Question

Xavier Company started construction of a warehouse building for its own use at an estimated cost of $6,000,000 on January 1, 2021, and completed the building on March 31, 2022. During the construction period, Xavier has the following debt obligations outstanding.

Construction loan of $2,000,000 - 12% interest, payable annually, issued December 31, 2020.

Long-term loan of 1,400,000 - 10% interest, payable annually, and principal payable at maturity on May 30, 2022

Long-term loan 2,000,000 - 11% interest, payable annually. Principal payable on January 1, 2024.

Total cost amounted to $6,200,000 and the weighted average of accumulated expenditures was $4,000,000 in 2021. Two additional expenditures of $200,000 each were made on January 2nd, 2022 and March 30th, 2022.

William Ross, the president of the company, has been shown the costs associated with this construction project and capitalized on the balance sheet. He is bothered by the “avoidable interest” included in the cost. He argues that, first, all the interest is unavoidable- no one lends money without expecting to be compensated for it. Second, why can’t the company use all the interest on all the loans when computing this avoidable interest? Finally, why can’t his company capitalize all the annual interest that accrued over the period of construction.

Required: You are the manager of accounting for this company. In a memo, explain what avoidable interest is, how you computed it (being especially careful to explain why you used the interest rates that you did), and why the company cannot capitalize all of its interest for the year. Attach a schedule supporting any computations that you use.