Interest capitalization; specific interest method
• LO10–7
On January 1, 2018, the Mason Manufacturing Company began construction of a building to be used as its office headquarters. The building was completed on September 30, 2019. Expenditures on the project were as follows:
January 1, 2018 | $1,000,000 |
March 1, 2018 | 600,000 |
June 30, 2018 | 800,000 |
October 1, 2018 | 600,000 |
January 31, 2019 | 270,000 |
April 30, 2019 | 585,000 |
August 31, 2019 | 900,000 |
On January 1, 2018, the company obtained a $3 million construction loan with a 10% interest rate. The loan was outstanding all of 2018 and 2019. The company’s other interest-bearing debt included two long-term notes of $4,000,000 and $6,000,000 with interest rates of 6% and 8%, respectively. Both notes were outstanding during all of 2018 and 2019. Interest is paid annually on all debt. The company’s fiscal year-end is December 31.
Required:
- 1. Calculate the amount of interest that Mason should capitalize in 2018 and 2019 using the specific interest method.
- 2. What is the total cost of the building?
- 3. Calculate the amount of interest expense that will appear in the 2018 and 2019 income statements.
1.
Interest Capitalization:
Interest capitalization refers to the interest amount that is added to the cost of the long-term asset. Such interest capitalization amount includes the interest amount of the debt which was financed for acquiring the asset.
To Calculate: The amount of interest that Company M should capitalize in 2018 and 2019 using the specific interest method.
Explanation of Solution
Calculate the amount of interest capitalized in the year 2018.
Month | Construction Expenditure ($) | Interest Outstanding (Number of months) | Accumulated Expenditure ($) | ||
January 1, 2018 | 100,000 | = | 1,000,000 | ||
March 1, 2018 | 600,000 | = | 500,000 | ||
June 30, 2018 | 800,000 | = | 400,000 | ||
October 1, 2018 | 600,000 | = | 150,000 | ||
Accumulated expenditures (before interest) | $3,000,000 | ||||
Average accumulated expenditures | $2,050,000 |
Table (1)
Determine the capitalized interest.
Calculate the amount of interest capitalized in the year 2019.
Month | Construction Expenditure | Interest Outstanding | Accumulated Expenditure | ||
January 1, 2019 | 3,205,000 | = | 3,205,000 | ||
January 31, 2019 | 270,000 | = | 240,000 | ||
April 30, 2019 | 585,000 | = | 325,000 | ||
August 31, 2019 | 900,000 | = | 100,000 | ||
Accumulated expenditures (before interest) | 4,960,000 | ||||
Average accumulated expenditure | 3,870,000 |
Table (2)
Determine the weighted average rate of all other debt.
Amount ($) | Interest rate | Interest Amount ($) | |||
Long-term note 6% | $4,000,000 | 6% | = | 240,000 | |
Long-term note 8% | $6,000,000 | 8% | = | 480,000 | |
Total | $10,000,000 | 720,000 |
Table (3)
Working Note:
Determine the weighted-average interest rate.
Determine the amount of difference.
Determine the interest on amount of difference.
Determine the interest on amount on the construction loan.
Determine the capitalized interest.
Hence, the amount of interest capitalized in the year 2018, and 2019 are $205,000, and $271,980 respectively.
2.
Explanation of Solution
Determine the total cost of the building.
Particulars | Amount ($) |
Accumulated expenditures as on September 30, 2019 before interest capitalization |
4,960,000 |
Add: Interest capitalization as on 2019 | 271,980 |
Total cost of building | 5,231,980 |
Table (4)
Hence, the total cost of the building is $5,231,980.
3.
To Calculate: The amount of interest expense that will appear in the 2018 and 2019 income statements.
Explanation of Solution
Calculate the amount of interest expense for 2018 and 2019.
2018 | 2019 | |
Amount ($) | Amount ($) | |
300,000 | 300,000 | |
240,000 | 240,000 | |
480,000 | 480,000 | |
Total interest capitalized | 1,020,000 | 1,020,000 |
Less: Interest capitalized | (205,000) | (271,980) |
Interest expense | 815,000 | 748,020 |
Table (5)
Hence, the amount of interest expense that will appear in the income statement for the years 2018 and 2019 are $815,000 and $748,020 respectively.
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