For beginners and experienced analysts alike, the accounting for both accrued interest and capitalized interest can seem unintuitive. However, when you dive into the logic that dictates how accountants record these transactions, you'll see that each is actually consistent with fundamental accounting principles.
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What is capitalized interest?
In simple terms, capitalized interest is interest that is kept on a company's balance sheet as a part of a long term, fixed asset's cost. There are other less common instances of capitalized interest, like in certain loan transactions at banks, but the vast majority of capitalized interest is seen when a company uses a loan to construct a fixed asset it will own and use. The most common examples are buildings and other fixed structures.
In these cases, the interest paid on the construction loan is considered part of the cost of construction, no different than the materials, labor, and other physical expenses. By this logic, the interest should be accounted for in the same way as those costs, which is to be held on the balance sheet and depreciated over the useful life of the asset.
By accounting for construction interest in this way, the process stays true to the matching principal of accounting, ensuring that expenses are reported in the appropriate period to match the related revenues earned.
What is accrued interest?
Accrued interest can best be explained with an example. Let's say a company takes out a loan of $100,000 with interest payments due monthly based on an annual interest rate of 10%. The loan will mature in one year with all outstanding principal and interest due in full at that time.
For every day the loan is outstanding, the bank charges the company interest on the principal. After one day, the company owes $27.40 in interest, assuming a 365-day year. After two days, the company owes the bank $54.79 in interest. After three days $82.19 is owed, and so on after that. These are real expenses and should be recognized as they build up over the month on the company's income statement even though no cash has actually changed hands (yet).
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At the end of the month, the company will pay the bank all of the interest that has accumulated, the accumulated interest to be paid will reset back to zero, and the process will start again. It's only at this point that the company actually cuts a check and sends the bank cash.
The interest that has accumulated but has not yet been paid is called accrued interest. Accrued interest effectively keeps track of the interest that has been expensed but has not yet been paid for with cash. While the interest is accruing, or accumulating, the company temporarily places the amount on the balance sheet as a liability called "accrued interest payable" to balance against the interest expense on the income statement. At the end of each period when the interest is paid to the bank, the accountant reduces the accrued interest payable by the amount paid and simultaneously reduces the company's cash balance to reflect the payment. The next day the process starts over for the next month.
Accrued interest is used in a similar way if the company makes a loan instead of borrowing one. The only difference is that the accruing interest would be shown as "interest income" on the income statement and would balance against an asset, "accrued interest receivables", on the balance sheet.
This accounting is driven by the most fundamental principal in accounting, the accrual principle, which dictates that revenue be recognized when earned not paid in cash and that expenses report when they are incurred not when they are paid.
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The article What is the Difference Between Accrued Interest and Capitalized Interest? originally appeared on Fool.com.
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