Flashcards in FAR 15 - PPE 2 - Interest Capitalization Deck (13):

1

## How is interest computed to be capitalized when using the weighted average method?

### This method uses the average interest rate on all interest bearing debt, weighted by principal. That rate is the quotient of the interest on all the debt divided by the principal on all the debt.

2

##
A company obtained a $300,000 loan with a 10% interest rate on January 1, year 1, to finance the construction of an office building for its own use. Building construction began on January 1, year 1, and the project was not completed as of December 31, year 1. The following payments were made in year 1 related to the construction project:

January 1 Purchased land for $120,000

September 1 Progress payment to contractor for $150,000

What amount of interest should be capitalized for the year ended December 31, year 1?

A. $13,500

B. $15,000

C. $17,000

D. $30,000

### C. Interest can be capitalized on the accumulated average expenditures during the year. During year 1 the weighted average expenditures were ($120,000 x 12/12) + ($150,000 x 4/12) = $170,000. Interest is capitalized based on the weighted average expenditures times the interest rate of 10% ($170,000 x .10 = $17,000).

3

##
Debt is frequently incurred when plant assets are acquired. For example, debt may be incurred on the purchase of plant assets. Debt may also be incurred during the construction of plant assets. How is the interest in these two cases treated for financial reporting?

Debt for purchase Debt during construction

expense capitalize

expense expense

capitalize capitalize

capitalize expense

###
Expense, Capitalize

Interest on debt incurred when purchasing a plant asset, is incurred after the asset has reached its intended condition and location. Therefore, it is expensed as incurred. Debt incurred during the construction of plant assets is considered avoidable and also incurred before the asset has reached its intended condition and location. Therefore, it is capitalized to the asset in the same way material, labor, and overhead are capitalized. The interest is expensed as part of depreciation during the service life of the asset.

4

##
Two approaches are available for applying interest rates to average accumulated expenditures for the purpose of capitalizing interest. These approaches are called the specific method and the weighted average method. In some cases, these approaches yield the same results. Two situations may be encountered in practice for a specific period:

(1) average accumulated expenditures exceed total interest bearing debt (principal) and

(2) the interest rates on all interest bearing debt instruments are the same.

Which situation yields the same results for the two approaches?

A. only (1).

B. only (2).

C. both (1) and (2).

D. neither (1) nor (2).

### C. When average accumulated expenditures exceeds interest bearing debt, all interest for the period is capitalized because all debt could have been avoided if the construction had not taken place. Also, if the interest rates on all debt are the same, then the two approaches yield the same results because, ultimately, only one interest rate is applied to average accumulated expenditures for computing capitalized interest.

5

##
At the beginning of the year, Cann Co. started construction on a new $2 million addition to its plant. Total construction expenditures made during the year were $200,000 on January 2, $600,000 on May 1, and $300,000 on December 1. On January 2, the company borrowed $500,000 for the construction at 12%. The only other outstanding debt the company had was a 10% interest rate, long-term mortgage of $800,000, which had been outstanding the entire year. What amount of interest should Cann capitalize as part of the cost of the plant addition?

A. $140,000

B. $132,000

C. $72,500

D. $60,000

###
C. First calculate the Average Accumulated Expenditures (AAE). This gives you the amount of borrowing from which to calculate avoidable interest ($625,000). Next calculate avoidable interest ($72,500) and actual interest (($500,000 x 12%) + ($800,000 x 10%) = $140,000). The amount that can be capitalized is the lesser of the avoidable interest or actual interest. The amount that can be capitalized is $72,500.

AAE

200,000 12/12 200,000

600,000 8/12 400,000

300,000 1/12 25,000

625,000

Avoidable interest

500,000 12% 60,000

125,000 10% 12,500

72,500

6

## T/F: Interest is capitalized on inventory only if a substantial period of time is required for its manufacture.

### False

7

## T/F: When interest is capitalized in a period, future depreciation expense is increased.

### True

8

## T/F: Capitalized interest is the interest that could have been avoided if construction activities had not taken place during the period.

### True

9

## A firm has spent the last two years constructing a building to be used as the firm's headquarters. At the end of the first year of construction, the balance of building under construction was $400,000, which includes capitalized interest. During year two, the firm paid $240,000 to the contractor on March 1, and $600,000 on October 1. The building was not finished by the end of the second year. The firm had one loan outstanding all year, an 8%, $3,000,000 construction loan. Compute capitalized interest for year two.

###
$60,000

Average accumulated expenditures for the second year = $400,000(12/12) + $240,000(10/12) + $600,000(3/12) = $750,000. Interest capitalized = .08($750,000) = $60,000. Note that the interest capitalized in year one is compounded in year two because year one capitalized interest is included in average accumulated expenditures for the second year.

10

## Average accumulated expenditures for year five on a construction project amounted to $70,000. The total cash invested in the project by the end of year five, was $160,000. During year six, the firm spent another $240,000 (total) on the project, uniformly throughout the year. Compute average accumulated expenditures for year six.

###
$180,000

Average accumulated expenditures is the amount of debt for the annual period that could have been avoided. In this case, the firm has $160,000 already invested in the project at the beginning of year six. That amount represents $160,000 in debt, that could have been avoided for year six if the firm had not been involved in the construction project. The expenditures during year six were incurred evenly. Average accumulated expenditures therefore = $160,000(12/12) + $240,000/2 = $280,000. Also, [$160,000 + ($160,000 + $240,000)]/2 = $280,000.

11

##
Cole Co. began constructing a building for its own use in January 2004. During 2004, Cole incurred interest of $50,000 on specific construction debt and $20,000 on other borrowings. Interest computed on the weighted-average amount of accumulated expenditures for the building during 2004 was $40,000.

What amount of interest cost should Cole capitalize?

###
$40,000

This question requires no calculation. The answer is given in the question.

Capitalized interest is limited to the interest that would have been avoided had the construction not occurred. This is the amount of interest based on average accumulated expenditures.

12

## T/F: Average accumulated expenditures is $30,000. A 4%, $20,000 construction loan was outstanding the entire period, and $60,000 of other debt with an average interest rate of 5% was also outstanding. Using the weighted average method, the firm will capitalize $1,425 interest.

### True

13