Lesson 17 - Intermediate Accounting Course 

17. Accounting for Capitalized Interest Costs

Capitalized interest is the interest expense incurred during the construction of a long-term asset, which is added to the cost of the asset instead of being expensed immediately. This process aligns with the accounting principle of matching costs with the revenues they help generate.

Companies that finance the construction of property, plant, equipment (PPE), or other long-term assets using loans or debt often capitalize the interest costs incurred during the construction period. This ensures that the total cost of the asset reflects all necessary expenditures to make it operational.

1️⃣ What is Capitalized Interest?

When a company borrows money to construct a long-term asset, it incurs interest costs on that debt. Instead of recognizing these interest costs as an expense in the income statement, they are added to the cost of the asset on the balance sheet.

📌 Example:
A company is building a new factory and takes out a loan of $5 million with an annual interest rate of 6%. The construction takes 2 years.

• Total interest for Year 1:
  
  

  • $5,000,000 × 6% = $300,000
    
    

• Total interest for Year 2:
  
  

  • $5,000,000 × 6% = $300,000
    
    

• Total capitalized interest added to the cost of the factory = $600,000
  
  

Instead of expensing this interest immediately, the company capitalizes it as part of the factory's total cost.

2️⃣ Why is Interest Capitalized?

Capitalizing interest helps:
✅ Reflect the true cost of constructing a long-term asset
✅ Improve short-term net income by delaying expense recognition
✅ Match costs with future revenues the asset will generate

However, interest capitalization is temporary—once the asset is completed and ready for use, interest is no longer capitalized and must be expensed in the income statement.

3️⃣ Conditions for Capitalizing Interest

Not all interest costs can be capitalized. To qualify, the following conditions must be met:

✔️ The asset must take substantial time to construct (e.g., buildings, ships, large equipment).
✔️ The interest must be incurred during the construction period.
✔️ The company must be actively developing the asset (if construction is stopped, interest capitalization stops too).
✔️ The asset must be for company use or sale as a long-term asset (not inventory).

4️⃣ How to Calculate Capitalized Interest

Interest capitalization follows these steps:

🔹 Step 1: Identify Qualifying Assets
Only assets under construction for long-term use qualify.

🔹 Step 2: Determine the Loan Amount Used for Construction
If multiple loans exist, companies must determine the portion used for the project.

🔹 Step 3: Calculate Interest Cost
Apply the interest rate to the qualifying loan amount. If multiple loans exist, companies use a weighted-average interest rate.

🔹 Step 4: Capitalize Interest Until the Asset is Ready for Use
Once the asset is completed, interest is expensed in future periods.

5️⃣ Accounting Treatment of Capitalized Interest

📌 Example Journal Entries

1️⃣ During Construction (Capitalizing Interest)

Dr. Construction in Progress (CIP)   $300,000  

    Cr. Interest Payable             $300,000  

2️⃣ Once Construction is Completed (Transferring to Fixed Asset) 

Dr. Factory (PPE)   $600,000  

    Cr. Construction in Progress   $600,000  

3️⃣ After Completion (Regular Interest is Expensed) 

Dr. Interest Expense   $100,000  

    Cr. Interest Payable   $100,000  

Once the asset is operational, interest can no longer be capitalized and must be recorded as an expense. 

6️⃣ GAAP vs. IFRS Treatment of Capitalized Interest 

While both GAAP and IFRS require interest capitalization, IFRS prioritizes specific borrowings first, while GAAP allows a weighted-average approach when multiple loans exist. 

7️⃣ Impact on Financial Statements

📌 How Capitalized Interest Affects Financial Statements:
✔ Balance Sheet: Increases the cost of the asset under PPE
✔ Income Statement: Reduces interest expense in the short term (increases net income)
✔ Cash Flow Statement: Classified as an investing activity instead of an operating expense

However, once the asset is complete, companies begin expensing depreciation and interest, which can reduce future net income.

8️⃣ When Not to Capitalize Interest

🚫 Interest should NOT be capitalized in these cases:
❌ If the asset is completed and in use
❌ If the asset is held for sale or investment (not long-term use)
❌ If interest is unrelated to the construction (e.g., loans for daily operations)

9️⃣ Summary & Key Takeaways

🔹 Capitalized interest is added to the cost of long-term assets under construction.
🔹 It is only capitalized during the construction period and stops once the asset is ready for use.
🔹 Companies must follow GAAP or IFRS rules to determine eligible loans and interest rates.
🔹 Financial statement impact: Increases asset value but can reduce future profits due to depreciation and interest expenses.

Understanding capitalized interest is essential for analyzing construction-heavy industries like real estate, manufacturing, and energy.