Harp signs a contract with Bob the Builder to construct an office building. The
ID: 2744118 • Letter: H
Question
Harp signs a contract with Bob the Builder to construct an office building. The contract is signed on 2-1-2015 and the estimated completion date is 7-1-2016. Work begins on 3-1-2015.
Expenditures
3-1-2015 $300,000
7-1-2015 400,000
10-1-2015 300,000
12-1-2015 200,000
3-1-2016 300,000
5-1 2016 500,000
6-1-2016 300,000
Debt of Harp includes:
General debt
Debentures of $4,000,000 issued in 2013 at par with a stated rate of 4%. 20 -year life
Note payable of $800,000 issued in 2014- 5 year life
Specific debt
3-1-2015 Construction loan of $600,000 at 5% - life 4 months
7-1-2015 Construction loan of $1,400,000 life of 8 months 6%
3-1-2016 Construction loan of $2,000,000 life of 3 months 6%
6-1-2016 Mortgage loan of $2,200,000 at 4%- life 20 years
Determine IDC in 2015 and 2016
Explanation / Answer
Capitalizing Interest Costs:
Interest is defined as a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds. When an asset is constructed, a company typically borrows funds to finance the costs associated with the construction. The amount of cash borrowed will incur interest expense to the borrower; the interest paid by the borrower serves as interest income to the lender. The capitalization of interest costs involves adding the amount of interest expense incurred and/or paid during the asset's construction phase to the asset's cost recorded on the balance sheet. The asset's intended use should be for the generation of company earnings. Interest cost capitalization does not apply to retail inventory constructed or held for sale purposes.
Interest Costs on the Balance Sheet:
The cost of interest incurred and/or paid is included as part of the historical cost of the asset under construction. No separate line item is needed on the balance sheet to disclose the interest costs associated with the asset. If any delays occur during the construction phase, the interest costs incurred during the delay are not capitalized. This interest cost is recorded as interest expense and reported as a period cost on the income statement rather than the balance sheet.
Interest Costs After Construction:
When the asset's construction is complete and the asset is ready for use, any additional interest expense incurred is no longer capitalized as part of the asset's cost. This interest is expensed on the income statement and reduces income for the accounting period.
Specific Debt Capitalised Interest Calculation:
Date
Particulars
Loan Amount
Life of a Loan
Interest Rate
Interest Amount
Remarks
3-1-2015
Construction loan
$6,00,000
4 Months
5%
$10,000
($ 600000 X5%X4/12)
To be Capitalised in 2015
7-1-2015
Construction loan
$14,00,000
8 Months
6%
$56,000($14,00,000 X6%X8/12)
To be Capitalised in 2015
3-1-2016
Construction loan
$20,00,000
3 Months
6%
$1,644 ($20,00,000X6%X5/365)
To be Capitalised in 2016
6-1-2016
Mortgage loan
$22,00,000
20 Years
4%
$482 ($ 22,00,000X4%X2/365)
To be Capitalised in 2016
Therefore, Interest During Construction for the year 2015 is $ 66,000 ($ 10,000 + $ 56,000) and Interest During Construction for the year 2016 is $ 2,126 ($ 1,644 + $ 482). And these amounts need to be Capitalised in the balance sheet.
Note:
Interest Costs After Construction is expensed on the income statement and reduces income for the accounting period.
Date
Particulars
Loan Amount
Life of a Loan
Interest Rate
Interest Amount
Remarks
3-1-2015
Construction loan
$6,00,000
4 Months
5%
$10,000
($ 600000 X5%X4/12)
To be Capitalised in 2015
7-1-2015
Construction loan
$14,00,000
8 Months
6%
$56,000($14,00,000 X6%X8/12)
To be Capitalised in 2015
3-1-2016
Construction loan
$20,00,000
3 Months
6%
$1,644 ($20,00,000X6%X5/365)
To be Capitalised in 2016
6-1-2016
Mortgage loan
$22,00,000
20 Years
4%
$482 ($ 22,00,000X4%X2/365)
To be Capitalised in 2016
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