How does capitalizing interest affect EBIT? From my understanding, 1. If interest is expensed, it is expensed under EBIT. 2. If interest is capitalized, it is added to PP&E. This increases depreciation. Therefore, if we capitalize interest, EBIT should be lower due to more depreciation. But from 2010 CFAI sample exam Q15 It says “the capitalization of interest costs increased EBIT by 30 million (the amount of total interest capitalized”. Since interest is normally expensed under EBIT, I don’t see why capitalized interest should be added to EBIT when we adjust the income statement. ----------------------------------------------- PS. For software development cost and other capitalized costs, I understand that if we choose to expense, they will be expensed above EBIT. Therefore, if we capitalize, EBIT should increase by the amount. Do I understand this correctly?
when 30mil of interest is expensed, it will show on balance sheet as interest (30mil) and deducted from EBIT, when it is capitalised, the interest would be (0mil) and nothing would be deducted off EBIT. When interest is capitalised EBIT is higher
“it will show on balance sheet as interest (30mil) and deducted from EBIT, when it is capitalised, the interest would be (0mil) and nothing would be deducted off EBIT.” You mean it will show on income statement, I presume. And why should EBIT change? When interest is expensed, it is deducted from EBIT, therefore EBT is affected, not EBIT. Capitalized interest should not be added back to EBIT. “When interest is capitalised EBIT is higher” On CFAI book 2 page 64 solution to 1, EBIT is higher if interest is expensed.
oh, yeh, I was thinking EBT, listen to someone else.
CFAI book 2 pg 64 #1: we are adding 475, the depreciation for 2008, to EBIT because now we are expensing, so we have to “unwind” the previous capitalization. So yes, EBIT is higher when expensing because we add back that depreciation. We are saying “had I expensed it, what would happen?” In your example on the mock, they are just comparing capitalization of interest to capitalization of software devel costs. So look at the interest costs table for 2009, you see 30, go to software devel costs table, you see they capitalized $4.5mm, which one is bigger- the 30. Does that help?
The question asks “Which accounting policies had the largest effect on the increase in EBIT?” (The vignette capitalized software costs and interest costs.) Since capitalizing interest costs should decrease EBIT, I think the correct answer should be B. Software costs because if expensed, software cost is above EBIT. Therefore EBIT is higher when capitalizing than when expensing software costs.
I don’t think capitalizing interest costs always decreases EBIT- in fact like here it probably usually increases it. Think capitalizing vs. expensing and the effects on earnings…if you capitalize something your earnings are higher.
Your earning (net income) are higher because you don’t expense your interest. However in this case, EBIT isn’t affected by interest expense. That’s why I don’t see how EBIT could increase by capitalizing interests.
oh right, well i think that’s the general idea…capitalizing increases earnings…maybe it’s technically wrong though
going through old 2011 mock exam and got stumped on this question too. why does capitalizing interest increase ebit?
if you capitalize interest, in the year OF the expenditure, nothing happens on the income statement. all the interest is capitalized, added to the cost of the asset. in subsequent years, it’ll show up in depreciation.
had you NOT capitalized, wouldn’t the interest associated with construction merely show up as normal interest expense? which in that case it still falls AFTER ebit in the income statement therefore ebit would remain unaffected…?
my point is either way, capitalize or expense, all the “effects” take place after EBIT within the income statement. it only shows up prior to EBIT in the income statement in subsequent years when it shows up in depreciation, which in that case it would lower ebit.
wow, talk about the MOTHER of all trick questions, i figured it out. the MD&A says “Interest is capitalized at our weighted average interest rate on long-term debt.” - implying (i think) that they don’t have any specific debt relating to the construction, so they’re basing interest expense on their general cost of debt. so i’m assuming that means this would normally be expensed ABOVE ebit, wtf!?