As a general rule, a careful distinction is maintained between interest and the cost of plant...
As a general rule, a careful distinction is maintained between interest and the cost of plant assets. In certain circumstances, however, it is appropriate to capitalize interest in establishing the correct historical cost of an asset. What are these circumstances?
Homework Answers
Capitalization of interest:
In many cases, assets are purchased or constructed by enterprises from borrowed capital. Normally, in such cases, the amount paid towards cost of the asset purchased and amount paid towards interest on borrowed capital are clearly distinguished.
However, there are cases where the amount paid towards interest on borrowed capital is also capitalized as part of the historical cost of the asset. The basis of capitalizing interest as part of the historical cost of the asset is that the cost of the asset acquired should include all the costs incurred in bringing the asset in the condition and location required for its intended use. This has been established by the Financial Accounting Standards Board in its Statement of Financial Accounting Standards No. 34.
In cases where an extended period is involved in the preparation of an asset for its intended use and amount incurred towards construction of the asset during the preparation period is significant, the amount of interest paid needs to be capitalized as part of the cost of acquiring the asset. The main objectives behind capitalization of interest in such cases are:
1. The cost so obtained clearly describes the total investment made by the enterprise towards procurement of the asset; and
2. While recognizing depreciation expense, the cost of services provided by the asset in future periods is adequately measured.
However, capitalization of interest as part of cost of the asset should be done only in cases where the benefits of capitalization of interest are more than the cost to be incurred for accumulating the required information. The circumstances, where it is appropriate to capitalize interest are as follows:
1. When the asset is constructed by the enterprise for its own use.
2. When the asset is constructed by another enterprise for the enterprise acquiring the asset, in case deposits or progressive payments have been made by the acquiring enterprise.
3. Land purchased for development for specific purpose.
4. Assets which are constructed as discrete projects intended for sale or lease.
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