Running head: CAPITALIZATION OF INTEREST

Capitalization of Interest

Author Note

Abstract

CAPITALIZATION OF INTEREST Capitalization of interest is in the best interest for businesses because it provides the most

accurate total cost for the acquisition of an asset. It also provides transparency when it comes to revenues and expenditures for the business and investors alike. The Financial Accounting Standards Board (FASB) is responsible for U.S. generally accepted accounting principles which provides the guidance for capitalization of interest. The FASB distributes this guidance through its online database known as the Accounting Standards Codification. The Codification provides the requirements necessary to capitalize interest. It covers the qualification of assets, the period for which interest can be capitalized, as well as the method with which to identify avoidable interest. Once these requirements are met, a final decision on how much interest to capitalize can be obtained. Documentation of this in the business financial statements provides the business as well as investors with a clear picture of the business financial practices.

Capitalization of Interest

CAPITALIZATION OF INTEREST Investors today have ample amounts of information readily available to them, and in order to garner interest in ones business it is ideal to be as transparent as possible. Therefore it is in a business best interest to accurately identify the impact of the acquisition of an asset on

ones financial statements. Accounting for such variances allows for the investor to differentiate between a drop in revenues and the reinvestment of revenues into the business. In order to obtain the cost that is the most accurate measure of a business total investment in an asset, interest must be capitalized. This allows for the business to expense the cost of the asset against the revenues generated during the periods in which interest could be capitalized. The financial accounting standards for capitalizing and reporting interest as part of the historical cost of acquiring an asset are established by the Financial Accounting Standards Board (FASB). The FASB utilizes their online Accounting Standards Codification to distribute guidance on matters related to nongovernmental U.S. generally accepted accounting principles (US GAAP). The Financial Accounting Standards Board (FASB) was founded in 1973 with the goal of providing investors with accurate and intelligible financial reports. The Securities and Exchange Commission (SEC) is the authority for establishing financial accounting and reporting standards per the Securities Exchange Act of 1934 ("Fasb: financial accounting,"). However, the SEC relies upon the FASB to develop and refine the financial accounting standards of nongovernmental entities. The FASB is an organization of seven, full time members, who are appointed by the Financial Accounting Foundation (FAF). These members come from accounting, finance, business, and investment backgrounds and bring a variety of experience and

CAPITALIZATION OF INTEREST expertise to the board. Their wealth of knowledge is used to accomplish the creation and refining of standards in a process that encourages public participation as well as transparency. The Financial Accounting Standards Board (FASB) uses the Accounting Standards Codification as online resource for accountants to access these standards. The Codification was launched in July of 2009. It is the product of five years of compiling by more than 200 people, and is considered the authoritative source for nongovernmental U.S. generally accepted accounting principles (US GAAP) ("Accounting standards codification," 2009). The Codification provides the most current standards and allows users to perform research, view recent Codification content updates, and provide feedback. The Accounting Standards Codification establishes the method of calculating and reporting the financial impact of capitalized interest as part of the historical cost in the acquisition of applicable assets. The historical cost includes all costs related to the acquisition that are necessary to bring the asset to the condition and location for its intended use. The historical also includes interest incurred due to expenditures for the asset during the period of time in which the asset is being prepared to reach condition and location of its intended use. In order for assets to qualify they must have a period of time required to make them ready for their intended use. The assets must also meet one of two criteria: The asset under construction must be for a companys own use. Or the asset intended for sale or lease is produced as a discrete project. A discrete project would be the construction of a ship or development of real estate. The capitalization period begins when three conditions occur. The first condition is that

expenditures for the asset have occurred. The second condition is that the activities necessary in

CAPITALIZATION OF INTEREST 5 readying the asset for its intended use are in progress. The third condition is that interest cost is being incurred. Capitalization of interest will carry on for as long these conditions continue to be present. Should any of these conditions be suspended, then capitalization will stop. When activities resume and the conditions are met, capitalization will begin again. Upon the asset being capable of its intended use, then the capitalization period will cease. The amount of interest to be capitalized is the portion of the interest cost incurred during the assets procurement period that could have been prevented had expenditures not occurred. An example of this would be the avoidance of acquiring additional loans to finance the construction of the asset. To identify the avoidable interest, a business determines the potential amount of interest available for capitalization during the accounting period and multiplies the interest rates against the weighted-average accumulated expenditures for qualifying assets. To acquire the weighted-average accumulated expenditures, a business identifies the amount of time for which interest costs occurred during the period (Wiley, 2009). The sum of the weightedaverage accumulated expenditures is the avoidable interest. The business then capitalizes the lesser of the actual interest costs or the avoidable interest. Interest capitalization is exceedingly beneficial to businesses. It provides businesses as well as investors with the most complete total acquisition cost of an asset. Since new assets such as factories require time to ready the location and construct the building before reaching their intended use, significant interest expenses can be incurred. These interest expenses can be included in the cost of the asset, and finally amortized over the life of an asset. Documentation of this can be provided to investors through footnotes in the financial statements. This provides

CAPITALIZATION OF INTEREST transparency for investors, allowing investors to differentiate between a drop in revenues and

expenses incurred through expansion of the business. The detailed documentation of capitalized interest allows for investors to make informed decisions about the financial future of the company while providing a clear outline of how their money is being spent to achieve that future.

CAPITALIZATION OF INTEREST References Accounting standards codification. (2009, July 1). Retrieved from http://asc.fasb.org/home Fasb: financial accounting standards baord. (n.d.). Retrieved from http://www.fasb.org/home Wiley, J. (2009). Wiley plus. Retrieved from https://edugen.wiley.com/edugen/secure/index.uni