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As noted in ASC 835-20, Interest, Capitalization of Interest, the objective of capitalizing interest is to obtain a measure of cost that more closely reflects a reporting entity’s total investment in the asset and to charge a cost that relates to the acquisition of a resource that will benefit future periods against the revenues of the period it benefits.

1.3.1 Accounting for capitalized interest

The historical cost of acquiring an asset should include all costs necessary to bring it to the condition and location necessary for its intended use. As a result, the cost incurred in financing expenditures for an asset during a required construction or development period is itself a part of the asset’s historical acquisition cost. The cause-and-effect relationship between acquiring an asset and the incurrence of interest costs makes interest cost analogous to a direct cost that is readily and objectively assignable to the acquired asset.
ASC 835-20-15-5 defines qualifying assets while ASC 835-20-15-6 lists those assets for which interest should not be capitalized.

>> Assets for Which Interest Shall Be Capitalized
Interest shall be capitalized for the following types of assets (qualifying assets):
a. Assets that are constructed or otherwise produced for an entity's own use, including assets constructed or produced for the entity by others for which deposits or progress payments have been made.
b. Assets intended for sale or lease that are constructed or otherwise produced as discrete projects (for example, ships or real estate developments).
c. Investments (equity, loans, and advances) accounted for by the equity method while the investee has activities in progress necessary to commence its planned principal operations provided that the investee's activities include the use of funds to acquire qualifying assets for its operations. The investor's investment in the investee, not the individual assets or projects of the investee, is the qualifying asset for purposes of interest capitalization.

>> Assets for Which Interest Shall Not Be Capitalized
Interest shall not be capitalized for the following types of assets:
a. Assets that are in use or ready for their intended use in the earning activities of the entity
b. Assets that are not being used in the earning activities of the entity and that are not undergoing the activities necessary to get them ready for use
c. Assets that are not included in the consolidated balance sheet of the parent entity and consolidated subsidiaries
d. Investments accounted for by the equity method after the planned principal operations of the investee begin (see paragraph 835-20-55-2 for clarification of the phrase after planned principal operations begin)
e. Investments in regulated investees that are capitalizing both the cost of debt and equity capital (see paragraph 835-20-55-3 for guidance on capitalization of costs by a regulated investee)
f. Assets acquired with gifts and grants that are restricted by the donor or grantor to acquisition of those assets to the extent that funds are available from such gifts and grants. Interest earned from temporary investment of those funds that is similarly restricted shall be considered an addition to the gift or grant for this purpose.
g. Inventories that are routinely manufactured or otherwise produced in large quantities on a repetitive basis.

The examples provided in  ASC 835-20 make it clear that a discrete project should involve a significant revenue-producing asset that is not produced in large quantities, but such an asset may be constructed or otherwise produced on an ongoing basis. The existence of the following characteristics may help in identifying discrete projects: (1) separate cost records, (2) a considerable time period involved in construction or manufacture, (3) significant expenditures, (4) compliance with customer specifications, or (5) progress payments.
When borrowings exist, the expenditures required by a discrete project result in a significant amount of interest cost to bring the project to its intended use. Thus, a discrete project differs from those assets produced routinely and repetitively for sale or lease that individually do not result in the incurrence of significant interest cost.
Failure to capitalize the interest cost associated with qualifying assets improperly reduces reported earnings during the period and increases reporting earnings in later periods. As such, ASC 835-20 requires interest cost to be included as a component of the historical cost of assets constructed for a company’s own use (e.g., facilities or internal-use software).

1.3.1.1 Amount of interest to be capitalized

Interest cost that theoretically could have been avoided if expenditures for qualifying assets had not been made should be capitalized. The interest to be capitalized is determined by applying a capitalization rate to the weighted-average carrying amount of expenditures for the asset during the period. The amount of interest cost capitalized should not exceed the amount of interest cost incurred by the reporting entity in that period.
ASC 835-30 permits some flexibility in determining the capitalization rate. It may be the rate of a specific new borrowing that can be associated with a qualifying asset or a rate determined by a weighted-average technique. We believe the weighted-average technique should be viewed as the primary method for determining a capitalization rate since proceeds from a specific borrowing are typically not identifiable to a particular qualifying asset. In identifying the borrowings to be included in the weighted-average carrying amount, the objective is to obtain a reasonable measure of the cost of financing the asset while getting the asset ready for its intended use. However, when a specific new borrowing can be identified with a qualifying asset, ASC 835-20-30-3 provides additional considerations for determining the capitalization rate.

