Many people in the real estate development industry know that in certain circumstances interest may be capitalized as part of the cost of a development project. For example, assume Company X intends to purchase land upon which to build a hotel. Company X gets a loan from the bank to fund this project and purchases the land. As construction of the hotel progresses, Company X capitalizes the related interest on the loan as part of this project’s cost. 192.168.o.1 admin “Pretty straight forward”, you say? Not so fast! There are a number of pitfalls to watch out for. Consider the following questions:
- Does the asset qualify? – In order to qualify as an asset for which interest must be capitalized, the asset must require a period of time to get ready for its intended use. It must be an asset constructed or otherwise produced for a company’s own use, or intended for sale or lease that is constructed or is an otherwise discrete project (e.g. ships or real estate developments). happy new year 2018 wishesAssets already completed for their intended use or that are not in the process of being readied for their intended use do not qualify. Assets that are routinely manufactured or otherwise produced in large quantities should also be excluded.[i] Some examples include cars, refrigerators and equipment.
- What is the beginning and ending of the capitalization period? – Three conditions must all be met for the capitalization of the interest to commence:
- Expenditures for the asset must have been made
- Activities necessary to get it to the intended use are in progress
- Interest cost is being incurred
Conditions 1 and 3 seem clear enough, however, condition 2 can get tricky. The term “activities” is to be construed broadly. It encompasses more than physical construction; it includes all the steps required to prepare the asset for its intended use. For example, it includes administrative and technical activities during the preconstruction stage, such as the development of plans or the process of obtaining permits from governmental authorities; it includes activities undertaken after construction has begun in order to overcome unforeseen obstacles, such as technical problems, labor disputes, or litigation. Also, if the enterprise suspends substantially all activities related to acquisition of the asset, interest capitalization shall cease until activities are resumed. However, brief interruptions in activities, interruptions that are externally imposed, and delays that are inherent in the asset acquisition process shall not require cessation of interest capitalization.[ii] Once any of the 3 conditions are not met, the capitalization period ends. In some cases, parts of the project can be completed while others or not. Such could be the case with condominiums. In this instance interest would continue to be capitalized on the unfinished parts.
- What interest should be capitalized to the asset? – Interest to be capitalized, in theory, is the amount of interest that could have been avoided if funds were used to pay off the debt instead of constructing the asset. A common misconception is that only interest related directly to the asset’s expenditures must be capitalized. All interest a company incurs is potentially subject to being capitalized no matter what the purpose is for the borrowings. Below is an illustration for clarification:
ABC Development bought a piece of land for $500,000 on January 1 and immediately began construction of a $2 million building. The land was paid for in cash, and a $2 million construction loan was obtained for the building. At December 31, the project was substantially complete at a total cost of $2,500,000.[iii]
The total interest incurred on the construction loan was $150,000. Additionally, the company has other borrowings at a weighted average rate of 10%. Total interest incurred on those borrowings was $200,000.[iv]
For the year, ABC should capitalize the $150,000 of construction loan interest. This represents interest on the construction of the $2 million building. [v]
Additionally (and often missed), ABC should capitalize interest associated with the land costs of $500,000. The amount of capitalized interest is the amount of average expenditures multiplied by an appropriate capitalization rate, in this case, the weighted average rate of the other borrowings,
$500,000 x 10% = $50,000
If the other interest cost incurred during the construction period was less than $50,000, then the lesser of $50,000 or the other interest cost actually incurred for the year would be capitalized.[vi]
In my experience, this component of “other” interest is often missed. Those accounting for construction or development projects would be wise to consider this as it could have a material impact on a company’s financial statements.
In this example the components of the assets end up as follows:
As shown the percentage of the total is small but considering the total funds involved even a low percentage can amount to significant dollars. The benefits of the capitalizing interest are a more accurate picture of the project’s cost, deferred expenses, and a better matching of revenue to expenses.
Capitalizing interest is not optional. Generally accepted accounting principles require the capitalization of interest given the proper circumstances.
Addressing the three questions of 1) does the asset qualify, 2) what timing to use for capitalization, and 3) how much interest to capitalize, will help you evaluate the impact of capitalized interest on your financial statements.
[i] Statement of Financial Accounting Standard Number 34, Capitalization of Interest Cost (FAS 34), paragraphs 8 – 9
[ii] FAS 34 paragraph 17
[iii] Real Estate Accounting and Auditing by Michael Ramos, CPA page 3-20