A company that builds its own plant pays interest during construction. ASC 835-20 says part of that interest belongs in the cost of the asset, not in the income statement. The part is the interest that could have been avoided if the construction spending had not been made. The calculation has four moving pieces: the expenditures, their timing, the rate and the cap. This guide works one example from start to entry, then lists the audit tests. The broader topic, including imputed interest, is on our ASC 835 standards page.
Which assets qualify?
PwC states that interest is capitalized for assets constructed or otherwise produced for the entity's own use and for discrete projects intended for sale or lease. KPMG adds that ships and real estate developments are examples.
Interest is not capitalized for assets in use or ready for their intended use, and not for inventory routinely produced in large quantities on a repetitive basis. KPMG notes that internal research and development is expensed as incurred under US GAAP, so it does not qualify, while capitalized internal-use software may be a qualifying asset. KPMG also notes that IFRS differs on repetitive inventory such as wine or cheese.
When does capitalization start and stop?
It starts when three conditions are all present: expenditures have been made, activities needed to ready the asset are in progress, and interest is being incurred. PwC says capitalization continues as long as those conditions are present. A long suspension of construction activity is a reason to test whether capitalization should pause, and the file documents the conclusion. Capitalization ends when the asset is substantially complete and ready for its intended use, a point the accountinginfo.com codification summary also makes.
What is avoidable interest?
The amount capitalized is limited to the interest that could have been avoided. PwC and the accountinginfo.com summary both state that capitalized interest cannot exceed the total interest cost incurred in the period. The calculation applies a capitalization rate to the average accumulated expenditures.
Which rate applies?
If a specific new borrowing is tied to the asset, its rate applies to expenditures up to the amount of that borrowing. For expenditures beyond that, PwC and the accountinginfo.com summary say the rate is a weighted average of the rates on the entity's other borrowings. KPMG adds that under US GAAP, interest income earned by temporarily investing the proceeds of a specific borrowing is generally not offset against interest cost, with an exception for certain externally restricted tax-exempt borrowings. It also notes that fair value changes on derivatives and foreign exchange gains and losses are generally excluded from eligible interest, with a narrow exception for fixed-rate debt designated in a fair value hedge.
Worked example
Illustration only, with round numbers. A manufacturer builds a plant for its own use. Construction runs for the full calendar year. Expenditures:
- January 1: $1,200,000
- April 1: $600,000
- October 1: $1,200,000
Weighted-average accumulated expenditures weight each by the fraction of the year it was outstanding:
| Date | Expenditure | Months outstanding | Weighted amount |
|---|---|---|---|
| January 1 | $1,200,000 | 12/12 | $1,200,000 |
| April 1 | $600,000 | 9/12 | $450,000 |
| October 1 | $1,200,000 | 3/12 | $300,000 |
| Total | $1,950,000 |
Borrowings:
- A $1,000,000 construction loan at 8%, drawn January 1 to fund the plant.
- General borrowings: $5,000,000 at 6% and $3,000,000 at 10%.
Step one: the specific loan covers the first $1,000,000 of weighted expenditures. Interest: $1,000,000 times 8% equals $80,000.
Step two: the excess weighted expenditures are $950,000. The rate is the weighted average of the general borrowings. Annual interest on the general borrowings is $300,000 plus $300,000, or $600,000, on $8,000,000, which is 7.5%. Interest: $950,000 times 7.5% equals $71,250.
Step three: avoidable interest is $80,000 plus $71,250, or $151,250.
Step four: the cap. Total interest incurred for the year is $80,000 plus $600,000, or $680,000. Avoidable interest of $151,250 is below that, so the cap does not bind. If it had, the lower figure would be capitalized.
The entries: first record the interest, then move the capitalized part into the asset.
| Account | Debit | Credit |
|---|---|---|
| Interest expense | $680,000 | |
| Cash (or interest payable) | $680,000 |
| Account | Debit | Credit |
|---|---|---|
| Construction in progress (capitalized interest) | $151,250 | |
| Interest expense | $151,250 |
The year's interest expense is $528,750. The plant's cost includes $151,250 of interest, which is recovered through depreciation after it is placed in service.
Audit angle
Capitalized interest is a computation with judgment at the edges. The auditor recomputes it and tests the inputs.
- Qualifying population. Agree the assets to the construction ledger. Check that each was being prepared for use and not idle, and exclude inventory and expensed research costs.
- Capitalization period. Test start and stop dates against permits, contractor billings, board minutes and inspection reports. Look for suspended activity that should have stopped capitalization, and for completion dates that moved.
- Expenditures. Agree each amount to the construction ledger and to payment or invoice evidence. Test the timing of each large item, since the weight depends on the date.
- Rates. Agree specific loans to the credit agreements and general borrowings to the debt schedule. Recompute the weighted-average rate and check that interest income was not netted against specific-borrowing interest.
- The cap. Compare capitalized interest to total interest incurred.
- Presentation and depreciation. Check that the interest is in the asset and depreciated from the in-service date. See PP&E accounting and debt classification and modifications for the loan terms.
Common misstatements: interest expensed on a project that qualified, capitalization continuing after completion or during a long suspension, expenditure dates that do not match the weighting, and a rate taken from one loan when general borrowings fund the excess.
CORAA prepares ready-to-review audit files for US CPA firms from QuickBooks books; you review and sign. See /us.
Sources
- PwC, Property, plant, equipment and other assets guide, 1.3 Capitalized interest: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/property_plant_equip/property_plant_equip_US/chapter_1_capitaliza_US/13_capitalized_inter_US.html
- KPMG, Borrowing costs (IAS 23 and US GAAP comparison), qualifying assets, R&D, interest income and derivatives: https://kpmg.com/us/en/articles/2023/borrowing-costs.html
- accountinginfo.com, U.S. GAAP Codification summary, 835-20 Interest Capitalization: https://accountinginfo.com/financial-accounting-standards/asc-800/835-20-interest-capitalization.htm
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