You normally treat interest as a deductible expense you incur during a certain period. However, the U.S. authority on all things accounting and guardians of generally accepted accounting priniciples, the Financial Accounting Standards Board, issued Statement 34 providing rules for how to stretch out tax deductions for the interest costs associated with building or preparing long-lived assets, such as property and equipment. Instead of immediately deducting those interest expenses, you add them to the cost -- in other word, you capitalize the interest -- of the long-lived assets and thereby include them in periodic deprecation, which expenses the asset's cost basis over time. The specific interest method describes how to apply these interest costs.
Capitalization vs. Expense
Companies usually book interest to the income statement account "interest expense." This account appears on the income statement below "earnings before interest and taxes" and reduces taxable income for the period. A capitalized cost, such as the cost of a new machine, is one you carry on the balance sheet. Instead of deducting the cost of the new machine all at once, you spread the depreciation expense over more than one reporting period. When you capitalize interest, you add the eligible interest to the depreciable cost basis of the asset.
To capitalize interest, the amount must be considered "material," although FAS 34 doesn't give a specific percentage. The assets must be ones that require preparation or construction before you can use or sell them. A yacht or raw land are examples of assets that need construction or preparation. You cannot capitalize interest associated with inventories, assets already in use, assets not intended for use and assets that are not involved in creating earnings. It might seem obvious, but you cannot capitalize interest if you carry no debt on your balance sheet.
Under the specific interest method, you identify borrowings or portions of borrowings specifically incurred to finance an eligible asset. The amount to capitalize is equal to the average accumulated expenditures for the asset's preparation multiplied by the interest rate of the specific borrowing. The average accumulated expenditures are equal to the difference between expenditures on the last and first days of the period divided by two. If the expenditure pattern is uneven, you must take a time-weighted average. If the specific borrowing is sufficient to finance all of the asset's preparation during the period, you need not include interest rates from other borrowings.
If you expend more in the period than covered by the specific borrowing, you must figure the interest to capitalize on the overage. You use the dollar-weighted average of the interest rates on your other debt to determine how much interest to capitalize on the expenditures not covered by the specific borrowing. FAS 34 notes that you must use judgment to identify the borrowings on which you base the average interest rate for the overage amount.
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