Chapter 10, Problem 8P

1.

To determine

Calculate the amount of interest costs capitalizes during each year.

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 2016:

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:

$\begin{array}{c}\text{Avoidable}\text{interest}\text{=}\left(\begin{array}{l}\text{Total}\text{of}\text{weighted}\text{average}\text{accumulated}\\ \text{expenditures}\text{×Percentage}\text{of}\text{interest}\end{array}\right)\\ \text{=\$1,000,000×12\%}\\ \text{=\$120,000}\end{array}$

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 $\text{(c)=(a)×(b)}$
$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 2017:

Step 1:

Expenditures		×	Portion of  year outstanding	=	Weighted average accumulated expenditures
January 1	$1,725,000 $(1,605,000+120,000)$	×	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, 2017 is calculated by adding January 1, 2016’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:

$\begin{array}{c}\text{Avoidable}\text{interest}\text{=}\left(\begin{array}{l}\text{Total}\text{of}\text{weighted}\text{average}\text{accumulated}\\ \text{expenditures}\text{×Percentage}\text{of}\text{interest}\end{array}\right)\\ \text{=\$1,362,500×12\%}\\ \text{=\$163,500}\end{array}$

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 $\text{(c)=(a)×(b)}$
$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 2016, Avoidable interest rate is lesser than actual interest rate; therefore avoidable interest of $120,000 is capitalized.
• For the year 2017, Avoidable interest rate is lesser than actual interest rate; therefore avoidable interest of $163,500 is capitalized.

Conclusion

• For the year 2016, Avoidable interest rate is lesser than actual interest rate; therefore avoidable interest of $120,000 is capitalized.
• For the year 2017, Avoidable interest rate is lesser than actual interest rate; therefore avoidable interest of $163,500 is capitalized.

2.

To determine

Calculate the straight-line depreciation for the year 2017.

Explanation of Solution

Calculate the straight-line depreciation for the year 2016:

$\begin{array}{c}\text{Straight-}\text{line}\text{depreciation}\text{=}\frac{\text{Cost}-\text{Estimated}\text{residual}\text{value}}{\text{Estimated}\text{service}\text{life}}\\ \text{=}\frac{\text{\$3,988,500}(1)-\text{\$0}}{\text{20}}\\ \text{=}\text{\$199,425}\end{array}$

Calculate the straight-line depreciation for the year 2017:

$\begin{array}{c}\begin{array}{l}\text{Straight-line}\text{depreciation}\\ \text{for}\text{the}\text{year}\text{2017}\end{array}\}\text{=}\text{Straight-line}\text{depreciation}\text{for}\text{the}\text{year}\text{2016×}\frac{\text{1}}{\text{2}}\\ \text{=\$199,425×}\frac{\text{1}}{\text{2}}\\ \text{=\$99,712}\text{.50}\end{array}$

Note: The asset is not placed into service till July 1 therefore, $\raisebox{1ex}{$1$}\!\left/ \!\raisebox{-1ex}{$2$}\right.$ year of depreciation is taken.

Working note:

(1)Calculate the amount of total costs:

$\begin{array}{c}\text{Total}\text{costs}\text{=}\left[\begin{array}{l}\left(\text{Expenditure}\text{for}\text{the}\text{year}\text{2016}\text{+Expenditure}\text{for}\text{the}\text{year}\text{2017}\right)\text{+}\\ \left(\text{Capitalized}\text{interest}\text{for}\text{the}\text{year}\text{2016+}\text{Capitalized}\text{interest}\text{for}\text{the}\text{year}\text{2017}\right)\end{array}\right]\\ \text{=}\left[\left(\text{\$1,605,000+\$2,100,000}\right)\text{+}\left(\text{\$120,000+\$163,500}\right)\right]\\ \text{=\$3,988,500}\end{array}$

Note: Only the expenditure for the month of March and June $(1,500,000+600,000)$ is taken for the year 2017.

3.

To determine

Provide explanation regarding the effects of the interest capitalization on the financial statements for the year 2016.

Explanation of Solution

Income Statement:

• During the year 2016, interest expense is decreased by $120,000 and net income is increased by $120,000.
• During the year 2017 Interest expense are decreased by $163,500a and Net income increased by $163,500.

Additionally, the amount of depreciation expense recognized in the year 2017 is increased by the capitalization of interest

Balance sheet:

• During the year December 31, 2016, retained earnings are increased by $120,000 and asset is increased by $120,000.
• During the year December 31, 2017, 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 2017 due to the capitalization of interest in 2016 and 2017.
• Retained earnings are decreased in the year 2017 due to depreciation expense on the capitalization of interest.

Statement of cash flows:

• 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.