1. Defining a Qualifying Asset
A qualifying asset is an asset that necessarily takes a substantial period of time to get ready for its intended use or sale (typically exceeding 12 months). Examples include manufacturing plants, power generation facilities, real estate developments, and customized heavy machinery. Assets that are ready for their intended use or sale when acquired are excluded.
2. Period of Capitalization: Commencing, Suspending, and Ceasing
Interest capitalization can only occur when all three of the following conditions are simultaneously met:
- Expenditures for the asset are being incurred.
- Borrowing costs are being incurred.
- Activities that are necessary to prepare the asset for its intended use or sale are actively in progress.
Capitalization must be suspended during extended periods in which active development is interrupted. Capitalization must cease when substantially all the activities necessary to prepare the qualifying asset for its intended use or sale are complete.
3. Mathematical Determination of Capitalization Rate
When an entity borrows funds specifically to obtain a qualifying asset, the capitalizable borrowing costs are the actual borrowing costs incurred on that loan, less any investment income earned on the temporary investment of those funds.
When general borrowings are used to finance the construction, a capitalization rate must be calculated using a weighted average of the borrowing costs applicable to the entity’s outstanding general loans:
Weighted Average Interest Rate = Total General Borrowing Costs Incurred in Period / Total Principal Amount of General Borrowings Outstanding
Capitalizable Interest = Capitalization Rate × Weighted Average (general borrowings outstanding) Average\ Capitalized\ Expenditures\ incurred\ on\ Asset}\)
The total amount of interest capitalized during a period cannot exceed the total amount of interest expense actually incurred by the entity during that same period.
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