Week 7 Pre-Assignment Part 1 Interest Capitalization The concept is that if you had an asset constructed and paid for it upon completion, the cost would include interest. Thus, interest a company incurs during construction can be added to the cost of the asset. Interest that would have otherwise been an expense of the period is rolled into the cost of the asset. Building the "base" to which interest is applied: Interest is applied to cost of land during construction period. Application starts the day construction starts and end on date of completion Interest is applied to construction expenditures during construction period from date of expenditure to date of completion Land and expenditures are "annualized". For example, $600,000 spent on June 1 and where project is completed October 1 would be $600,000 X 4/12 - $200,000, Applying Interest: Loans are also annualized. A $200,000 loan that starts on April 1 and is paid off on October 1 at 6%. Would be $200,000 X 6/12 -$100,000. The interest would be $100,000 X 6% - $6,000. Interest is first applied on construction loans at the applicable rate. The limit on interest capitalized is the "base" (the annualized expenditures on asset) If there is remaining base, interest is applied at the weighted average interest rate on all other debt during the period. Again, the limit is the "base". Try working the following example: Assume Construction started on March 1, 2016 and was completed on Oct. 1, 2016 First, build the "base" based on the following expenditures during 2016: Completion Amount expenditure Jan 1 June 1 Oct 1 date Oct 1 Oct 1 Oct 1 Land Expenditure 1 Expenditure 2 $240,000 840,000 400,000 Second, apply interest to the base, construction interest first. Here are the loans: Rate Start date 6/1/2016 10/1/2015 Date repaid 11/1/2016 10/1/2017 Loan Construction General 10% 8% Amount $550.000 1,000,000 Part 2 Asset Exchanges Apply the full gain model. That means that full gain or loss is recorded on asset leaving The asset entering is recorded at market value. For the following example, first calculate the gain (or loss) for Joe and Bob. Then make the entry to record the exchange: Joe's Gas Welder Cost $ 18,000 Accum. Dep 4,000 Book Value 14,000 Market Value 18,000 Bob's Boat $ 15,000 5,000 10,000 14,400 Joe gets boot of $3,600 Bob gives boot of $3,600 Gain recorded Gain recorded Make the entries for both parties