Capitalized Interest: Impact to Cash Flow Statements

CFA Level II
#1

Couple of questions:

  1. When we say that capitalized interest “impacts” CFI, we’re saying the periodic interest payment is a CFI outflow opposed to CFO (assuming GAAP)?

  2. I came across this problem that totally confused me and I think it’s due to the Bold text below. They’re stating if the capitalized interest is included as a part of COGs, it doesn’t impact the cash flow from operations. How can that be if the capitalized interest is an outflow from CFI, and thus has to be added back to CFO as a non-cash item?

"Under U.S. GAAP, interest expense is part of cash from operations on the cash flow statement. Normally, when interest is capitalized as part of capital assets, it increases cash from operations (because it is not included as an outflow in CFO). However, XYZ is capitalizing the interest to the cost of manufacturing (inventory), which is also an operating activity; thus, there is no effect on the cash flow from operating activities."

#2

Yes.

What they’re saying is that if you capitalize interest in manufacturing inventory, it’s CFO, and when you expense it as part of COGS, it’s also CFO, so there’s no net change to CFO (or CFI, or CFF for that matter).

#3

Wouldn’t the capitalization of interest, as COGS, be a CFI activity?

#4

Interest is usually per year… how can interst be capitalized?

I never understood this. Every year there is new interest expense. Shouldn’t it just be expensed?

#5

It can be included as part of a capital project and expensed over its life.

#6

No.

Inventory is operations. You don’t invest in inventory; you purchase inventory to sell, as part of your normal operations.

#7

Ordinarily it is.

However, if you borrow money specifically to finance the construction of an asset you’ll be using in your business (e.g., a warehouse, or a special machine), you do not expense the interest on the borrowed money: you add it to value of the asset. If you pay interest every year for 10 years, then you add it to the value of the asset every year for 10 years.

#8

I see where my confusion is now. Even though these COGs are for use in a “capital project” (specifically, production of an Airplane), this specific company is in the business of selling planes, so the capitalized interest is a function of operations like you say.

Okay, fair enough. Thanks for the explaination S2000

#9

My pleasure.