ASC 835 Interest: Capitalized Interest on Construction and Imputed Interest on Notes

ASC 835, Interest, has two subtopics that come up in audits. Subtopic 835-20 requires interest incurred while an asset is being built or readied for use to be added to the asset's cost instead of expensed. Subtopic 835-30 deals with notes that carry no stated interest or an unreasonable rate, and with how discounts and issuance costs are presented. This page concentrates on capitalized interest, where errors are more common, and then covers imputation briefly. For the asset itself, see PP&E capitalization and depreciation.

Which assets are qualifying assets?

ASC 835-20-15-5 requires interest to be capitalized on three types of assets:

• assets constructed or otherwise produced for the entity's own use, including assets produced for it by others for which deposits or progress payments have been made;
• assets intended for sale or lease that are constructed or produced as discrete projects, such as ships or real estate developments; and
• equity method investments, while the investee has activities in progress necessary to commence its planned principal operations, if those activities include using funds to acquire qualifying assets.

ASC 835-20-15-6 lists assets for which interest is not capitalized. They include assets already in use or ready for their intended use, assets not being used and not being readied for use, assets not on the consolidated balance sheet, equity method investments after planned principal operations begin, and inventories routinely manufactured in large quantities on a repetitive basis. PwC's PP&E guide points to features that identify a discrete project: separate cost records, a long construction period, significant expenditures, customer specifications and progress payments.

Capitalization is required only when the benefit of the information justifies the cost of implementation (ASC 835-20-15-3). That judgment turns on whether the amount would be material if expensed.

How much interest is capitalized?

The amount capitalized is the interest cost that theoretically could have been avoided if the expenditures for the qualifying asset had not been made. It is computed by applying a capitalization rate to the weighted-average accumulated expenditures for the asset during the period. The amount capitalized cannot exceed total interest cost incurred by the entity in that period.

• Expenditures are measured on a cash basis, unless accruals bear interest, and are reduced by progress payments received from customers on discrete projects. Equity issued in exchange for the asset counts as an expenditure. Capitalized asset retirement costs are not expenditures for this purpose. See ASC 410-20 asset retirement obligations.
• The capitalization rate is the rate on a specific new borrowing if the entity's financing plans associate that borrowing with the asset, applied to the portion of average accumulated expenditures up to the borrowing amount. For expenditures above that, the rate is a weighted average of the rates on the entity's other borrowings (ASC 835-20-30-3).
• Tax-exempt borrowings used to finance a qualifying asset are capitalized in full from inception of borrowing, and interest earned on unspent proceeds of those borrowings is netted against it (ASC 835-20-30-10 through 30-12, per PwC).

When does capitalization begin and end?

Capitalization begins when three conditions are present: 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 (ASC 835-20-25-3). "Activities" is read broadly and includes steps before physical construction, such as design and permitting. It continues while those conditions remain, and stops no later than when the asset is substantially complete and ready for its intended use (ASC 835-20-25-5), whether or not it has been leased or occupied. Brief interruptions and delays inherent in construction do not stop capitalization, but an intentional suspension does. Interest on land is capitalized only while development activities are underway, and only for the portion being developed.

Illustrative example

Figures are illustrative. A manufacturer builds its own warehouse during the calendar year. It spends $600,000 on January 1 and $400,000 on July 1, with construction continuing through December 31. It has a $500,000 construction loan at 6%, outstanding all year and associated with the project, plus general borrowings of $2,000,000 at 5% and $1,000,000 at 7%.

• Weighted-average accumulated expenditures: ($600,000 x 12/12) + ($400,000 x 6/12) = $600,000 + $200,000 = $800,000.
• Specific borrowing: $500,000 x 6% = $30,000.
• Expenditures above the specific borrowing: $800,000 - $500,000 = $300,000.
• General borrowing rate: ($100,000 + $70,000) / $3,000,000 = 5.667%.
• Interest on the excess: $300,000 x 5.667% = $17,000.
• Interest capitalized: $30,000 + $17,000 = $47,000.
• Check against the cap: total interest incurred is $30,000 + $170,000 = $200,000, so the cap is not binding. Interest expense is $200,000 - $47,000 = $153,000.

The $47,000 is part of the warehouse cost and is depreciated once the asset is placed in service.

What must be disclosed?

For any period in which interest cost is capitalized, the entity discloses the total interest cost incurred and the amount capitalized (ASC 835-20-50-1). A company that does not separately track the two figures cannot comply, so they should appear in the fixed asset and debt workpapers.

What is imputed interest?

ASC 835-30 applies when a note is exchanged for property, goods or services and carries no stated interest, an unreasonable stated rate, or a face amount materially different from the cash price or fair value of what was exchanged. The note is measured at its present value using an imputed rate, and the discount is amortized to interest expense for a liability, or interest income for an asset, using the interest method (ASC 835-30-35-2). Scope exceptions in ASC 835-30-15-3 exclude certain items, including normal trade payables and receivables with customary short terms. Debt discount and debt issuance costs are presented as a direct deduction from the face amount of the debt (ASC 835-30-45-1A, as amended by ASU 2015-03). For shareholder loans or seller notes at below-market rates, the related party rules may also apply. See ASC 850 related party disclosures.

What do auditors test?

These are practice procedures, not steps from a standard.

• Identify qualifying assets from construction in progress, build-outs, software projects and equity method investees still in a development stage.
• Agree expenditures to invoices and payments, and confirm they are measured on a cash basis (unless accruals bear interest).
• Recompute weighted-average expenditures, the capitalization rate and the cap. The fixed asset rollforward template can carry capitalized interest as a separate column.
• Check start and stop dates against permits, certificates of occupancy and placed-in-service records.
• Compare capitalized interest to the debt schedule and interest expense in the trial balance, and test that interest is not both capitalized and expensed.
• Confirm that the capitalized amount is within the cap and that the disclosure agrees to the schedule.
• For notes with no stated interest, recompute the discount and amortization.

Frequently asked questions

Is capitalizing interest optional?

No, where it applies. Interest must be capitalized on qualifying assets, though ASC 835-20-15-3 allows an entity to skip it when the benefit does not justify the cost, which generally means when the amount is immaterial.

Do you capitalize interest on inventory?

Not on inventory that is routinely manufactured in large quantities on a repetitive basis. Discrete projects such as ships or real estate developments are qualifying assets.

When does capitalization stop?

When the asset is substantially complete and ready for its intended use, even if it has not yet been leased or occupied.

Can capitalized interest exceed interest expense incurred?

No. The amount capitalized cannot exceed the total interest cost incurred by the entity in the period.

Sources

• FASB, Accounting Standards Codification Subtopic 835-20, Capitalization of Interest: 15-2, 15-3, 15-5, 15-6, 25-3, 25-5, 30-3, 30-10 through 30-12, 50-1. https://asc.fasb.org
• FASB, ASC Subtopic 835-30, Imputation of Interest: 15-3, 35-2, 45-1A, and ASU 2015-03. https://www.fasb.org
• PwC, Viewpoint: Property, plant, equipment and related assets, section 1.3, Capitalized interest.
• Deloitte, Roadmap: Debt, section 4.3, Debt subject to ASC 835-30.

Related

• PP&E capitalization, depreciation and disposals
• ASC 410-20 asset retirement obligations
• Fixed asset rollforward
• Debt issuance costs
• ASC 850 related party disclosures

CORAA prepares ready-to-review audit files for US CPA firms from QuickBooks books; you review and sign. See /us.

AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error