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Lesson 78
From: Joe
(a) – We had the most visitors in our history this past week and went over 15 million total page views on our website. Yeah!!! And a whole lot of the thanks go to everyone who helps to spread the word about www.CPAreviewforFREE.com.
(b) – Last spring, I made available a practice quiz for FAR of 20 new questions and answers so that you can look for your strengths and weaknesses. Take 30 – 40 minutes and see how you feel in an exam mode. The questions are on a variety of topics. If anyone is interested in receiving these, I’ll make those same 20 Q & A available for a few days. Drop me an email at Jhoyle@cpareviewforfree.com
(c) – Our new subscription service for FAR is up and running and doing great. We are currently putting the final touches on Regulation and hope to have it available in a week or two. For $15 per month or $30 for 3 months, you get online access that allows you to review 620+ slides covering all of the important information in FAR. This is not a quick cram—this is a legitimate program that marries our free questions with our 620 content slides.
--To gain access, go to www.CPAreviewforFREE.com. Click on “Store” at the top right of the home page, click on “here” under the “Essential Content,” log into your account (or register if you have not registered previously), and click on “Paid Content.” Then, purchase one month of online access for $15 or 3 months for $30.
--How does it work? Well, here’s an example. For land, buildings, and equipment, we have dozens of slides that explain all aspects of the financial accounting for these assets. Four of those slides are specifically about the capitalization of interest. To illustrate, here are those four. For this topic, this is exactly what I believe you need to know.
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Slide One:
Capitalization of Interest
Capitalization of interest cost is necessary during the period of time when fixed assets (and inventory specially built for a customer) are constructed. This interest is incurred prior to any revenues being generated so the matching principle requires that the expensing of the interest be delayed (by being added to the cost of the asset). Expensing eventually takes place through the depreciation process. Interest is only capitalized during the period of construction.
It is not the amount of interest paid that is capitalized. The amount capitalized is computed as:
Average accumulated expenditures X Interest rate X Period of construction
Slide Two:
If a building project has no accumulated expenditures on the first day of the year but work gradually increases the accumulated expenditures to $1.2 million by the last day of the year, a simple average of those accumulated expenditures is $600,000 ([-0- + $1,200,000]/2).
The interest rate to be used in this computation is the rate for any money specifically borrowed to finance the construction project. For example, if a company borrows $1.2 million at an annual rate of 5 percent to finance this building, then 5 percent is the applicable rate.
However, if no debt is incurred specifically for a construction project, the interest rate to be used is the weighted average rate of the company’s other debts. (Note that interest must be capitalized during construction even if no specific debt was incurred for the project.)
Slide Three:
Example. The Jones Company borrows $5 million on January 1, Year One to build a new warehouse. This debt has an annual interest rate of 8 percent. During Year One, $2 million is spent on this construction project evenly throughout the period. During Year Three, $3 million is spent on this construction project evenly throughout the period.
What is the capitalized cost of this warehouse on December 31, Year One? What is the capitalized cost of this warehouse on December 31, Year Two?
December 31, Year One: The accumulated expenditure total on this warehouse on the first day of the year was zero but had risen steadily to $2 million as of the last day of the year. The average accumulated expenditures for the period was $1,000,000 ([-0- + $2,000,000]/2). Since the annual interest rate was 8 percent, the capitalized interest was $80,000. That amount is removed from interest expense and reclassified as part of the cost of the warehouse which now has a reported cost to date of $2,080,000.
Slide Four:
December 31, Year Two: The accumulated expenditure total on this warehouse on the first day of the second year is $2,080,000 (see above). Another $3,000,000 is spent evenly over the year to arrive at $5,080,000. The average accumulated expenditures for Year Two is $3,580,000 ([$2,080,000 + $5,080,000]/2). The amount of interest to be capitalized is $3,580,000 X 8 percent or $286,400. This interest charge raises the capitalized cost from $5,080,000 by $286,400 to $5,366,400.
After the asset is completed and used in generating revenues, all further interest is expensed. In addition, at that time, the depreciation of the cost can begin so that these costs (interest and depreciation) are matched with revenues.
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Four slides and you should know enough to be able to pass the topic of capitalized interest. That is how you pass the CPA Exam; you learn to pass each topic—one at a time.
(1) – I have been reading a book (“Mao’s Last Dancer”) about a Chinese peasant boy who works incredibly hard and eventually becomes one of the top ballet dancers in the world. A lot of the book focuses on his early training when he moves quickly from extreme poverty to a national dance academy where he is pushed to learn ballet—something he does not even understand at first.
In the book, he talks about how difficult it is to learn each dance movement. He is shown a new step or a turn and his first reaction is “I cannot possibly do that. Someone else may be able to do it, but not me.”
And, sure enough, for the longest time, he cannot master the new move. He tries and fails, he tries and fails, and he tries and fails. However, what really sets this young man apart from the other dancers in the academy is that he keeps trying even though he continues to fail. The other dancers practice three times each day (in a building without air conditioning) but he practices six times each day (at times breaking into the studio at night so he can practice alone). The other dancers are satisfied with being okay; he wants to be great. His desire is as large as his talent. His desire may be more important than his talent.
So many times, after he has failed and failed and failed with a new dance movement, he’ll have a break-through and suddenly he can do it. It just happens—almost without warning. With enough practice, one day he can actually do what he had originally thought was impossible.
