(1) CA10-3 (Capitalization of Interest)
Langer Airline is converting from piston-type planes to
jets. Delivery time for the jets is 3 years, during which substantial progress payments must be made. The multimillion-dollar 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 interest costs in the second year of the period will be equal to one-third 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 would be substantially increased. The jet planes have a 7-year service life.
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.)
(2) 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 loan—12% interest, payable semiannually,
issued December 31, 2013 ¥2,000,000
Short-term loan—10% interest, payable monthly, and
principal payable at maturity, on May 30, 2015 1,400,000
Long-term loan—11% 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 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 this avoidable interest? Finally, why can't her company capitalize all the annual interest that accrued over the period of construction?
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.
Could you help me understand and solve these?
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