What Is Avoidable Interest?
Avoidable interest is the amount of interest cost that a company could have avoided if it had not used borrowed funds for a specific purpose, such as financing a construction project or purchasing an asset. It represents the hypothetical savings on interest expense if internal funds had been used instead of external debt.
Think of it as the “what-if” scenario in accounting. What if the company didn’t borrow money for that project? The interest cost associated with the borrowed funds would be the avoidable interest.
Understanding Avoidable Interest in Detail
Avoidable interest is most relevant when companies are constructing their own assets, like a factory or office building. During the construction phase, companies often finance these projects with borrowed money. Accounting standards allow them to capitalize a portion of the interest incurred, meaning they add it to the cost of the asset instead of expensing it immediately.
Key Features of Avoidable Interest:
- Specific to Capital Projects:
Avoidable interest applies to projects under construction or major asset acquisitions. - Calculated on Borrowed Funds:
It is based on the actual borrowing costs incurred for the specific project. - Not Always Entirely Capitalized:
Only the portion directly related to the construction period is capitalized, while the rest is expensed.
How Is Avoidable Interest Calculated?
The calculation involves:
- Identifying the funds used for the construction project.
- Calculating the weighted average interest rate on borrowed funds.
- Applying this rate to the portion of funds specifically used for the project during the construction period.
Formula:
Formula:
Real-World Example
Imagine ABC Corp is constructing a new office building.
- Construction Cost: $5 million
- Borrowed Funds: $3 million at an interest rate of 5% annually
- Construction Period: 1 year
The avoidable interest is calculated as:
This $150,000 can be capitalized as part of the building’s cost.
Why Does Avoidable Interest Matter?
- Tax Benefits:
Capitalizing interest may result in deferred tax liabilities, as the expense is spread over the asset’s useful life. - Accurate Asset Valuation:
Including avoidable interest ensures the total cost of the asset reflects all expenditures, including financing. - Matching Principle in Accounting:
By capitalizing the interest, the cost is matched with the revenue the asset will generate in the future.
Use Cases in Accounting Practices
- Construction of Long-Term Assets:
Companies constructing factories, office buildings, or machinery often capitalize avoidable interest. - Accounting for Borrowing Costs:
Helps accountants determine what portion of borrowing costs can be added to the asset’s value versus expensed immediately.
FAQs About Avoidable Interest
1. Can avoidable interest be capitalized for all assets?
No, avoidable interest can only be capitalized for qualifying assets, typically those under construction for internal use or development.
2. Is avoidable interest always the same as total interest cost?
No, avoidable interest is only the portion of total interest cost directly attributable to the project during its construction period.
3. How does avoidable interest differ from expensed interest?
Avoidable interest is capitalized as part of an asset’s cost, while expensed interest is reported as a period expense in the income statement.
Quiz: Test Your Knowledge of Avoidable Interest
Question:
ABC Corp borrowed $10 million at an annual interest rate of 6% to finance a new factory. The construction period is 2 years, and the average construction expenditure is $7 million. What is the total avoidable interest?
- A) $420,000
- B) $700,000
- C) $1,260,000
- D) $840,000
Get Answer
Correct Answer:
D) $840,000
Explanation:
Avoidable Interest = Average Construction Expenditure × Interest Rate × Construction Period
