FAR Interest Capitalization question

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    Topic
  • #1326574
    Nancy
    Participant

    Can someone please explain the answer to this question and why the expenses need to be divided by 2? The explanation they give is not clean to me.

    On January 1, Year 3, Starlight Construction Co. began a construction project qualifying for capitalization of interest. The total amount spent on this project during Year 3 was $250,000, spent uniformly during the year. To help pay for construction, $200,000 was borrowed at 10% on January 1, Year 3, and funds not needed for construction were temporarily invested in short-term securities, yielding $3,000 in interest revenue. Other than the construction funds borrowed, the only other debt outstanding during the year was a $150,000, 10-year, 7% note payable dated January 1, Year 1. How much interest should be capitalized by Starlight during Year 3?
    a.
    $22,000
    b.
    $25,000
    c.
    $9,500
    d.
    $12,500

    Choice “d” is correct. The calculations are:
    Total expenditures of $250,000 ÷ 2 =
    $125,000
    Average accumulated expenditures
    x .10
    Interest rate on specific borrowing
    $12,500
    Avoidable interest
    Compare avoidable interest to actual total interest cost incurred and capitalize the lower amount.
    Actual interest:
    $200,000 x .10
    =
    $20,000
    150,000 x .07
    =
    10,500
    Total actual interest cost
    =
    $30,500 > $12,500 avoidable interest
    Capitalize the lower amount. Interest earned on money invested is interest revenue. It does not affect the amount of interest expensed or capitalized.
    Choice “b” is incorrect. Total expenditures of $250,000 must be divided by two to arrive at “average accumulated expenditures,” since the expenditures were incurred evenly throughout the year. Failure to divide by two would result in an erroneous calculation ($25,000) for avoidable interest.
    Choices “c” and “a” are incorrect. These answers assume avoidable interest is either $12,500 or $25,000 and then offsets this amount by the net the interest earned. Interest earned does not reduce interest expense or the amount capitalized.

    For I can do everything through Christ, who gives me strength.
    Philippians 4:13

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  • #1326598
    Mike J
    Participant

    From the given info: “…spent uniformly”

    You have to allocate the expense. Since we don't know when what was spent, we have to assume it was spread evenly. So we take an average of 0 (beginning of the period) and 250,000 (end of the period) and divide by two (because there are only two elements 0 & 250,000).

    Hopefully someone can verify that explanation for me. That is how i understand this concept. FAR loves *falking* with the concept of time and allocation.

    #1326641
    Nancy
    Participant

    Thanks!! That actually makes a lot of sense now!

    For I can do everything through Christ, who gives me strength.
    Philippians 4:13

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