Question

Vania Magazines started construction of a warehouse building for its own use at an estimated cost of $5,000,000 on January 1, 2019, and completed the building on December 31, 2019. During the construction period, Vania has the following debt obligations outstanding.

Construction loan—12% interest, payable semiannually, issued December 31, 2018		$2,000,000
Short-term loan—10% interest, payable monthly, and principal payable at maturity, on May 30, 2020		1,400,000
Long-term loan—11% interest, payable on January 1 of each year; principal payable on January 1, 2022		1,000,000

Total cost amounted to $5,200,000, and the weighted average of accumulated expenditures was $3,500,000.

Jane Esplanade, the president of the company, has been shown the costs associated with this construction project and capitalized on the balance sheet. She is bothered by the “avoidable interest” included in the cost. She argues that, first, all the interest is unavoidable—no one lends money without expecting to be compensated for it. Second, why can’t the company use all the interest on all the loans when computing this avoidable interest? Finally, why can’t her company capitalize all the annual interest that accrued over the period of construction?

You are the manager of accounting for the company. In a memo, explain what avoidable interest is, how you computed it (being especially careful to explain why you used the interest rates that you did), and why the company cannot capitalize all its interest for the year. Attach a schedule supporting any computations that you use.

Answer 1

1	Following schedule calculates the weighted-average accumulated expenditures:
	Date	Expenditure	capitalisation period	Weight	Weighted expenditure
		a	b	c=b/12	d=a*c
	Total	$                   3,500,000.00
			Specific borrowing		$                   2,000,000.00
			General Borrowing		$                   1,500,000.00
2	Out of this $35,00,000/- $20,00,000 is financed by specific loan. The rest i.e. $15,00,000 is financed out of the general loans. The interest rate on specific loan is 12% while the weighted interest rate on the general loans is calculated below:
	Loan	Principal	Rate	Annual Interest
	10% Short term loan payable	$ 1,400,000.00	10%	$              140,000.00
	11% Long term loan payable	$ 1,000,000.00	11%	$              110,000.00
		$ 2,400,000.00	10.4167%	$              250,000.00
	Weighted-average Interest Rate= $250,000/$24,00,000=10.4167%
3	Computation of avoidable interest
	Loan	Amount	Rate	month	Avoidable Interest
	Specific loan	$ 2,000,000.00	12.00%	12	$                             240,000
	General loan	$ 1,500,000.00	10.4167%	12	$                             156,250
		$ 3,500,000.00			$                             396,250

We cannot expense off all the interest expense on the loan taken for the construction of the property as borrowing cost incurred before the completion of the constrution period is required to be capitalised calculated as above. Therefore, in the given case interest amount of $396,250 is to be capitalised along with the asset constructed.

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