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11.5 Bonds payable—capitalized interest
Publication date: 30 Nov 2022
us NFP guide
During construction of a debt-financed project, interest costs must be capitalized as part of the cost of the asset (or assets). Pursuant to ASC 835-20, the capitalization rules for interest associated with tax-exempt municipal bonds differ from the rules generally used for determining capitalized interest. The primary differences are the dates when capitalization should begin, the calculation of amounts capitalizable during the capitalization period, and the treatment of investment income earned on unexpended bond proceeds. This special treatment, described in ASC 835-20-30-10, is due to the interrelationship of the IRS rules governing permitted uses of bond proceeds, investment income earned on those proceeds, and the plan of financing undertaken.
Excerpt from ASC 835-20-30-10
[In tax-exempt borrowings,] the funds flows from borrowing, temporary investment, and construction expenditures are so intertwined and restricted as to require accounting for the total net cost of financing as a cost of the qualifying assets.
Under the tax-exempt debt rules in ASC 835-20-25-8, the capitalization period begins at the inception of the borrowing and extends through the date that the constructed asset is ready for use. For example, if the financing is executed (and proceeds are received) six months prior to commencing construction, all of the interest cost incurred prior to commencing construction would be capitalized.
In situations involving qualifying assets financed with the proceeds of tax-exempt borrowings that are externally restricted as specified in this Subtopic, the capitalization period begins at the date of the borrowing.
Contrast this with the general rules, which require that an entity wait until construction expenditures commence to begin capitalization. Under those rules, interest incurred on funds borrowed six months prior to commencing construction would have to be expensed as period costs. Once construction begins, the amount capitalizable each period under the general rules is limited to the amount of interest attributable to the cumulative funds actually expended for construction. Under the tax-exempt rules, the issuer capitalizes all of the bond-related interest cost associated with the project during the capitalization period, without regard to the extent to which construction expenditures have been made.
The rules also differ with respect to the interest earned on unexpended debt proceeds. IRS rules require issuers to invest tax-exempt borrowed proceeds in interest-bearing securities until they are needed to pay for construction costs. Under the terms of the bond indenture (and IRS rules), the estimated earnings on unexpended funds are restricted for payment of project costs and thus, are factored into the calculation of the amount borrowed. Said differently, the issuer will need to borrow less than would be the case if it were not required to apply the investment income toward defraying the cost of the project. Accordingly, ASC 835-20-30-11 requires an issuer of tax-exempt bonds to offset the interest earned on unexpended debt proceeds against the interest cost associated with the borrowing during the capitalization period, so that only the net cost of financing is capitalized.
The amount of interest cost capitalized on qualifying assets acquired with proceeds of tax-exempt borrowings that are externally restricted as specified in the previous paragraph shall be all interest cost of the borrowing less any interest earned on related interest-bearing investments acquired with proceeds of the related tax-exempt borrowings from the date of the borrowing until the assets are ready for their intended use. The interest cost and interest earned on any portion of the proceeds of the tax-exempt borrowings that are not designated for the acquisition of specified qualifying assets and servicing the related debt are excluded.
During the early stages of construction, investment income earned may exceed the interest cost incurred on the borrowed funds. Thus, application of this net approach may actually result in capitalization of net investment income during the early years of a project.
Under the general rules, because capitalizable interest costs are linked to construction expenditures, the concept of “unexpended proceeds” is irrelevant and thus, any income on those proceeds is included in current period income.
Once the tax-exempt project is completed, the issuer will continue to incur interest costs on the outstanding bonds. At that point, if the issuer has other construction projects underway, interest on the tax-exempt debt may be capitalizable as part of the other projects, consistent with the “avoidable-interest concept” of the general rules.
ASC 835-20-55-4 (Example 1) illustrates the special capitalization rules for interest on tax-exempt debt. For additional information on the interest capitalization rules, see PPE 1.3, Chapter 9 of AAG-NFP, and Chapter 6 of AAG-HCO.
Question NP 11-1
Sometimes an issuer will finance a construction project with a combination of tax-exempt and taxable municipal bond proceeds. Should the treatment of interest costs and investment income on unexpended proceeds of the taxable bond issue be consistent with the special rules for tax-exempt bonds?
Sometimes an issuer will finance a construction project with a combination of tax-exempt and taxable municipal bond proceeds. Should the treatment of interest costs and investment income on unexpended proceeds of the taxable bond issue be consistent with the special rules for tax-exempt bonds?
PwC response
No. In such situations, capitalization of interest on the taxable bonds is determined using the general rules in ASC 835-20-30-2 through ASC 835-20-30-7.
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