Capitalized Interest on Lease Liabilities: Finance vs. Operating
Capitalized interest on lease liabilities is limited to finance leases. The ASC 835-20 glossary (ASC 835-20-20) defines interest cost to include "interest related to a finance lease determined in accordance with Topic 842." So finance lease interest joins the pool a company capitalizes while it builds a qualifying asset, such as a plant built for its own use.
An operating lease produces a single lease cost under ASC 842-20-25-6, not interest, so it adds nothing to that pool.
This page covers the lessee side. It shows which lease interest counts, how the rate and amount are worked out, and what happens to the lease cost itself during construction. It assumes you know how the lease liability is measured.
What does ASC 835 say about lease liabilities and capitalized interest?
ASC 835-20 capitalizes interest cost, and nothing else. Deloitte's Foreign Currency Roadmap, section 4.18 reproduces the glossary definition. Deloitte then states it plainly: "Interest costs are the only costs that are eligible for capitalization under ASC 835-20."
The ASC 835-20-20 definition names three sources of interest cost: debt with an explicit rate, interest imputed under Subtopic 835-30, and interest related to a finance lease under Topic 842. Operating leases are not on the list.
On a finance lease, that interest is real and you can measure it. ASC 842-20-35-1 has the lessee increase the lease liability "to reflect interest on the lease liability" each period. ASC 842-20-25-5 then sends that interest to profit or loss, "unless the costs are included in the carrying amount of another asset in accordance with other Topics."
ASC 835-20 is one of those other Topics. Deloitte's Leasing Roadmap, section 8.4 reproduces both paragraphs.
Does any part of operating lease cost count as interest?
No. Under ASC 842-20-25-6, the lessee recognizes a single lease cost. It is spread over the remaining lease term, generally on a straight-line basis. The income statement shows one operating cost, not interest.
KPMG's borrowing costs comparison of IFRS and US GAAP spells out the result. Under IFRS 16, it says, companies "capitalize eligible interest on any lease liability." US GAAP is narrower. In KPMG's words, "the new definition of interest costs only includes interest related to a finance lease determined under ASC 842."
On the books, that makes lease classification matter for capitalized interest. A finance lease adds interest cost. An operating lease adds none.
A finance lease also raises the interest cost ceiling in ASC 835-20-30-6. If the company counts the lease liability among its borrowings, the lease's rate also moves the weighted-average capitalization rate. PwC's PP&E guide, section 1.3, does not say whether a lease liability belongs in the weighted-average borrowings, but it says that in choosing the borrowings, "judgment will be required." An operating lease does neither.
Which assets qualify, and when does capitalization start and stop?
ASC 835-20-15-5 lists the qualifying assets. The two that matter here come first.
One is assets "constructed or otherwise produced for an entity's own use." That includes assets others build for the entity once it has paid deposits or progress payments. The other is assets built for sale or lease as discrete projects, such as ships or real estate developments.
ASC 835-20-15-6 shuts out assets already in use or ready for use. It also excludes inventory "routinely manufactured or otherwise produced in large quantities on a repetitive basis." A right-of-use asset for a building already in service is not a qualifying asset. A plant you are building for your own use can be.
Under ASC 835-20-25-3, the capitalization period begins when three conditions are present. You have spent money on the asset, work to get it ready for use is in progress, and interest cost is being incurred. Capitalization goes on as long as all three hold.
The PwC Viewpoint PP&E guide, section 1.3 applies this to land. Interest on land debt is capitalized only while development is in progress. PwC adds that this covers "interest on a ground lease that is classified as a finance lease."
A cost-benefit test governs whether you do this at all. ASC 835-20-15-3 requires capitalization "only when the balance of the informational benefit and the cost of implementation is favorable." The standard points to discrete projects that take a long time and cost a lot.
How is the capitalizable amount calculated?
The amount is avoidable interest. PwC's guide calls it interest cost "that theoretically could have been avoided if expenditures for qualifying assets had not been made." You apply a capitalization rate to the weighted-average spending on the asset for the period.
ASC 835-20-30-3 sets the rate. If a specific new loan funds the asset, you may use that loan's rate on the spending it covers. Any excess takes "a weighted average of the rates applicable to other borrowings of the entity."
PwC treats that weighted average as the primary method. Which borrowings go into it is a judgment call, as noted above.
ASC 835-20-30-6 caps the result. Interest capitalized in a period "shall not exceed the total amount of interest cost incurred by the entity in that period." Deloitte's Equity Method Roadmap, section 5.8 reproduces that paragraph. PwC adds that spending is measured on a cash basis, unless accrued amounts bear interest.
Worked example: a plant under construction with a finance lease outstanding
A manufacturer builds a new plant for its own use over a full calendar year. Work runs without a break, so all three ASC 835-20-25-3 conditions hold all year. It has no loan tied to the plant. Here is every input:
| Input | Amount |
|---|---|
| Bank term loan, outstanding all year | $6,000,000 at 6% |
| Finance lease liability on production equipment, balance on January 1 | $2,000,000 at 5% |
| Finance lease payment timing | Annual, on December 31 |
| Plant spending on January 1 | $1,200,000 |
| Plant spending on April 1 | $2,400,000 |
| Plant spending on October 1 | $800,000 |
Because the only payment falls on December 31, the principal outstanding is $2,000,000 all year. Its interest is $2,000,000 × 5% = $100,000. The example uses $2,000,000 as the lease's weight in the borrowings average.