Excerpt from ASC 835-20-30-3

If an entity’s financing plans associate a specific new borrowing with a qualifying asset, the entity may use the rate on that borrowing as the capitalization rate to be applied to that portion of the average accumulated expenditures for the asset that does not exceed the amount of that borrowing. If average accumulated expenditures for the asset exceed the amounts of specific new borrowing associated with the asset, the capitalization rate to be applied to such excess shall be a weighted average of the rates applicable to other borrowings of the entity.

Judgment will be required to select borrowings that best accomplish the objective of identifying a reasonable measure of the cost of financing the asset while getting the asset ready for its intended use. Example PPE 1-5 illustrates how to calculate the capitalization rate using the weighted average of borrowings.
EXAMPLE PPE 1-5
Calculating the capitalization rate using the weighted average of borrowings
PPE Corp begins construction on a new corporate office building on September 1, 20X1. Construction continues without interruption through March 31, 20X2. Directly attributable expenditures for the year ended December 31, 20X1 are:
September
$100,000
October
$400,000
November
$400,000
December
$400,000
View table
PPE Corp has assumed a mid-month convention for the attributable expenditures. Therefore, the weighted average carrying amount of the asset during the period is as follows:
Date
Qualifying expenditures
(A)
Capitalization period
(B)
Weighted average qualifying expenditures
(A × B)
September
$100,000
3.5/12
$29,167
October
$400,000
2.5/12
$83,333
November
$400,000
1.5/12
$50,000
December
$400,000
0.5/12
$16,667
Total
$1,300,000
$179,167
View table
PPE Corp has not taken out any specific borrowings to finance the construction of the asset, but has incurred finance costs on its general borrowings during the construction period. PPE Corp had a $9,000,000 loan outstanding with a 4% interest rate and a $5,000,000 loan outstanding with a 6% interest rate during the construction period. The loans were not for specific expenditures.
What is the amount of interest that can be capitalized for the year ended December 31, 20X1?
Analysis
The annualized interest costs on the general borrowings outstanding during the construction period is $660,000 ((4% × $9,000,000) + (6% × $5,000,000)), which results in a weighted-average rate of 4.71% ($660,000/$14,000,000).
The amount of interest that can be capitalized is $8,439, calculated as the weighted-average interest rate multiplied by the weighted-average qualifying expenditures amount (4.71% × $179,167).

The objective of ASC 835-20 is to include the interest incurred as a consequence of getting the asset ready for its intended use. Therefore, accumulated expenditures eligible for interest capitalization should be determined on a cash basis rather than on an accrual basis (unless accruals bear interest). Expenditures on discrete projects should be reduced by progress payments received from customers. Equity exchanged for a fixed asset is also considered an expenditure, since debt would not be paid down and interest costs would be incurred if equity had not been issued as consideration to acquire the asset. Capitalized asset retirement costs are not considered expenditures for the purposes of capitalizing interest.

1.3.1.2 Interest capitalization period

As described in ASC 835-20-25-3, interest incurred during the period in which the activities required to get the asset ready for its intended use are performed should be capitalized, provided that expenditures for the asset have been made. Interest capitalization continues as long as those activities continue.

ASC 835-20-25-3

The capitalization period shall begin when the following three conditions are present:
a. Expenditures for the asset have been made.
b. Activities that are necessary to get the asset ready for its intended use are in progress.
c. Interest cost is being incurred.
Interest capitalization shall continue as long as those three conditions are present.

Reporting entities should cease capitalizing interest if substantially all activities related to construction of the asset are suspended. However, brief interruptions in activities, interruptions that are externally imposed, and delays that are inherent in the asset construction process would not require cessation of interest capitalization. For example, some assets must be completed in their entirety before any part of the asset can be used, such as a facility with a sequential production line that requires the entire facility to be completed in order to start production. Therefore, interest capitalization would continue until the entire asset is substantially complete. Conversely, other assets are completed in parts and therefore the entire asset does not need to be completed in order to utilize the individual parts on their own. For example, the structure of a high-rise building may be complete but certain of the individual floors are not. In this example, interest capitalization would only continue for the parts that are not substantially complete.
The guidance prohibits continuation of interest capitalization when completion of the asset is intentionally delayed. For example, interest is not to be capitalized during periods when the reporting entity intentionally defers or suspends activities related to the asset.
It is generally not appropriate to capitalize interest on an asset that was already functioning for its intended purpose prior to being removed from service. However, capitalization of interest on incremental expenditures related to the refurbishment and/or expansion activities related to the asset may be appropriate. When the asset was acquired with the intention of performing immediate refurbishments or expansion (i.e., the asset has not been in operation), this may indicate that the interest on the asset’s original cost can be capitalized.
The impairment of a long-lived asset below its acquisition cost does not affect the continuation of interest capitalization after the impairment is recorded.

