Difficulty: Intermediate | Prerequisites: PPE Acquisition and Classification notes; comfort with journal entries (debits and credits) and the concept of book value vs. fair value.
Companies do not always buy PPE with cash. Sometimes they swap old assets for new ones (nonmonetary exchanges), and sometimes they build assets themselves (self-construction). Both situations raise questions about what cost to put on the books. Interest capitalisation adds another layer: when a company borrows to fund construction, part of that interest becomes part of the asset's cost rather than hitting the income statement. This set of topics sits between acquisition (how do we first record PPE?) and depreciation (how do we allocate that cost over time?).
When trading one asset for another, record the new asset at fair value, remove the old asset's book value, record any cash paid or received, and plug the difference as a gain or loss. When a company builds its own asset, interest on borrowings during construction gets capitalised as part of the asset's cost, up to (but never exceeding) the total interest the company actually incurred.
Nonmonetary asset exchange
A transaction in which a company acquires a new asset by giving up an old asset (and possibly some cash), rather than paying entirely in cash.
Think of it as a trade-in, like swapping your old car plus some cash for a newer model.
Commercial substance
An exchange has commercial substance when the future cash flows of the company change as a result of the transaction (in timing, amount, or risk). If the exchange has commercial substance, gains and losses are recognised immediately.
In simple terms, if the swap meaningfully changes what the company will earn going forward, it has commercial substance.
Book value (net book value / carrying value)
The original cost of an asset minus its accumulated depreciation. This is what the asset is "worth" on the company's books, which is usually different from its market value.
Self-constructed asset
A PPE item that a company builds for its own use rather than purchasing from an outside party. All reasonable construction costs are capitalised.
Interest capitalisation
The process of adding borrowing costs incurred during the construction of a qualifying asset to the cost of that asset, rather than expensing them on the income statement.
Think of it as: interest during construction is part of what it cost to build the thing, so it goes on the balance sheet with the rest of the construction costs.
Accumulated expenditures (weighted-average accumulated expenditures)
The running total of construction spending, weighted by how long each payment has been outstanding during the period. This figure determines how much interest can be capitalised.
Construction-specific loan
A borrowing taken out specifically to fund the construction of an asset. Its interest rate is used first when calculating capitalised interest.
Average interest rate on other debt
When accumulated expenditures exceed the construction-specific loan, the excess is multiplied by the weighted-average rate on the company's other outstanding interest-bearing debt.
Incremental overhead approach
Only the additional overhead caused by the construction project is capitalised to the asset. Overhead that would have been incurred anyway is expensed.
Full cost approach
All overhead allocated to the construction project (including a share of existing overhead) is capitalised to the asset.
A nonmonetary exchange is a trade: give up an old asset, receive a new one, and sometimes pay or receive cash to even things out. Assume all transactions have commercial substance (unless told otherwise).
Record the new asset at its fair value. If the new asset's fair value is not given, use the fair value of the old asset plus any cash paid (or minus any cash received).
Remove the book value of the asset given up. Debit accumulated depreciation and credit the old asset at its original cost.
Record any cash received or paid.
Plug the entry to gain or loss. The gain or loss is whatever makes the journal entry balance.
Elcorn trades old laser equipment for newer equipment. Facts:
Old equipment: cost $500,000, net book value $100,000 (so accumulated depreciation = $400,000)
Fair value of old equipment: $150,000
Cash paid to American Laser: $430,000
Fair value of new equipment = fair value of old equipment + cash paid = $150,000 + $430,000 = $580,000.
Account | Debit | Credit |
|---|---|---|
Equipment (new) | $580,000 | |
Accumulated Depreciation (old) | $400,000 | |
Loss on Exchange | ||
Equipment (old) | $500,000 | |
Cash | $430,000 | |
Gain on Exchange | $50,000 |
The gain of $50,000 = fair value of old asset ($150,000) minus book value of old asset ($100,000).
Cedric trades an older model of equipment for a new model. Facts:
Old equipment: original cost $400,000, book value $180,000 (accumulated depreciation = $220,000)
Fair value of old equipment: $170,000
Cash paid: $60,000
Fair value of new equipment = $170,000 + $60,000 = $230,000.
Account | Debit | Credit |
|---|---|---|
Equipment (new) | $230,000 | |
Accumulated Depreciation (old) | $220,000 | |
Loss on Exchange | $10,000 | |
Equipment (old) | $400,000 | |
Cash | $60,000 |
The loss of $10,000 = fair value of old asset ($170,000) minus book value of old asset ($180,000).
When a company builds its own PPE (e.g. Nike building its own manufacturing centre), two accounting questions arise.
Incremental overhead approach: capitalise only the extra overhead caused by the project
Full cost approach: capitalise a proportional share of all overhead, including existing costs
Because the asset must include all costs necessary to get it ready for intended use, interest incurred on borrowings during the construction period is capitalised rather than expensed.
Step 1: Determine weighted-average accumulated expenditures
Weight each construction payment by the fraction of the year it has been outstanding.
