Question

Your client is in the planning phase for a major plant expansion, which will involve the construction of a new warehouse. The assistant controller does not believe that interest cost can be included in the cost of the warehouse, because it is a financing expense. Others on the planning team believe that some interest cost can be included in the cost of the warehouse, but no one could identify the specific authoritative guidance for this issue. Your supervisor asks you to research this issue.

Instructions

If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses.

1. Is it permissible to capitalize interest into the cost of assets? Provide authoritative support for your answer.
2. What are the objectives for capitalizing interest?
3. Discuss which assets qualify for interest capitalization.
4. Is there a limit to the amount of interest that may be capitalized in a period?
5. If interest capitalization is allowed, what disclosures are required?

Short answer

1. Yes, it is permissible to capitalize the interest.
2. The purpose of capitalizing interest is to calculate the acquisition cost.
3. Assets that are constructed, assets intended for sale or lease, and investments.
4. The total capitalized amount shall not exceed the total amount of interest cost.
5. Expenses should be disclosed when interest costs are incurred.

Step-by-step solution

Meaning of Capitalization of Interest.

As with other interests, capitalized interest accumulates on an asset or loan, but it is not immediately recognized as an expense on the income statement.The accrued interest is instead deducted from the asset's value on the income statement, which includes the interest in its total value on the balance sheet.

(a) Explaining the possibility of capitalizing interest on the cost of assets.

According to FASB ASC 835-20-05, interest must be capitalized into the cost of assets that fulfill the conditions outlined in step 4 below.

(b) Explaining the objectives of capitalizing interest.

According to FASB ASC 835-20-10-1,

The capitalizing interest aims to measure acquisition cost that more accurately reflects an entity's entire investment in the asset and to charge a fee associated with purchasing a resource that will benefit future periods against the revenues of those periods.

(c) Explaining the assets that qualify for interest capitalization.

According to FASB ASC 835-20-15-5

The following sorts of assets (qualifying assets) must have the interest capitalized:

1. An entity's construction and productions and assets have been constructed or produced for it by others for which contributions have been made.
2. Assets are built or manufactured as distinct projects (for example, ships or real estate developments) and designed for sale or leasing.
3. A company should account for investments (equity, loans, and advances) using the equity method when it is engaged in activities required to commence its anticipated primary operations if the company is using money to acquire qualifying assets.

(d) Explaining whether there is a limit to the amount of interest that may be capitalized in a period.

According to FASB ASC 835-20-30-6,

The entire amount of interest expense capitalized in a given accounting period must not exceed the company's total interest expense incurred. That limitation will be applied to the total interest expense incurred by the parent business and consolidated subsidiaries on a consolidated basis in consolidated financial statements. The rule shall be used by reference to the total amount of interest cost (including interest on intra-entity borrowings) incurred by the separate entity in any separately issued financial statements of a parent entity or consolidated subsidiaries and the financial reports (whether separately issued or not) of unconsolidated subsidiaries and other investees accounted for by the equity method.

(e) Explaining the disclosure.

According to FASB ASC 835-20-50-1,

In its financial statements or associated notes, an organization must report the following information about interest costs:

1. For accounting periods in which interest is not capitalized, the interest expense is incurred during that period.
2. The overall amount of interest charges incurred over a financial year and the capitalized amount.