I was asked a question that had me thinking. “is capitalized interest cost” an immediate cash outflow?
My thinking: During the construction phase interest on the debt borrowed is “capitalized”. This word, made me think the interest expense due to the banks was delayed and added to the asset. In my thinking, the banks would not get paid until the project was complete (or whatever was stipulated in the contract).
If banks due get paid interest whether the project is one year in or three years in, is capitalized interest not a cash outflow already?
how would this work? assuming 10 is interest due?
Cash down by 10
asset is up by 10
interest payable is down by 10 (paid out)
I’m not sure how the debits and credits work here.
The Schwser says capitalized interest doesn’t go go through the income statement as interest rather as depreciation expense and is recorded as and investing outflows. Meaning and increase in the asset, which is a greater negative CFI number as report in the statment of cash fows and to adjusted we add back capitalized interest to CFF and substracted from CFO.
I think i got it now, but i am still not understaning how is the cash paid to the banks recorded?
Rasec, in terms of what happens in the financial statements, you seem to be mixing up the accrual of interest with the payment/settlement of interest. Normally (with no capitalization involved) we would have:
Interest accrual: - a charge to interest expense in the Income Statement, which is a drag on net profit and ultimately, once the results for the period are transferred to Retained Earnings in the balance sheet, a drag on Equity, and
an increase to interest payable in liabilities, by the same amount.
Interest payment (settlement): - a drop in interest payable (Liabilties), and
a drop in cash (Assets)
With interest capitalization, the difference is in only in the accrual bit. Instead of charging the expense to the income statement, you charge it to non-current assets (whatever asset you are financing through the debt that carries interest), so:
The fact that a company is capitalizing interest within assets, does not affect the way it makes payments over to the bank. That still works in exactly the same way as before:
Interest payment: - a drop in interest payable (Liabilties), and
a drop in cash (Assets)
Please note that the effect of capitalization is that the non-current asset being constructed will have a higher carrying amount and as a result, there will be more depreciation to charge to the Income Statement in later periods. In that sense, the interest expense that was capitalized will affect the company’s performance but via depreciation expense and not interest expense.