Who is Interested in Capitalization (NYSE: CHK)

The new accounting standards, IFRS (Internationally Financial Reporting Standards) has copied FASB (Financial Accounting Standards Board) with regards to interest capitalization. Capitalization is the process of adding a expense to an asset.

The current standard (IAS 23) allows a company which borrows money to buy an asset the ability to add the cost of borrowing (the interest) to the carrying value of the asset. The current accounting standards only allow a company to do this when the funds are specifically borrowed to purchase an asset. But this rule should be changed.

A certain offender is Chesapeake Energy Corporation, the second largest natural gas producer in the U.S. Chesapeake has capitalized nearly $2 billion of interest in the last two years. There is nothing inherently wrong with Chesapeake for doing this based on current accounting standards.

Here is an example which proves why all interest should never be capitalized. If there were two people, one person was financially well off and bought a house for $400 K the other person was not and also bought a house for 400 K. The second person borrowed a mortgage to purchase the house which amounted to this person paying 16 K in interest a year. At the end of year 1 the financially well off person would state that his house was worth 400 K but the second person would say his house was worth 416 K.

So the second person not only gets an asset upward revision but he is financially worse-off since he also needed to pay the extra 16K. While, the first person who is financially better off is penalized for being so. Interest capitalization essentially is the "cream rising to the top," only if we were to replace the word "cream" with financially less well off.

It is important when buying companies especially those in mining to consider if they capitalize interest payments. If it is a substantial amount, then the company is less attractive.

To read the full Chesapeake report click here.