Capitalized Interest Journal Entry
Capitalized interest is the borrowing cost that company spends to construct fixed assets, and it must be capitalized as part of assets.
Interest is the cost that incurs to acquire a loan from a bank or other creditors. The bank or creditors will charge interest over the amount of loan provided to the company. It is usually recorded as finance cost which is classified as a non-operating expense on the income statement. The company will charge it to expense immediately when the loan is used to support operation, business expansion, and so on.
On the other hand, this same finance cost will be capitalized as part of fixed assets when the loan is used for the construction of these assets. The accounting standard allows the company to capitalize interest during the construction period. The same interest will be classified as an expense after the construction is complete and the asset is ready to use.
The interest will be capitalized as part of fixed assets. It will increase the value of the assets. After the asset is ready to use, the total cost will be depreciated over the useful life of fixed asset. As the result, the interest will be allocated to asset life and record as depreciation expense.
The interest capitalization only happens on the assets that require a substantial time of construction. Base on the standard, these assets are considered qualifying assets. These assets require a period of time to construct and are ready for use. They include building, investment property, biological assets, and other types of machinery. The company constructs these assets for internal use and support business operation. If the company constructs assets for sale, it is considered as inventory, so the interest is not allowed to be capitalized.
Calculated Capitalized Interest
The amount of interest capitalized is equal to the lower actual interest on loan or the avoidable interest. The company needs to calculate both interests and capitalize the lower one.
- Actual Interest: is the amount of interest that bank/creditor charges to the company. It is the amount that we need to pay to receive a loan from them. It will be calculated by the accrued basic rather than cash payment. Interest is equal to the multiple outstanding loans with interest rates.
- Avoidable Interest is the interest on a loan that would be avoidable if the construction of fixed assets does not happen. It is the interest that happens due to the construction of the fixed assets. The company may acquire a loan but not all of loan will be spent on the construction. It is not reasonable to capitalize the interest which loan spend on other purposes rather than the construction.
Avoidable interest amount is different from the actual interest due to the amount of loan and time period while the interest rate is the same. The company may borrow the money from the bank but only a certain percentage is used for the construction. The bank charge interest from the date of loan disbursement, but the construction may start on a different date.
Avoidable Interest = (% of loan use for construction) * (No of months construction/12 months) * Interest rate
The interest rate needs to be weighted average if the company borrows many loans at a different rate. These loans are not specifically used for construction.
The company needs to calculate both types of interests and capitalize on the lower interest. The actual interest is the maximum amount that allows the company to capitalize. The avoidable interest will never be greater than the actual interest.
Capitalized Interest Journal Entry
When company calculates the amount of interest capitalized, they need to record the interest into the qualifying assets. The calculation will base on the accrued basic rather than cash paid.
The journal entry is debiting qualified assets and credit interest payable.
| Account | Debit | Credit |
|---|---|---|
| Fixed Assets | ### | |
| Interest Payable | ### |
The transaction will increase the balance of qualifying assets on the balance sheet. The interest payable will record as the current liability on balance sheet.
The company makes interest payments based on the loan schedule, they need to reverse the interest payable and cash out.
The journal entry will debit interest payable and credit cash. If the amount paid is higher, we need to record additional assets.
| Account | Debit | Credit |
|---|---|---|
| Interest Payable | ### | |
| Cash | ### |
The interest payable will eliminate from balance sheet and the cash is reduced.
Capitalized Interest Journal Entry Example
On 01 July 202X, company ABC borrow loan from the bank of $ 1,000,000 to construct a new factory building and support the business operation. The bank charges an interest rate of 6% per year and needs to pay every month end.
The construction start in August and the company has spent on the following:
| Month | Construction Cost |
| September | 100,000 |
| October | 50,000 |
| November | 150,000 |
| December | 200,000 |
| Total | 500,000 |
Company has paid monthly interest to bank from 31 July to 31 December, however, the accountant records all of them as interest expenses.
Please calculate the capitalized interest during the year and make a journal entry to reverse the interest expense.
ABC borrow this loan for a general purpose which includes construction purposes.
The loan disburses from 01 July, so the bank also calculates interest from that date. The company spends interest for 6 months from July to December 202X.
Actual interest
Actual interest = Loan * interest rate * Coverage months
= 1,000,000 * 6% * 6/12 = $ 30,000
Avoidable interest
The construction starts on September 202X so we need to calculate the interest amount spend on the construction.
| Month | Construction Cost | Number of months | Interest rate | Interest Capitalized |
| September | 100,000 | 4 | 6% | 2,000 |
| October | 50,000 | 3 | 6% | 750 |
| November | 150,000 | 2 | 6% | 1,500 |
| December | 200,000 | 1 | 6% | 1,000 |
| Total | 500,000 | 5,250 |
Interest capitalized = (construction cost * interest rate * number of month cover)/12months
ABC pays interest to the bank $ 30,000 over the period of 6 months. However, they only use some portion of the loan to construct the factory. And the interest capitalized is only $ 5,250 which should be included in the factory cost.
Accountant has recorded the whole interest as interest expense, we need to reverse back the interest expense to the cost of the fixed asset.
The journal entry is debiting fixed assets $ 5,250 and credit interest expense $ 5,250.
| Account | Debit | Credit |
|---|---|---|
| Fixed Assets – Construction in Progress | 5,250 | |
| Interest Expense | 5,250 |
Fixed assets (construction in progress) are present as the construction on the balance sheet. Interest expense will be decreased as it should record as the Fixed Assets.
Loan borrow for construction purpose
If the company’s loan is for the construction purpose only, so the company must capitalize the actual interest expense less the interest income from the unused fund. Not all funds are used for construction immediately, company may invest in short-term investments such as term deposits. The interest from unused will reduce the amount of interest capitalization.
Capitalized interest = Actual Interest – Income from short term investment of the unused fund