Avoidable Interest: Calculation and Journal Entries
Avoidable interest is the interest a company could have avoided if it had not spent money on a qualifying asset, such as a building under construction. Under ASC 835-20, multiply weighted average accumulated expenditures by the appropriate borrowing rates. Capitalize the lower of avoidable interest and actual interest incurred, and expense the rest.
This comparison connects the construction schedule to the accounting entry. It prevents a company from capitalizing every dollar of interest simply because a building is under construction, or capitalizing more interest than it actually incurred.
Avoidable Interest Formula
Avoidable interest = (WAAE up to the specific construction loan × specific loan rate) + (WAAE above the specific loan × weighted average rate on other debt)
Capitalized interest = the lower of avoidable interest or actual interest incurred
Interest expense = actual interest incurred − capitalized interest
WAAE stands for weighted average accumulated expenditures: construction spending adjusted for how long each payment was outstanding during the period.
Video lesson with Professor Farhat
Start at 6:34 for borrowing-rate selection. The comparison with actual interest begins at 9:56, followed by the journal entry at 10:29.
Watch Professor Farhat’s interest capitalization example on YouTube.
Avoidable interest vs actual interest
| Amount | How it is determined | Role |
|---|---|---|
| Avoidable interest | Eligible weighted expenditures × appropriate borrowing rates | Measures interest attributable to preparing the asset |
| Actual interest | Total interest cost incurred on all outstanding debt during the accounting period | Provides the overall ceiling |
| Capitalized interest | Lower of the two amounts | Added to asset cost |
| Interest expense | Actual interest − capitalized interest | Recognized currently |
“Avoidable” is a measurement concept, not permission to skip a lender’s bill. Construction spending uses funds that otherwise could have reduced borrowings. Begin with the qualifying-asset and capitalization-period rules, then calculate weighted average accumulated expenditures, abbreviated WAAE.
What counts as a qualifying asset? It is an asset that takes time to get ready for its intended use, such as a building a company constructs for its own use, or a real estate project built for sale as a discrete project. Inventory that is routinely produced in large quantities and assets already in use do not qualify.
Capitalization runs only while three conditions are all met: expenditures for the asset have been made, activities to get it ready are in progress, and interest cost is being incurred. It stops when the asset is substantially complete and ready for its intended use.
Which rates determine avoidable interest?
For the specific-borrowing method used in this lesson, apply the construction loan’s rate to WAAE up to that loan’s amount. Apply the weighted average rate on other debt to the excess. If there is no specific loan, use the appropriate general-borrowing rate for the eligible base.
General borrowing rate = Annual interest on included general debt ÷ Principal of that debt, when the balances and rates remain constant all year. Weight by principal, not by the number of loans. If borrowing balances change, time also matters; do not treat a year-end balance as though it existed all year.
Quick example with a mid-year loan. A company has a $600,000 note at 8% outstanding all year and borrows $400,000 at 11% on July 1. The new loan is outstanding for only six months, so it counts as $200,000 of weighted principal and $22,000 of interest ($400,000 × 11% × 6/12). The general rate is ($48,000 + $22,000) ÷ ($600,000 + $200,000) = $70,000 ÷ $800,000 = 8.75%. Using the full $1,000,000 year-end balance and $92,000 of full-year interest would give 9.2%, which overstates the rate.
Calculate avoidable interest step by step
Hypothetical example. Harbor Tools has WAAE of $630,000 for its building, as calculated in the linked expenditure lesson. Construction qualifies throughout the year and is ready December 31. All debt below is outstanding all year at the stated annual rates; assume no discounts, premiums, or other interest adjustments.
| Borrowing | Principal | Annual rate | Actual interest |
|---|---|---|---|
| Specific construction loan | $400,000 | 6% | $24,000 |
| General note | $600,000 | 8% | $48,000 |
| General bonds | $400,000 | 10% | $40,000 |
| Total | $1,400,000 | — | $112,000 |
1. Compute the general borrowing rate
Exclude the specific construction loan from this pool. The general rate is ($48,000 + $40,000) ÷ ($600,000 + $400,000) = 8.8%. A simple average of 8% and 10% would be wrong because the principal balances differ.
2. Apply the rates to the correct portions
Specific portion: $400,000 × 6% = $24,000. Excess portion: ($630,000 − $400,000) × 8.8% = $20,240. Total avoidable interest is $44,240. The expenditure base is already time-weighted; do not apply the month fractions again.
3. Apply the actual-interest limit
Actual annual interest is $112,000. Capitalize the lower amount, $44,240. Recognize $67,760 as interest expense. Check that $44,240 + $67,760 = $112,000.
Exam tip: Multiple-choice questions often include tempting wrong answers. Watch for total actual interest ($112,000 here), $44,700 from using a simple-average 9% general rate, or $37,800 from applying the 6% construction rate to all $630,000 of WAAE. Compute avoidable interest first, compare it with actual interest, and only then choose your answer.
The general rate and the actual-interest ceiling serve different purposes. The rate pool excludes the specific loan to avoid using it twice. Actual interest includes that loan when measuring the company’s total incurred interest.
Record the capitalized interest journal entry
Assume Harbor pays the full annual interest at year-end and has not already recorded it. Record the following combined entry. Use Interest Payable instead of Cash for an unpaid amount.
| Account | Debit | Credit |
|---|---|---|
| Building / Construction in Progress | $44,240 | — |
| Interest Expense | $67,760 | — |
| Cash | — | $112,000 |
If all $112,000 was previously recorded as Interest Expense, make only the adjustment: debit Building / Construction in Progress $44,240 and credit Interest Expense $44,240. Do not record the full cash payment twice.
