The financial accounting term interest costs during construction refers to the financing charges incurred during the creation or acquisition of assets such as property, plant, and equipment. Companies can capitalize interest costs if they are material, otherwise they should be expensed.
Generally, accountants have three choices with respect to interest charges during construction:
In SFAS 34, the FASB stated the interest charges that could be capitalized are limited to those that would have been avoided if the asset were not constructed. Capitalization of interest charges is allowed if the impact on the company's financial statements is material versus expensing these costs.
Avoidable interest should be calculated as the interest expense times the weighted average costs in each period. Generally, the interest rate applied should be:
Four conditions need to be met before interest can be capitalized:
Capitalization of interest would stop once the asset is substantially complete, or placed into service.
Company A is constructing a new service center. The total cost of construction is budgeted at $1.1 million and occurs over a six month timeframe. The costs include the initial purchase of the building for $500,000, and construction costs of $100,000 per month. Company A financed the purchase of the building with debt at 7.0%, while the remaining costs of the project were financed using Company A's existing debt structure at 5.0%.
The interest costs during construction would be calculated as:
|Expenditure||Percentage of Year||Rate||Avoidable Interest|
|500,000||6 months or 50%||7.0%||17,500|
|300,000||6 months or 50%||5.0%||7,500|
Note: Expenditure is a weighted average during the construction timeline ($300,000), not the total ($600,000).