Question

Interest Cost during Construction and Various Accounting Topics" Please respond to the following:

Discuss the most challenging topics that you encountered within Chapters 8-11, and briefly summarize the manner in which you overcame such challenges. Suggest the primary ways in which the challenges that you identified could impact the financial statements if they are recorded incorrectly. Justify your response.

You are the construction accountant for an organization, and management is unsure of the manner in which it should record interest cost during the construction of a new building that will take five (5) years to complete. Compare and contrast the three (3) approaches to account for interest cost during the five-year period, and give your opinion of the method that you believe would result in the lowest net income over the first three (3) years. Ascertain the overall impact that interest cost has on the balance sheet.

Answer 1

As per IAS 23 Interest Cost directly related to an asset that takes a substantial period of time to get ready for its intended use or sale should be accounted as part of the cost of such an asset.

Here there are 2 aspects that need to be analysed in order to capitalize the interest cost. Firstly, does the asset take a substantial period of time to get ready? The answer is yes considering that the new building requires 5 years to be constructed.

Secondly, we need to analyse if the interest cost is directly attributable to the building.

We will analyse the 3 approaches for accounting interest cost based on this second aspect:

a. Borrowing cost is not attributable to asset:

If the borrowing cost is in no way related to the construction of the building then the entire expense needs to be expensed off. The would in-turn impact the finacial statements by reducing the companies net income by the amount of interest cost every year.

The value of the asset would not include any interest and as a result it would be lowest in this case.

b. Borrowig costs are partly attributable to the asset but cannot be identified:

In this case, we assume that a general borrowing is made for multiple projects, one of which is the interest cost. In this case, we would need compute the pro-rata interest related to the new building. This can be computed by using a capitalization rate on the total expenditure on the new building. The capitalization is a time weighted average borrowing costs on all the loans that the Company has had outstanding during the year.

In this case part of the borrowing costs are included in the cost of the asset. The remaining would be charged to expense and as a result net income woudl reduce by the amount of non-capitalized interest cost. Net Income as a result would be more than net income computed in option a

The value of the asset will be more than in case a, while a proporionate amount will be adjusted against equity due to the increased net income.

c. If the entire interest is directly attributable to the Building, the entire interest cost can be capitalized. In this case the Building Value would increase while the net income will also be the highest, since no interest will be charged to expense.

The value of the asset will be the highest in this case, and so will retained earnings due to the increased net income.

From the above analysis, it is clear that the company would need to charge the interest to expense as shown in Option a in order to have the lowest net income in the first three years. However, following this option would reduce the depreciation chargeable and as a result in future years(after Year 5) the depreciation expense would be lower than in case b and c where the value of the Building is higher. As a result net income in those years would be higher.