The advantages and disadvantages of capitalizing interest for tax purposes lie in a company's ability to manage or manipulate both the period in which the capitalized interest is recognized as an expense on the income statement and by the way in which the capitalized interest is recognized on the income statement.
Key Takeaways
- Capitalized interest is associated with the cost of borrowing to acquire or construct a long-term asset.
- Unlike typical interest expenses, capitalized interest is not expensed immediately on a company's income statement.
- For tax purposes, you cannot deduct the full interest expense in the current period, but you can depreciate it over time.
What Is Capitalized Interest?
Capitalized interest is interest on an asset or loan that is not immediately reported on the company’sincome statementas an expense. Instead, it is reported as an asset on the balance sheet. Full recognition of the expense is delayed.
Companies often finance the construction of long-term assets with debt and generally accepted accounting principles (GAAP)allow them to avoid expensing interest on such debt andinclude it on their balance sheetsas part of the historical cost of long-term assets. Costs that benefit companies for years to come are capitalized and expensed to reflect the lifespan of the item or items being purchased.
When a company capitalizes interest, the cost of the interest is added to the book value of the long-term asset and is recognized as periodic depreciation expense on the income statement.
Capitalized interest can only be used for long-term assets that the company will use for many years to come.
Capitalized Interest vs. Expensed Interest
Capitalized interest and expensed interest have the same impact on a company's financial statements over the long term. The difference is the timing in which the expense shows up on the income statement.
Capitalizing interest helps tie the costs of using a long-term asset toearningsgenerated by the asset in the same periods of use. It can also potentially help a company secure more financing and pay less tax.
Tax Advantages of Capitalizing Interest
When a company capitalizes its interest and adds the cost to its long-term asset, it effectively defers the interest expenses to a later accounting period. When it comes to taxes, the company can recognize the interest expense in the form of a depreciation expense in a later period when its tax bill is higher. This reduces the amount of taxes that the company owes.
Tax Disadvantages of Capitalizing Interest
When a company capitalizes its interest on a loan used to construct a long-term asset, it cannot reduce its tax bill in the current period because the interest expense is deferred to a later period. It is unable to realize the tax benefits in the period in which the loan was taken out.
Example of Capitalized Interest
Consider a company that builds a small production facility worth $5 million with a useful life of 20 years. It borrows the amount to finance this project at an interest rate of 10%. The project will take a year to complete to put the building to its intended use, and the company is allowed tocapitalizeits annual interest expense on this project, which amounts to $500,000.
The company capitalizes interest by recording a debit entry of $500,000 to afixed assetaccount and an offsetting credit entry to cash. At the end of construction, the company's production facility has a book value of $5.5 million, consisting of $5 million in construction costs and $500,000 in capitalized interest.
In the next year, when the production facility is used, the company books a straight-line depreciation expense of $275,000 ($5.5 million of the facility's book value divided by 20 years of useful life) of which $25,000, ($500,000 of capitalized interest divided by 20 years), is attributable to the capitalized interest.
Is Capitalized Interest Good or Bad?
Capitalizing interest comes with many benefits, including increasing the amount of debt financing available and enabling companies acquiring new assets with long-term lifespans to amortize or depreciate the costs. There can be drawbacks as well, though, including not being able to maximize tax benefits in the period the loan was taken out.
How Does Capitalization Affect Income?
Expensing the cost of expensive long-term assets over future periods reduces fluctuations in income.
How Does Capitalizing Interest Affect Financial Statements?
Capitalized interest appears as an asset on the balance sheet rather than an expense on the income statement. The cost only shows up on the income statement as a depreciation of the asset.
The Bottom Line
Capitalizing interest means the total interest amount is not deductible in the current accounting period but can be depreciated over time. That can be good or bad. Companies can take advantage by recognizing the expense in a later period when its tax bill is higher and the asset being financed is generating income.
Deferring the interest expense deduction to future periods, however, also means having to wait to get tax benefits. If the interest were to be expensed immediately all in one hit, the current year’s tax bill would be lower.
