Interest capitalization is the inclusion of interest that businesses incur at some point of the accounting techniques for the building of fixed assets. Interest capitalization at some stage in the construction technique is an integral method for ensuring that businesses provide correct facts regarding the values of fixed assets. The US GAAP has installed three prerequisites that an asset wants to meet to qualify for activity capitalization. One of the necessities is that an asset must be to be undergoing preparation for use through the company. Also, the asset must be one that a company intends to use in the generation of revenues. Finally, the asset ought to no longer be one that an employer is already the use of in its each day operations. Also, the accounting managers have set a condition that an interest capitalization period commences at the time an institution initiates a construction program. The capitalization period should begin when a business incurs interest in the course of the construction activity.
Accountants also require that the computation of capitalized interest use a specific set of costs to help generate accurate information regarding the construction of a fixed asset. Therefore, accountants need to be cautious when identifying the costs to use in the interest capitalization process. GAAP refers to the figures that do not account in the computation of capitalization of interest as the avoidable costs. It is important that a company use the interest rates on the loans that it utilizes in the construction programs to compute the capitalized interest. However, in a situation where an institution has incorporated its general funds to undertake the construction process, it is necessary that accountants use a weighted-average in the capitalization process. Therefore, accountants need to be cautious and accurate capitalize interest during the construction activities.
Capitalization of Interest during Construction
Business operators need to be careful during the performance of various activities within their premises. In particular, the activities that entail the use of cash require utmost care to help managers account for the various costs that a company has incurred and the profits that specific transactions have generated. In accounting, it is prudent that financial managers capitalize the interest that a company has incurred during the construction process. According to Wahlen et al. (10-18), US GAAP refers to the process of including the interest in the accounting process as interest capitalization, which is an important process in the analysis of the value of assets that a firm owns. Capitalization of interest during the construction also plays a critical role in the provision of accurate financial information to the investors.
Policies and Procedure for interest capitalization during construction
Wahlen et al., (10-18) argue that various policies guide the choice of assets to use during interest capitalization strategies in an organization. Specifically, assets that are already in use do not qualify for use in the interest capitalization. Also, assets that a company does not use to generate income or the business does not intend to dispose of do not qualify for the interest capitalization. For instance, an undeveloped land and assets that a company does not use due to obsolescence or are more than the needed quantity need not account in the interest capitalization process. The rationale for the capitalization of interest during the construction is that the assets do not generate income for an institution during the building process thus it becomes essential that financial managers account for the costs that an agency incurs during the periods of development. Consequently, the capitalization of interests aids a company in incorporating the expenses that one cannot immediately use in the valuation of an asset. Besides, the capitalization of an asset is an essential strategy for the accurate analysis of the depreciation of an asset that a company acquired through construction (Whalen et al. 10-18).
The asset regulations authorities have set policies to guide when to undertake capitalization of interest during the construction process. The first rule is that an organization should capitalize interest when the construction process stops unexpectedly. For instance, it is admissible that a company capitalizes interest when there is a natural calamity that prompts the construction process to end. However, in the case where a constructor intentionally halts the construction process, it is necessary not to capitalize interest until the building processes resume (Wahlen et al. 10-19). The purpose of stopping the capitalization of interest in the situations where a company terminates the construction activities is to ensure that a constructor does not overprice the construction process. Also, the stopping of the interest capitalization during the intentional halt of a construction aids in ensuring that constructors do not intentionally stop the construction processes to increase the period of construction. During the interest capitalization, it is conditional for an accountant to incorporate the only materials that are useful in the estimation of the long-term value of an asset. However, if all the costs that a company incurred in the construction processes are essential, then it is vital that an accountant follow specific accounting concepts to obtain accurate figures concerning the value of the fixed asset.
An analysis of the interest capitalization during construction indicates that it is necessary for the financial managers to make appropriate choices on the interest rates to use. Therefore, US GAAP has established that a finance manager needs to use the interest rates for the loans that a firm secured for a building project to help in the capitalization. On the condition that an institution had to use its general capital to help meet the construction costs, it is necessary that the finance managers utilize the weighted average of the bank loans and the company’s funds to capitalize interest (Wahlen et al. 10-19). After the determination of the interest rates that are applicable, a company needs to identify the type of the cost that is necessary for the capitalization of interest. GAAP refers to the concept of choosing the expenses to use as the avoidable interest. The choosing of expenditures to use is essential for a firm because it helps in the computation of accurate figures concerning the expenses that a company incurs during the construction of a physical asset.
Wahlen et al. (10-19) argue that the avoidable interest provides auditors with reliable information concerning the costs that a company would not have undergone if it did not undertake the construction activities. The concept of avoidable interest requires that an enterprise determines the amount interest to capitalize by calculating the product of weighted-average accumulated expenses for the assets and interest rates on the loans from the banks. The third principle regarding the capitalization of interest during the construction is that it is necessary to relate the cost of completing a project with the period of developing a plan because it is preferable that an institution annualizes the interest rates.
According to Wahlen et al. (10-18), capitalization period, the time within which a company needs to capitalize its interest on the construction projects, has three distinct conditions that financial managers need to observe. The first requirement is that the capitalization period begins at the time an enterprise spends on the given asset. Secondly, the capitalization period commences when the activities necessary to initiate the usefulness of an asset starts. For instance, the interest capitalization process during a construction needs to begin at the time an institution issues a constructor the authority to undertake the building activity. Finally, an interest capitalization period starts when an enterprise incurs interest costs. Therefore, a time that does not exhibit the conditions described above does not qualify to be a capitalization period. Besides, financial administrators need to follow the appropriate procedure in the identification of the costs to use and the time of interest capitalization to help generate reliable data during the construction process.
Impact of interest capitalization during construction
Capitalization of interests during the construction has a significant impact on the financial statements of an organization. Specifically, a decline in the revenues a building company obtains from the building programs leads to a reduction in the value of shares that the institutions provide to their clients thereby significantly affecting the figures in the financial records such as the income statements Wahlen et al. 10-22). Therefore, an accurate capitalization of interest during the construction processes is an essential strategy for presenting valuable information to the investors who significantly rely on the financial records of businesses to make decisions. It is ethical for a company to disclose the revenues that it obtains through the interest capitalization during the construction activity. Consequently, the decision by a firm to conceal information regarding the capitalized interest during the construction can significantly affect the relationship between the business and the investors or regulatory authorities.
Issues in interest capitalization during construction
Wahlen et al. (10-21) opine that two significant issues are prevalent during the capitalization of interest in the course of construction. One of the primary problems is the accounting for the purchase of land that an institution intends to use in the construction programs. It is essential that an agency incorporates the costs that it incurs in the process of land meant for development in the interest capitalization activity. Also, the management of interest revenues is essential during the capitalization. According to Wahlen et al. (10-23), an institution should not offset interest revenues against the interest costs that a firm incurs as a way of ensuring that a company does not give a false impression of its transactions during the construction activities.
To conclude, interest capitalization during construction is an essential activity that aids in the provision of relevant information concerning the operations of an organization. As discussed in this essay, the period within which a company capitalizes interest during construction has a set of conditions that accountants need to observe. Notably, the time that one needs to consider in the interest capitalization during construction should be one where a firm has incurred some interest. There are also distinct features that assets need to exhibit to qualify for the interest capitalization during the construction. Finally, the choice of costs to use in the interest capitalization during construction also plays a significant role in proper accounting for the operations of a firm.
Wahlen, M. James et al. Intermediate Accounting: Reporting and Analysis: Cengage Learning, 2015. Print