 Hello, and welcome to the session in which we will discuss interest capitalization. What is the big idea for interest capitalization? Well, simply put, when you are constructing an asset, a building, a machinery, office complex, well, you're going to capitalize labor, material, and overhead. What does that mean? It means you're going to treat them as an asset as part of your basis. So when you incur those expenditure, they're not really expenses, they're part of the asset. The question is, how about interest? So should you expense that interest, or should you capitalize? What does that mean? Expense, it goes to the income statement. Capitalize, it means the expenditure goes on the balance sheet. And the answer, yes, you can expense interest under certain condition with slight modification, not all the interest, some interest. So what conditions are required to capitalize the interest? One is the asset that you are dealing with has to be considered a qualifying asset. Well, if you are doing the construction of an asset as a discrete project for sale lease, or for your own use, then this is considered a qualifying asset. So the asset itself, whatever you are doing has to be a qualifying asset. And these are the conditions. This does not include inventory, if you are producing inventory, or, or routine produced asset, you produce it on a regular basis, you cannot capitalize the interest. Then you have to know when does the capitalization period start? So when do you start to treat interest expense as an asset? Well, first interest has to be incurring, you have to have interest costs. It starts with when the expenditure made for the asset, and the construction or the activity is in progress. And this process ends, the capitalization process end, when the asset ready for its intended use, so you are done with building the asset. Now you no longer capitalize the asset. Any interest expense, I'm sorry, you no longer capitalize the interest expense. Any interest expense now is actually interest expense. Now this topic is covered in intermediate accounting as well as the CPA exam. Whether you are an accounting student or a CPA candidate, I strongly suggest you take a look at my website, farhatlectures.com. I don't replace your CPA review course. I'm a useful addition. I'm a supplemental material to your CPA review course. I explain the material differently, slower. I will show you the theory behind the concept than your CPA review course. Your risk is one month of subscription. Your potential gain is passing the exam. If not for anything, take a look at my website to find out how well or not well your university doing on the CPA exam. This is a list of all my college courses, which include lectures, lectures, and practice multiple choice questions. My CPA supplemental resources are aligned with your Becker, Wiley, Roger, and Gleam. So it's very easy to go back and forth between my material and your CPA review course. I have all the previously released AI CPA questions, almost 1,500 of them with detailed solution. If you haven't connected with me on LinkedIn, please do so. Take a look at my LinkedIn recommendation. Like this recording, share it with other connect with me on Instagram, Facebook, Twitter, and Reddit. So why do we capitalize interest and how much do we capitalize? It's based on the matching principle. And what's the matching principle? The expense, the cost, when the asset provide the service through depreciation. What does that mean? It means right now you are building an asset. So this is the building stage. When you are building the asset, you are not using the asset. So the asset is not in service yet. So any expenditure you include in this operation, it's considered an asset. Then in future period, when this asset started to service the business, in the year of service, this is where you start to expense it. So you expense it during the service years through depreciation expense. So how much to capitalize? Well, it's going to be the lower off your actual interest, how much interest you actually incurred, or the avoidable interest. Now, how do we compute the avoidable interest? Well, we're going to take an interest rate, some percentage, and multiplied by something called average accumulated expenditure, or for short, AAE. Now, what is AAE? AAE is the expenditure during the construction period that could have been avoided, that could have been avoided, if no construction took place. The assumption here is, you did not have to borrow money, if the construction is not undergoing, if the construction is not undergoing, you would not have to borrow any money. Therefore, you have to compute this AAE, which we would learn how to compute the AAE, multiplied by a certain interest rate. And this is going to give us the avoidable interest. So what is the avoidable interest is the interest that we could have avoided, if that project, if that asset was not being built. So we have to know how to compute this. So we have to know how to compute the AAE. So what is the AAE, average accumulated expenditure? It's the weighted average accumulated expenditure, which is way during the construction period. So we can compute this in two ways, either the weighted average, or we can use the simple average. I'm going to show you the weighted average, but the simple average is pretty straightforward, or the simple average of the expenditure was occurring equally throughout the period. Now, on the CPA exam in your classroom, make sure whether you are being asked to use the simple average or the weighted average. Okay, so let's just kind of walk through this so I can show you how the weighted average work. When you start construction, maybe at the beginning, you need to clear the land. So you