When should a company capitalize interest costs instead of expensing them, and how does it affect financial ratios?

Both IAS 23 (IFRS) and ASC 835-20 (US GAAP) require capitalization of borrowing costs that are directly attributable to the acquisition, construction, or production of a qualifying asset. A qualifying asset is one that takes a substantial period of time to get ready for its intended use or sale.

When Capitalization Starts Three conditions must all be met:

1. Expenditures for the asset are being incurred.
2. Borrowing costs are being incurred.
3. Activities necessary to prepare the asset for use are in progress.

When Capitalization Stops When the asset is substantially complete and ready for its intended use. If construction is suspended for an extended period, capitalization must also be suspended.

Example: Granite Properties borrows $20,000,000 at 6$20M x 6% x 1.5 = $1,800,000.

Capitalizing vs. Expensing -- Side-by-Side:

	Capitalize	Expense
Building cost on BS	$20M +$1.8M = $21.8M	$20M
Interest expense (Y1)	$0 during construction	$1,200,000
Year 1 net income	Higher (no interest hit)	Lower
Total assets	Higher	Lower
CFO	Higher (interest in CFI)	Lower (interest in CFO)
CFI	Lower	Higher

Impact on Ratios:

• Interest coverage -- Higher when interest is capitalized because reported interest expense is lower.
• Asset turnover -- Lower because total assets are inflated by capitalized interest.
• ROA -- Can go either way: higher income but also higher assets.
• Debt-to-equity -- Unchanged (total debt is the same regardless of capitalization).

IFRS vs. GAAP Nuance Under IFRS, if funds are borrowed generally (not specifically for the asset), the company uses a weighted average rate of outstanding borrowings. Under US GAAP, specific borrowings are matched first, then a weighted average rate is applied to excess expenditures.

Exam Tip: The exam loves to test the financial statement impact of capitalizing vs. expensing. Remember the key trade-off: capitalizing increases current income and total assets but reduces both in future periods (through higher depreciation). Over the asset's total life, cumulative net income is the same under both methods.

Explore our CFA Level I FRA course for more capitalization analysis.