Langer Airline is converting from piston-type planes to jets. Delivery time for the jets is 3 years, during which time substantial progress payments must be made. The multimilliondollar cost of the planes cannot be financed from working capital; Langer must borrow funds for the payments.

Because of high interest rates and the large sum to be borrowed, management estimates that borrowing costs in the second year of the period will be equal to onethird of income before interest and taxes, and one-half of such income in the third year.

After conversion, Langer’s passenger-carrying capacity will be doubled with no increase in the number of planes, although the investment in planes will be substantially increased. The jet planes have a 7 year service life.

Instructions

Give your recommendation concerning the proper accounting for interest during the conversion period. Support your recommendation with reasons and suggested accounting treatment. Disregard income tax implications.

Construction loan—12% interest, payable semiannually, issued
December 31, 2020 ................................................................................... ¥2,000,000
Short-term loan—10% interest, payable monthly, and principal
payable at maturity, on May 30, 2022 ...................................................... 1,400,000
Long-term loan—11% interest, payable on January 1 of each year.
Principal payable on January 1, 2024 ...................................................... 1,000,000

Total cost amounted to ¥5,200,000. Payments were made during the year as follows.

Date ............................................. Amount
January 1, 2022 ....................... ¥1,500,000
March 1, 2022 ........................... 1,250,000
September 1, 2022 ................... 1,250,000
December 1, 2022 .................... 1,200,000
Total ......................................... ¥5,200,000

Jane Edo, the president of the company, has been shown the costs associated with this construction project and capitalized on the statement of financial position. She is bothered by the “borrowing 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 the capitalized borrowing cost? Finally, why can’t her company capitalize all the annual interest that accrued over the period of construction?

Instructions

You are the manager of accounting for the company. In a memo dated January 15, 2023, explain what borrowing cost 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.