All businesses are required by the Internal Revenue Service to report their income and expenses and pay their business taxes annually. They are also required by law to keep accurate accounting records. The government realizes, however, that certain business expenses are long-term ones and large enough that the business could use some tax relief from the government by accounting for these expenses over a longer period of time than one year. To accomplish this, the IRS has endorsed an accounting technique called the specific interest method.
There are two basic accounting methods businesses must follow: actual or accrual. Actual accounting reports money that has actually been paid to or by the company. Accrual accounting, though, reports money that is promised to the company (e.g., for sales that have been made to customers but not paid for yet) and money that is owed by the company (e.g., outstanding bills) but not yet paid. When it comes to reporting capital expenses like loans, however, a third option is available for reporting the interest on the loans: the specific interest method.
Companies often obtain long-term loans to cover expenses for items like building construction. The loan is considered a long-term liability, and the company must pay back the principal on the loan, as well as interest on the loan balance. When an expense is capitalized, it is accounted for and reported over a long period of time. Companies usually want to capitalize their expenses so they do not appear to suddenly reduce their profits for their shareholders or show little or no profit on their balance sheet for a particular year. Loans may be capitalized over many years, spreading out the large expense into much smaller portions.
Actual Interest Paid
The actual interest a company pays on loans is not necessarily the same amount of money the company reports on its taxes, since the company has the option of capitalizing loan interest. For instance, take a company that hires a contractor to construct a new building. The construction begins on Jan. 1, 2010 and concludes 18 months later, on June 30, 2011. Assume that the company makes three payments to the contractor during 2010: $500,000 on Jan. 5, $400,000 on March 30, and $600,000 on Sept. 30. Payments for the year therefore total $1.5 million. The company received a construction loan of $1 million with an interest rate of 8 percent on Jan. 3, 2010, and also has two other long-term interest-bearing notes of $2 million and $4 million, bearing 6 percent and 12 percent interest rates, respectively. So during 2010, the company is bearing $7 million of debt, for which it has to pay the various loan holders a total of $680,000 ($80,000 on the $1 million construction loan at 8 percent, plus $120,000 on the $2 million note at 6 percent, plus $420,000 on the $4 million note at 12 percent).
Calculated Interest Reported (Specific Interest Method)
If the company uses the specific interest method for capitalizing loan interest, however, it will calculate the expenses only for the months that the expenses were made and therefore that it incurred debt. Furthermore, it will simply use the 8 percent interest rate of the the construction loan to calculate the interest. Continuing with the example, the first contractor payment of $500,000 was made in early January, so the company will report the full amount ($500,000) on its tax return. The second payment on March 30 for $400,000 was only in existence for nine months out of the year, so the company will report the payment as $300,000 instead (9/12 of $400,000). The third payment on Sept. 30 for $600,000 will be reported as $150,000 since it was made when only three months remained in the year (3/12 of $600,000). In other words, although the company paid the contractor $1.5 million during 2010, it will report that it paid the contractor $950,000 instead ($500,000 plus $300,000 plus $150,000). Furthermore, because it is capitalizing the loan interest through the specific interest method, it will report that it paid $76,000 in interest during 2010 ($950,000 times 8 percent) rather than the $680,000 in interest that it actually paid to the loan holders.
Reporting lower expenditures by capitalizing them looks better on the company's balance sheet, and is endorsed by the IRS, assuming the company uses proper capitalization accounting techniques.