I spent the last three hours trying to understand this and I’m still confused. I’m sorry for being stupid but accounting has never been my thing.
Let’s say a company is using $300 m debt to finance a construction of a plant over a 3 year period. $300 m is evenly spread over 3 years - $100 m in year 1, $100 m in year 2 and $100m in year 3. Let’s assume we are paying 10% interest and are capitalizing interest. How does it flow through the income statement, balance sheet and cash flow statements over the next few years?
The capitalized interest now forms part of the total cost of the plant and will be depreciated in the normal manner over the useful life of the asset. The expenditure therefore appears on the Income statement as depreciation expense, rather than interest expense. The company capitalizes interest by issuing a debit entry of $30 m (=10%*300m) to a fixed asset account and a credit entry to cash, and the cash equivalent for the same amount when an interest payment is made to a lender. After the end of construction, the company’s production facility has a book value of $330 million, consisting of $300 million in construction costs and $30m in capitalized interest. In the following years the company books a straight-line (or other) depreciation expense of the book value of the fixed asset (together with the capitalized interest expense) in a normal manner. This depreciation expense appears in the Income statement.
A company that capitalizes its costs will display higher net profits in the first years and will have to pay higher taxes than it would’ve had to pay if it expensed all of its costs. That said, over a long period of time, the tax implications would be the same.Regarding the cash flow statement if a company expenses its cost it will be included in cash flow from operations (interest expense). If it capitalizes, then it will be included in cash flow from investing (lower investment cash flow and higher cash flow from operations).