12 July 2017
Suppose we take a loan to construct a building on 01.04.2017. Annual Interest is say ₹5,00,000. The term of the loan is 5 years. The building gets constructed by 31.03.2019. Then, Interest paid on the loan for the pre-construction period, i.e. 2 years, is capitalized. Why?
14 July 2024
Interest paid on a loan during the pre-construction period is capitalized because of the specific accounting treatment required for assets under construction, such as buildings. Let’s break down the reasons why interest incurred during the construction period is capitalized rather than expensed immediately:
### Reasons for Capitalizing Interest:
1. **Matching Principle (Accrual Basis Accounting):** - The matching principle dictates that expenses should be recognized in the same period as the revenues they help generate. For assets under construction, including buildings, interest is considered a cost incurred to finance the construction process. - Capitalizing interest aligns with this principle by spreading the interest expense over the period during which the asset (building) is being constructed and readied for use.
2. **Time Frame of Construction:** - In your example, the building construction spans from 01.04.2017 to 31.03.2019, a period of 2 years. - The interest incurred on the loan during these 2 years is directly related to the financing of the construction activities during this period.
3. **Interest Capitalization Criteria (As per Accounting Standards):** - Accounting standards (such as Ind AS 23 or IAS 23) provide specific criteria for capitalizing interest during the construction period: - The expenditures for the asset’s construction are being incurred. - Borrowing costs are being incurred. - The activities necessary to prepare the asset for its intended use or sale are in progress. - Once these criteria are met, interest is capitalized as part of the cost of the asset.
4. **Enhancement of Asset’s Cost:** - By capitalizing interest, the total cost of the asset (building) is increased. This reflects the true cost incurred by the entity to acquire or construct the asset. - It ensures that the balance sheet reflects the total investment in the asset, including the costs of financing its construction.
### Example Application:
- If the annual interest on the loan is ₹5,00,000, and the building construction took 2 years, the total interest incurred during the construction period would be ₹10,00,000. - This ₹10,00,000 is added to the cost of the building under construction. Instead of expensing ₹10,00,000 immediately, it is spread over the useful life of the building through depreciation, reflecting the matching principle.
### Conclusion:
Interest incurred on a loan during the construction period of an asset, such as a building, is capitalized to adhere to accounting principles that ensure accurate matching of expenses with related revenues or asset usage. By capitalizing interest, the financial statements provide a more accurate representation of the cost of the asset and the entity’s financial position during the construction phase.
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