Interest Capitalization: Rules & Example

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  • 0:00 Lots of Loans
  • 1:42 Different Rules
  • 3:19 Lesson Summary
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Lesson Transcript
Instructor: Adam Gifford

Adam holds an MBA and a MS in Human Resources

In this lesson, we'll discuss the interest capitalization rule in accounting. We'll define interest capitalization, and explore how it's used. We'll also review an example to see how this rule is applied in real-world accounting.

Lots of Loans

Amanda is the head accountant at Cool Optics, a large chain of sunglass stores. Last year, Cool Optics had to take out a $1,000,000 loan in order to complete a large inventory purchase. The interest rate on that loan was 7%, which means that the total amount of interest that will be paid is $70,000. Amanda knew that the accounting rule for a loan like this required her to record two accounting entries into her accounting software every month when a loan payment was made.

ENTRY #1 - Amanda deducts the amount of the loan principal that was paid from the balance sheet. The balance sheet is an accounting report that summarizes the assets that the company owns and the debts that the company owes.

ENTRY #2 - Amanda records the amount of the interest paid as an expense on the income statement. The income statement is an accounting report that summarizes the revenue that comes into the company and the expenses that are paid out to vendors and employees.

These entries continue for the life of the loan. Last year, Cool Optics also decided they needed a new corporate office. Instead of paying rent on a building, it was decided that the company would take out a loan and construct a new building. Cool Optics borrowed $1,000,000 for the construction of their new corporate office space. When a business decides to construct a new building that they'll use for the business operation, it is called a long-term asset. A long-term asset is defined as something that the business owns that will not be converted into cash in a year or less. The inventory that was purchased with the first loan is not a long-term asset because the business will hopefully sell it for cash within a year.

Different Rules

The accounting entries for a loan used to finance the purchase of a long-term asset is different than the accounting entries that are used for other types of loans. When a company borrows money to purchase a long-term asset, it must apply the interest capitalization rule to the accounting. Interest capitalization means that the total amount of interest that will be charged for the life of the loan is added to the total cost of the purchase. This means that Amanda will have to make different accounting entries for this loan than she did for the inventory loan.

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