 Hello and welcome to this session. This is Professor Farhad in which we would look at CPA questions and simulations that deals with a topic that gives students a lot of issues and that's interest capitalization. This topic is covered on the far section of the CPA exam and cover an intermediate accounting. What I do, what I offer you, farhadlectures.com is detailed explanation about this topic on my website farhadlectures.com. You will have additional resources to understand, to comprehend this topic in contrast to a CPA prep company. If you have Becker, Roger, Wiley, Gleim, that's fine. You can keep them. Those are excellent resources for your preparation. However, they don't go in depth the way I do when I explain the material. So as always, I'm going to remind you to connect with me on LinkedIn. If you haven't done so, YouTube is where you would need to subscribe. I have 1800 plus accounting, auditing, tax, finance, as well as Excel tutorial. Please like and share my recording. However, on my website farhadlectures.com, you will have additional resources to understand this topic. So when I present this topic, it's part of my intermediate to accounting as well as part of my CPA courses, CPA exam courses. I cover this topic in details. So I cover it as if you never saw it before in contrast to a CPA prep company. My subscription is pretty nominal. It's going to help you tremendously understand the material so you could use your CPA course much, much more efficient to pass the exam. We're going to look at two multiple choice then assimilation. Let's start with the first multiple choice question. If more company capitalized the maximum amount of interest allowable under gap, how much will mark report as interest expense? So the first thing here you have to be careful is they're asking about interest expense, not the capitalized amount. They're going to tell you if they capitalize how much they will have an interest expense. Let's take a look at this question. During 20X1, more company manufactured equipment for its own use a total cost of 2.4 million. The total project required the entire year to complete at all costs were incurred uniformly throughout the year. At the beginning of the period, more was able to borrow 1.5 million at 6% specifically. This is an important word for the purchase of material and manufactured equipment. So they borrowed specifically for the project 1.5 million. This is called specific borrowing. And this is important to know how much we borrowed for the project because we're going to need this information later. The total cost was 2.4 million and they told us it was spent equally throughout the year. So we could just find the average and find out what's our weighted average accumulated expenditure. That's an important number. The entire debt with interest was repaid on December 31st replaced with a long term loan. That's fine. That's what they did throughout 20X1. Our company had additional debt of a million with the weighted average interest rate of 7%. Sorry. They gave you the weighted average interest. Sometimes you have to compute that. That's fine. So simply put, how much are we going to expense? So you have to be very careful here. So what do we have to do? First, we have to find out how much interest do we have? How much our interest cost? What's our total interest cost? Let's start with that. Okay. We borrowed 1.5 million. Let's start with kind of make this easy. Just find the total interest cost first. The reason I'm doing this is just for explanatory purposes. So we borrowed 1.5 million. That's the specific borrowing times 6%. And we had a million at 7%. So this is going to give us $70,000 of interest expense. And this is going to give us $60,000, $60,000 plus $30,000. That's going to give us $90,000 if my math is right. It should be $60,000. Yeah. Plus, okay. So the total interest expense is $160,000. And notice one of the answers is $160,000. They're not asking you about the interest expense. They are, but you have to be very careful. Part of that interest expense was capitalized. So part of it will not be expense. Part of it will be added to the manufacturing equipment. Now I'm kind of going backward because the question is asked, the question is about interest expense. I want to make sure you understand the big picture. Interest expense, $160,000. How much of that interest expense is capitalized? So part of it could be all of it, could be some of it. I know it's not going to be all of it, but some of it will not be interest expense. It's going to be capitalized. How much of that will be capitalized? Well, you have to find out something called the weighted average accumulated expenditure. Simply put, we have to compute how much money was spent on the project that was consuming interest. Well, we spent on the project 2.4 million, but we did not spend the January 1st. We spend it equally throughout the year. So if we spend it equally throughout the year, we'll take 2.4 million, and we're going to divide this since it's throughout the year, divided by two on average, two. So we spend our weighted average accumulated expenditure is 1.2 million. Now don't worry, we're going to compute this again in another problem, the weighted average accumulated expenditure. But just simply put, you did not spend the whole thing all at once. You spend it throughout the year. And you spend it equally. So you could