Capitalization of Interest Expenditure on Large Building Construction Project

C

Interest capitalization results in higher earnings compared to the case where it is expensed. This results in higher retained earnings and higher equity, thus reducing the debt-to-equity ratio.

When a firm decides to capitalize the interest expenditure on a large building construction project, it means that instead of immediately expensing the interest payments as an operating expense, they treat it as part of the cost of the project and include it in the value of the constructed asset. This is done in accordance with accounting standards such as International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP).

Capitalizing interest expenditure has an effect on the firm's debt-to-equity ratio, which is a measure of the proportion of debt and equity financing used by the firm. The debt-to-equity ratio is calculated by dividing total debt by total equity.

The decision to capitalize interest expenditure increases the total value of the construction project because the interest is added to the cost of the asset. This increase in the asset value affects both the numerator (total debt) and the denominator (total equity) of the debt-to-equity ratio.

Here's a detailed explanation of the effects of capitalizing interest expenditure on the debt-to-equity ratio:

1. Total Debt: Capitalizing interest expenditure increases the total debt of the firm. The interest payments that would have been expensed are now added to the cost of the asset, which is financed through debt. Therefore, the numerator (total debt) in the debt-to-equity ratio increases.

2. Total Equity: Since the interest expenditure is capitalized and included in the cost of the asset, it is not immediately recognized as an expense, which means it does not reduce the firm's net income. As a result, retained earnings increase, and total equity also increases. This, in turn, increases the denominator (total equity) in the debt-to-equity ratio.

As a result of both the increase in total debt and the increase in total equity, the debt-to-equity ratio increases. Therefore, the correct answer to the question is D. increases.

It's important to note that while capitalizing interest expenditure affects the debt-to-equity ratio, it does not directly impact the firm's overall financial leverage or the actual amount of debt and equity it has. It simply changes the way interest expenses are accounted for and reported in the financial statements.