 Hello and welcome to this session in which you would look at this exercise or a CPA exam simulation that's going to illustrate how much interest to capitalize. What does that mean? Well, we are building a new warehouse and as a result, we borrowed some money and we have some outstanding debt. As a result, we are going to have interest expense. We are going to incur interest expense. Well, the question is how much of that interest expense we are going to capitalize and how much of it we are going to expense. Generally speaking, interest expense is an expense. However, when we are building a new building, a new warehouse and we incur interest, certain amount of the interest will be capitalized. In other words, as treated as an asset, added to the warehouse, added to the building that we are constructing. So this is what we're going to be illustrating in this concept. Obviously, we learned about the rules in the prior session, but in this session, we are going to go ahead and illustrate this concept. So December 31, 2021, Adam borrowed $2 million at 10% to finance the construction of a new warehouse. We call this $2 million specific borrowing. It means we borrowed this money specifically for the project. At the beginning of X2, we incurred the following expenditure related to the warehouse. March 1, 450,000, June 1, 630,000, July 1, 1.9 million, and December 1, 1.8 million. The warehouse was completed March 20, X3. We have other debt outstanding as of the beginning of the year. We have a bond that pays interest at 10% and the bond has a face value of 8 million. We have another note, 8% note, $2 million alone that's paying interest 8%. And we generated interest revenue in that year of 70,000. So the question is, how much of the interest are we going to capitalize? In order to solve this problem, I'm going to move to the an Excel sheet because we're going to have some computation. We'll go ahead and solve this problem. Now you can go ahead and try to do it by yourself before we go to the Excel sheet and see if you can get to the right answer. Before we proceed any further, I have a public announcement about my company farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises. Go ahead, start your free trial today. So how do we solve this problem? The first thing we have to compute is something called the weighted average accumulated expenditure. The weighted average accumulated expenditure. Now what does that mean? Look, we spend 450,000 as of March. We started the expenditure in March. So we need to figure out how much of this amount incurred interest because the assumption is this, if we borrow two million dollars and that money is sitting in the bank, in our bank account, well, we have to pay interest on it because, you know, there's a 10% interest cost on that money. But as far as the project is concerned, that money does not generate any interest until we start to spend money on the project. So we started March 10th. March 10th of this of the amount that we have in the bank, we spent 450,000. Now we need to compute the weighted average accumulated expenditure to figure out how much interest we need to allocate to this project, to this warehouse. This is what we do. So I have this formula here. We have the date. The date is March 1st. This is when we start to spend money on this project. March 1st. And March 1st, we spent, we spent 450,000. Capitalization period. Well, in other words, we spent this money. How much of this money? Now think of it. We took the money out of the account, out of the bank account on March 1st, and we paid labor, material, overhead for this project. So this money is now incurring interest, but it's incurring interest for the project. Therefore, we have to compute our capitalization period. In other words, if this money was spent on the project, how much of that interest on this money specifically was incurred? Well, since we spent the money in March 1st, we have 10 out of 12 months. March, April, May, June, July, August, September, October, November, and December. That's 1012. In other words, 1012, I like to use percentages. 1012 is 0.833 of the year. So 833, it means 10 divided by 12. I like to use this percentage or this decimal. Now what I do to find the weighted average accumulated expenditure, how much money that I really spent equivalent time-wise to figure out my interest on that money, and that amount is 375,000. What I did is I took the 450,000 and that 450,000 started to be spent on March 1st. Therefore, I have to figure out how much of that time was incurring interest to compute the interest for this project. It's 375,000. Now, June 1st, and be careful, June 1st, I spent 630,000. I'm going to do the same thing. I'm saying, okay, June 1st, let's go ahead and put the date. I spent 630,000. So June 1st, from June 1st, that's 712 of the year. 712, because I have all of June, July, August, September, October, November, and December. I compute the percentage. I like to compute the percentage. You're going to see why toward the end. I like to compute the percentage. That's 0.583 of a year. Well, and I need to compute the weighted average accumulated expenditure, and that amount is 367,500, which is 630,000. I did spend it. I did not spend it as of the beginning of the year. I spent it July, starting in June 1st, which is seven months of the year, equivalent to weighted average, it's 367. Now, July 1st, I also incurred 1.9 million. There's a lot of work done during the summer. Well, now this money will be prorated since I spent it half of the year. It will be prorated for 612 or 50%. 