Interest capitalization methods: time for a change?
This pronouncement requires that under certain conditions, entities must add interest incurred to the historical cost of assets acquired instead of expensing it. This article reviews the requirements of SFAS No. 34 that practitioners should be following, presents an example of the application of the pronouncement and gives a general critique of this practice. The article concludes with a recommendation that the FASB should consider halting the interest capitalization requirements of SFAS No. 34.
A Review of the Pronouncement
If an enterprise is incurring interest when certain assets are acquired, SFAS No. 34 mandates that the enterprise add a specified amount of the interest to the cost of the asset instead of expensing it. Hence, the interest becomes a part of historical cost basis of the asset. If the asset is acquired for sale, the capitalized interest is expensed through the cost of goods sold account when the asset is sold. If the enterprise acquires the asset for its own use, the capitalized interest is expensed through the depreciation process. SFAS No. 34 is very specific regarding which assets qualify for interest capitalization, the time period for which interest may be capitalized and the amount of interest that may be capitalized.
SFAS No. 34 indicates that interest should be capitalized only for those assets that require a period of time to prepare them for their intended use.  Assets constructed or produced for an enterprise' own use qualify. Likewise, assets constructed or produced for sale or lease as separate projects, such as ships or real estate developments, qualify for capitalization. Enterprises are not allowed to capitalize interest on inventories routinely produced in large quantities. 
The interest capitalization period commences when the following three conditions are being met:
1 . Interest is being incurred,
2. Activities are being undertaken to get an asset ready for its intended use, and
3 . Expenditures have been made on the asset.
After the asset is ready for its intended use, the capitalization period ends. 
Amount to be Capitalized
The amount of interest that may be capitalized is a function of 1) the "average accumulated expenditures" (AAE) made on the asset, 2) the interest rate incurred on any debt incurred specifically for the qualifying asset ("specific debt" hereafter), and 3) a weighted average interest rate (WAIR) on other debt obligation ("general debt" hereafter) of the enterprise. In general, the AAE is multiplied by the specific debt rate resulting in interest to be capitalized. When the AAE exceeds the specific debt amount, the excess AAE is multiplied by the WAIR resulting in additional interest to be capitalized.  However, by no means can the amount of interest capitalized exceed the actual interest cost incurred by the enterprise during the accounting period.  Also, in situations in which there is no specific debt incurred for a qualifying asset, enterprises are to capitalize interest based solely on their general debt obligations, if any. Further, SFAS No. 34 allows enterprises to simply find one weighted average interest rate for all outstanding debt (specific and general) and use this rate in determining the amount of interest to be capitalized.  The following example uses the two rate method (specific debt rate and WAIR on other debt) since this alternative is more logical.
Table 1 [omitted] contains a numerical example of the application of SFAS No. 34. In the example, ABC Company is having an office building constructed for its own use that takes one year to complete. Note that three essential elements (preparation activities, expenditures and interest) are necessary for the capitalization period to start. This period culminates with the completion of the building. Note also that since ABC did not have to pay the entire $10M cost at the start of the capitalization period, the AAE is less than total $ 10M cost of the buildings. This will result in the. company not being able to capitalize interest on the entire construction cost. If the payment schedule called for the total cost of $10M to be paid upon completion, the AAE would be zero and none of the interest incurred could be capitalized. This is true even when interest is incurred during the period. In theory, SFAS No. 34 attempts to capitalize only that interest that would have been avoided had expenditures for the asset not been made. Thus, the mere borrowing of funds for a qualifying asset will not trigger the capitalization requirements. Again, expenditures must also be made.
In determining the interest to be capitalized, notice that the AAE exceeds the specific debt. Therefore, two interest rates are used in determining the amount of interest to be capitalized: (1) the rate on the specific debt, and (2) the weighted average fate on the two general debt obligations. The appropriate application of the rates to the AAE results in $647,500. Since this amount is less than the total interest incurred by ABC during the accounting period of $1,060,000. the entire $647,500 should be capitalized.
In making the year-end interest accrual on all of the outstanding debt, the capitalized interest is debited to the Building account with the remaining interest going to the Interest Expense account. Therefore, the basis of the building for financial reporting purposes will be $10,647,500. The figure will be used in determining the depreciation to be charged on the building during its life.
