v.s.
CAPITALIZATION OF INTEREST COSTS

What is "capitalization?

Instead of expensing the interest costs now, you add them to the cost of an asset. That way they are "expensed" as part of the depreciation as the asset is used.

When do you do this?

Only when assets are either (1) for your own business’ personal use or (2) are large discrete projects for sale (like building a ship.)

Basic rule:

Capitalize the LOWER of either the avoidable interest or the actual interest cost incurred during the project.

Steps to do this:

1. Calculate the weighted average amount of capital expenditures this year associated with the project. (WACE)


2. Determine the actual interest incurred in two steps:


a) specifically related to the project (SI)
b) other interest incurred - determine average rate (OI)



3.
WACE minus
-Specific debt x SI = XXX
=Remainder x OI = XXX
Avoidable interest




4. Compare avoidable interest to actual interest incurred during the project and capitalize the lower of the two.
Example: Lucky Company undertook a large construction project for its own use in 1998. Expenditures for the project were: $8,000,000 on May 1, 1998; $4,000,000 on August 1, 1998 and $3,000,000 on December 1, 1998. At the end of the year the project is still underway. The company has construction bonds specifically for this project of $5,000,000 with interest of 12%. They have general debt of $6,000,000 at an interest rate of 13% and $3,000,000 at an interest rate of 8%. How much interest is capitalized in 1998?

1.Determine weighted average capital expenditures (WACE)

May 1 - $8,000,000 x 8/12 = 5,333,333
August 1 - $4,000,000 x 5/12 = 1,666,667
December 1 - $3,000,000 x 1/12 = 250,000
7,250,000


2. The construction began on May 1 so 8 months of actual interest =

Specific debt: $5,000,000 x .12 x 8/12 = 400,000
Other debt: $6,000,000 x .13 x 8/12 = 520,000
$3,000,000 x .08 x 8/12 = 160,000
Actual interest: 1,080,000


You will need the average rate of interest on other debt for step 3. Be sure to figure out an ANNUAL average rate of interest!



$3,000,000 x .08 = 240,000
6,000,000 x .13 = 780,000
9,000,000 1,020,000

1020/9000 = 11.3% average rate

3. The avoidable interest =

W.A.C.E. $7,250,000
Specific debt: $5,000,000 x .12 = 600,000
Other debt: $2,250,000 x .113 = 254,250
Avoidable interest: 854,250


4. The avoidable interest is the lower of the actual and avoidable, so it is capitalized.

©Sharon M. Bruns, 1998