CA10-4 (Capitalization of Interest)

Vang Magazine Company started construction of a warehouse building for its own use at an estimated cost of 5,000,000 on January 1, 2014 and completed the building on December 31, 2014 (all amounts in thousands). During the construction period, Vang has the following debt obligations outstanding.

Construction loan12% interest, payable semiannually,

issued December 31, 20132,000,000

Short-term loan10% interest, payable monthly, and

principal payable at maturity, on May 30, 20151,400,000

Long-term loan11% interest, payable on January 1 of

each year. Principal payable on January 1, 2017 1,000,000

Total cost amounted to 5,200,000, and the weighted-average accumulated expenditures was 3,500,000.

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 "avoidable interest" included in the cost. She argues that, first, all the interest is unavoidableno 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 this avoidable interest? 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, 2016, explain what avoidable interest 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.