1.3.1.3 Materiality of interest (interest capitalization)

As detailed in ASC 835-20, interest is only required to be capitalized when the benefit outweighs the cost.

ASC 835-20-15-2

In concept, interest cost is capitalizable for all assets that require a period of time to get them ready for their intended use (an acquisition period). However, in many cases, the benefit in terms of information about the entity's resources and earnings may not justify the additional accounting and administrative cost involved in providing the information. The significance of the effect of interest capitalization in relation to the entity's resources and earnings is the most important consideration in assessing its benefit. The ease with which qualifying assets and related expenditures can be separately identified and the number of assets subject to interest capitalization are important factors in assessing the cost of implementation.

ASC 835-20-15-3

Interest capitalization is required only when the balance of the informational benefit and the cost of implementation is favorable. A favorable balance is most likely to be achieved where an asset is constructed or produced as a discrete project for which costs are separately accumulated and where construction of the asset takes considerable time, entails substantial expenditures, and is likely to involve a significant amount of interest cost. A favorable balance is unlikely in the case of inventory items that are routinely manufactured or otherwise produced in large quantities on a repetitive basis. Accordingly, this Subtopic proscribes interest capitalization on those types of inventories (that is, inventory items that are routinely manufactured or produced in large quantities on a repetitive basis) and provides for interest capitalization on assets that are constructed or produced as discrete projects.

The principle objective of ASC 835-20 is to require capitalization of interest on major construction projects when the financial statement effect of capitalization vs. current expense recognition is likely to be material. In addition, ASC 835-20 speaks to minimum thresholds that require capitalization, which are common in inventory and PP&E accounting. These thresholds are designed to minimize a reporting entity’s burden of capitalizing interest associated with a large number of assets and accounting for those costs as the assets are used. Companies should apply judgment in determining whether the interest associated with self-constructed assets would have a material effect on the financial statements if not capitalized.

1.3.1.4 Capitalization of interest associated with land expenditures

Interest on debt used to purchase land (including interest on a ground lease that is classified as a finance lease) should only be capitalized when development activities are in progress. When a large tract of land is acquired for development, only the interest applicable to the portion of land for which development activities are actually underway should be capitalized. Interest applicable to the portions of the land held for future development do not qualify for capitalization, until such future development begins.

1.3.1.5 Capitalization of interest (equity method investments)

ASC 835-20 addresses the capitalization of interest on investments accounted for using the equity method. ASC 835-20 requires interest to be capitalized by the investor on investments, advances, or loans to equity affiliates, providing the equity affiliate has not begun its planned principal operating activities and its activities include the use of funds to acquire qualifying assets for its operations. Total capitalized interest by the investor pursuant to ASC 835-20 cannot exceed interest cost incurred. Interest capitalized to an equity method investment will create an outside basis difference. For further considerations regarding accounting for basis differences, see CG 4.4.5.

1.3.1.6 Tax-exempt debt financings (capital projects)

In accordance with ASC 835-20-30-10 through ASC 835-20-30-12, reporting entities that finance qualifying assets with the proceeds of tax-exempt debt (such as industrial revenue bonds), should capitalize the entire amount of interest cost associated with the borrowing from the inception of borrowing through the end of the capitalization period. The reporting entity does not need to wait until construction begins to start capitalization.
Ordinarily, the offsetting of interest income against interest cost is not appropriate. However, in the case of tax-exempt debt financings, the direct funds flow from borrowing to temporary investment to construction expenditures are so intertwined and restricted that the interest cost should be offset by any interest earned on unexpended proceeds of the related tax-exempt borrowings. Therefore, the total net cost of financing is accounted for as a cost of the qualifying asset.
Once the interest is no longer eligible for capitalization as part of the specified qualifying assets, interest on the tax-exempt debt may be capitalized as part of other qualifying assets (as defined in ASC 835-20-15-5) of the reporting entity. If no other qualifying assets are available, the interest expense and any associated interest income would be recognized in the income statement.
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