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New Building Capitalization of Interest
ASC 835-20 states that institutions are required to capitalize the interest cost incurred during the acquisition process or construction of the asset. The capitalized interest would be added to the historical cost of the asset, and therefore depreciate over its useful life. The capitalization of interest is required if the additional benefit of the additional information outweighs the cost. All the interest expense incurred for the period to get the asset ready for its intended use should be capitalized. The capitalization period begins when expenditures for the intended asset have been made, the entity is taking the necessary steps to put the asset in service, and interest is being incurred.
One of the asset categories that interest capitalization is allowable includes assets constructed for the entity’s own use. This includes the construction of a new branch building.
The types of property defined under section 263A of the Internal Revenue Code include:
- All real property
- Tangible personal property with a class life of 20 years or more
- Tangible personal property with an estimated production period exceeding two years
- Tangible personal property with an estimated period exceeding one year and an estimated cost of production exceeding $1 million
Interest should not be capitalized for assets already in service, assets not intended to be used in the earning activity of the entity, and assets not included on the balance sheet. Also, if there is an intentional delay in the progression of the asset, you should not capitalize the interest cost incurred during this period as this would result in a holding cost.
When land is purchased with the intention of constructing a building, the interest expense incurred on the land would be added to the cost basis of the building, and when capitalizing interest costs, you must not exceed the total amount of interest incurred during the financial reporting period.
The rate used to determine the amount being capitalized for financial institutions would be the cost of funds. The cost of funds calculation should be based on the ratio of interest expense to average deposits plus average borrowings. The average can be calculated based on monthly or quarterly amounts. You should use the average that reflects a realistic rate and not just a favorable rate. See below for a hypothetical example.
In this example assume a building with current construction in process (CIP) of $50,000 is being constructed over a seven-month period.
Cost of Funds Calculation
|Interest Expense||1/1/2009 to 7/31/2009||$800,000|
|Interest Expense Annualized||($800,000/7 months) x 12 months||$1,371,429|
|Cost of Funds||($1,371,429/$50,000,000)||2.74%|
|Average Construction in Process for Period||(Monthly or Quarterly)||$50,000|
|Cost of Funds||X 2.74%|
|Interest to be Capitalized for Period||(Monthly or Quarterly)||$1,370|
The capitalization of interest expense on a project can sometimes be overlooked, which would cause the asset value to be understated. Although the capitalization of interest can seem counter intuitive at times, it is required by GAAP and the Internal Revenue Code.