
Which Assets Qualify
A qualifying asset is one that requires a period of time to get it ready for its intended use: assets an entity constructs or produces for its own use, and assets intended for sale or lease that are constructed as discrete projects, such as ships or real estate developments (FASB Statement No. 34, paragraph 9).
The exclusions do most of the work. Interest is not capitalized for inventories routinely manufactured in large quantities on a repetitive basis, for assets already in use or ready for their intended use, or for assets neither being used nor undergoing the activities needed to get them ready (FASB Statement No. 34, paragraph 10). Expenditures to acquire land qualify while development for a particular use is in progress, and land not undergoing such activities is not a qualifying asset (FASB Statement No. 34, paragraph 11). Capitalization is required where its effect compared with expensing the interest is material, and is not required where it is not (FASB Statement No. 34, paragraphs 8 and 9).
The Capitalization Period
The capitalization period is the window in which interest may be added to the asset. It begins when three conditions are present at once: expenditures for the asset have been made, activities necessary to get it ready for its intended use are in progress, and interest cost is being incurred. It ends when the asset is substantially complete and ready for that use, and suspending substantially all activity stops capitalization until work resumes (FASB Statement No. 34, paragraphs 17 and 18).
How the Amount Is Computed
Capitalized interest for a period = capitalization rate x average accumulated expenditures for the asset during that period.
The capitalization rate is an interest rate, or rates, based on the rates applicable to borrowings outstanding during the period, and average accumulated expenditures is the average amount of accumulated expenditures for the asset during that same period (FASB Statement No. 34, paragraph 13). Where a financing plan ties a specific new borrowing to the asset, that borrowing’s rate may be applied to the portion of the average that does not exceed the amount of that borrowing, with a weighted average of the rates on the entity’s other borrowings applied to the excess.
Two limits shape the answer. Expenditures here are capitalized expenditures, net of progress payment collections, that required cash, other assets, or a liability on which interest is recognized, not trade payables, accruals or retainages; and the total capitalized in a period cannot exceed the total interest cost the entity incurred in that period (FASB Statement No. 34, paragraphs 15 and 16).
Say the period ran for part of a year and total interest cost came in below the computed amount.
Average accumulated expenditures over the capitalization period 600,000
Capitalization rate 7%
Portion of the year the capitalization period ran 9/12
Computed amount 600,000 x 7% x 9/12 31,500
Total interest cost incurred by the entity in the year 28,000
Interest capitalized limited to interest cost incurred 28,000Interest is an integral part of the cost of acquiring a qualifying asset, so its disposition matches that of the other components of asset cost (FASB Statement No. 34, paragraph 20). On a depreciable asset, that cost comes back on the schedule set out in straight line depreciation, and it builds the contra account covered in where does accumulated depreciation go on a balance sheet. Separately, for a period in which some interest is capitalized, the note discloses both the total interest cost incurred and the amount capitalized (FASB Statement No. 34, paragraph 21).
The Tax Test Is a Different One
A client can capitalize nothing on the books and still capitalize on the return. Under section 263A, interest is capitalized only where it is paid or incurred during the production period and allocable to property the taxpayer produces that has a long useful life, an estimated production period exceeding 2 years, or an estimated production period exceeding 1 year and a cost exceeding $1,000,000, and long useful life means real property or property with a class life of 20 years or more (26 U.S.C. 263A(f)).
The method has a name of its own. Capitalization of interest under the avoided cost method is required for the production of designated property, which means produced property that is either real property or tangible personal property meeting one of those three tests (Treasury Regulation 1.263A-8). Under that method, in general any interest the taxpayer theoretically would have avoided had accumulated production expenditures been used to repay or reduce outstanding debt must be capitalized (Treasury Regulation 1.263A-9).
The requirement does not reach every taxpayer. A taxpayer that meets the gross receipts test of section 448(c) for the taxable year, other than a tax shelter prohibited from using the cash receipts and disbursements method of accounting under section 448(a)(3), is not required to capitalize costs, including interest, under section 263A (Treasury Regulation 1.263A-8(a)(1)).
Electing to capitalize is a separate route rather than an exception to that one. After applying Treasury Regulations 1.263A-8 through 1.263A-15, a taxpayer may elect to capitalize interest under section 266 with respect to designated property, provided no computation under any provision of the Internal Revenue Code is thereby materially distorted (Treasury Regulation 1.266-1(a)(2)).
The gross receipts exemption and the general allocation machinery behind it sit in costing overheads, with the underlying capitalize or expense decision in opex versus capex.
What It Is Confused With
The consumer lending sense is a different thing wearing the same word: in the Department of Education’s Direct Loan rules, unpaid accrued interest added to a borrower’s unpaid principal balance is itself named capitalization (34 CFR 685.202(b)).
Common Questions
Neither. On a qualifying asset, where the effect is material, capitalizing the interest is a required treatment rather than a discretionary one (FASB Statement No. 34, paragraphs 8 and 9), so the question is whether the conditions are met, not whether the outcome is preferred. What it changes is when the cost reaches income, not how much of it does.
Accrued interest is about whether interest has been paid yet, while capitalized interest is about whether the cost lands on an asset or in expense. On a consumer loan the two connect instead of separating, because it is the unpaid accrued interest that gets added to principal and that addition is what the rules call capitalization (34 CFR 685.202(b)).
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