SFAS 34 Capitalization of Interest Cost
SFAS 34 Capitalization of Interest Cost was enforced in Oct 1979 and laid out standards for capitalization of interest cost as a part of the historical cost of acquiring certain assets. The interest cost that may be material and eligible for capitalization includes the cost of borrowing and other obligations to carry out expenditures for a specific period of time for the asset required to bring the asset to its current state and location (Williams & Carcello, 2005). The rate used to capitalized depends upon the company’s existing borrowings, and if fresh borrowing is carried out for the specific asset, then the rate of new borrowing is to be applied to the portion of expenditure or weighted average rate to be used if the combination of borrowing is used however judgment is to be applied. The objectives of capitalization of interest cost are (1) to ensure that the acquisition cost reflects the company’s total investment in the asset and (2) to include acquisition cost incurred, which would generate revenue in future periods. However, there are certain ambiguities related to this statement which allow twelve alternate treatments of the interest cost capitalization (SFAS 34, 1979).
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Qualifying assets under SFAS 34 include (1) assets that are constructed or produced by the company (or others) for its own use and (2) assets intended for sale or lease constructed or produced as discrete projects. However, interest cannot be capitalized for assets (1) that are already in use or ready for their intended use in the earning activities of the company (2) that are not being used in the earning activities of the company and are not undergoing activities to get them ready for use. Furthermore, interest cost cannot be capitalized for those assets which are routinely manufactured or produced in large quantities on a repetitive basis (SFAS 34, 1979).
The interest cost to be capitalized during the acquisition period of assets is that which could be theoretically avoided if the expenditures of the assets had not been made. The expenditure to be capitalized at a rate discussed above would require payment of cash, the transfer of other assets, or the incurring of a liability on which interest is recognized. In the absence of these, a reasonable approximation of net capitalized expenditures may be used (SFAS 34, 1979).
SFAS 34 Paragraph 17 outlines three conditions for the recording of capitalization period as (1) expenditures for the asset have incurred (2) work is in progress for an asset to be ready for its intended use (3) interest cost is occurring. Interest capitalization will continue till these conditions are met.
Ocean transport plans to convert its container ship to passenger-container ship via borrowing of funds. The intended use of the modified ship is for the company and is not intended to be sold; however, there still exists a ready market for the sale of such ships. The modification of the ship to its intended use would only require few parts to be removed, which could be used for other ships in the company’s fleet. We will now discuss both scenarios presented as questions to be addressed in light of the standards set out by SFAS 34 described above.
Where the ship has been in use for earning revenues for the company and is fully utilized on charter, in this case, the condition set out by SFAS 34 for qualifying asset as above is not satisfied; therefore, the net book value of the ship cannot be used for capitalization of the interest cost. The interest incurred on borrowing of funds to carry out activities for modification of the ship will be treat as interest expenses and will not become part of the acquisition cost.
Where the ship has not been in the use of the company for the last one year period, and the company plans to convert this container shipment into a combination of both passenger and container ship. This implies that the ship has not been generating revenues for the company in this period. In this case, the net book value of the ship can be used for the capitalization of the interest. However, the net book value needs to take into account the market value of those parts which would no longer be used in the ship, and this will be deducted from its book value. The capitalization period will start from the time when the ship will be dry-docked to carry out activities to convert it, and borrowing has been made for these expenditures. The intention of the company is to bring the converted into its own use; however, if the company decides to take advantage of the market and sell the ship at a profit, then capitalization of interest cost will not be allowed because distinction would not be made regarding its intentions. If a fresh borrowing is made for these expenditures, then the interest rate used for capitalization is the cost of borrowing; otherwise, alternate treatment and where expenditure amount exceeds specific borrowing then weighted average interest rate to be used for capitalization (CPAClass.com, 2007).
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“Capitalization of Interest Cost”. 2008. Web.
Financial Accounting Standards Board (FASB). 1979. “Statement of Financial Accounting Standards No. 34: Capitalization of Interest Cost”. Connecticut. 2008. Web.
Williams, J. R. & Carcello, J. V. 2005. “2006 Miller GAAP Guide Level A: Restatement and Analysis of Current FASB Standards”. CCH Tax and Accounting. 2008. Web.