CA 10-4 (Capitalization of Interest) Vania Magazine Company started construction of a warehouse building for its own use at an estimated cost of $5,000,000 on January 1, 2011, and completed the building on December 31, 2011. During the construction period, Vania has the following debt obligations outstanding:
Construction loan - 12% interest, payable semiannually, Issued December 31, 2010 - $2,000,000
Short term loan - 10% interest, payable monthly, and principal payable at maturity, on May 30, 2012 - $1,400,000
Long-term loan - 11% interest - payable on January 1 of each year. Principal payable on January 1, 2014 - $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 compensalted 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 use 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.