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As with other interests, capitalized interest accumulates on an asset or loan, but it is not immediately recognized as an expense on the income statement.The accrued interest is deducted from the asset's value on the income statement, which includes the interest in its total value on the balance sheet.

To: Jane Esplanade, President

From:

Date:

Subject: Capitalization of avoidable interest in the warehouse construction project

I'm writing in response to your inquiries concerning the capitalized interest charges of the warehouse development projects. This quick explanation of my estimates should help you grasp the magnitude of these expenditures.

In general, the accounting profession does not allow accumulated interest to be capitalized alongside the cost of an asset. However, interest charges spent during construction were exempted by the FASB. However, to qualify for the treatment, the developed asset must take time to become ready for its intended use.

Because interest capitalization is only permitted in exceptional situations, the corporation must be careful to capitalize just the interest related to the construction. As a result, GAAP gives guidelines on how much interest might be linked with the construction, i.e., the lesser of real or avoidable interest.

On the surface, this standard appears straightforward. The actual interest paid throughout the construction period equals all interest paid on any outstanding loan at the time. The amount of interest that would not have been incurred if the building project had not been conducted is avoidable interest. The interest capitalized amount is the lesser of the two.

The company must compute the actual and avoidable interest throughout 2016 to estimate the capitalized amount. Actual interest is calculated by multiplying the interest rates of 12 percent, 10%, and 11% by the debt amount. As a result, the total real interest for this time is $490,000. (See schedule 1)

Calculating unnecessary interest is more difficult. First, only the weighted-average amount of cumulative expenses can be capitalized as interest. Despite the project鈥檚 overall expenses being $5,200,000, the company owed an average of just $3,500,000 during development.

Second, only $2,000,000 of the entire $4,400,000 debt owed during this p back to the actual building project. Instead of picking an interest rate for the other loans, we must calculate the weighted-average interest rate. This rate is calculated by dividing the total interest paid on the other loans by the principal amount owed. This interest rate is 10.42 percent for the balance of $1,500,000 in weighted-average cumulative expenses. (See schedule 2)

Third, determine how much interest we can avoid: Determine the interest on the construction financing. To balance the weighted-average cumulative expenses, apply the weighted-average interest rate. In 2016, $396,300 in unnecessary interest was paid. (See schedule 3)

We capitalize the lesser of the two鈥�$396,300鈥攁long with the other building expenditures to avoid overstating the interest connected with the construction. The remaining interest ($93,700) is written off.

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Working note:

Interest Capitalized

Because avoidable interest is lower than actual interest, use avoidable interest.