Example: if $500,000 is paid on 1 January and $400,000 on 31 March, the weighted amounts for the year are:
$500,000 x 12/12 = $500,000
$400,000 x 9/12 = $300,000
Weighted-average accumulated expenditures = $800,000
Step 2: Calculate interest to capitalise
Apply the interest rates in order:
First, use the construction-specific loan rate on as much of the accumulated expenditures as the loan covers
For any excess above the construction loan, use the weighted-average interest rate on the company's other debt
Weighted-average rate on other debt = total interest on other debt / total principal of other debt.
Step 3: Cap the amount
Capitalised interest can never exceed total actual interest incurred during the period (across all borrowings). If the Step 2 calculation produces a number larger than total actual interest, cap it at total actual interest.
Component | Formula |
|---|---|
Weighted-average accumulated expenditures | Sum of (each payment x fraction of period outstanding) |
Interest on construction loan portion | Min(accumulated expenditures, construction loan) x construction loan rate |
Interest on excess | Max(accumulated expenditures minus construction loan, 0) x average rate on other debt |
Capitalised interest | Min(sum of above two, total actual interest incurred) |
Interest expense | Total actual interest incurred minus capitalised interest |
Students often calculate the gain or loss on an exchange by comparing the fair value of the new asset to the book value of the old asset. The gain or loss comes from comparing the fair value of the old asset to its own book value.
When calculating interest to capitalise, students sometimes use the total amount spent on construction (not weighted). You must weight each expenditure by the fraction of the period it was outstanding.
Students sometimes capitalise more interest than the company actually incurred. Capitalised interest is capped at total actual interest, always.
Students forget that the weighted-average rate on other debt uses all non-construction borrowings, not just the largest one.
⚠️ The 4-step exchange method is a near-certainty on the exam. Practise until you can write the journal entry from a set of facts without hesitation.
⚠️ Interest capitalisation problems are calculation-heavy. Expect a multi-year construction scenario with a specific loan and general borrowings. You will need to compute weighted-average accumulated expenditures for each year separately.
⚠️ Know the difference between the incremental and full cost approaches to overhead on self-constructed assets.
⚠️ Remember: capitalised interest can never exceed actual interest incurred. If your calculation gives a larger number, use actual interest as the cap.
True or false: In a nonmonetary exchange, the new asset is always recorded at the book value of the old asset. (False. The new asset is recorded at fair value.)
Fill in the blank: The gain or loss on an exchange equals the fair value of the ______ asset minus its ______ value. (old; book)
True or false: If accumulated expenditures exceed the construction-specific loan, the excess uses the construction loan rate. (False. The excess uses the weighted-average rate on other debt.)
Fill in the blank: Capitalised interest can never exceed ______. (total actual interest incurred)
True or false: Interest capitalisation continues after construction is complete. (False. It stops when the asset is substantially complete and ready for use.)
Q: Elcorn Company trades old laser equipment (cost $500,000, book value $100,000, fair value $150,000) for new equipment and pays $430,000 cash. What is the fair value of the new equipment, and what gain or loss is recognised?
A: New equipment fair value = $150,000 + $430,000 = $580,000. Gain = $150,000 - $100,000 = $50,000.
Q: A company began construction on 1 January 2024. It spent $500,000 on 1 January, $400,000 on 31 March, and $600,000 on 30 September. What are the weighted-average accumulated expenditures for 2024?
A: $500,000 x 12/12 = $500,000; $400,000 x 9/12 = $300,000; $600,000 x 3/12 = $150,000. Total = $950,000.
Q: Using the facts above, the company has a $1,000,000 construction loan at 8% and other debt of $2,000,000 at 6% and $4,000,000 at 12%. What is the capitalised interest for 2024?
A: Weighted-average accumulated expenditures ($950,000) are less than the construction loan ($1,000,000), so all $950,000 uses the 8% rate. Capitalised interest = $950,000 x 8% = $76,000. Actual interest = ($1,000,000 x 8%) + ($2,000,000 x 6%) + ($4,000,000 x 12%) = $80,000 + $120,000 + $480,000 = $680,000. Since $76,000 < $680,000, no cap is needed. Capitalised interest = $76,000.
Q: What is the interest expense that appears on the 2024 income statement?
A: Total actual interest ($680,000) minus capitalised interest ($76,000) = $604,000.
Nonmonetary exchanges require you to know book value, which depends on depreciation from the previous set of topics. Interest capitalisation adds to the asset's cost on the balance sheet, which in turn becomes the depreciable base. Once construction is complete and the asset transfers out of CIP, all the depreciation and disposal rules from the next set of notes apply.
nonmonetary exchange, asset exchange, trade-in, commercial substance, gain on exchange, loss on exchange, self-constructed asset, interest capitalisation, interest capitalization, capitalised interest, accumulated expenditures, weighted-average accumulated expenditures, construction loan, specific interest method, avoidable interest, CIP interest, overhead capitalisation, incremental overhead, full cost approach, ACCT MIS 3200, Chapter 10, Chapter 11, LO 10-7, LO 10-6