(Capitalization of Interest) On December 31, 2016, Main Inc. borrowed \(3,000,000 at 12% payable annually to finance the construction of a new building. In 2017, the company made the following expenditures related to this building: March 1, \)360,000; June 1, \(600,000; July 1, \)1,500,000; December 1, \(1,500,000. The building was completed in February 2018. Additional information is provided as follows.

1. Other debt outstanding

10-year, 13% bond, December 31, 2010, interest payable annually \)4,000,000

6-year, 10% note, dated December 31, 2014, interest payable

annually \(1,600,000

2. March 1, 2017, expenditure included land costs of \)150,000

3. Interest revenue earned in 2017 $49,000

Instructions

(a) Determine the amount of interest to be capitalized in 2017 in relation to the construction of the building.

(b) Prepare the journal entry to record the capitalization of interest and the recognition of interest expense at December 31, 2017.

Short Answer

Expert verified

a) Avoidable interest = $183,000

b) Interest expense = $857,000

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 instead deducted from the asset's value on the income statement, which includes the interest in its total value on the balance sheet.

02

(a) Determining the amount of interest be capitalized in 2017

Computation of Weighted-Average Accumulated Expenditures

Expenditures

Date Amount Capitalization Period

Weighted-Average Accumulated Expenditures

March 1 $ 360,000 10/12

$ 300,000

June 1 600,000 7/12

350,000

July 1 1 1,500,000 6/12

750,000

December 1 1,500,000 1/12

125,000

$3,960,000

$1,525,000

Computation of Avoidable Interest

Avoidable=WeightedAverage×Intrest=$1,525,000×0.12=$183,000

Computation of Actual Interest

Calculation

Actual interest

localid="1656925479965" $3,000,000×12%

$ 360,000

localid="1656925485760" $4,000,000×13%

520,000

localid="1656925491546" $1,600,000×10%

160,000

$1,040,000

Note: Use avoidable interest for capitalization purposes because it is lower than actual.

03

(b) Preparing journal entry

Date

Particular

Debit ($)

Credit ($)

Buildings

183,000

Interest Expense

857,000

Cash

($360,000+$520,000+$160,000)

1,040,000

Working Notes:

Calculation of Interest expense

Actual interest for year

$1,040,000

Less: Amount capitalized

183,000

Interest expense debit

$ 857,000



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Most popular questions from this chapter

Previn Brothers Inc. purchased land at a price of \(27,000. Closing costs were \)1,400. An old building was removed at a cost of $10,200. What amount should be recorded as the cost of the land?

Crowe Company purchased a heavy-duty truck on July 1, 2014, for \(30,000. It was estimated that it would have a useful life of 10 years and then would have a trade-in value of \)6,000. The company uses the straight-line method. It was traded on August 1, 2018, for a similar truck costing \(42,000; \)16,000 was allowed as trade-in value (also fair value) on the old truck and $26,000 was paid in cash. A comparison of expected cash flows for the trucks indicates the exchange lacks commercial substance. What is the entry to record the trade-in?

(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 − $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.

Indicate which of the following costs should be expensed when incurred.

(a) \(13,000 paid to rearrange and reinstall machinery.

(b) \)200,000 paid for addition to building.

(c) \(200 paid for tune-up and oil change on delivery truck.

(d) \)7,000 paid to replace a wooden floor with a concrete floor.

(e) $2,000 paid for a major overhaul on a truck, which extends the useful life

Johnson & Johnson, the world’s leading and most diversified healthcare corporation, serves its customers through specialized worldwide franchises. Each of its franchises consists of a number of companies throughout the world that focus on a particular healthcare market, such as surgical sutures, consumer pharmaceuticals, or contact lenses. Information related to its property, plant, and equipment in its 2014 annual report is shown in the notes to the financial statements below.

1.Property, Plant and Equipment and Depreciation

Property, plant and equipment are stated at cost. The Company utilizes the straight-line method of depreciation over the estimated useful lives of the assets:

Building and building equipment 20–40 years

Land and leasehold improvements 10–20 years

Machinery and equipment 2–13 years

4. Property, Plant and Equipment

At the end of 2014 and 2013, property, plant and equipment at cost and accumulated depreciation were:

(dollars in millions) 2014 2013

Land and land improvements \( 833 \) 885

Buildings and building equipment 10,046 10,423

Machinery and equipment 22,206 22,527

Construction in progress 3,600 3,298

36,685 37,133

Less accumulated depreciation 20,559 20,423

\(16,126 \)16,710

The Company capitalizes interest expense as part of the cost of construction of facilities and equipment. Interest expense capitalized in 2014, 2013 and 2012 was \(115 million, \)105 million and \(115 million, respectively. Depreciation expense, including the amortization of capitalized interest in 2014, 2013 and 2012, was \)2.5 billion, \(2.7 billion and \)2.5 billion, respectively.

Johnson & Johnson provided the following selected information in its 2014 cash flow statement.

Johnson & Johnson

2014 Annual Report

Consolidated Financial Statements (excerpts)

Net cash flows from operating activities \(18,471

Cash flows from investing activities

Additions to property, plant and equipment (3,714)

Proceeds from the disposal of assets 4,631

Acquisitions, net of cash acquired (2,129)

Purchases of investments (34,913)

Sales of investments 24,119

Other (primarily intangibles) (299)

Net cash used by investing activities (12,305)

Cash flows from financing activities

Dividends to shareholders (7,768)

Repurchase of common stock (7,124)

Proceeds from short-term debt 1,863

Retirement of short-term debt (1,267)

Proceeds from long-term debt 2,098

Retirement of long-term debt (1,844)

Proceeds from the exercise of stock options/excess tax benefits 1,782

Net cash used by financing activities (12,260)

Effect of exchange rate changes on cash and cash equivalents (310)

Increase in cash and cash equivalents (6,404)

Cash and cash equivalents, beginning of year (Note 1) 20,927

Cash and cash equivalents, end of year (Note 1) \)14,523

Supplemental cash flow data

Cash paid during the year for:

Interest $ 603

Income taxes 3,536

Instructions

  1. What was the cost of buildings and building equipment at the end of 2014?
  2. Does Johnson & Johnson use a conservative or liberal method to depreciate its property, plant, and equipment?
  3. What was the actual interest paid by the company in 2014? ‘
  4. What is Johnson & Johnson’s free cash flow? From the information provided, comment on Johnson & Johnson’s financial flexibility.
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