Adjusting for Capitalized Interest

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dtrynoski

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During 20x6, the company capitalized $20 of construction interest. The capitalized interest increased depreciation expense $5 for the year. For analytical purposes, you have decided to treat the capitalized interest as an immediate expense.
Adjustmented total assets: The capitalized interest, net of related depreciation is removed from total assets (net property, plant, and equipment). Adjusted total assets are $2,045 ($2,060 - $20 capitalized interest + $5 related depreciation)
Adjusted net profit margin: The capitalized interest is treated as interest expense and the related depreciation is eliminated from operating expense. Adjusted net profit margin is 4.6% ($200 net income - $20 interest expense +$5 related depreciation / $4000 revenue)
My question is, why are they adding the related depreciation? what is depreciating if you are adjusting the capitalized interest as an expense??
 
If you are adjusting all of capitalized interest as expense, there is NO depreciation anymore.
All you are adjusting for is the previous $5 depreciation figure, by undoing its effect.
 
Thanks rus1bus.
Related queries on the same question:
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(Source: Schweser SS9, page 171)
Soprano Co Income Statement
Sales - 4000
COGS - 3000
Gross Profit - 1000
Operating Exp - 650
EBIT - 350
Int Exp - 50
EBT - 300
Taxes - 100
NI - 200
——-
Questions:
1) Schweser states the following:
Adjusted net profit margin: The capitalized interest is treated as interest expense and the related depreciation is eliminated from operating expense. Adjusted net profit margin is 4.6% ($200 net income - $20 interest expense +$5 related depreciation / $4000 revenue)
Sujan’s comments:
They have adjusted the calculations directly from NI - shouldn’t they first add $5 to EBIT and subtract $20 (along with the existing $50 interest exp) from EBIT instead to reflect the tax savings:
Depreciation exp - 5
EBIT - 355 (existing EBIT plus the $5 dep exp)
existing interest exp - 50
capitalized interest - 20
EBT - 285 (new EBIT minus the existing int exp and the capitalized int)
Taxes - 95 (EBT times the existing tax rate, .33)
NI - 190
According to their calculation, new NI is 185. What is the rationale behind not adjusting for tax in their calculations?
2) Schweser states the following:
Adjusted long-term debt-to-equity: The capitalized interest, net of the related depreciation expense, is subtracted from net income; thus, shareholders’ equity (retained earnings) decreases by the same amount. Adjusted long-term debt-to-equity is 60.7% [$610 / ($1020 reported equity - $20 capitalized interest + $5 related deprecitaon)].
Sujan’s comments:
Again, they have directly made the adjustments to equity. Should not they first make the tax adjustments in the Income Statements, as in #1 above, and only then apply the adjusted NI to retained earnings to get a final figure for total equity?
Thanks.
 
Sujan, this is a very valid question.
If your get your new NI, after adjusting for Taxes, then you are also changing Tax Expenses. Correct?
Tax Expenses are something that you CANNOT change as an analyst. Whatever tax expenses have been reported in financial statements, WILL need to be PAID at those reported amounts. Analysts have to take them at THAT value and cannot adjust them.
That is why adjustments to NI or other ratios are done, keeping in mind that Tax Expenses will and should remain the same, howeverway these ratios are adjusted.
Does it clarify?
 
Yes it does. Thank you rus1bus.
So, this means the firm will take the new NI at face value (even though the above adjustment recounted less tax expense). I would have never guessed this exception to the rule in million years b/c the calculations just did not make sense. Thanks for sharing.
Cheers
 
I’m still confused as to why they are adding back 5$ of depreciation when it is part of the $20 interest that was capitalized. Shouldnt it be, add back in 15$ of capitalized interest (since the $5 of that 20$ number was depreciated) and add back the 5$ related depreciation?
 
The aim of the excercise is to undo the previously capitalized interest and record it as an expense.
I will try and qualify rus1bus’s comments from above:
“If you are adjusting all of capitalized interest as expense, there is NO depreciation anymore.”
The following is the impact of the interest capitalization on the I/S and B/S:
At the end of the accounting cycle, depreciation expense for the capitalized interest is recorded in the income statement. Accumulated depreciation is subtracted on the balance sheet to offset the expense.
So, essentially the question asks to undo this capitalized interest and record it as an expense. So the adjustment needed are:
B/S - The capitalized interest of $20 is subtracted from net asset (since this was included as part of PP&E) and the accumulated depreciation of $5 needs to be added back (since this is as part of accumulated depreciation account, and earlier we subtracted the same amount).
I/S - The capitalized interest of $20 is subtracted from net income (since interest expenses are subtracted to arrive at EBT - remember that earlier we only recorded depreciation expense on the capitalized interest as part operating expense to arrive at EBIT). Also, as per rus1bus’s comments above the tax implication of doing this is gnored since analysts are NOT allowed to adjust tax expense. Since depreciation expense was subtracted earlier we simply add $5 back.
Cheers
 
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