Interest Capitalization

CFA Level II
#1

Is anyone else facing problems with Interest capitalization concepts?

I was doing a CFAI mock which said that the greatest positive effect on EBIT was interest capitalization. Interest ideally should not have any effect on earnings before interest and taxes (EBIT). Even on a CFAI EOC problem, it mentioned that coverage ratios are not impacted by interest capitalized. Is it to be treated as an operating expense?

#2

When you’re capitalizing interest, you are effectively creating an asset on the balance sheet and depreciating it. The depreciation expense should affect EBIT. As a result of capitalized interest, EBIT/I is overstated because interest expense is lower than it should have been.

Most of the questions that I’ve seen are asking us to reverse the capitalized interest. So you would:

  1. Add the interest capitalized back to interest expense

  2. Remove the allocation of cap. interest from depreciate expense from previous yrs

  3. you have to reclassify the interst expense as CFO and not CFI

  4. Interest expense net of depreciation is removed from the Balance sheet.

EBIT will most likely be lower now that you’ve adjusted it.

#3

Thanks for responding. The MOCK question actually referred to the effects of capitalization on EBIT. The firm capitalized 34 million of interest during the year and this according to the answer had the biggest positive effect on EBIT. I can understand having a positive effect on NI but why EBIT?

#4

EBIT is affected by the depreciation of the capitalized amount of $34m. Instead of expensing this $34m, this amount is treated as an $34m asset so we need to depreciate it , right ? assume 10y straight line depreciation, it is $3.4m per year and EBIT is increase by this $3.4m

#5

Should the asset not be depreciated from the next year (not in the year of capitalization)?

#6

depends. if the question stated that they capitalized the interest in Jan then you will see the impact at year end report.

#7

i dont get it

EBITDA

minus the new 3.4$ of D&A

would decrease EBIT, not increase EBIT

whereas prior to this 0 depreciation existed (under expensing interest)

#8

sativa, you are removing the effect of capitalized, so you need to add it back

#9

in the schweser videos the reversal of capitalized interest shows that EBIT increases by the amount of depreciation …

simply makes no sense that the EBIT would decrease, when the effects of capitalization are reversed

i am convinced CFAI puts these little “easter eggs” in the fcking mocks so that people really study concepts harder and to the T

there is no fucking way that year after year they can make so many mistakes