In section 2.1, Reading 17: Long-lived Assets, Example 3 (BB) for the MTR Gaming group.
Solution to (1) for the interest coverage ratio:
10.63 [($432,686 + $475) ÷ $40,764] including an adjustment to EBIT for depreciation of previously capitalised interest.
Why is the depreciation expense of 475 (due to capitalization of interest) added to the numerator? Can someone pleae clarify. Thanks
By the time you’ve gone down the income statement to EBIT, you’ve accounted for your depreciated assets. Here, your adjustment is conveying the argument that: if interest has been capitalized, it shouldn’t be expensed until you’ve gone from EBIT to EBT (rather than when working down from EBITDA to EBIT). EBT will be the same under both scenarios.
Rather than capitalizing interest payments and depreciating (one way of expensing) them like a normal asset, writing off the interest expense as an interest payment (like you would a bond payment) makes more analytical sense because it portrays the economic reality of the company.
Also, it may help make MTR more comparable to its peers (once they have also been adjusted) because some company executives may be more or less inclined to capitalize and depreciate interest when having their financial statements created than other companies might, and, also, auditors give relatively significant flexibility on this decision.
Hi, had the same problem as well…
We start with just looking at the expensed interest, but now on top of that, we’re considering the capitalized portion of interest as well.
Shouldn’t the $475 be deducted from EBIT since the question adds that “capitalised interest increases depreciation expense by 475”? It is a deduction from EBIT right?
Should be added to EBIT, since it’s basically saying you subtracted too much “D,” when you went from EBITDA to EBIT. This is because the interest payment is likely to be paid at another time (which is when it should have been shown on the IS), not (as the IS currently shows, before you add back the extra portion of Dep) at the time of your item/project’s physical depreciation. The issue in these problems is the company management is coming up with some sort of depreciation expense that isn’t real (in the normal sense of the word). Interest doesn’t depreciate. It gets paid back. But by “capitalizing” it, this allows management a lot more (selective) flexibility, which makes for confusing situations and difficulties comparing time periods and other companies.