Assignment No.

Course Name: “Financial Reporting And Disclosure”

Submitted By:

Saqib Sarwar 18221554-005

Muammad Umar 18221554-007
Sibghatullah 18221554-025
Zain-Ul-Abideen 18221554-054

Section: Bs 5th Accounting & Finance

Topic: “Capitalization Of Interest Expense”

Submitted To: Mr. Yasir Nadeem

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 TABLE OF CONTENTS

 Borrowing costs

 Qualifying assets

 Calculation of capitalized interest

 Capitalization period

 Weighted-average accumulated expenditures

 Specific borrowings and weighted-average interest rate.

 Calculation of avoidable interest

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 Capitalized Interest Expense

 Capitalized interest is an accounting practice required under the accrual basis of accounting.
Capitalized interest is interest that is added to the total cost of a long-term asset or loan balance.
This makes it so the interest is not recognized in the current period as an interest expense.
Instead, capitalized interest is treated as part of the fixed asset or loan balance and is included
in the depreciation of the long-term asset or loan repayment. Capitalized interest appears on
the balance sheet rather than the income statement.
 When a company capitalizes accrued interest, it takes the total amount of interest it owes on a
long-term asset or loan balance since the last payment, and capitalizes it by adding the total
interest owed to the total cost of the long-term asset or loan balance.

Borrowing Costs

 In US GAAP, ‘capitalized interest’ is the part of interest expense that is capitalized as part of
the cost of asset. IFRS on the other hand, uses the term ‘borrowing costs’ to refer to the costs
incurred in relation to a debt used for construction of the asset. This may include (effective)
interest expense on debt, finance cost of a finance lease, etc.
 Not all interest costs are capitalized. Instead, only such costs are capitalized that are incurred
on qualifying assets during the eligible capitalization period and that too only to a certain
maximum limit.

Qualifying Assets

 In the context of capitalization of interest, a qualifying asset is an asset for which capitalization
of borrowing cost is allowed. It is an asset that takes substantial time is its construction, whether
for internal use, sale or as an investment property. Typical examples of qualifying assets
include plant, buildings, intangible assets, customized inventory, etc. However, normal
production of inventories doesn’t qualify for capitalization of interest even if it takes
substantial amount of time.

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 Calculation Of Capitalized Interest

 The calculation of capitalized interest depends on the actual financing arrangement. An asset
may be financed by a loan raised specifically for the asset or by funds withdrawn from the
general pool of funds available or a combination of both. In general, calculation of capitalized
interest involves the following steps:
 Preparation of a schedule of expenditures incurred on the asset, differentiating between the
asset-specific borrowing and general funds.
 Calculation of capitalization period.
 Calculation of weighted-average accumulated expenditures.
 Determination of interest rate on the specific borrowing and the weighted-average interest rate
on funds drawn from general pool.
 Calculation of avoidable interest.

Capitalization Period

Capitalization period is the time period during which interest expense incurred on a qualifying
asset is eligible for capitalization. Interest is eligible for capitalization when

 The expenditures have been made,

 Activities related to construction of asset are ongoing, AND
 Interest cost is being incurred.
 Capitalization period begins when all the conditions are met and ceases when the asset is ready.
Capitalization also ceases when all the activities related to the project are suspended except
where such delay is normal.

Weighted-Average Accumulated Expenditures

 Weighted-average accumulated expenditure is the product of expenditures incurred on a

qualifying asset and a fraction representing the capitalization period in terms of years.

Weighted-average accumulated expenditures = expenditure incurred * months in capitalization

period of the relevant year/12

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Specific Borrowings And Weighted-Average Interest Rate.

 Interest rate on the loan specifically raised for the construction of asset is straightforward. It is
the negotiated contract rate on the loan.
 Interest rate on funds withdrawn from general pool of debts is called the weighted-average
interest rate and is calculated by dividing the annual interest expense on loans other than the
specific loan by the total principal balance of the loans.

Calculation Of Avoidable Interest

 The final step in calculation of capitalized interest involves calculating avoidable interest,
using the following formula:

Capitalized interest = weighted-average accumulated expenditures up to the principal balance

of specific borrowing * interest rate on that specific borrowing + weighted-average accumulated
expenditures in excess of specific borrowing * weighted-average interest rate.

Journal Entries

Capitalized interest is included in the cost of the qualifying assets using the following journal
entry:
Qualifying Asset xxxxx(Dr.)

Interest Expense xxxxx(Cr.)

Example

KPK Infrastructures, Inc. (KPKI) is a company set up to build, own and operate all key public
infrastructure projects in KPK. On 1 January 2013, it contracted Gandahara Inc. (GI) to build a
bridge over Indus at a total cost of $8,000,000. Following is the schedule of payments made by
KPKI to GI over the year:

Payment Date Expenditure

01-Jan-13 3,000,000
01-May-13 1,000,000
01-Sep-13 2,000,000

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 01-Dec-13 2,000,000
Half of the project cost is financed by a specific loan carrying annual interest rate of 8% and the
rest is financed out of two general loans: a loan from MCB of $10,000,000 carrying 10% annual
interest rate and another loan from UBL of $5,000,000 carrying 11% annual interest rate. GI
ceases work on the project in the monsoon season i.e. July and August.

Calculate the interest expense that KPKI can capitalize.

Solution

Following schedule calculates the weighted-average accumulated expenditures:

Payment Date Expenditures

(A) Capitalization Period

(B) Weight

(C=B/12) Weighted Expenditures (A×C)

01-Jan-13 3,000,000 12 months 1.00 3,000,000

01-May-13 1,000,000 8 months 0.67 666,667
01-Sep-13 2,000,000 4 months 0.33 666,667
01-Dec-13 2,000,000 1 month 0.08 166,667

4,500,000 (Answer)  Total Capitalized Interest

Out of this $4.5 million, $4 million is financed by specific loan. The rest i.e. $500,000 is financed
out of the general loans. The interest rate on specific loan is 8% while the weighted interest rate
on the general loans is calculated below.

Loan Principal Rate Annual Interest

MCB 10,000,000 10% 1,000,000
UBL 5,000,000 11% 550,000
Total 15,000,000 1,550,000
Weighted-average Interest Rate = $1,550,000/$15,000,0000 = 10.33%

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The above calculations furnish us with all the data needed to arrive at an estimate of avoidable
interest.

Funding Amount Rate Avoidable Interest

Specific Loan 4,000,000 8% 320,000
General pool 500,000 10.33% 51,667

371,667 Total Avoidable Interest

 This $371,667 is the amount of interest that could have been avoided. This much interest can
be capitalized provided it doesn’t exceed the actual interest expense for the period.
 KPKI should pass the following journal entry while recording the capitalized interest.

Bridges-Indus $371,667 (Dr.)

Interest expense $371,667 (Cr.)

This would form part of the total cost of the bridge and will be amortized over the useful life of
the bridge.