Chapter 10, Problem 10.9P

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. 1. Calculate the amount of interest that Mason should capitalize in 2018 and 2019 using the specific interest method.
2. 2. What is the total cost of the building?
3. 3. Calculate the amount of interest expense that will appear in the 2018 and 2019 income statements.

To determine

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	$\times$	$\frac{12}{12}$	=	1,000,000
March 1, 2018	600,000	$\times$	$\frac{10}{12}$	=	500,000
June 30, 2018	800,000	$\times$	$\frac{6}{12}$	=	400,000
October 1, 2018	600,000		$\frac{3}{12}$	=	150,000
Accumulated expenditures (before interest)	$3,000,000
			Average accumulated expenditures		$2,050,000

Table (1)

Determine the capitalized interest.

$\begin{array}{c}\text{Capitalized}\text{interest = }\left(\begin{array}{l}\text{Accumulated expenditure}\\ \times \text{ Interest rate }\end{array}\right)\\ =\$2,050,000\times \frac{10}{100}\\ =\$205,000\end{array}$

Calculate the amount of interest capitalized in the year 2019.

Month	Construction Expenditure		Interest Outstanding		Accumulated Expenditure
January 1, 2019	3,205,000	$\times$	$\frac{9}{9}$	=	3,205,000
January 31, 2019	270,000	$\times$	$\frac{8}{9}$	=	240,000
April 30, 2019	585,000	$\times$	$\frac{5}{9}$	=	325,000
August 31, 2019	900,000	$\times$	$\frac{1}{9}$	=	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	$\times$	6%	=	240,000
Long-term note 8%	$6,000,000	$\times$	8%	=	480,000
Total	$10,000,000				720,000

Table (3)

Working Note:

Determine the weighted-average interest rate.

$\begin{array}{c}\text{Weighted average =}\frac{\text{Interest amount}}{\text{Amount}}\times 100\\ \text{=}\frac{\text{\$720,000}}{\$10,000,000}\times 100\\ =7.2\%\end{array}$

Determine the amount of difference.

$\begin{array}{c}\text{Amount of difference = }\left(\begin{array}{l}\text{Average accumulated expenditure}\\ \text{– Construction loan }\end{array}\right)\\ \text{= \$3,870,000 – \$3,000,000}\\ \text{=\$870,000}\end{array}$

Determine the interest on amount of difference.

$\begin{array}{c}\text{Interest on amount of difference = \$870,000 }\times \text{ 7}\text{.2\%}\times \frac{9}{12}\\ =\$46,980\end{array}$

Determine the interest on amount on the construction loan.

$\begin{array}{c}\text{Interest on amount on the construction loan = \$3,000,000 }\times \frac{\text{10}}{\text{100}}\times \frac{9}{12}\\ =\$225,000\end{array}$

Determine the capitalized interest.

$\begin{array}{c}\text{Capitalized}\text{interest = }\left(\begin{array}{l}\text{Interest on connstruction loan}\\ \text{+ Interest on amount}\end{array}\right)\\ =\$225,000+\$46,980\\ \text{= \$271,980}\end{array}$

Conclusion

Hence, the amount of interest capitalized in the year 2018, and 2019 are $205,000, and $271,980 respectively.

To determine

The total cost of the building.

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)

Conclusion

Hence, the total cost of the building is $5,231,980.

To determine

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 ($)	Amount ($)
$\$3,000,000\times 10\%$	300,000	300,000
$\$4,000,000\times 6\%$	240,000	240,000
$\$6,000,000\times 8\%$	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)

Conclusion

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.