Question

Pretend that you are at a cocktail party talking to the CEO of a small company who has a minimal understanding of accounting. She learns that you are a CPA, buys you a beverage (adult-type if that is your preference), and engages you in conversation. She explains that her company is acting as the general contractor for the construction of its own manufacturing plant. She's been advised that the company must "capitalize interest" in connection with the project. She has no idea what that means. She's concerned that this will cost her company money. Explain the concept, the reasoning behind it, and potential advantages to the company from this entirely appropriate accounting. Remember, she is a knowledgeable business person, but not as well versed in accounting as she would like to be. Your explanation should be careful not to assume that she understands much accounting jargon.

Confidential note: She's seeking out every CPA she can find. The one who provides the best answer will be her new accountant!! If you want the business, (and the full 10 points), you might want to subtly and professionally "supplement" the responses of your competition. However, don't be a jerk...nobody likes a jerk :)

It's ok to have a little fun here, just make sure to be respectful of your classmates! Your score will be based upon the substance of your response, but if I'm entertained a little, I don't see how that could hurt.

Answer 1

The given scenario relates to the concept of capitalization of interest expense incurred on a Qualifying Asset. Generally Interest expenses are charged to Income statement during which it is accrued. But in case of Plant, Property and Equipment if it is a Qualifying Asset it can be capitalized. Now let us understand what is a Qualifying Asset. If an Asset requires a period of time to get ready for its intended use then the cost of interest involved in it can be capitalized along with the Qualifying Asset cost. In the given case the firm is buildings its own manufacturing asset. This requires a reasonable period of time to get ready for its intended use of manufacturing. Hence the construction of manufacturing plant can be recognized as “Qualifying Asset”. The interest involved in borrowing of money to construct this asset can be capitalized along with the cost of construction. Once the Asset is ready for intended use no further cost can be capitalized.

This type of Accounting is beneficial because these expenses are not accrued in Income statement since there is no accrual of income during this period. Hence if capitalized along with asset cost shows the true and fair view of the business activities.