divide by two. So this is what's called the weighted average accumulated expenditure. Now we're going to take this amount and we're going to see that this amount, this amount that we, what we are going to apply the interest capitalization against. Now notice, we spent or we could have avoided 1.2 million of expenditure, but we borrowed for the project 1.5 million. So the specific borrowing, remember I told you the specific borrowing by itself without going using other money, covered the project. Therefore 1.2 million times 6%, it's going to have a 60,000, that's going to give us 72,000. Well guess what? 72,000 is the amount that we are going to capitalize. Why? It's the weighted average accumulated expenditure. Again, we're going to look at a more detailed computation of this times the specific borrowing. So simply put, we said this project costs us on average 1.2 million. And guess what? The borrowing that we made for this project is good enough to cover this expense. Therefore, we multiply it by 6, and it's going to give us 72,000. Now let's answer the question. So of the total interest expense, of the total interest expense that we incurred, 160,000, of the total interest expense, 160,000, 72,000 was capitalized. What's left is 88,000, that's expense. And this is the answer, 88,000. Now let's go a step further and journalize the entry. So how would we journalize the entry? Assuming we paid all the interest in cash, we're going to credit cash 160. We're going to debit interest expense 88,000 and we're going to debit equipment, manufacturing equipment. We're going to credit equipment. So we add it to the equipment, 72,000 of interest expense computed as the weighted average accumulated expenditure times the specific borrowing. We did not have to use any money from the 7% from the additional borrowing because what we borrowed specifically for the project was enough to cover our expenditure. So the answer is 88,000. Be careful because of the answer how much was capitalized, the answer would have been 72,000. If the question is what's the total interest expense, the answer is 160,000. So be careful of what you are being asked in these problems. Let's take a look at another problem that deals with the same topic. What amount should James report as capitalized interest? Now I'm asking you for the capitalized interest. Okay. On January 1st, James signed a contract to have MCL construct a major plant facility costing half a million. It was estimated that it will take two years to complete the project. In addition, James financed the construction cost by borrowing 5 million. This is the specific borrowing. So they borrowed 5 million for the project and the interest rate of 9%. During the year, James made deposit and progress payment totaling 2 million under the contract. The average amount of accumulated expenditure, they gave us this answer 750. In the prior problem, we took 2.4 million and they said it's spread evenly. We divided by two. We came up with 1.2 million here. It's giving the next problem. We're going to have to compute it. The access borrowed fund were invested in short-term securities James realized 300,000. So what's the amount that James report as capitalized interest? Well, if I'm giving the weighted average accumulated expenditure 750 and I borrowed half a million, what I borrowed is plenty to cover the project and it's going to be times 9%. And the answer will be 67,500. That's the amount that we are going to capitalized. Now, if we are being asked, what's the interest expense? Well, simply interest expense, if you just want to know what's the total interest expense, we borrowed 5 million at 9%. We deposit totaling 2 million. It doesn't matter. So if we borrowed 5 million and we multiplied by 9%, we'll find out what's the total interest expense. Then we subtract 67,500 from it for the capitalized interest. We don't net. If we received interest revenue, be careful under GAP, under US GAP. Notice we received 300,000 of interest revenue. The interest revenue, we don't net. No netting against interest expense. So interest revenue is not netted against interest expense. Now, let's take a look at this question. So this question would require us, this is basically quasi, not outside assimilation or quasi-simulation. Let's take a look at it in an Excel sheet this way we can look at it and start to answer the questions for this problem. So this is the problem. On December 31, 2019, Bumble company borrowed 4.2 million at 12%. Remember, this is called the specific borrowing payable annually to finance the construction of a new building. In 2020, the company made the following expenditure related to this building. On March 1, they spent 511,200. June 1, they spent 852. July 1, 2,130,000. And December 1, they spent 2,130,000. The building was completed on February 21. Other that, now they have other that, other than this borrowing, other the specific borrowing. They have a 10-year, 13% bond interest payable annually 5,680. Six-year, 10% bond interest payable annually 2,272,000. On March 1, the expenditure included 213,000 of the land cost. Interest revenue earned in 2020, $69,580. Really, when they give you the interest revenue, be careful. Interest revenue is just, it's a way to trick you. It's a way to trick you to make you think you're going to need it for anything. For USGAP interest revenue, you debit cash credit interest