Question

(Capitalization of Interest) The following three situations involve the capitalization of interest

Situation I: On January 1, 2017, Oksana Baiul, Inc. signed a fixed-price contract to have Builder Associates construct a major plant facility at a cost of \(4,000,000. It was estimated that it would take 3 years to complete the project. Also on January 1, 2017, to finance the construction cost, Oksana Baiul borrowed \)4,000,000 payable in 10 annual installments of \(400,000, plus interest at the rate of 10%. During 2017, Oksana Baiul made deposit and progress payments totaling \)1,500,000 under the contract; the weighted average amount of accumulated expenditures was \(800,000 for the year. The excess borrowed funds were invested in short-term securities, from which Oksana Baiul realized investment income of \)250,000.

Instructions

What amount should Oksana Baiul report as capitalized interest at December 31, 2017?

Situation II: During 2017, Midori Ito Corporation constructed and manufactured certain assets and incurred the following interest costs in connection with those activities.

	Interest Costs Incurred
Warehouse constructed for Ito’s own use	\(30,000
Special-order machine for sale to unrelated customer, produced according to customer’s specifications	9,000
Inventories routinely manufactured, produced on a repetitive basis	8,000

All of these assets required an extended period of time for completion.

Instructions

Assuming the effect of interest capitalization is material, what is the total amount of interest costs to be capitalized?

Situation III: Peggy Fleming, Inc. has a fiscal year ending April 30. On May 1, 2017, Peggy Fleming borrowed \)10,000,000 at 11% to finance construction of its own building. Repayments of the loan are to commence the month following completion of the building. During the year ended April 30, 2018, expenditures for the partially completed structure totaled \(7,000,000. These expenditures were incurred evenly throughout the year. Interest earned on the unexpended portion of the loan amounted to \)650,000 for the year.

Instructions

How much should be shown as capitalized interest on Peggy Fleming’s financial statements on April 30, 2018?

Short answer

Situation I: - Capitalized interest = $80,000

Situation II: - The amount to be capitalized is $30,000 and $9,000

Situation III: - The amount of interest that must be capitalized is $385,000

Step-by-step solution

Meaning of Capitalization of Interest

As with other interests, capitalized interest accumulates on an asset or loan, but it is not immediately recognized as an expense on the income statement. The accrued interest is deducted from the asset's value on the income statement, which includes the interest on its total value on the balance sheet.

(Situation I) Determining the amount that Oksana Baiul should report as capitalized interest on December 31, 2017

$80,000 is the amount Oksana Baiul should declare as capitalized interest on 12/31/17. The amount of interest that can be capitalized is:

$\begin{array}{rcl}\mathbf{Avoidable}\mathbf{}\mathbf{Interest}& \mathbf{=}& \mathbf{Weighted}\mathbf{-}\mathbf{Accumulated}\mathbf{}\mathbf{expenditure}\mathbf{\times }\mathbf{Interest}\mathbf{}\mathbf{rate}\end{array}$

As Oksana Baiul has outstanding debt for the building project over the weighted-average cumulative expenditures of $800,000, the interest rate is 10%. As a result, the avoidable interest is $80,000, less than the actual interest.

$\begin{array}{rcl}\mathbf{Avoidable}\mathbf{}\mathbf{Interest}& \mathbf{=}& \mathbf{Weighted}\mathbf{-}\mathbf{Accumulated}\mathbf{}\mathbf{expenditure}\mathbf{\times }\mathbf{Interest}\mathbf{}\mathbf{rate}\\ & \mathbf{=}& \mathbf{\$}\mathbf{800}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{0}\mathbf{.}\mathbf{10}\\ & \mathbf{=}& \mathbf{\$}\mathbf{80}\mathbf{,}\mathbf{000}\end{array}$

Finally, the interest generated of $250,000 is immaterial to the situation because interest paid on the unexpended portion of the loan is not to be deducted against the amount eligible for capitalization.

(Situation II) Computing the total interest costs to be capitalized.

Total interest expenses must be capitalized, which costs $39,000. Assets developed for an enterprise's use and assets intended for sale or lease that are generated as distinct projects are identified as assets that qualify for interest capitalization under GAAP. Interest capitalization does not apply to inventories consistently produced in big numbers regularly. Only $30,000 and $9,000 are capitalized as a result.

(Situation III) Computing the amount that should be shown as capitalized interest on Peggy Fleming’s financial statements on April 30, 2018

$385,000—the goal is to figure out how much interest should be capitalized on the financial statements as of April 30, 2018. The criteria of GAAP are met:

1. The asset has been purchased,
2. The actions required to prepare the asset for its planned use are underway, and
3. Interest costs are being incurred. The amount to be capitalized is calculated by multiplying the weighted-average amount of cumulative expenditures for the asset during the period by an interest rate.

The weighted-average amount of expenditures for the year ending April 30, 2018, is $3,500,000 ($7,000,000/2). As a result, the amount of interest that must be capitalized is $385,000 ($3,500,000 X 11%). The entire amount of interest cost to be capitalized at any given time must not exceed the total amount of interest cost incurred by the business. (The total amount of interest is $1,100,000.)

Finally, since interest collected on the unexpended portion of the loan is not to be adjusted against the amount eligible for capitalization, the $650,000 in interest generated is irrelevant to the point addressed in this problem.