When a company self-constructs a long-term asset for its own use, its accountants treat the interest paid on loans to finance the asset as part of the asset's cost. They add the interest to the balance sheet instead of treating it as an expense on the income statement, and include it when calculating the depreciation expense. The company may also capitalize the interest paid on loans to finance large, discrete projects for sale or lease, such as a real estate development.
Multiply the expenditure on the asset during the period by the annual interest rate of the specific borrowing. For example, if the company borrows $2 million at an annual interest rate of 5 percent to complete a project and spends $1 million on construction in the first year, multiply $1 million by 5 percent, which equals $50,000 interest available for capitalization.
Credit the bank account and debit the loan account with repayments made during the period. These payments are a combination of capital repaid and interest. For example, the company makes repayments during the year of $475,000.
Debit the cost of the asset and credit the loan account with the capitalized interest. In the example, debit the asset cost and credit the loan account with $50,000. The asset cost available for depreciation at the end of Year One is therefore $1,050,000.
Debit the interest expense account and credit the loan account with any interest paid in excess of the interest capitalized. For example, if the total interest paid in the first year was $75,000, debit the interest expense account and credit the loan account with $75,000 minus $50,000, or $25,000.