revenue, it doesn't go into the computation of capitalizing interest. It's a trick. And they throw it out there to see if you're going to slip on it. So be careful. Under USGAP, you don't have to do that. Now let's go ahead and start to compute the weighted average accumulated expenditure. So the first thing you do is you compute this number, the weighted average accumulated expenditure. And how do you do that? Well, we're going to have to take the amount that we spent and prorated throughout the year. Well, March 1, we spent $511,200. And this is where the interest will start to incur. If you don't spend the money, there is no interest incurring. The amount is 512,200,000. The capitalization period. So if you spend it in March, it's going to incur interest. All of March, April, May, June, July, August, September, October, November, December, it's going to incur interest for 1012. The weighted average accumulated expenditure is $511,200 times 1012. You spent June 1, you spent additional amount of money. And that's $852,000. Be careful. If you spend the June 1, the amount is 712. You have seven months from June 1. Then you multiply the amount, 852 times 712. Now, you spent some money July 1. Now, the reason June and July are giving is to confuse you. Don't put June 1, 6 months. If you spend it in July, that's half a year. And that's the amount of $1,065 on December 1. You spent the same amount, $2,130,000. And that amount will incur interest for one month. Now, we computed the kind of the most, in my opinion, the most challenging number. And that's the weighted average accumulated expenditure, which is $2,165,500. Why is this number important? Why is this number important? This number is important because this is going to give you. So if you take this amount, which is $2,165,500, this is the amount that you, on average, spent on this project. And you multiply it by the amount that you borrowed. Now, you borrowed $4.2 million and $60,000. You borrowed plenty of money to cover the weighted average accumulated expenditure. If we take this number, multiply it by 12%. Why 12%? Because this is how much we borrowed for the project. And once again, it's plenty of money. That's going to give us something called the avoidable interest. And that's a very important number, 259,860. Again, the technical word for this, they could ask you about this. What is the avoidable interest? And what is the avoidable interest? It's the interest that you could have avoided if you never undertook this project. So simply put, if you did not undertake this project, you wouldn't have to borrow this money. You wouldn't have to spend this money. Therefore, you could avoid it in interest $259,860. This is called avoidable interest. The interest that you could have avoided in theory if you did not undertake this project. So it's this number times 12%, 2,165,500 times 12%. Now, how much of interest are you going to capitalize? Well, you're going to capitalize the lower of avoidable interest or actual interest. Now, we already know the actual interest is higher. Because look, if we compute 4,260,000 times 12%, only the borrowing from this loan is more than 259,860. So you already answered the first question. You're going to capitalize 259,860. But let's go ahead and compute the actual interest because I want to make sure you're comfortable with computing the actual interest. You had 4.2 million, 60,000 at 12%. Another loan, 5,680 at this one at 13%. And you had a loan 2,272 at 10%. Now, basically, you compute all of your interest expense. And what you do is, again, you would compare the actual interest. This is the actual interest. This is how much you're going to pay an actual interest. You compare this to avoidable. And the lower of the two is what gets capitalized. I already told you. I already know the answer because only from this loan you incurred interest more than the avoidable interest. So you should know this right away. So on the exam, if they ask you, what is the capitalized interest, and you find out it's 259,860, the avoidable, don't compute the actual interest. It should be higher. Therefore, that's not the number that you need. Now, let's prepare the journal entry. The journal entry will be debit interest expense, debit the asset, whatever asset we are putting on the books, and credit cash. Simply put, we're going to credit cash. The amount that we spent, which is 1,476,800, we're going to debit the building. It's 259,860. This is how much we're going to capitalize and the difference. So we paid that much cash and we capitalized 259. We capitalized, let me see, C. So it's this amount minus C25, minus C25. And that's going to give us 1,216,940. That's the interest expense. So to prepare the journal entry, this will be the journal entry. So part of the cash will go toward the building and some of it toward the interest expense. Now, as always, I'm going to ask you to like this recording, share it, put it in playlist. Once again, on farhatlectures.com, you will find additional resources to complement and supplement your accounting courses, your CPA preparation. On my website, you will have much, much more detailed explanation about the topic as if you never looked at it before. If you're studying for your CPA exam, don't short change yourself. My subscription is nominal. The CPA exam is a lifetime investment. Take it seriously, study hard and good luck.