Direct Expensing of Interest by Homebuilders

Implications: Not capitalizing interest in inventory causes acceleration of losses and deterioration of book value.

Analysis: Direct Expensing of Interest by Homebuilders

Traditionally, homebuilders interest costs have been capitalized in inventory accounts and end up being expensed through cost of goods sold as the inventory is sold.  Such interest costs have been capitalized under generally accepted accounting principles because the active inventory has exceeded the aggregate amount of debt on the homebuilder's balance sheet.   In these situations, aggregate interest costs are allocated prorata over aggregate active inventories and capitalized therein.  "Active inventory"  would include developments in the planning or development phase and homes with construction occurring.  Raw land, finished lots and completed homes would not be "active inventory" and would not be subject to interest capitalization, while in these categories.  And, capitalized interest in inventories typically will be around 3-5% of the total inventory, depending upon financial leverage.  Interest income is not netted against interest expense to determine the pool of capitalizable costs.

The sharp contraction in homebuilding has changed this.  Recently, and in the near future, we will see instances where aggregate debt exceeds "active inventory" and interest expense will be a separate line
in the income statement.  Most recently, Meritage Homes and Centex have recorded direct interest expense.  WCI traditionally has incurred some interest directly.  Such treatment will cause near term losses to increase as there will not be a built in delay for some of the interest that is currently incurred.  Rather a portion of the current interest amount will be recorded directly on the income statement as such and not through cost of goods sold.  This will further delay the turnaround of current losses and further impair book value until the debt is "right sized" through debt reductions or homebuilding production increases.