When machinery and equipment to be used by an entity are constructed rather than purchased, a problem exists concerning the allocation of overhead costs. These costs may be handled in one of two ways: (a) assign no fixed overhead to the cost of the constructed asset,
or (b) assign a portion of all overhead to the construction process. The second method called a full costing approach appears preferable because of its consistency with the historical cost
principle. It should be noted that the cost recorded for a constructed asset can never exceed the price charged by an outside produce.
Capitalization of interest cost incurred in connection with financing the construction or acquisition of property, plant, and equipment generally follows the rule of capitalizing only the actual interest costs incurred during construction. While some modification to this general rule occurs, its adoption is consistent with the concept that the historical cost of acquiring an asset includes all costs incurred to bring the asset to the condition and location necessary for its intended use.
To qualify for interest capitalization, assets must require a period of time to get them ready for their intended use. Assets that qualify for interest cost capitalization include assets under construction for an enterprise’s own use such as buildings, plants, and machinery) and assets intended for sale or lease that are constructed or otherwise produced as discrete projects (like ships or real estate developments). The period during which interest must be capitalized begins when three conditions are present: (a) expenditures for the asset have been made; (b) activities
that are necessary to get the asset ready for its intended use are in progress; and (c) interest cost is being incurred.
The amount of interest to capitalize is limited to the lower of (a) actual interest cost incurred during the period or (b) the amount of interest cost incurred during the period that
theoretically could have been avoided if the expenditure for the asset had not been made (avoidable interest). The potential amount of interest that may be capitalized during an accounting period is determined by multiplying interest rate(s) by the weighted average amount of accumulated expenditures for qualifying assets during the period.
12. Examples which demonstrate computation of the weighted average accumulated expenditures and selecting the appropriate interest rate are included in the chapter. Also, a
comprehensive illustration of interest capitalization is shown in the text. This illustration includes both the computations and the related journal entries that should be made in a situation when an
asset is constructed and capitalizable interest is a part of the transaction. Two special issues relate to interest capitalization. If a company purchases land as a site for a structure, interest costs capitalized during the period of construction are part of the cost of the plant, not the land. In addition, companies should generally not net or offset interest revenue against interest cost.
Interest capitalization, self constructed asset, GAAP, non current assets, plan assets,. fixed assets, Plant assets, property plant and equipment, PP&E, fixed assets, depreciation expense, accumulated depreciation, gain on disposal of plant assets, acquisition cost, land improvement, salvage value, residual value, useful life, straight line method, units of production, double declining balances, MACRS, ACRS, book value, carrying value,