Interest costs during construction Discussion
In the operations of the business, the companies will face a huge expenditure. In financial accounting, the companies will record certain expenses are capital expenditures, or these expenses will be capitalized on the basis of the nature of that expense. These amounts may be spending for the maintenance of machines, acquisition of assets, or its construction. In the case of machines, if the expenses incurred for these machines are benefiting for a term operation, resulting in the creation of profits, it can be capitalized. The interest cost during construction is an expense borne by the company at the time of the creation of a new building or an asset. This interest cost is usually interest on the loan taken for these constructions. In every case interest of the loans is treated as an expense and deducted from the taxable income. However, the construction interest expenses are treated differently.
Interest Cost or Expense
The interest expenses are the amount that a company records while borrowing funds from financial institutions. These interest expenses are usually deductible from the taxable income. These amounts are shown in financial statements as the non-operating expenses. The interest for the construction of the assets would be treated in a particular manner. This kind of interest is also known as capital interest. The business cannot make deductions at the time of its payment because this kind of interest is calculated along with the cost of the asset. The interest cost is usually seen at the bottom of the company’s balance sheet. It depends upon the nature of the balance sheet that whether it should be treated as the current liabilities or current assets. If the payment of interest is yet to happen, it is shown as current liabilities, and it will come under the liability side of the financial statements. Similarly, if the payment is made in advance, it comes under the category of current assets on the asset side of the balance sheet. The business usually has two choices. These include the following choices.
Not capitalizing the expense: In the case of projects, the company management will decide which type of finance might be used. Whether it should be debt or equity, this interest cost will be charged against the cost of finance.
The real transaction: In this approach, the company will aid the real transaction related to finance these construction projects. This method business faces a challenge that the real cost of the asset will vary according to the decisions of the management regarding the funding of the project.
Capitalization of Interest
The interest is the expenses incurred by the company at the time of borrowing the money required to built or obtain assets. In case of the assets that will benefit the long–term run, these expenses or costs will be capitalized; such methods are called the capitalization of interest. The capitalized interest will not be shown as a cost in the financial statement. It will be capitalized, which results in the cost of a long-term asset. The company will depreciate or amortize these long-term expenses. It is charged over the life of these assets. This is treated as a historical cost. In the U.S, the companies can deduct the capitalized interest as it is eligible for deduction as per the tax policy of the U.S. This interest can be charged throughout the financial years. The businesses consider it a capital expense because it can create the cash flow or generate revenue from long-term use. As per the GAAP, the business can include this in its financial statements. The business can only make it as a long-term asset, or these expenses can be treated as capital expenditures only if the balance sheet of a firm is material in nature.
Rules for Capitalizing
The rules of capitalizing includes
Time of Expenditure The expenditure incurred for the creation of the assets should begin at the time of the construction.
Purpose of construction The assets constructed should be used for the long-term benefit of the company. It should not be constructed for the purpose of sale. If the assets are acquired, they should not be used to generate revenue through the sale.
Continuation in the Construction The construction of the asset should be going on. There must not be any halt in the construction of the assets. Such lags should be avoided as much as possible. The real cost of the assets should exist.
