Reading 18 EOC number 8 suggests that capitalizing interest costs will not change the interest coverage ratio. Their logic is that ALL interest payments should already be included in the denominator, regardless as to whether they’re capitalized or not. I understand this. But shouldn’t it DECREASE the ratio by decreasing EBIT in the numerator. The text goes over how adding the capitalized interest to the asset base increases depreciation expense, which makes sense.
Following that logic, the numerator decreases b/c of added deprecitaion, and the denominator remains unchanged b/c all of the interest should be included already. This would result in a declining interest coverage ratio.
the interest coverage ratio can be refered as either EBIT/interest or EBITDA/interest, dont know if the articulation of “no chanage” indicates the latter raio? just a thought, equally confused
I know, I understand the denominator. It’s the numerator that I am confused on. Capitalizing interest increasing depreciation expense, which reduces EBIT. So the decision to capitalize or expense should affect the overall ratio, even if it doesn’t change the denominator.
Depreciation should increase, and EBIT should be reduced - maybe it’s just a mistake. I reviewed a BB yesterday in that reading that showed a reduced numerator due to depreciation expense.
The EOCs are often written by different people than the reading itself (and often several people contribute to the item sets at the end).
Either way, the only possible correct answer for that question is B as EBIT won’t increase (and we’re arguing it should decrease) and the denominator will stay the same.
As i see it the first problem is your question regarding depreciation component in the numerator and the second problem is with denominator (do we use interest expense or interest payments). If we use interest expense than capitalized interest should be adedd to interest expense, on the other hand if we use interest payments than all of the payments are already included in the denominator and do not need to be included again.
The problem is, at least in my view, that they adjusted capitalized interest in their example on page 54 (as kobi mentioned) as: Interest coverage ratio = EBIT+depreciation expense/interest epense+ capitalized interest expense but when the EOC problem 8 asked if the capitalizing vs. expensing changes the Int. cov. ratio, the answer is it doesn’t bcs it is based on interest payments!? I think this is very ambigous in the material and i would appreciate if some AF authority like Smagician could pass the final verdict as i wouldn’t want to enter the test room without being 100% positive on this!
I am not sure this is correct. If a company is depreciating interest that was capitalized in previous years, net income should be adjusted to remove the effect of depreciation of capitalized interest when calculating adjusted interest coverage ratio.
So, EBIT (numerator) should be adjusted upwards to include depreciation on interest that were capitalized. The adjusted interest expense (denominator) should be adjusted to include interest capitalied in the current period.
I see where I made an error in my thought process and I THINK you pointed it out if I’m understanding what you’re saying. I neglected to account for the effect of adding the interest to EBIT to eliminate to effect of expensing it, after which I would reduce EBIT by the depreciation expense attributable to the capitalized interest. After thinking it through, I was wrong there - is that what you’re saying?
To be honest, at this point I’ve lost sight of what the question asked and what mpearc originally was looking for clarification on so I’m gonna stop responding and add this to my review list this week!