Question

Accounting

Read the case ‘April Company’ and answer the questions below:

April Company (‘April’) is a well-known diversified corporation with many different businesses in Hong Kong.

In order to meet the long term growth and diversification strategy under the direction of the new Chairman; the company has purchased assets and constructed a new building as its new head office in Hong Kong as follows:

i 1 Jan 2017: truck and equipment: These assets were purchased as a lump sum for $150,000 cash. The following information was gathered.

Description	Initial cost on seller's books	Depreciation to date on seller's books	book value on seller's books	Appraised value
Truck	$200,000	$100,000	$10,000	$130,000
Equipment	150,000	70,000	80,000	70,000

ii 1 Feb 2017: A new piece of machinery was acquired by trading in a used piece of machinery. (The exchange was with commercial substance.) Facts concerning the trade-in are as follows.

Cost of used machinery traded	$ 200,000
Accumulated depreciation to date of sale	36,000
Fair value of the machinery traded	150,000
Cash payment	10,000
Fair value of new machinery acquired	160,000

iii 1 Jan 2017: A building was constructed as the new head office of the company. Construction began on 1 January 2017 and would be completed in 15 months. The payments to the contractor in the first year (2017) were as follows.

Date	Payment
1 Jan	$ 250,000
1 Feb	120,000
1 June	360,000
1 Sept	480,000
1 Dec	300,000

On 1 January 2017, April Company secured a specific construction loan ($400,000) with an 8% interest rate to finance the construction of the new building. The building expenditures are qualifying assets of the construction in capitalization of interest costs and the capitalized interest costs should be included in the building. April drew down on the construction loan and other outstanding debt (if required) to meet the payment schedule shown above.

The other outstanding debt in the company during 2017:

* $1,000,000 bonds (due in year 2025), with 6% effective annual interest rate

* $500,000 long term note (due in 2030), with 7.5% interest rate per annum.

The company, according to the accounting standards in Hong Kong, will capitalize the maximum allowable interest costs for this construction.

The CFO of April estimated that the truck and the new machinery would be used for ten years, with an estimated residual value of $20,000 and $40,000 respectively. He also estimated that the equipment would have a useful life of five years and a residual value of $5,000. April’s depreciation policy specifies the 200% double-declining balance method for equipment and the straight-line method for the truck and machinery. (The building was not yet ready for use in 2017.)

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Required:

a     For each of the above assets purchased, traded or constructed, determine the amount of each of them clearly and record the transactions by journal entries in the books of April Company for the year ended 31 December 2017. Interest expense for the year has been recorded.

b     For each of the assets above (except the building), calculate April Company’s 2017 depreciation expense, for book purposes. Assume monthly depreciation had not been provided before the end of the year.

c     Discuss the arguments for and against the capitalization of interest costs.

Answer 1

a. Date	Account Title	Debit	Credit
Jan 1 2017	Truck	130000
	Equipment	70000
	Cash		150000
	Gain on purchase		50000
	Building Construction-in-Progress	250000
	Cash		250000
Feb 1,2017	Building Construction-in-Progress	120000
	Cash		120000
Feb 1,2017	New machinery	160000
	Acc. Depn.-old m/c	36000
	Loss on exchange(bal.fig.)	14000
	Old machinery		200000
	Cash		10000
Jun 1,2017	Building Construction-in-Progress	360000
	Cash		360000
Sep 1,2017	Building Construction-in-Progress	480000
	Cash		480000
Dec 1,2017	Building Construction-in-Progress	300000
	Cash		300000
31-Dec-17
b.	Depreciation expense	11000
	Accumulated Depreciation-Truck		11000
	(130000-20000)/10
	Depreciation expense
	Accumulated Depreciation-Machinery
	(160000-40000)/10yrs./12mths *11 mths.
	Depreciation expense	28000
	Accumulated Depreciation-Equipment		28000
	70000*20%*2

c. Interest costs are capitalised when the utility for which they are incurred extends beyond one accounting year , in which case, conceptually it goes to increase the cost of the asset, before the same is put to its intended use.

Arguments for capitalisation:

Measures accurately the cost of the asset , so that future depreciation amounts will also be proper & the company can save on tax cash outflows in all the accounting years , till the asset is in use.

Against capitalisation:

By capitalising interest costs, company get to lose the immediate tax deduction from ordinary net income , for the current accounting year.