CFA CFA Level 2 Capitalising Interest Expense

Capitalising Interest Expense

  • This topic has 12 replies, 3 voices, and was last updated Mar-17 by vincentt.
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    • vincentt
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      Hi guys,
      got a little confused with this and couldn’t figure out why.

      1. Why does capitalised interest payment get moved to CFI from CFO? I thought it would be categorised under CFO(US & IFRS) or CFF (IFRS)?

      2. Does it mean any item (or expenses) that gets capitalised should be moved to CFI?

      thanks

    • Zee Tan
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      This is a question of capitalizing vs expensing your interest cost. If a company expenses its costs (including interest) this should be included in cash flow from operations (CFO). If it’s capitalized it should be in cash flow from investing (CFI).

      Since CFI is based on the money earned or spend on long-term assets the company possesses. Upgrading or buying new equipment for example, or even buying another company are considered investment activities, and the money spent should be considered a negative cash flow from investing. If the company generated cash in a similar fashion (such as selling equipment) this would be positive cash flow from investing.

      So if interest costs are capitalized they should be treated as assets, and therefore any costs associated from this is accounted for in the CFI.

      So to answer your question #2: yes 🙂

      Hope that helps!

    • Sophie Macon
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      Ok @vincentt – this is gonna be a long one, be patient 🙂

      When do we capitalise interest and when do we expense it? In general, the key to this is whether the costs have future economic value.

      Costs should be capitalised or recorded as assets when the costs have not expired and they have future economic value. In other words, all costs incurred in bringing the asset to its present location and condition are capitalised. This is prevalent when a company needs builds a tangible asset that needs huge financing upfront, takes time and/or the asset built will have a long economic ‘life’. A good example is investment in building new plant/machinery.

      Since these projects are likely to be debt financed and part of an investment, it will distort the income statement if its left as an expense. To obtain the true cost of the long-lived assets, a better treatment is to capitalise interest as part of the cost of acquiring the plant/machinery itself for an accurate view.

      Therefore, to answer 1), this interest is not expensed (hence not in CFO) but is capitalised into asset (cost of acquiring asset), and should be included in CFI. Asset value increases, CFI reduces (as reduction in investment cashflow). In the future (once asset is completely built), depreciation of asset occurs, which will reduce net profit, but has no impact on future cashflows.

      The categorisation under CFO (US GAPP) and CFO/CFF (IFRS) is for normal interest expense treatment (not capitalised as asset).

      2. Yes.

    • vincentt
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      @zee just to clarify some doubts:

      when you say upgrading/buying new equipment, could you still expense it and deduct from CFI (since it’s investment activities) ? Or did you mean only if the item is capitalised.

      Also, is the categorization method above affected by whether the purchased item is available-for-sale or held for own use?
      e.g. if item is purchased for sale it wouldn’t be under CFI, etc?

    • Zee Tan
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      Only if the item is capitalized, but chances are it should be! e.g. if you’re buying equipment for your business, it’s an asset (‘held for own use’) and should be CFI.

      If you sell physical items and you’re buying inventory (I think that’s what you mean by purchase-for-sale), then that’s CFO, not CFI.

    • vincentt
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      I think got it now! Capitalised = “charge” it to CFI.

      One more question (I hope 🙂 ), when you capitalised interest does it mean you are paying the interest over a certain period (years) ? Something like ‘amortizing’ ?

    • Sophie Macon
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      Therefore, to answer 1), this interest is not expensed (hence not in CFO) but is capitalised into asset (cost of acquiring asset), and should be included in CFI. Asset value increases, CFI reduces (as reduction in investment cashflow). In the future (once asset is completely built), depreciation of asset occurs, which will reduce net profit, but has no impact on future cashflows.

      To your answer @vincentt, see above emboldened sentence. So yes, capitalised interest into asset, it will depreciate (amortise) over time in the future.

    • Zee Tan
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      @vincentt – exactly – that’s amortization (reduction in value of an intangible asset). Depreciation is almost the same thing, except it’s for physical assets.

    • vincentt
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      Since these projects are likely to be debt financed and part of an investment, it will distort the income statement if its left as an expense. To obtain the true cost of the long-lived assets, a better treatment is to capitalise interest as part of the cost of acquiring the plant/machinery itself for an accurate view.

      Therefore, to answer 1), this interest is not expensed (hence not in CFO) but is capitalised into asset (cost of acquiring asset), and should be included in CFI. Asset value increases, CFI reduces (as reduction in investment cashflow). In the future (once asset is completely built), depreciation of asset occurs, which will reduce net profit, but has no impact on future cashflows.


      @sophie
      just saw your post after I’ve posted my earlier respond.

      Thanks for the good example that you have given above, the example that I had in mind which confuses me was why would anyone be allowed to capitalised interest expense on say annual coupon payment on the bond they issued. So could a company capitalised the interest/coupon on a bond?

      Your example definitely helped me understand this better. So say a company issued a debt or obtained a bank loan (loan tenure of say 20 years) to build a factory (useful life of say 30 years), the factory will be an asset and will be depreciated over 30 years.

      But what happens to the interest cost payable to the financial institute? I know now that it will get capitalised, but will it be capitalised over the 20 years or along with the life of the factory, 30?

    • Sophie Macon
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      @vincentt – lets use your example:

      one missing information from your example is how long it takes to build your factory. Let’s say its 10 years.

      So you have: construction time 10 years, loan length 20 years, factory life 30 years (after its built).

      The interest you can capitalise is only during construction period, so 10 years worth of interest can be capitalised into asset.

      After that factory + capitalised interest is depreciated over 30 years depending on stated depreciation method.

    • vincentt
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      @sophie so the remaining 10 years of the loan (which is from the day the factory is completed) should be expense accordingly each year (this is excluding the 10 years capitalised interest during the construction period)?

    • Sophie Macon
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      yes, because there is no justification for capitalising for the remaining 10 years of the loan (unless its used to construct another long-live asset). The question should state what if its used for (after year 10).

      Normally questions won’t have the maturity of loan longer than asset construction period (to avoid confusion), but I thought your random example was a great case to illustrate the principle behind capitalised interest, so no matter how it’s twisted you’re gonna get it right!

    • vincentt
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      thanks @sophie , and of course @zee as well 😀

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