Interest In Capitalization: What It Is, How It Operates, and a Sample
Apr 26, 2023 By Kelly Walker

Borrowing money to buy or build a long-term asset incurs interest costs, which are capitalised. Unlike other types of interest expenses, capitalised interest is not immediately deducted from earnings in the income statement.

Companies do not expense interest but rather raise the cost base of the corresponding long-term asset on the balance sheet by the amount of interest paid. Interest that has been capitalised is amortised during the life of the corresponding long-term asset through the entry of depreciation expenditure at regular intervals.

Comprehension of Accrued Interest

Investments in long-term assets have costs, including interest, that are capitalised. Generally Accepted Accounting Standards (GAAP) enable enterprises to include the interest paid on debt used to finance the building of long-term assets in their balance sheets rather than deducting it as an operating expense.

Capitalising interest on long-term assets like factories, warehouses, and ships is common practice. Large amounts of a product made repeatedly cannot have their interest capitalised. Interest can be capitalised under U.S. tax law and written off as a depreciation expenditure in subsequent years.

Invested Interest vs Spent Interest

Capitalizing interest is a key component of accrual accounting because it links the expenses incurred while utilising a long-term asset with the revenues earned over the same period. Interest may be capitalised if the effect on the financial statements is significant.

Alternatively, interest payments can be expensed as they are made rather than capitalised. Capitalized interest is not shown in the income statement when booked but in the following quarters as depreciation expenditure.

If the interest is paid, a credit is made to the cash account, and a debit is made to the capitalised asset account; if the interest is not paid, a credit is made to the open liability account.

Capitalized vs Accrued Interest

Accrued interest is the total amount built on debt since the last payment. For instance, if a loan requires a monthly payment and the borrower misses a payment, interest will continue until the next payment.

In this context, "accrual" refers to the interest that has accumulated but has not yet been paid. Interest that has accumulated and interest that has been capitalised are sometimes different. For instance, if unpaid interest is capitalised by adding it to the outstanding principal balance, the accruing interest amount is the same as the capitalised interest amount. Accrued interest is often capitalised.

However, this is only sometimes the case due to its unique handling. A missing interest payment, for instance, may be treated like any other period expenditure and included in the income statement immediately. Accrued interest in this situation will not be capitalised but immediately expensed.

Financial Aid and Capitalized Interest

In addition, many student loans have capitalised interest. In the case of student loans, capitalised interest refers to interest that has accrued and been added to the loan's principal sum. This typically occurs when a student is enrolled in school when the borrower cannot pay the loan, yet interest continues to accrue.

The borrower may be under any deferral term for their student loans. Loan interest may continue to accumulate, though, during this period. The borrower may be required to pay interest on the increased principal balance of the loan, which occurs when interest is added to the loan's principal sum.

A Capitalized Interest Example

Let's say a business invests $5 million on a modest production plant that will serve it well for the next two decades. It borrows the money at 10% interest to fund the endeavour. Putting the facility to its intended use will take a year, and the corporation can capitalise on the $500,000 in yearly interest expenditure associated with this undertaking.

When the interest is capitalised, a debit of $500,000 is made to the fixed asset account, and a credit of the same amount is made to the cash account. After deducting the initial $5,000,000 in construction expenses and the $500,000 in capitalised interest, the final book value of the company's manufacturing facility is $5.5,000,000.

Conclusion

The term "capitalised interest" refers to adding unpaid interest to a loan's main debt. When a borrower defaults on a loan and interest continues to collect despite the borrower's inability to pay, the interest becomes capital interest.

As interest is added to the principal balance, the borrower's repayment obligations will be based on a larger principal sum in subsequent periods. Capitalized interest can occur on student loans during deferral periods when the borrower is exempt from making interest payments.