Capitalization of Interest
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Zucker Airline is converting form piston type planes to jets. Delivery time for the jets is 3 years, during which substantial progress payments must be made. The multi million dollar cost of the planes cannot be financed from working capital. Zucker must borrow funds for the payments.
Because of high interest rates and the large sum to be borrowed, management estimates that interest cost in the second year of the period will be equal to one third of income before interest and taxes, and one half of such income in the third year.
After conversion, Zucker's passenger carrying capacity will be doubled with no increase in the number of planes, although the investment in planes would be substantially increased. The jet planes have a 7 years' service life.
Instructions:
1 - Give your recommendation concerning the proper accounting for interest during the conversion period. Support your recommendation with reason and suggested accounting treatment. (Disregard income tax implications.) Provide your recommendation.
2 - Respond to this post like discussion if you agree or disagree with this opinion.
The actual interest costs should be capitalized during the time that the jet is being constructed. Zucker Airline would capitalize the interest until the jet is ready to be used for its intended use. The reason would be because the jet is not generating any revenue until it is put into use. Once the jet is ready to be included in the everyday operations of the company, interest costs should be expensed to match the revenues that the jet would produce.
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This solution provides explanations for various questions regarding capitalization of interest.
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(1) Three approaches have been suggested to account for actual interest incurred in financing the construction or acquisition of property, plant, and equipment. One approach is to capitalize no interest during construction. Under this approach interest is considered a cost of financing and not a cost of construction. It is contended that if the company had used stock financing rather than debt financing, this expense would not have developed. The major arguments against this approach are that an implicit interest cost is associated with the use of cash regardless of the source.
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