Question

(Capitalization of Interest) Laserwords Inc. is a book distributor that had been operating in its original facility since 1987. The increase in certification programs and continuing education requirements in several professions has contributed to an annual growth rate of 15% for Laserwords since 2012. Laserwords’ original facility became obsolete by early 2017 because of the increased sales volume and the fact that Laserwords now carries CDs in addition to books.

On June 1, 2017, Laserwords contracted with Black Construction to have a new building constructed for \(4,000,000 on land owned by Laserwords. The payments made by Laserwords to Black Construction are shown in the schedule below.

Date	Amount
July 30, 2017	\) 900,000
January 30, 2018	1,500,000
May 30, 2018	1,600,000
Total payments	\(4,000,000

Construction was completed and the building was ready for occupancy on May 27, 2018. Laserwords had no new borrowings directly associated with the new building but had the following debt outstanding at May 31, 2018, the end of its fiscal year

10%, 5-year note payable of \)2,000,000, dated April 1, 2014, with interest payable annually on April 1.

12%, 10-year bond issue of $3,000,000 sold at par on June 30, 2010, with interest payable annually on June 30.

The new building qualifies for interest capitalization. The effect of capitalizing the interest on the new building, compared with the effect of expensing the interest, is material.

Instructions

1. Compute the weighted-average accumulated expenditures on Laserwords’ new building during the capitalization period.
2. Compute the avoidable interest on Laserwords’ new building. (Round to one decimal place.)
3. Some interest cost of Laserwords Inc. is capitalized for the year ended May 31, 2018.
   1. Identify the items relating to interest costs that must be disclosed in Laserwords’ financial statements.
   2. Compute the amount of each of the items that must be disclosed.

Short answer

1. Total weighted expenditure = $1,250,000
2. Avoidable interest = $140,000
3. 1. Actual interest cost,interest capitalized, and interest expensed should be included in financial statements

2.Total interest expense = $420,000

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 in its total value on the balance sheet.

(a) Computing the weighted-average accumulated expenditures

Computation of Weighted-Average Accumulated Expenditures

Expenditures
Date	Amount Capitalization Period	Weighted-AverageAccumulated Expenditures
July 30, 2017	$ 900,000 10/12	$ 750,000
Jan. 30, 2018	1,500,000 4/12	500,000
May 30, 2018	1,600,000 0	0
	$4,000,000	$1,250,000

(b) Computing the avoidable interest in Laserwords’ new building

Weighted-Average Weighted-Average Accumulated Expenditures Interest rate	Avoidable Interest
$1,250,000 11.2%	$140,000

Loans Outstanding During Construction Period
	Principal	Actual Interest
10% five-year note	$2,000,000	$200,000
12% ten-year bond	3,000,000	360,000
	$5,000,000	$560,000

Working notes:

Calculation of weighted average rate

$\begin{array}{rcl}\mathit{W}\mathit{e}\mathit{i}\mathit{g}\mathit{h}\mathit{t}\mathit{e}\mathit{d}\mathbf{}\mathit{a}\mathit{v}\mathit{e}\mathit{r}\mathit{a}\mathit{g}\mathit{e}\mathbf{}\mathit{r}\mathit{a}\mathit{t}\mathit{e}& \mathbf{=}& \frac{\mathbf{T}\mathbf{o}\mathbf{t}\mathbf{a}\mathbf{l}\mathbf{}\mathbf{i}\mathbf{n}\mathbf{t}\mathbf{e}\mathbf{r}\mathbf{e}\mathbf{s}\mathbf{t}}{\mathbf{T}\mathbf{o}\mathbf{t}\mathbf{a}\mathbf{l}\mathbf{}\mathbf{p}\mathbf{r}\mathbf{i}\mathbf{n}\mathbf{c}\mathbf{i}\mathbf{p}\mathbf{a}\mathbf{l}}\\ & \mathbf{=}& \frac{\mathbf{\$}\mathbf{560}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{5}\mathbf{,}\mathbf{000}\mathbf{,}\mathbf{000}}\\ & \mathbf{=}& \mathbf{11}\mathbf{.}\mathbf{2}\mathbf{\%}\\ & & \end{array}$

(c1) Identifying the items relating to interest costs

The following items related to interest cost should be mentioned in Ladderwords' financial statements:

1. The total actual interest cost
2. Total interest capitalized
3. Total interest expensed

(c2) Computing the amount of each of the items that must be disclosed

Some interest costs of Laserwords Inc. are capitalized for the year ended May 31, 2018.

The total actual interest cost	$560,000
Total interest capitalized	$140,000
Total interest expensed $\left(\$560,000-\$140,000\right)$	$420,000