Answer

You are the manager of accounting for the company. In a memo, explain what
avoidable interest is, how you computed it (being especially careful to explain
why you use 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. 

To: Jane Esplanade, the president

From: Manager of the Company

Date:

Subject: Capitalization of avoidable interest on the warehouse construction project

The accounting profession does not allow the accrued interest to be capitalized along
with the cost of the asset. But FASB allows the interest cost incurred during construction
as an exception. According to this exception, the constructed asset must require a
period of time to become ready for its intended use. Therefore, interest capitalization is
allowed in only special circumstances which indicates only that portion of interest should
be capitalized which is associated with construction itself. According to FASB the
standard specified is lower of actual or avoidable interest which is associated with the
construction.

Actual interest incurred during the construction period is equal to the all interest accrued
on any debt outstanding during that period. Avoidable interest is that portion of interest
which would not have incurred if the construction project had not been taken. According
to standard specified by the FASB is that the amount of interest is capitalized whichever
is lower of these two. The following are the ways;

1) To find out the amount of interest to be capitalized we must first of all calculate
the actual interest on the debt. Thus total amount of actual interest is $490,000
(Calculated below schedule 1). For calculating the avoidable interest can be
capitalized on the basis of weighted average amount of accumulated
expenditure. Although total cost of the project is $5,200,000, and the weighted
average of accumulated expenditures was $3,500,000. 
2) The actual debt associated with the project is $2,000,000 although $4,400,000 is
associated during this period. To choose the interest rate we must calculate the
weighted average rate of interest. (For calculations see schedule 2)
3) For calculating the avoidable interest we must calculate the interest associated
with the construction. We multiply this with the weighted average interest rate
 and then add up all these to find out the accumulated expenditure. (For
calculations see schedule 3)
4) According to rule, we capitalize the smaller of these two i.e. in this case the
avoidable interest of $396,300 is the smaller of these two and it is to be added in
cost to find out the total cost and remaining interest of $93,700 ($490,000 -
$396,300) is expensed.
I hope that the above explanation has cleared you how to capitalize the interest.

Regards;

Calculations

Schedule 1

Calculation of actual interest

Particulars Actual Interest Amount $

Construction Loan 2,000,000 *12% 240,000
Short term Loan 1,400,000 *10% 140,000
Long term loan 1,000,000 *11% 110,000
Total 490,000

Schedule 2

Calculation of Weighted Average Interest Rate

Particulars Principal Interest Amount $

10% Short term Loan 1,400,000 140,000
11% Long term loan 1,000,000 110,000
Total 2,400,000 250,000

Weighted Average interest rate = Total Amount of interest * 100

Total principal

= $250,000 /$2,400,000 *100

= 10.42%

Schedule 3

Calculation of Avoidable Interest

Weighted Average Interest Rate Avoidable Interest

Accumulated Expenditure
2,000,000 12% 240,000
1,500,000 10.42% 156,300
3,500,000 396,300

Schedule 4

Calculation of Interest to be capitalized

From the above calculations it has been cleared that avoidable interest is lower than the
actual interest therefore we take the avoidable interest.

Particulars Amount $
Cost 5,200,000
Interest capitalized 396,300
Total Cost 5,596,300