started by clearing the land on January 1st, and you incurred $10,000. Then you had to dig the foundation on February 1st, you paid $5,000. Then you had to pour the concrete on March 1st, $15,000. Then you started the actual construction on April 1st, you paid $100,000. Then you started the framing, the painting, the electrician started their work, someone and so forth. So notice you are spending money, okay? And on each date, you know, when did you start that expenditure? So how do you compute the weighted average accumulated expenditure? Well, when we spend this $10,000, think of it this way. Think of it as on January 1st, we went to the bank and borrowed this money, and we spend it. How much did we borrow $10,000? Therefore, the money was outstanding for 12 months. Then the following $5,000, we went to the bank, we borrowed it, and I'm going to put borrowed in quote because we could have borrowed it earlier, but the point is this is where the interest start. On March 1st, we pour the concrete, same thing. Therefore, what we do is we take $10,000 times 12 over 12. Why? Because the $10,000 expenditure spent on land was outstanding for 12 months. The second $5,000 to dig the foundation, we took this money out February 1st. Therefore, we multiplied by 1112. The $15,000 was taken out March 1st. It will be $15,000 times 1012. The $100,000 was taken out on April. Therefore, it would be $100,000 times April, May, June, July, August, September, October, November, December, 912. So on and so forth. So for framing, for electrician. So the point is theoretically you borrowed the money when you actually started the spending. That's not true. This is theoretically. So this is when you start to compute the interest. So this is how you compute when you did all of those, then you will get your weighted average accumulated expenditure that's needed. And that's what's going to be multiplied by the interest rate, by the interest rate, which we will see which interest rate do we use now for using the simple average. It's pretty straightforward expenditure. We assume the expenditure was incurred spent evenly throughout the year. Okay, for let's assume for a total of 150. Therefore, our average accumulated expenditure is 150 divided by two. So if you are told on the problem, the expenditure was occurred evenly. That's easy. You will take the amount divided by two. And that's going to be your way or your average accumulated expenditure times the percentage versus you might have to do the computation. Let's take a look at an example to further illustrate this concept. Adam Company started construction on a building for its own use on January 1st, 20x5. We're going to assume this is a qualifying asset. Adam borrowed 300,000 at 10% for this project from Wells Fargo Bank. So this 300,000 we're going to call it. I'm going to call it here just kind of if you want to write this down just for a moment. Specific borrowing. What does that mean? It means you borrowed this money specifically for this project. Otherwise, you would not have to, if you did not undertake this, if you are not undertaking this project, you wouldn't have to borrow the money. Construction on the building started on January 1st, 20x5. And the following expenditure were made prior to the completion of the building. So this is what we did. We spent 150,000 January 1st. April 30th, we spent 250. November 1st, we spent 100,000. December 31st, we spent 80,000. Hold on a second. I borrowed 300,000. How come I'm saying I spent 580? Well, I borrowed this money for the project, but I also had other sources of money. That's not the only funds I have. So the next thing you have to do, you have to compute the weighted average accumulated expenditure, but we have to know, too, that you have other debt. Other debt, you have $400,000 bonds payable and you're paying 14% on it. It's a 10-year bond and you have another loan for $200,000 at 12%. So you do have other debt. This is where the money is coming from. It could be coming from that money as well because notice we spent 580. The point is you spent more money than the 300,000 at least total expenditure, but that doesn't mean anything. Why? Because we need to compute the weighted average accumulated expenditure. So how do we do this? Well, we're going to start the 150. We spent the 150 on January 1st. We're going to take 150 multiplied by 12 divided by 12 and we're going to come up with a weighted average accumulated expenditure of 150,000. The April 30th, be careful whether it's April 1st or April 30th. If it's April 30th, so it's only outstanding for May, June, July, August, September, October, November and December, it's outstanding for eight months. Be very careful whether it's April 1st or April 30th. So we take the 250 multiplied by 812 rounded 166,666. So simply put, think of it this way, on April 30th you went to the bank, theoretically you took that money out to spend it on the project because this is when your interest expense should start to count. On November 1st you took out 100,000 and you still have November and December 2 divided by 12 times 100,000 is 16,666. On December 31st you spent 100,000. There is no interest incurring because there is no time that took place. So all in all, all in all your weighted average accumulated expenditure is 333,332. So this is the weighted average accumulated expenditure. So this is the amount, this is the WAAE, sounds like a wrestling federation but yes, this is the weighted average accumulated expenditure. Once you find the weighted average accumulated expenditure, well you said I borrowed specifically, you remember when I talked about specifically, I borrowed specifically for this project 300,000. So let's go back here. So since I borrowed