BACKGROUND INFORMATION
Frosty Co. is a publicly traded, medium-sized manufacturing firm that produces refrigerators, freezers, ice makers, and snow cone machines. During the past three years, the company has struggled against increasing competition, sluggish sales, and a public relations scandal surrounding the departure of the former Chief Executive Officer (CEO) and Chief Financial Officer (CFO). The new CEO, Jane Mileton, and CFO, Doug Steindart, have worked hard to improve the company's image and financial position. After several difficult years, the company now seems to be resolving its difficulties, and the management team is considering new investment opportunities. The team hopes that diversification into a line of professional ice cream makers, and perhaps a line of consumer products, will help the company continue its recent growth and effectively compete with future competitors.
In order to raise the funds needed for these new investments, Frosty Co.'s Board of Directors has approved a seasoned equity offering (SEO). The discussions regarding the new investment opportunities and the equity offering have been kept quiet until a positive set of financial statements can provide strong evidence that the company has turned around, leading to an increase in the company's stock price.
INTRODUCTION
After a full week of carefully examining financial statements, Simon was exhausted. He had become Frosty Co.'s corporate controller only a month ago, after several years as an auditor at a public accounting firm, and was excited about the move to corporate accounting. The first few weeks had gone well, as Simon met his accounting staff and settled into his new responsibilities. Then, he had started reviewing Frosty Co.'s financial statements for the prior year to make sure they correctly followed GAAP, and to familiarize himself more with the company and industry. Unfortunately, his relative inexperience with the industry and Frosty's accounting procedures had required him to spend more time on the review than he had anticipated.
He still had a few questions about the financial statements, but he needed to start preparing for the upcoming SEO. He decided that he would talk to his staff about his lingering questions tomorrow morning, just before his meeting with the CEO and CFO. The three of them were to discuss the upcoming audit and the earnings announcement and how they would impact the proposed SEO. He rubbed his tired eyes and headed home to get a little sleep.
MEETING OF THE ACCOUNTING STAFF
Simon looked up as the divisional controllers, Elsa Pilebody and John Mortenson, came into his office. Elsa worked with Frosty Co.'s fridge and freezer division; John worked with the ice maker and snow cone machine division. So far, Simon had enjoyed working with them, especially since neither of them seemed to resent him stepping in as their new boss. They were both smiling as they came through the door, and their good-natured teasing started almost before they had finished shaking hands.
"Sorry we're a little late," Elsa started, "but John had to stop for the last jelly donut."
"I did not!" John said indignantly. He looked at Simon. "It was chocolate."
Because of his busy schedule that day, Simon got down to business instead of joining the banter as he normally would have done. "Thanks for coming by, Elsa and John. We have several issues to discuss before I have to meet with Jane and Doug this afternoon." He paused for a second. "I've spent the past week going over the financial statements. Overall, they look well done, but I need clarification on a few details. To start with, I want to discuss the construction project we began last year."
"That's our big project at the moment. We're building a new factory that should be done next summer," Elsa said. "Construction is going well, and we've been careful to capitalize all of the expenditures."
Simon shook his head. "That's the problem. I think we capitalized more than we should have. More specifically, it looks like we capitalized all of the interest on our most recent bank loan."
"We did," Elsa replied. "Since we're using all of the loan proceeds to build the new factory, we felt it was appropriate to capitalize all of the interest." John nodded in agreement.
"I disagree," said Simon. "Here's a breakdown of the payments we made on our new building and a list of our outstanding long-term debt (see tables below). Did we take out any of these loans specifically for the new factory?"
Elsa shook her head. "No, we took out the new loan, Loan 2, for general expansion, then decided the most appropriate use of the funds would be for the new factory."
Simon frowned. "Why are we capitalizing the interest on Loan 2 if it wasn't originated specifically for the new factory?"
"Well, if the capital from the loan is eventually used on a specific construction project, then I think we should be able to capitalize the interest on that loan as part of the historical cost of the project. Of course," Elsa frowned, "maybe we are capitalizing too much. Perhaps we need to calculate avoidable interest to determine the amount of interest that should be capitalized."
"You are right that generally we would need to calculate avoidable interest before capitalizing any interest," Simon answered. "But in this case, we don't need to do that. I believe GAAP allows interest to be capitalized only if a specific construction loan is used."
"Well, I still think that we should be able to capitalize at least some of the interest. But I'll do some research to make sure."
Expenditures
February 15 $90,000
April 1 $125,000
June 30 $200,000
October 1 $300,000
November 15 $585,000
Outstanding Borrowings
Bond A $678,000 @ 7.1%
Loan 1 $650,000 @ 6%
Loan 2 $1,000,000@ 7%
Answer the following questions based on the information above:
Capitalizing interest on the new factory:
1) During the year, Frosty Co. paid all of the interest accrued on Bond A and Loan 1, but only $50,000 of the interest accrued on Loan 2. Using one journal entry, summarize how Frosty originally recorded the accrued interest on all three long-term debts.
2) Assuming John and Elsa are right that the new loan meets the standards for capitalizing interest, calculate avoidable interest.
3) What correcting entries would need to be made to properly record interest on Frosty Co.'s construction project if John and Elsa are right?
4) What would be the effect of interest adjustments on net income, assuming that Frosty Co.'s income tax rate is 30 percent?