The word that I really like in that story is “break-through.” That is the way learning, especially when you are dealing with a very difficult topic, usually happens. Learning is just full of epiphanies. You miss the question, you miss the question, you miss the question and suddenly you have a break-through. Without warning, you see how the pieces fit together to form the correct answer. Once you catch on, the process frequently seems rather simple: “Why did I not see that before now—it is obvious how it works.”
But that is just the way learning often works—you have to miss and practice, miss and practice until eventually you’ll have your own personal break-through and you will find that you have mastered the concept. That is a wonderful feeling. In learning, there is little that feels better than that quiet pause followed by “Oh, I see it now.”
In learning, too many people give up too quickly. They never reach the “break-through” point. The work is too hard or the failure is too devastating. They don’t have enough confidence to keep pushing or they don’t want success badly enough. They walk away saying “I just cannot do this.”
Here’s what I want you to know: Those frustrations are normal; they are no reason to quit. Failure is a natural part of getting to success. Yeah, it is tough to miss questions but that is just the way the learning process works. If you keep plugging, if you keep pushing yourself, you will have a break-through and suddenly you’ll say “Oh, I see it now.” And, that is going to feel great.
(2) – As always, I want to remind you that you can always unsubscribe from these email lessons at any point in time. We love having you with us but we don’t want you to stay one minute longer than you wish. To unsubscribe, scroll to the bottom of this lesson (or any lesson) and click on the unsubscribe button.
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(3) – Practice (and if you had not anticipated the first question, you have not been getting these lessons for very long).
FAR
The Mills Company can buy a retail store for $1 million on January 1, Year One and start selling inventory immediately. However, company officials decide to build a store instead so they can get everything exactly as they want. They borrow $1 million on that date and spend the money evenly over the year and the store is completed on December 31, Year One. They start making sales the next day. The building has a 10-year life and no salvage value and straight-line depreciation is used. Which of the following statements is not true?
A – No depreciation expense will be recognized in Year One.
B – Interest expense of $35,000 is reported on the company’s income statement in Year One.
C – On the 12/31/1 balance sheet, the building is reported at $1,070,000.
D – Depreciation expense for Year Two is $103,500.
Answer is C
Interest paid for this first year is $70,000 ($1,000,000 X 7%). Because the building is constructed, a part of that interest is capitalized. The average accumulated expenditure figure for that period is $500,000 which is (0 + 1,000,000)/2. The interest rate is 7 percent so $35,000 is capitalized ($500,000 x 7 percent). That amount is moved from interest expense to the building account. Interest expense is dropped from $70,000 to $35,000 and the cost of the building is raised from $1,000,000 to $1,035,000. No revenues are earned in Year One so no depreciation expense is recognized. Depreciation for Year Two is $1,035,000/10 years or $103,500.
Regulation
Wilson owns stock in two companies. Each investment cost $10,000. Both investments drop in value to $9,000. At that point, he gives one investment to Adam and the other investment to Sara. Adam’s investment goes up in value to $10,400 and he sells it. Sara’s investment goes down in value to $8,500 and she sells it. What are the tax effects created by these sales?
A. Adam has a $400 taxable gain and Sara has a $1,500 taxable loss.
B. Adam has a $1,400 taxable gain and Sara has a $500 taxable loss.
C. Adam has a $400 taxable gain and Sara has a $500 taxable loss.
D. Adam has a $1,400 taxable gain and Sara has a $1,500 taxable loss.
Answer is C
Adam has a gain and Sara has a loss. If property is received as a gift, a gain on the eventual sale is determined by comparing the amount received to the previous owner’s basis. Adam’s gain is $10,400 less $10,000 or $400. If property is received as a gift, a loss on the eventual sale is determined by comparing the amount received to the lower of the previous owner’s basis or the fair value at the date of gift. Fair value of $9,000 was lower than the previous basis of $10,000 so $9,000 is used. Sara’s loss is $9,000 less $8,500 or $500.
Auditing
An auditor finds a journal entry where a company records the acquisition of a machine for $7,000 cash. The auditor then searches for the related source documents—original documents on which the acquisition was initially recorded (such as a purchase requisition, receiving report, and vendor invoice). Which of the following assertions is the auditor most likely seeking evidence to substantiate?
A – Allocation
B – Presentation
C – Existence
D – Completeness
Answer is C
When an auditor starts at the end of the accounting process where the recording has been made and then moves backwards toward the beginning of the system to find relevant source documents, the auditor is usually trying to substantiate proof of the existence of the transaction. Here, the company is reporting a machine but did they really buy a machine, is there adequate proof that the reported account does exist. (Completeness is usually substantiated by starting at the beginning of the process with the source documents and then following the information through the system to ensure that nothing got lost along the way.)
BEC
Henri Corporation produces product XC7. They plan to hire workers for $18.00 per hour and produce 8,000 units of XC7. Each unit should take four hours of labor to produce. In actual practice, Henri produces 9,000 units of XC7 but it takes the workers 35,000 hours at a total labor cost of $683,000. What is the labor rate variance for this period?
A. $35,000 unfavorable
B. $53,000 unfavorable
C. $18,000 favorable
D. $19,514 favorable
Answer is B
The company paid $683,000 for 35,000 hours of labor. At the standard rate of $18.00 per hour, the company should only have paid $630,000. The company paid $53,000 more for those hours than the standard. That is the labor rate variance and it is unfavorable because they paid more than anticipated.
Keep working – you will get there.
Joe Hoyle
President
CPA Review for FREE
www.CPAreviewforFREE.com
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