Question

(Capitalization of Interest) Vania Magazine Company started construction of a warehouse building for its own use at an estimated cost of \(5,000,000 on January 1, 2016, and completed the building on December 31, 2016. During the construction period, Vania has the following debt obligations outstanding.

Construction loan—12% interest, payable semiannually, issued December 31, 2015	\)2,000,000
Short-term loan—10% interest, payable monthly, and principal payable at maturity, on May 30, 2017	1,400,000
Long-term loan—11% interest, payable on January 1 of each year; principal payable on January 1, 2019	1,000,000

Total cost amounted to \(5,200,000, and the weighted average of accumulated expenditures was \)3,500,000.

Jane Esplanade, the president of the company, has been shown the costs associated with this construction project and capitalized on the balance sheet. She is bothered by the “avoidable interest” included in the cost. She argues that, first, all the interest is unavoidable—no one lends money without expecting to be compensated for it. Second, why can’t the company use all the interest on all the loans when computing this avoidable interest? Finally, why can’t her company capitalize all the annual interest that accrued over the period of construction?

Instructions

(Round the weighted-average interest rate to two decimal places.)

You are the manager of accounting for the company. In a memo, explain what avoidable interest is, how you computed it (being especially careful to explain why you used the interest rates that you did), and why the company cannot capitalize all its interest for the year. Attach a schedule supporting any computations that you use.

Short answer

1. Total actual interest is $490,000
2. Weighted-Average Interest Rate is 10.42%
3. Avoidable interest is $396,300

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 in its total value on the balance sheet.

Making a memo

To: Jane Esplanade, President

From:

Date:

Subject: Capitalization of avoidable interest in the warehouse construction project

I'm writing in response to your inquiries concerning the capitalized interest charges of the warehouse development projects. This quick explanation of my estimates should help you grasp the magnitude of these expenditures.

In general, the accounting profession does not allow accumulated interest to be capitalized alongside the cost of an asset. However, interest charges spent during construction were exempted by the FASB. However, to qualify for the treatment, the developed asset must take time to become ready for its intended use.

Because interest capitalization is only permitted in exceptional situations, the corporation must be careful to capitalize just the interest related to the construction. As a result, GAAP gives guidelines on how much interest might be linked with the construction, i.e., the lesser of real or avoidable interest.

On the surface, this standard appears straightforward. The actual interest paid throughout the construction period equals all interest paid on any outstanding loan at the time. The amount of interest that would not have been incurred if the building project had not been conducted is avoidable interest. The interest capitalized amount is the lesser of the two.

The company must compute the actual and avoidable interest throughout 2016 to estimate the capitalized amount. Actual interest is calculated by multiplying the interest rates of 12 percent, 10%, and 11% by the debt amount. As a result, the total real interest for this time is $490,000. (See schedule 1)

Calculating unnecessary interest is more difficult. First, only the weighted-average amount of cumulative expenses can be capitalized as interest. Despite the project’s overall expenses being $5,200,000, the company owed an average of just $3,500,000 during development.

Second, only $2,000,000 of the entire $4,400,000 debt owed during this p back to the actual building project. Instead of picking an interest rate for the other loans, we must calculate the weighted-average interest rate. This rate is calculated by dividing the total interest paid on the other loans by the principal amount owed. This interest rate is 10.42 percent for the balance of $1,500,000 in weighted-average cumulative expenses. (See schedule 2)

Third, determine how much interest we can avoid: Determine the interest on the construction financing. To balance the weighted-average cumulative expenses, apply the weighted-average interest rate. In 2016, $396,300 in unnecessary interest was paid. (See schedule 3)

We capitalize the lesser of the two—$396,300—along with the other building expenditures to avoid overstating the interest connected with the construction. The remaining interest ($93,700) is written off.

Preparing Schedule 1

	Actual Interest
Construction loan	$\mathbf{\$}\mathbf{2}\mathbf{,}\mathbf{000}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{12}\mathbf{\%}$	$240,000
Short-term loan	$\mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{400}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{10}\mathbf{\%}$	140,000
Long-term loan	$\mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{000}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{11}\mathbf{\%}$	110,000
		$490,000

Preparing Schedule 2

Weighted-Average Interest Rate
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

$\begin{array}{rcl}\mathit{W}\mathit{e}\mathit{i}\mathit{g}\mathit{h}\mathit{t}\mathit{e}\mathit{d}\mathbf{-}\mathit{A}\mathit{v}\mathit{e}\mathit{r}\mathit{a}\mathit{g}\mathit{e}\mathit{I}\mathit{n}\mathit{t}\mathit{e}\mathit{r}\mathit{e}\mathit{s}\mathit{t}\mathit{R}\mathit{a}\mathit{t}\mathit{e}& \mathbf{=}& \frac{\mathbf{T}\mathbf{o}\mathbf{t}\mathbf{a}\mathbf{l}\mathbf{}\mathbf{I}\mathbf{n}\mathbf{t}\mathbf{e}\mathbf{r}\mathbf{e}\mathbf{s}\mathbf{t}}{\mathbf{T}\mathbf{o}\mathbf{t}\mathbf{a}\mathbf{l}\mathbf{}\mathbf{P}\mathbf{r}\mathbf{i}\mathbf{n}\mathbf{c}\mathbf{i}\mathbf{p}\mathbf{a}\mathbf{l}}\\ & \mathbf{=}& \frac{\mathbf{\$}\mathbf{250}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{2}\mathbf{,}\mathbf{400}\mathbf{,}\mathbf{000}}\\ & \mathbf{=}& \mathbf{10}\mathbf{.}\mathbf{42}\mathbf{\%}\\ & & \end{array}$

Preparing Schedule 3

Avoidable Interest
Weighted-Average Accumulated Expenditures Interest Rate = Avoidable Interest
$2,000,000 12%	$240,000
1,500,000 10.42%	156,300
$3,500,000	$396,300

Working note:

Interest Capitalized

Because avoidable interest is lower than actual interest, use avoidable interest.

Cost	$5,200,000
Interest capitalized	396,300
Total cost	$5,596,300