This example assumes the company includes the finance lease liability among its borrowings. Its interest is interest cost under ASC 835-20-20. Which borrowings go into the average is a judgment call, as noted above.
Step 1: weighted-average spending. Weight each payment by the months it was outstanding:
| Date spent | Amount | Months outstanding | Weighted amount |
|---|---|---|---|
| January 1 | $1,200,000 | 12/12 | $1,200,000 |
| April 1 | $2,400,000 | 9/12 | $1,800,000 |
| October 1 | $800,000 | 3/12 | $200,000 |
| Total | $4,400,000 | $3,200,000 |
Step 2: capitalization rate. The loan costs $6,000,000 × 6% = $360,000, and the lease adds $100,000, for $460,000 of interest incurred. Borrowings total $8,000,000. The weighted-average rate is $460,000 ÷ $8,000,000 = 5.75%.
Step 3: avoidable interest and the ceiling. Capitalized interest is $3,200,000 × 5.75% = $184,000. That is below the $460,000 incurred, so the ASC 835-20-30-6 cap does not bind. The rest, $460,000 − $184,000 = $276,000, stays in interest expense.
The table below runs the same year twice, once with the equipment lease classified as finance and once as operating.
| Line | Lease is a finance lease | Same lease is an operating lease |
|---|---|---|
| Interest cost incurred | $460,000 | $360,000 |
| Borrowings in the weighted average | $8,000,000 | $6,000,000 |
| Capitalization rate | 5.75% | 6.00% |
| Capitalized interest ($3,200,000 × rate) | $184,000 | $192,000 |
| Interest left in expense | $276,000 | $168,000 |
The operating column shows the effect of ASC 842-20-25-6. The lease's cost sits in operating expense, outside the interest pool, so the rate is the loan's 6% alone. Here the lease's lower rate pulled the blended rate down, so the finance case capitalizes less. With a higher lease rate, the effect would run the other way.
The year-end entry in the finance case is a debit to construction in progress of $184,000 and a credit to interest expense of $184,000. The finance lease's own entries do not change. Our operating and finance lease journal entries walk through those.
Can the lease cost itself be capitalized into the asset being built?
Sometimes, but under other guidance, not ASC 835-20.
ASC 842-20-25-5 and 842-20-25-6 send lease cost to profit or loss unless other Topics put it in the carrying amount of another asset. KPMG's Handbook: Leases covers this in paragraph 6.4.70. It says "some or all of the cost of a lease may be capitalized as part of the cost of another asset." Its examples are property, plant and equipment, or inventory.
Operating ground and building leases are the exception people ask about most. ASC 842-10-55-21 says lease costs during a construction period "should be recognized by the lessee" under Subtopic 842-20. PwC's PP&E guide, section 1.2 takes the case of a company building property for its own use. There, it says, operating ground or building lease costs during construction "should be recognized as lease expense."
A finance ground lease is different. As noted above, PwC's section 1.3 capitalizes the interest on it while development is in progress.
ASC 842-10-55-21 leaves one case open. It does not address whether a lessee that accounts for the sale or rental of real estate projects under Topic 970 should capitalize rental costs on ground and building leases. If you build real estate for sale or rental, read the Topic 970 guidance on its own. Our ASC 842 guide for construction companies covers the lease side of a building program.
How does capitalized lease interest show up in the lease disclosures?
ASC 842-20-50-4 defines total lease cost to include "any amounts capitalized as part of the cost of another asset." So the $100,000 of finance lease interest is still reported in full as interest on lease liabilities. That holds even though part of the company's interest went to the plant.
PwC's Financial Statement Presentation guide, section 14.2 makes the same point. Lease cost, it says, "may include items not recognized as lease expense." Expect the auditor to tie the lease cost footnote to the general ledger. The gap should reconcile to capitalized amounts.
Frequently asked questions
Can interest on an operating lease be capitalized under ASC 835-20?
Not as interest. The ASC 835-20 glossary counts interest related to a finance lease as interest cost. KPMG reads that definition, under US GAAP, as including only finance lease interest. An operating lease produces a single lease cost under ASC 842-20-25-6, not interest, so none of it enters the capitalized interest calculation.
Is interest on a finance lease liability eligible for capitalized interest?
Yes. Interest on a finance lease liability is interest cost under the ASC 835-20 glossary. It is capitalized only while a qualifying asset is being built, only up to the avoidable amount, and never above the total interest cost incurred in the period (ASC 835-20-30-6).
Sources and further reading
- PwC Viewpoint, PP&E and other assets guide, 1.3: Capitalized interest
- PwC Viewpoint, PP&E and other assets guide, 1.2: Accounting for capital projects
- PwC Viewpoint, Financial statement presentation guide, 14.2: Lessees
- Deloitte DART, Foreign Currency Roadmap, 4.18: Capitalized Interest
- Deloitte DART, Leasing Roadmap, 8.4: Recognition and Measurement
- Deloitte DART, Equity Method Roadmap, 5.8: Interest Costs (reproduces ASC 835-20-30-6)
- KPMG, Borrowing costs: IFRS Accounting Standards vs US GAAP
- KPMG, Handbook: Leases
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