Justification and Reconsideration
The FASB's mandate that under certain conditions enterprises must capitalize interest was based on the board's belief that the cost of an asset should include all necessary cost incurred to get the asset ready for its intended use. By capitalizing interest, the asset account more closely reflects the total investment in it. Also the board felt that capitalization results in a better matching of revenues with expenses since the capitalized interest is expensed only when the related asset is sold or after the enterprise begins to use it. 
In evaluating the interest capitalization requirements of SFAS No. 34, the theoretical question which must be addressed is whether the interest simply represents financing cost for funds borrowed, or is it also a part of the cost of the asset? From the standpoint of the borrower, interest has traditionally been viewed as a cost of money for a specified period of time. What one does with the money (for example, have an asset constructed for sale) is another issue. This line of reasoning suggests that all interest cost should be expensed as incurred since the payment (or accrual) is for the use of funds for a specific time period which has elapsed.
If one takes the position that interest incurred during the time necessary to get an asset ready for its intended use is not just a cost of money but also a cost of the asset, it becomes necessary to explore the definition of an asset to determine whether capitalization is warranted. FASB Concept Statement 6 makes it clear that costs themselves are not necessarily assets.  Costs simply represent one common way of measuring assets. The providing of future economic benefits is the essence of an asset.  As such, costs which increase future economic benefits are indicative of the existence of an asset and should be capitalized. Other costs should be expensed. Interest incurred during the time an asset is being made ready for its intended use does not increase the future benefits to be derived from the asset via increased utility, value or otherwise. Alternatively stated, the "future benefits" to be derived from a given asset are independent of the amount of interest, if any, incurred to get the asset ready for its intended use. This line of reasoning, again, suggests that interest cost should be expensed. This is especially true
for interest not specifically associated with a qualifying asset for which SFAS No. 34 allows capitalization.
Regarding the claim that capitalization provides for better matching, Concept Statement 6 defines matching as the simultaneous or combined recognition of revenues and expenses that result directly and jointly from the same transaction or event." It is true that an asset constructed or produced for sale or lease in one period will result directly in revenues to be reported in a subsequent period(s) if the related sale or lease takes place in a later period. Likewise, an asset constructed or produced for an entity's own use in one period may bear some relationship to revenues to be reported in another period, especially when the asset is to be used to help generate revenues (for example, a manufacturing facility). Therefore, the argument that capitalization of certain interest cost provides for better matching than does expensing all interest is to some extent valid. However, capitalization results in better matching to the detriment of proper asset valuation. The process of deferring interest cost by attaching it to an asset account when in fact increased value or utility is not derived from the interest is suspect. This practice could lead to assets appearing on the balance sheet at amounts in excess of their realizable value. This is especially true for fixed assets for which definitive alternative cost valuation guideline (like lower of cost or market which must be applied to certain marketable securities) are not well established. Therefore, care must be taken in limiting the elements of "cost" for these assets. In summary, deferring interest cost for better matching cannot be defended if asset valuation problems result. To be placed in an asset account, a cost should have definite future benefits. This is not the case for the interest which SFAS No. 34 requires capitalization.
The major virtue of SFAS No. 34 is better matching of revenues with expenses. However, this virtue is achieved to the detriment of proper asset valuation. The accounting profession must stop the common practice of deferring cost which are not in fact assets in the name of matching. To this end, the FASB should consider halting the interest capitalization requirement of SFAS No. 34.
1 Statement of Financial Accounting Standards No. 34, Capitalization of Interest Cost (Stamford: FASB, 1979).
2 Ibid., para. 8.
3 Ibid., paras. 9 and 10.
4 Ibid., para. 17.
5 Ibid., para. 13.
6 Ibid., para. 15.
7 Ibid., para. 13.
8 Ibid., paras. 6 and 7.
9 Statement of Financial Accounting Concepts No. 6, Elements of Financial Statements (Stamford: FASB, 1985), para. 179.
11 Ibid., para. 146
Quinton Booker, CPA, DBA, is associate professor of accounting in Jackson State University's School fo Business. Professor Booker has a BS degree in accounting, master of professional accountancy and doctor of business administration from Mississippi State Univarsity. He is also a certified public accountant (Mississippi).
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|Title Annotation:||Statement of Financial Accounting Standards No. 34|
|Publication:||The National Public Accountant|
|Date:||Jan 1, 1991|
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