Capitalized Interest

Capitalized interest is the cost of borrowing to acquire or construct a long-term asset. Unlike an interest expense incurred for any other purpose, capitalized interest must not be expensed on the income statement of a company's financial statements, and instead, firms capitalize it, meaning such interest increases the cost basis of a long-term asset on a balance sheet. Capitalized interest shows up on a company's income statement through a periodic depreciation expense recorded on the associated long-term asset throughout its useful life.

Capitalized interest is part of the historical cost of acquiring assets that require a period of time to set them up for their intended use. Because many companies finance the construction of long-term assets with debt, the Generally Accepted Accounting Principles (GAAP) allow firms to avoid expensing interest on such debt, and include it on their balance sheets as part of a historical cost of long-term assets. Typical examples of long-term assets for which capitalizing interest is allowed include various production facilities, real estate and ships. Capitalizing interest is not permitted for inventories that are manufactured repetitively in large quantities. As far as tax books, U.S. tax laws also allow the capitalization of interest, which provides a tax deduction in future years through a depreciation expense.

From the perspective of accrual accounting, capitalizing interest helps a user of financial statements obtain an accurate measure of the acquisition cost of an asset and have a better allocation of costs to earnings in the periods when an acquired asset is being used. Capitalized interest can only be booked if its impact on a company's financial statements is material. Otherwise, interest capitalization is not required. When booked, capitalized interest has no immediate effect on a company's income statement, and instead, it appears on the income statement through a depreciation expense.

Consider a company that builds a small production facility worth $5 million with a useful life of 20 years, and it borrows the same amount to finance this project at an interest rate of 10%. The project will take a year to complete to put the asset to its intended use, and the company is allowed to capitalize its annual interest expense on this project, which amounts to $500,000. The company capitalizes interest by issuing a debit entry of $500,000 to a fixed asset account and a credit entry to cash, and the cash equivalent for the same amount when an interest payment is made to a lender. After the end of construction, the company's production facility has a book value of $5.5 million, consisting of $5 million in construction costs and $500,000 in capitalized interest.

In the next year when the production facility is used, the company books a straight-line depreciation expense of $275,000 — $5.5 million of the facility's book value divided by 20 years of useful life — of which $25,000, ($500,000 of capitalized interest divided by 20 years), is attributable to the capitalized interest.