specifically 300,000, the first thing I'm going to do, I'm going to say well of this amount, the Wells Fargo amount, the 300,000 it's going to be applied toward that project. So first I'm going to use the 300,000 to I'm going to assume I used specifically this 300,000 to cover my weighted average accumulated expenditure. So what I'm left with is 33,332. So what I'm going to do next, I'm going to say since I spent this 300,000 from the Wells Fargo bank loan, I'm going to incur 10% interest and as a result I have 30,000 of interest expense and this could, this is considered avoidable. Why avoidable? Because if I did not undertake this project, I wouldn't have to borrow the money, I wouldn't have the interest expense. So now the remaining amount, how about the remaining, the 33,332. Well we have to find the average interest rate of other debt and I emphasize here other debt. So you have to find the average interest rate of other debt. You have two other debt, you have those two debt. Now we have to find the average rate. Well the loan, the 200,000 dollar loan is 12%. It's going to give you 24,000 dollar in interest expense. The 400,000 dollar loan is incurring 14% and that's 56,000. Together those two together will give us 80,000. So we have interest of 80,000 and we have loans of 600,000. 80,000 divided by 600,000. The average interest of other debt is 13.33. Now bear in mind it has to fall between these two and it should be closer, it should be closer to 14 because we have 400,000 at 14. The answer makes sense. So the remaining 33,332 will be multiplied by the average of other debt. So what we are saying is this. What we are saying is the amount that we used to cover the additional expenditure, the additional 33,332 is coming from the other debt. Now who knows where it's coming from. Maybe it's coming from our revenue but the assumption is since we cannot differentiate where it's coming from we assume it's coming from the other debt. That's also considered avoidable interest expense because if we did not undertake this project we wouldn't have this additional 33,332 of the weighted average accumulated expenditure. So now the total avoidable interest to that potentially could be capitalized is 34,343 which is what which is the 30,000 let me 30,000 here. Let me put it in a different color. Let me erase everything. So now we are computing the avoidable interest. So the avoidable interest is 30,000 here. Whoops go back. 30,000 and 4,443 so in total 34,443. Remember we have to choose between the avoidable interest and the actual interest. What's the actual interest? We already know the actual interest on the 2 debt is 80,000 right here on the 2 debt is 80,000 24 and 56, 24 and 56 plus we have a third debt they went from Wells Fargo at 10 percent that's an additional 30,000. So the actual interest was 110,000. Now we compare the 110,000 to the 34,443 and we capitalize the lower of the two. Hopefully you know the lower of the two is 34,443. Now this is called the specific method. How about if you are told use the average method. What is the average method? The average method simply put you have weighted average accumulated expenditure of 333,332 multiplied by the weighted average of all interests of all interests. Well what's the weighted average of all interests? Well let we can compute this real quick. We know those two loans it's 80,000 and 600,000 therefore 80,000 in the numerator 600,000 in the denominator then this is we already computed this then we do have another loan that for 300,000 for 300,000 and that loan incurred 10,000 of interest expense. So now what we do is we divide I'm sorry 30,000 not 10,000 30,000 of interest expense therefore now what we do is we'll divide 110,000 of interest cost divided by the total amount of loan 900,000 and this will give us 12.22 percent. So our average interest for all loans now all loans including the Wells Fargo Bank and the other two loans is 12.22 so if we're using the average method you will take 333,332 times 12.22 percent and this will be your avoidable interest and you'll compare your avoidable interest to your actual interest the avoidable is lower and you'll go with avoidable. Now what's the journal entry that you have to make? Well the journal entry is we're going to assume that you always debited interest expense as you are accounting for your interest expense so you have to do now you have to take out you have to back out you have to credit interest expense you have to remove from interest expense 34,443 and debit the building increase the asset and what we did is we reduced the expense and increased the building now 34,000 is part of our assets part of the building and this is what it looks like on the income statement let's assume we have income from operation 400,000 interest expense is 110 we computed this less the capitalized interest so we have to show on the face of the financial statement and in the notes this information so we told the users look we had interest expense total of 110 we subtracted out of it 34,443 what's left on the income statement is 75,567 gives us income before taxes then we deduct the taxes then we come up to net income to net income so this is the presentation now the best way to learn this is to work additional multiple choice questions additional exercises go to my website to do that this is what you want to do if you want to practice this at the end of this recording i'm going to remind you again to visit my website farhatlectures.com i don't replace your cpr view course nor your accounting course i'm a useful addition i can help you understand the material better the cpa exam is worth it study hard for your exam it's a lifetime investment you have to pass once do it get it done and move on