I was embarrassed at work because I didn’t know the answer. One would think it would be part of depreciation expense, which is added back to CFO. Is that right, and so you have to manually tease out the capitalized interest?
Using an example of contructing a building, one may wish to capitalize interest to better match the cost of financing to the revenue generated by the building. From what I understand capitalizing interest is controversial since a project should be independent of financing decisions. In any case, the firm should take an immediate hit to CFO in the period that the interest was paid. If you mean calculating CFO from NI, then yes, capitalized interest should be added back to NI and the total interest expense paid should be deducted from NI.
Thanks for the response but I am looking for an accounting, rather than analytic, answer. Does the CFO stated in the financials include capitalized interest? Or is that charge obscured in the cash flows because it is packaged with depreciation?
nyfinance, the capitalized interest will be a component of the constructed asset’s book value and, as you said, be packaged with depreciation. However, you should be able to distinguish what portion of the asset’s book value actually stems from capitalized interest (from footnote disclosures). This is LI FSA material, and accordingly, I’ll quote a page from my 2006 LI Schweser notes that’ll hopefully provide a more complete explanation. Book 3, p. 201: “Capitalized interest is the interest incurred during the construction of long-lived assets. It is included in the initial cost of the asset on the balance sheet instead of being charged off as interest expense on the income statement. The argument for interest capitalization is that the cost of the self-constructed asset should be identical to the cost of the asset purchased after completion. The argument against the capitalization of interest is that the interest expense is the result of a financing decision and not an operating or investment decision. Internationally, capitalization of interest is optional. In the U.S., Statement of Financial Accounting Standards (SFAS) 34 requires the capitalization of interest costs incurred during the construction period. Interest incurred on borrowed funds during construction must be capitalized (i.e. included in cost of asset) and not expensed (SFAS 34), and the amount capitalized must be disclosed. If no specific borrowing is identified, the interest is estimated using the weighted average interest rate on outstanding debt for the amount of the investment. (Note: if the firm is not levered, there is no interest.) When a firm constructs its own operating facilities (e.g. machinery or a building), then interest costs incurred during the period of construction are capitalized by adding that interest cost to the cost of the facility. To be capitalized, the interest must actually be paid by the firm (no opportunity costs are capitalized). The capitalized interest cost is based upon the average cost of the partially completed facility, first using the interest rate associated with borrowings to directly finance construction. Then the average interest rate of the firm’s outstanding debt is applied to the excess of the investment in the project over these project-specific borrowings, if any. Thus, during construction, interest expense is total interest paid less capitalized interest.”
I think I get it but please correct me if I’m wrong: So CFO, in subsequent years, will be overstated because the undiscounted value of the interest is included with the cash outflow related to the purchase of the building. That means that, in the short run, cash statements won’t represent reality because a portion of cash expenses that are paid out over time (interest expense) will have already been counted (CFI outflow associated with the building puchase).