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Chapter 10: Q8Q (page 531)

Question: One financial accounting issue encountered when a company constructs its own plant is whether the interest cost on funds borrowed to finance construction should be capitalized and then amortized over the life of the assets constructed. What is the justification for capitalizing such interest?

Short Answer

Expert verified

Answer

Interest cost is capitalized because all cost incurred on the construction should be included in the construction cost. So, financing cost also included in the construction cost.

Step by step solution

01

Interest cost during construction

Normally companies use the three approaches to treat the interest costs. These are the:

  1. No capitalization of interest cost incurred in construction.
  2. Capitalization of all financing cost from debt or stock.
  3. Capitalization of interest cost of the debt only.
02

Reason for capitalization of interest cost

Company needs to capitalize all the cost incurred on the assets to made asset ready for use. According to this view point, company also need to capitalize the financing cost incurred in the construction of the assets. So, interest cost incurred for construction of plant assets is capitalized.

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Most popular questions from this chapter

(Purchases by Deferred Payment, Lump-Sum, and Nonmonetary Exchanges) Klamath Company, a manufacturer of ballet shoes, is experiencing a period of sustained growth. In an effort to expand its production capacity to meet the increased demand for its product, the company recently made several acquisitions of plant and equipment. Rob Joffrey, newly hired in the position of fixed-asset accountant, requested that Danny Nolte, Klamath’s controller, review the following transactions.

Transaction 1: On June 1, 2017, Klamath Company purchased equipment from Wyandot Corporation. Klamath issued a \(28,000, 4-year, zero-interest-bearing note to Wyandot for the new equipment. Klamath will pay off the note in four equal installments due at the end of each of the next 4 years. At the date of the transaction, the prevailing market rate of interest for obligations of this nature was 10%. Freight costs of \)425 and installation costs of \(500 were incurred in completing this transaction. The appropriate factors for the time value of money at a 10% rate of interest are given below.

Future value of \)1 for 4 periods

1.46

Future value of an ordinary annuity for 4 periods

4.64

Present value of \(1 for 4 periods

0.68

Present value of an ordinary annuity for 4 periods

3.17

Transaction 2: On December 1, 2017, Klamath Company purchased several assets of Yakima Shoes Inc., a small shoe manufacturer whose owner was retiring. The purchase amounted to \)220,000 and included the assets listed below. Klamath Company engaged the services of Tennyson Appraisal Inc., an independent appraiser, to determine the fair values of the assets which are also presented below.

Yakima Book Value

Fair Value

Inventory

\( 60,000

\) 50,000

Land

40,000

80,000

Buildings

70,000

120,000

\(170,000

\)250,000

During its fiscal year ended May 31, 2018, Klamath incurred \(8,000 for interest expense in connection with the financing of these assets.

Transaction 3: On March 1, 2018, Klamath Company exchanged a number of used trucks plus cash for vacant land adjacent to its plant site. (The exchange has commercial substance.) Klamath intends to use the land for a parking lot. The trucks had a combined book value of \)35,000, as Klamath had recorded \(20,000 of accumulated depreciation against these assets. Klamath’s purchasing agent, who has had previous dealings in the secondhand market, indicated that the trucks had a fair value of \)46,000 at the time of the transaction. In addition to the trucks, Klamath Company paid $19,000 cash for the land.

Instructions

  1. Plant assets such as land, buildings, and equipment receive special accounting treatment. Describe the major characteristics of these assets that differentiate them from other types of assets.
  2. For each of the three transactions described above, determine the value at which Klamath Company should record the acquired assets. Support your calculations with an explanation of the underlying rationale.
  3. The books of Klamath Company show the following additional transactions for the fiscal year ended May 31, 2018.
    1. Acquisition of a building for speculative purposes.
    2. Purchase of a 2-year insurance policy covering plant equipment.
    3. Purchase of the rights for the exclusive use of a process used in the manufacture of ballet shoes.

For each of these transactions, indicate whether the asset should be classified as a plant asset. If it is a plant asset, explain why it is. If it is not a plant asset, explain why not, and identify the proper classification.

Use the information presented for Ottawa Corporation in BE10-14, but assume the machinery is sold for \(5,200 instead of \)10,500. Prepare journal entries to (a) update depreciation for 2018 and (b) record the sale.

(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.

Hanson Company (see BE10-2) borrowed \(1,000,000 on March 1 on a 5-year, 12% note to help finance construction of the building. In addition, the company had outstanding all year a 10%, 5-year, \)2,000,000 note payable and an 11%, 4-year, $3,500,000 note payable. Compute the weighted-average interest rate used for interest capitalization purposes.

(Nonmonetary Exchanges) On August 1, Hyde, Inc. exchanged productive assets with Wiggins, Inc. Hyde’s asset is referred to below as “Asset A,” and Wiggins’ is referred to as “Asset B.” The following facts pertain to these assets.

Asset A

Asset B

Original cost

\(96,000

\)110,000

Accumulated depreciation (to date of exchange)

40,000

47,000

Fair value at date of exchange

60,000

75,000

Cash paid by Hyde, Inc.

15,000

Cash received by Wiggins, Inc.

15,000

Instructions

  1. Assuming that the exchange of Assets A and B has commercial substance, record the exchange for both Hyde, Inc. and Wiggins, Inc. in accordance with generally accepted accounting principles.
  2. Assuming that the exchange of Assets A and B lacks commercial substance, record the exchange for both Hyde, Inc. and Wiggins, Inc. in accordance with generally accepted accounting principles.
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