The capitalized interest definition is the interest on the cost of construction, or a self constructed asset by a company. Interest capitalization occurs because it is a part of the cost in developing the asset for the company’s future use.
Capitalized interest means that a company is usually developing its own assets. Or it may be involved in the construction industry where a bid on a project typically includes the interest. Typically, interest capitalization construction occurs when a company is developing assets for its own use like the construction of a building for new office space. It might also include the construction and development of equipment items that a company uses in its operations. Construction companies use capitalized interest accounting because it is considered like the self-constructed assets as part of their cost. Because construction companies do not receive full payment for a construction project until it is completed, the companies have a need to go out and finance the majority of the construction costs until they receive payments.
Therefore, consider the interest expense to be part of the normal costs associated with construction. Thus, properly account for the capitalized interest expense on the balance sheet instead of the income statement. Do this until the company completes the project.
For example, Jimbo Slice is the CEO of Chupacabra Inc.. He is looking to construct a new building in downtown Houston, Texas. The company must first secure capitalized interest mortgage for the new office space. Jimbo goes to visit the bank to try and gain access to a loan. After consideration, the bank grants Jimbo the loan for the construction. It will cost an estimated $4 million to complete at an interest rate of 9%. The interest expense is thus capitalized on the balance sheet because the construction is for Chupacabra’s new office space and no one else in particular. Given the numbers, Chupacabra will capitalize the interest expense of $90,000 per year assuming that the company will complete construction in 4 years.
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