## Monday, October 10, 2011

### Computing the Effect of Capitalizing vs. Expensing

CFA Level 1 - Assets

If interest is capitalized, it is included in the cost of carry. Capitalizing interest is common in construction projects. The interest cost is included as an asset versus being expensed on the income statement for the period it occurred.
In the U.S., SFAS 34 governs the capitalization of interest cost during an accounting period. SFAS 34 requires that the interest cost incurred during a construction period is accounted for as a long-lived asset. To be capitalized, the interest must be from borrowed money. If no specific borrowing is identified, interest can be estimated by means of a weighted average interest rate on outstanding debt for the amount invested.

Example:

A company built a building for \$1m. It borrowed \$500,000 at 5% to build the building. In this case the interest capitalized will amount to \$25,000.
Another company built a building for \$1m. It borrowed \$500,000 at 5% to build the building; it also had an outstanding debenture of \$3m at 10% and a \$1M mortgage at 15%. In this case, the interest capitalized will amount to:
500,000 * 5%   =         25,000
500,000 * 10% =         50,000
Total                             75,000
Interest to be expensed = total interest paid - capitalized interest

= 25,000+300,000+150,000-75,000= 400,000

The total capitalized interest is \$75,000 because we assume the \$500,000 balance was financed through the debenture. The reason we do not consider the mortgage is that it is already assigned to another identifiable asset.

Some argue that the capitalization costs of self-financed assets should not be included.
The decision to capitalize interest will have an effect on a company's:

• Net income - In the current period earnings will be higher (overstated).
• CFO - In the current period, CFO will be higher (overstated) because the interest expense will be included in CFI.
• CFI - In the current period, CFI will be lower (understated).
• Assets - Total assets will be overstated because they include the capitalized interest.
• Solvency ratios - Since assets, EBIT and stockholders' equity will be higher, all solvency ratios will be overstated.

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