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Chapter 10: Q7P (page 544)

(Capitalization of Interest) Laserwords Inc. is a book distributor that had been operating in its original facility since 1987. The increase in certification programs and continuing education requirements in several professions has contributed to an annual growth rate of 15% for Laserwords since 2012. Laserwords鈥� original facility became obsolete by early 2017 because of the increased sales volume and the fact that Laserwords now carries CDs in addition to books.

On June 1, 2017, Laserwords contracted with Black Construction to have a new building constructed for \(4,000,000 on land owned by Laserwords. The payments made by Laserwords to Black Construction are shown in the schedule below.

Date

Amount

July 30, 2017

\) 900,000

January 30, 2018

1,500,000

May 30, 2018

1,600,000

Total payments

\(4,000,000

Construction was completed and the building was ready for occupancy on May 27, 2018. Laserwords had no new borrowings directly associated with the new building but had the following debt outstanding at May 31, 2018, the end of its fiscal year

10%, 5-year note payable of \)2,000,000, dated April 1, 2014, with interest payable annually on April 1.

12%, 10-year bond issue of $3,000,000 sold at par on June 30, 2010, with interest payable annually on June 30.

The new building qualifies for interest capitalization. The effect of capitalizing the interest on the new building, compared with the effect of expensing the interest, is material.

Instructions

  1. Compute the weighted-average accumulated expenditures on Laserwords鈥� new building during the capitalization period.
  2. Compute the avoidable interest on Laserwords鈥� new building. (Round to one decimal place.)
  3. Some interest cost of Laserwords Inc. is capitalized for the year ended May 31, 2018.
    1. Identify the items relating to interest costs that must be disclosed in Laserwords鈥� financial statements.
    2. Compute the amount of each of the items that must be disclosed.

Short Answer

Expert verified
  1. Total weighted expenditure = $1,250,000
  2. Avoidable interest = $140,000
  3. 1. Actual interest cost,interest capitalized, and interest expensed should be included in financial statements

2.Total interest expense = $420,000

Step by step solution

01

Meaning of Capitalization of Interest

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.

02

(a) Computing the weighted-average accumulated expenditures

Computation of Weighted-Average Accumulated Expenditures

Expenditures

Date

Amount

Capitalization Period

Weighted-AverageAccumulated Expenditures

July 30, 2017

$ 900,000 10/12

$ 750,000

Jan. 30, 2018

1,500,000 4/12

500,000

May 30, 2018

1,600,000 0

0

$4,000,000

$1,250,000

03

(b) Computing the avoidable interest in Laserwords’ new building

Weighted-Average Weighted-Average

Accumulated Expenditures Interest rate

Avoidable

Interest

$1,250,000 11.2%

$140,000

Loans Outstanding During Construction Period

Principal

Actual Interest

10% five-year note

$2,000,000

$200,000

12% ten-year bond

3,000,000

360,000

$5,000,000

$560,000

Working notes:

Calculation of weighted average rate

Weightedaveragerate=TotalinterestTotalprincipal=$560,000$5,000,000=11.2%

04

(c1) Identifying the items relating to interest costs

The following items related to interest cost should be mentioned in Ladderwords' financial statements:

  1. The total actual interest cost
  2. Total interest capitalized
  3. Total interest expensed
05

(c2) Computing the amount of each of the items that must be disclosed

Some interest costs of Laserwords Inc. are capitalized for the year ended May 31, 2018.

The total actual interest cost

$560,000

Total interest capitalized

$140,000

Total interest expensed

($560,000-$140,000)

$420,000

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Most popular questions from this chapter

(Accounting for Self-Constructed Assets) Troopers Medical Labs, Inc., began operations 5 years ago producing stetrics, a new type of instrument it hoped to sell to doctors, dentists, and hospitals. The demand for stetrics far exceeded initial expectations, and the company was unable to produce enough stetrics to meet demand.

The company was manufacturing its product on equipment that it built at the start of its operations. To meet demand, more efficient equipment was needed. The company decided to design and build the equipment, because the equipment currently available on the market was unsuitable for producing stetrics.

In 2017, a section of the plant was devoted to development of the new equipment and a special staff was hired. Within 6 months, a machine developed at a cost of \(714,000 increased production dramatically and reduced labor costs substantially. Elated by the success of the new machine, the company built three more machines of the same type at a cost of \)441,000 each.

Instructions

a. In general, what costs should be capitalized for self-constructed equipment?

b. Discuss the propriety of including in the capitalized cost of self-constructed assets:

(1) The increase in overhead caused by the self-construction of fixed assets.

(2) A proportionate share of overhead on the same basis as that applied to goods manufactured for sale.

c. Discuss the proper accounting treatment of the \(273,000 (\)714,000 鈭� $441,000) by which the cost of the first machine exceeded the cost of the subsequent machines. This additional cost should not be considered research and development costs.

Magilke Industries acquired equipment this year to be used in its operations. The equipment was delivered by the suppliers, installed by Magilke, and placed into operation. Some of it was purchased for cash with discounts available for prompt payment. Some of it was purchased under long-term payment plans for which the interest charges approximated prevailing rates. What costs should Magilke capitalize for the new equipment purchased this year? Explain.

(Acquisition, Improvements, and Sale of Realty) Tonkawa Company purchased land for use as its corporate headquarters. A small factory that was on the land when it was purchased was torn down before construction of the office building began. Furthermore, a substantial amount of rock blasting and removal had to be done to the site before construction of the building foundation began. Because the office building was set back on the land far from the public road, Tonkawa Company had the contractor construct a paved road that led from the public road to the parking lot of the office building.

Three years after the office building was occupied, Tonkawa Company added four stories to the office building. The four stories had an estimated useful life of 5 years more than the remaining estimated useful life of the original office building.

Ten years later, the land and building were sold at an amount more than their net book value, and Tonkawa Company had a new office building constructed in another state for use as its new corporate headquarters.

Instructions

  1. Which of the expenditures above should be capitalized? How should each be depreciated or amortized? Discuss the rationale for your answers.
  2. How would the sale of the land and building be accounted for? Include in your answer an explanation of how to determine the net book value at the date of sale. Discuss the rationale for your answer.

Martin Buber Co. purchased land as a factory site for \(400,000. The process of tearing down two old buildings on the site and constructing the factory required 6 months. The company paid \)42,000 to raze the old buildings and sold salvaged lumber and brick for \(6,300. Legal fees of \)1,850 were paid for title investigation and drawing the purchase contract. Martin Buber paid \(2,200 to an engineering firm for a land survey, and \)68,000 for drawing the factory plans. The land survey had to be made before definitive plans could be drawn. Title insurance on the property cost \(1,500, and a liability insurance premium paid during construction was \)900. The contractor鈥檚 charge for construction was \(2,740,000. The company paid the contractor in two installments: \)1,200,000 at the end of 3 months and \(1,540,000 upon completion. Interest costs of \)170,000 were incurred to finance the construction. Instructions Determine the cost of the land and the cost of the building as they should be recorded on the books of Martin Buber Co. Assume that the land survey was for the building.

New machinery, which replaced a number of employees, was installed and put in operation in the last month of the fiscal year. The employees had been dismissed after payment of an extra month鈥檚 wages, and this amount was added to the cost of the machinery. Discuss the propriety of the charge. If it was improper, describe the proper treatment.
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