1.
Calculate the amount of interest costs capitalizes during each year.
1.
Explanation of Solution
Weighted average interest rate:
Weighted average interest rate is the total of the construction expenses weighted by the measure of time that interest cost is acquired on those expenditures during the period of construction.
Capitalized interest:
Interest Cost incurred to finance the construction of a long-term construction projects are known as capitalized interest.
Calculate the weighted average accumulated expenditure for the year 2019:
Step 1:
Expenditures | × | Portion of year outstanding | = | Weighted average accumulated expenditures | |
January 1 | $540,000 | × | 12/12 (January 1-December 31) | = | $540,000 |
May 1 | $465,000 | × | 8/12 (May 1-December 31) | = | $310,000 |
October 1 | $600,000 | × | 3/12 (October1-December 31) | = | $150,000 |
$1,605,000 | $1,000,000 |
Table (1)
Step 2:
Interest rate is 12%.
Step 3:
Calculate the avoidable interest:
Therefore, the avoidable interest is $120,000.
Step 4:
Calculate the amount of total actual interest:
Debts borrowed (a) | Percentage of interest (b) |
Actual interest |
$1,500,000 | 12% | $180,000 |
$6,000,000 | 14% | $840,000 |
$14,000,000 | 8% | $1,120,000 |
$2,140,000 |
Table (2)
Therefore, total actual interest is $2,140,000.
Calculate the weighted average accumulated expenditure for the year 2020:
Step 1:
Expenditures | × | Portion of year outstanding | = | Weighted average accumulated expenditures | |
January 1 |
$1,725,000 | × | 6/12 (January 1-June 30) | = | $862,500 |
March 1 | $1,500,000 | × | 4/12 (March 1- June 30) | = | $500,000 |
June 30 | $600,000 | × | 0/12 (June 30-June 30) | = | $0 |
$1,362,500 |
Table (3)
Note: Amount of expenditure ($1,725,000) for January 1, 2020 is calculated by adding January 1, 2019’s expenditure of $1,605,000 and the capitalized interest of $120,000.
Step 2:
Interest rate is 12%.
Step 3:
Calculate the avoidable interest:
Therefore, the avoidable interest is $163,500.
Step 4:
Calculate the amount of total actual interest:
Debts borrowed (a) | Percentage of interest (b) |
Actual interest |
$1,500,000 | 12% | $180,000 |
$6,000,000 | 14% | $840,000 |
$14,000,000 | 8% | $1,120,000 |
$2,140,000 |
Table (4)
- For the year 2019, Avoidable interest rate is lesser than actual interest rate; therefore avoidable interest of $120,000 is capitalized.
- For the year 2020, Avoidable interest rate is lesser than actual interest rate; therefore avoidable interest of $163,500 is capitalized.
- For the year 2019, Avoidable interest rate is lesser than actual interest rate; therefore avoidable interest of $120,000 is capitalized.
- For the year 2020, Avoidable interest rate is lesser than actual interest rate; therefore avoidable interest of $163,500 is capitalized.
2.
Calculate the straight-line depreciation for the year 2020.
2.
Explanation of Solution
Calculate the straight-line depreciation for the year 2019:
Calculate the straight-line depreciation for the year 2020:
Note: The asset is not placed into service till July 1 therefore,
Working note:
(1)Calculate the amount of total costs:
Note: Only the expenditure for the month of March and June
3.
Provide explanation regarding the effects of the interest capitalization on the financial statements for the year 2019.
3.
Explanation of Solution
Income Statement:
- During the year 2019, interest expense is decreased by $120,000 and net income is increased by $120,000.
- During the year 2020 Interest expense are decreased by $163,500a and Net income increased by $163,500.
Additionally, the amount of depreciation expense recognized in the year 2020 is increased by the capitalization of interest
Balance sheet:
- During the year December 31, 2019,
retained earnings are increased by $120,000 and asset is increased by $120,000. - During the year December 31, 2020, retained earnings are increased by $163,500, for a total of $283,500 and asset increased by $163,500.
- Accumulated depreciation is increased by half year of depreciation in 2020 due to the capitalization of interest in 2019 and 2020.
- Retained earnings are decreased in the year 2020 due to depreciation expense on the capitalization of interest.
Statement of
- The interest capitalized is included in
cash outflows under investing activities instead of reporting it under operating activities, since the assets are produced by the company for its own use. - Moreover, there will be no effect, if the asset is produced by the company for the use of others.
- Additionally, the interest capitalized increases the adjustment of depreciation in the operating section of the cash flow statement under direct method.
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