Question

(Capitalization of Interest) On December 31, 2016, Main Inc. borrowed \(3,000,000 at 12% payable annually to finance the construction of a new building. In 2017, the company made the following expenditures related to this building: March 1, \)360,000; June 1, \(600,000; July 1, \)1,500,000; December 1, \(1,500,000. The building was completed in February 2018. Additional information is provided as follows.

1. Other debt outstanding

10-year, 13% bond, December 31, 2010, interest payable annually \)4,000,000

6-year, 10% note, dated December 31, 2014, interest payable

annually \(1,600,000

2. March 1, 2017, expenditure included land costs of \)150,000

3. Interest revenue earned in 2017 $49,000

Instructions

(a) Determine the amount of interest to be capitalized in 2017 in relation to the construction of the building.

(b) Prepare the journal entry to record the capitalization of interest and the recognition of interest expense at December 31, 2017.

Short answer

a) Avoidable interest = $183,000

b) Interest expense = $857,000

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

(a) Determining the amount of interest be capitalized in 2017

Computation of Weighted-Average Accumulated Expenditures

Expenditures
Date Amount Capitalization Period	Weighted-Average Accumulated Expenditures
March 1 $ 360,000 10/12	$ 300,000
June 1 600,000 7/12	350,000
July 1 1 1,500,000 6/12	750,000
December 1 1,500,000 1/12	125,000
$3,960,000	$1,525,000

Computation of Avoidable Interest

$$\begin{gathered} Avoidable=WeightedAverage\times Intrest \\ =\$1,525,000\times 0.12 \\ =\$183,000 \end{gathered}$$

Computation of Actual Interest
Calculation	Actual interest
localid="1656925479965" $\$3,000,000\times 12\%$	$ 360,000
localid="1656925485760" $\$4,000,000\times 13\%$	520,000
localid="1656925491546" $\$1,600,000\times 10\%$	160,000
	$1,040,000

Note: Use avoidable interest for capitalization purposes because it is lower than actual.

(b) Preparing journal entry

Date	Particular	Debit ($)	Credit ($)
	Buildings	183,000
	Interest Expense	857,000
	Cash $\text{(\$360,000+\$520,000+\$160,000)}$		1,040,000

Working Notes:

Calculation of Interest expense

Actual interest for year	$1,040,000
Less: Amount capitalized	183,000
Interest expense debit	$ 857,000