50%, it will be prorated for 50%. Now, again, I will take 1.9 million. I spent it July 1st, from July 1st, at the end of the year. That's half a year, times 1.5 will give me 950,000. Now, December 1st, I spent, notice here, December 1st, we spent 1.8 million, but that was the last month of the year. Last month of the year, 1.12 of the year, 1.12 of the year. I will compute the percentage for that. Compute the percentage, that's 0.083. Then, I have to basically find the weighted average accumulated expenditure, and that amount is 150,000. Now, I'm going to add them all up. Let me just put the decimal, make sure things make sense here. Okay, so I'm going to add up the weighted average accumulated expenditure, that's the total, and the total is 1,842,500. Okay? Now, I borrowed, remember, I borrowed $2 million specifically for this project. What I spent, my weighted average accumulated expenditure is $1,842,500. It means whatever I borrowed specifically was enough to finance my project, to finance my project. What does that mean? It means my avoidable interest, I'm going to take this amount times 10%, which is the amount I borrowed equal to 184,250, I call this my avoidable interest. Now, what does it mean my avoidable interest? My avoidable interest is the interest I could have avoided if I did not undertake this project. If I did not undertake this project, I would not have to borrow the money. And even though I borrowed the money, my average accumulated expenditure is $1,842,000. So, whatever I borrowed was good enough. Now, you might be saying, but look, you spent $4,780,000. I did spend this much, but I did not spend it as of the beginning of the year. I only compute my interest through the time, through time. So, when I started to incur the money, I'll have to prorate the amount of time I incur interest on that money for this project. Therefore, my avoidable interest is 184,250. Now, the rule for how much to capitalize, it's the lower of avoidable interest or actual interest. Well, we know avoidable interest will be lower because only the loan that I took out, the $2 million, it's going to have an interest of $200,000. That loan alone, the actual interest is more than the avoidable. Therefore, I capitalize the avoidable. Now, bear in mind, when you compute your actual interest, you have to compute the $2 million plus the $8 million plus the other $2 million. So, the actual interest incurred for this company is $1,160,000. It's way less than the avoidable, way more than the avoidable interest. Therefore, I capitalize the avoidable interest. Now, what's the entry? Let me show you the entry. So, what I do is this. Let's assume I paid all of this in cash. So, let's assume I paid all this interest in cash. It could be cash, it could be interest payable. But let's assume I paid it all in cash just for simplicity. So, I credit cash $1,160,000. This is how much cash I paid in interest. It doesn't have to be paid. It could be just incurred. I debit the warehouse $184,250, and I will debit interest expense for the difference, which I have to compute the difference now. So, the difference between how much interest I incurred minus how much I am going to capitalize, and that's $975,750. So, this will be the entry. In other words, I capitalized $184,250, which is I capitalized my avoidable interest, the lower avoidable and actual interest. Now, let's change the scenario a little bit because I want to make this a little bit more interesting. And rather than $450,000 and $630,000, what I incurred March and June, I'm going to change it to $900,720. So, I'm going to assume this is how much money I spent. So, if I do that, if I do that, my weighted average accumulated expenditure is $2,270,000, which is it used to be $1,840,000. Now, it's $2,270,000. What does that mean? Why did I do this? I do this to show you. Remember, I borrowed $2,000,000, I borrowed $2,000,000, but I spent more than $2,000,000. What does that mean? It means now to compute my avoidable interest. First, I used up my, I'm going to assume the first $2,000,000 of this $2,270,000, it's from the $2,000,000 I borrowed. Therefore, the avoidable interest part of the avoidable interest is $200,000. Now, look, I spend $270,000 more than $2,000,000. That $270,000, I will have to compute it. I have to compute the interest on that. Well, what do I do now? I have to compute my weighted average interest rate, my weighted average interest rate on other debt, and that's why I have those in yellow. So, I have my loan. This is the specific loan, which is I already used it up, used up the loan. Now, the remaining $270,000, I'm going to assume it's coming from those two loans, but which loan? I don't care which loan. I'm going to compute the weighted average interest. How do I compute the weighted average interest? I have interest of $800,000 plus $160,000. So, I have interest of $960,000, and I have loans total of $10,000,000 divided by $10,000,000. My average interest rate is $9.6%, and this is how I computed the $9.6%, which is the interest divided by the outstanding loan. Therefore, my avoidable interest now is the $2,000,000, the specific loan times $10%, and the remaining money, I assume I spend it evenly from the other debt, which has an average interest rate of $9.6%. Therefore, now my avoidable interest is $225,920. Again, my actual interest is still $1,160,000. That did not change. So, now my avoidable interest is this much. Therefore, under those circumstances, I'll have to change, I'll have to capitalize $225,920, and the difference between $1,160,000 and $225,920 is the interest expense that I'm going to expense. Now, there's one more thing here is interest revenue. What do you do with this interest revenue? This interest revenue simply put debit cash credit interest revenue. You cannot offset your interest revenue with your interest expense based on the United States generally accepted accounting principle. So, this is how you would solve an interest capitalization problem on the exam. You could see this as a simulation. You could see this as a multiple choice. You could only be asked to compute the weighted average. You might be asked to compute the weighted average interest on other debt. There's many things you could be asked to do here. You could be asked to compute the actual interest. This is easy. Just compute the actual interest, which is the total interest, or you could be asked to compute the avoidable interest, which is the avoidable interest will take a lot of computation because you need to compute the weighted average accumulated expenditure, then compute the avoidable interest. And sometimes to compute the avoidable interest, as you saw, you have to compute the weighted average interest rate as well. Interest capitalization is a topic that you need to be very familiar with, comfortable with, whether you face a multiple choice, a CPA exam simulation. What should you do now? Go to Farhad Lectures and look at additional resources that's going to help you understand this important topic. Good luck, study hard, and of course, stay safe.