Question

Problem 10-12 Acquisition costs; lump-sum acquisition; noninterest-bearing note; interest capitalization [LO10-1, 10-2, 10-3, 10-7]

Early in its fiscal year ending December 31, 2018, San Antonio Outfitters finalized plans to expand operations. The first stage was completed on March 28 with the purchase of a tract of land on the outskirts of the city. The land and existing building were purchased for $1,160,000. San Antonio paid $380,000 and signed a noninterest-bearing note requiring the company to pay the remaining $780,000 on March 28, 2020. An interest rate of 10% properly reflects the time value of money for this type of loan agreement. Title search, insurance, and other closing costs totaling $38,000 were paid at closing.
   
During April, the old building was demolished at a cost of $88,000, and an additional $68,000 was paid to clear and grade the land. Construction of a new building began on May 1 and was completed on October 29. Construction expenditures were as follows: (FV of $1, PV of $1, FVA of $1, PVA of $1, FVAD of $1 and PVAD of $1) (Use appropriate factor(s) from the tables provided.)

May 1	$	3,900,000
July 30		2,400,000
September 1		1,980,000
October 1		2,880,000

San Antonio borrowed $6,300,000 at 10% on May 1 to help finance construction. This loan, plus interest, will be paid in 2019. The company also had the following debt outstanding throughout 2018:

$3,800,000, 8% long-term note payable

$5,800,000, 5% long-term bonds payable

In November, the company purchased 10 identical pieces of equipment and office furniture and fixtures for a lump-sum price of $780,000. The fair values of the equipment and the furniture and fixtures were $572,000 and $308,000, respectively. In December, San Antonio paid a contractor $375,000 for the construction of parking lots and for landscaping.
  
Required:
1. Determine the initial values of the various assets that San Antonio acquired or constructed during 2018. The company uses the specific interest method to determine the amount of interest capitalized on the building construction.
2. How much interest expense will San Antonio report in its 2018 income statement?

Answer 1

Requirement 1

          Land

          Purchase price (determined below)           $1,024,631

          Closing costs                                              38,000

          Removal of old building                            88,000

          Clearing and grading                                68,000

                                                                    $1,218,631

          Purchase price of land:

               Cash paid                                          $380,000

               Value of note^†                                   644,631

                                                                    $1,024,631

          ^† Present value of note payment:

          PV = $780,000 (.82645) = $644,631

          Present value of $1: n = 2, i = 10% (from Table 2)

          Land improvements

          Parking lot and landscaping                   $375,000

          Building

          Construction expenditures:

                   May 1                                       $3,900,000

                   July 30                                        2,400,000

                   September 1                                1,980,000

                   October 1                                    2,880,000

                      Total expenditures                  11,160,000

          Interest capitalized (determined below)            312,000

               Total cost of building                   $11,472,000

          Average accumulated expenditures:

          May 1, 2018             $3,900,000 x   6/6 = $ 3,900,000

          July 30, 2018             2,400,000 x   3/6 =    1,200,000

          September 1, 2018    1,980,000 x   2/6 =       660,000    

          October 1, 2018        2,880,000 x   1/6 =         480,000

                                                                              $6,240,000

          Interest capitalized:

          $6,240,000 x 10% x 6/12 =                            $312,000

Equipment and furniture and fixtures

                                                                                                  Initial

                                                             Percent of Total           Valuation

                                     Fair Value             Fair Value            % x $780,000

Equipment                     $572,000                   65%                  $507,000

Furniture & fixtures         308,000                  35%                    273,000

          Totals                   $880,000                 100%                  $780,000

Initial valuation:

Equipment                     $507,000

Furniture & fixtures         273,000

Requirement 2

Interest expense:

     Note issued to purchase land and building,

         $644,631 x 10% x 9/12 =                                $ 48,347

     Construction loan, $6,300,000 x 10% x 8/12         420,000

     Long-term note, $3,800,000 x 8%                         304,000

     Long-term bonds, $5,800,000 x 5%                       290,000

         Total                                                               1062,347

     Less: Interest capitalized (determined above)         (312,000)

Interest expense                                                         $750,347