Handle land cost and interest revenue separately
Harbor’s construction-related payments total $1,020,000, including $60,000 for the building site. The site is actively being developed for the building. The purchase remains Land at $60,000. Direct building cost is $960,000; adding capitalized interest produces a building cost of $1,004,240.
Eligible interest on the site expenditure goes to the building because the building is the asset being prepared. This differs from simply holding undeveloped land. FASB’s Statement 34, paragraph 11, explains that distinction; its historical guidance is now organized in ASC 835-20.
Suppose Harbor also earns $2,500 by temporarily investing unused loan proceeds. In this ordinary U.S. GAAP construction example, recognize Interest Revenue separately. Do not subtract $2,500 from avoidable interest, actual interest, or the $44,240 capitalized amount. Special borrowing arrangements and international rules are outside this lesson.
What appears in the financial statements?
Capitalized interest is part of the building’s cost and is subsequently depreciated with it once ready for use. The current income statement includes the $67,760 interest expense and separately recognized interest revenue. The total interest incurred and the amount capitalized are disclosed in the financial statements or accompanying notes.
On the statement of cash flows, interest paid that is capitalized into the building is an investing outflow, because it is part of the cost of acquiring the asset. Interest paid that is expensed is an operating outflow. For Harbor, that means $44,240 in investing activities and $67,760 in operating activities, and the supplemental disclosure of interest paid is shown net of the amount capitalized.
A company annual report filed with the SEC, page 68, illustrates a policy using specific or general borrowing rates and ending capitalization at readiness. It is an example of reporting practice, not a substitute for the accounting standard.
Common calculation and entry mistakes
Watch out for these common mistakes:
- Applying the construction loan rate to all of WAAE, even the amount above the loan balance.
- Including the construction loan again when computing the general borrowing rate.
- Using a simple average of rates instead of weighting by principal.
- Applying month fractions to WAAE a second time.
- Capitalizing all actual interest instead of the lower amount.
- Subtracting interest earned on temporarily invested loan proceeds from the capitalized amount.
- Adding capitalized interest to Land instead of the building being constructed.
Keep the expenditure schedule, rate schedule, and journal entry connected but distinct.
Key Takeaways
- Avoidable interest = WAAE × the appropriate borrowing rates.
- Use the specific construction loan rate up to the loan amount and the weighted average rate on other debt for any excess.
- Capitalize the lower of avoidable interest and actual interest incurred. The rest is interest expense.
- Capitalized interest becomes part of the building’s cost and is depreciated with it.
- Under ordinary U.S. GAAP, interest earned on temporarily invested loan proceeds is recorded as revenue, not netted.
- Disclose the total interest incurred and the amount capitalized.
Want to keep going? The Intermediate Accounting course has more video lessons like this one, and you can try the Farhat Lectures free sample course first.
Interactive interest capitalization exercise
Test your understanding of the U.S. GAAP interest capitalization limit for a qualifying asset. Work through four questions on actual interest, avoidable interest, and materiality before reviewing the worked practice questions below.
Practice questions with explained answers
1. WAAE is $250,000 and a $400,000 specific loan carries 7%. Actual interest is $28,000. What is capitalized?
Answer: $17,500: $250,000 × 7%. It is below $28,000 actual interest; the remaining $10,500 is expense.
2. A verified calculation gives $31,000 avoidable interest, but actual interest is $26,000. What is the limit?
Answer: Capitalize $26,000. The actual-interest ceiling prevents capitalizing an additional $5,000 that was not incurred.
3. General debt is $200,000 at 5% and $800,000 at 10%, outstanding all year. What rate applies to excess WAAE?
Answer: 9%: ($10,000 + $80,000) ÷ $1,000,000. The larger loan receives more weight.
Frequently asked questions
What Is The Formula For Avoidable Interest?
Avoidable interest equals weighted average accumulated expenditures (WAAE) multiplied by the appropriate borrowing rates. Use the specific construction loan rate on WAAE up to the loan amount and the weighted average rate on other debt for any excess. In the Harbor example, $400,000 × 6% + $230,000 × 8.8% = $44,240.
Can avoidable interest exceed actual interest?
Yes. This is normal when construction spending is large compared with the company’s debt, for example when much of the project is paid for with equity or cash on hand. In that case, capitalize only the actual interest incurred. If avoidable interest is $31,000 and actual interest is $26,000, capitalize $26,000 and record no interest expense.
Is capitalized interest a separate permanent asset?
No. It becomes part of the qualifying asset’s cost, such as Building, rather than remaining a separate interest asset.
Does interest revenue reduce interest expense in the capitalization entry?
No. In the ordinary U.S. GAAP example here, record revenue separately and reconcile the entry to actual interest cost incurred.
Where Does Capitalized Interest Go On The Statement Of Cash Flows?
Interest that is capitalized into a building is reported as an investing cash outflow, because it is part of the asset’s cost. Interest that is expensed is reported as an operating cash outflow.
Is Interest Capitalized On Land?
Only while the land is being developed for a specific use. Idle land held for future use is not a qualifying asset. When land is developed for a building, the interest on land expenditures is added to the building’s cost, and the land itself stays recorded at its purchase price.
Sources and lesson context
This original study guide follows Wiley Intermediate Accounting, section 9.2: Interest Costs During Construction. All examples and practice questions here are hypothetical and original. The current U.S. GAAP reference is FASB ASC 835-20, Capitalization of Interest. FASB Statement 34 provides accessible historical background; the Codification is the current authoritative source.
Continue learning: Intermediate Accounting course · Farhat Lectures free sample course.
About The Author
Mansour Farhat, CPA, CIA, DBA, is the instructor behind Farhat Lectures, where he teaches accounting courses and CPA and CMA exam review lessons. The examples and practice questions in this guide are his original teaching material.
Responses