Question

(Capitalization of Interest) Harrisburg Furniture Company started construction of a combination office and warehouse building for its own use at an estimated cost of \(5,000,000 on January 1, 2017. Harrisburg expected to complete the building by December 31, 2017. Harrisburg has the following debt obligations outstanding during the construction period.

Construction loan—12% interest, payable semiannually, issued December 31, 2016	\)2,000,000
Short-term loan—10% interest, payable monthly, and principal payable at maturity on May 30, 2018	1,400,000
Long-term loan—11% interest, payable on January 1 of each year. Principal payable on January 1, 2021	1,000,000

Instructions

(Carry all computations to two decimal places.)

(A) Assume that Harrisburg completed the office and warehouse building on December 31, 2017, as planned at a total cost of \(5,200,000, and the weighted-average amount of accumulated expenditures was \)3,600,000. Compute the avoidable interest on this project.

(B) Compute the depreciation expense for the year ended December 31, 2018. Harrisburg elected to depreciate the building on a straight-line basis and determined that the asset has a useful life of 30 years and a salvage value of $300,000.

Short answer

Answer

(a) Weighted-average interest = 10.42%

(b) Depreciation = $176,891

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 instead deducted from the asset's value on the income statement, which includes the interest in its total value on the balance sheet.

Computing the avoidable interest

Calculation	Answer
Weighted-Average Accumulated Expenditures Interest Rate	Avoidable Interest
$2,000,000 12%	$240,000
1,600,000 10.42%	166,720
$3,600,000$	$\$406,72$

Weighted-average interest rate computation	Principal	Interest
10% short-term loan	$1,400,000	$140,000
11% long-term loan	1,000,000	110,000
	$2,400,000	$250,000

Calculation of weighted-average interest

$$\begin{gathered} Weightedaverageinterest=\frac{TotalInterest}{TotalPrincipal} \\ =\frac{\$250,000}{\$2400,000} \\ =10.42\% \end{gathered}$$

Computing the depreciation expense

	Calculation	Actual interest
Construction loan	$\$12,000\times 12\%$	$240,000
Short-term loan	$\$1,4000,000\times 10\%$	140,000
Long-term loan	$\$1,000,000\times 11\%$	110,000
	Total	$490,000

Because avoidable interest is lower than actual interest, use avoidable interest.
Cost	$5,200,000
Interest capitalized	406,720
Total cost	$5,606,720

Calculation of depreciation expense

$$\begin{gathered} Depreciation=\frac{Total1Cost-Sa1vageValue}{UsefulLife} \\ =\frac{\$5,606,720-\$300,000}{30} \\ =\$176,891 \end{gathered}$$