Merage Inc. needs a new school building and decides to build one in sunny southe
ID: 2575993 • Letter: M
Question
Merage Inc. needs a new school building and decides to build one in sunny southern California. The building will be quite elegant and will house state-of-the-art technology. As a consequence, Merage projects it will take two years to construct the building. To finance the project during construction, Merage borrows $2,000,000,000 at 2% interest from the Bank of California on January 1, 2012. It pays Irvine Construction Company $1,000,000,000 on January 1, 2012 to begin work on the building, $500,000,000 on December 31, 2012 as a progress payment, and $500,000,000 on December 31, 2013 when the building is completed. Merage invests all spare cash from the loan in marketable securities that yield 3%. How much interest should Merage capitalize as a result of these activities if Merage uses IFRS? How much interest should Merage capitalize as a result of these activities if Merage uses US GAAP?
Explanation / Answer
1. As per IFRS, any interest cost incurred specifically for the construction of a qualifying asset shoud be capitalized in the cost of that asset as reduced by any income incurred on invesment of spare amount.
Calculation of Interest Expense = $2,000,000,000 x 2% x 2 years = $80,000,000
Income on spare Amount = (1,000,000,000 x 3%) + (500,000,000 x 3%) = $45,000,000
NOTE: $1 billion & $500 Million is the spare amount after payment.
Interest expense to be capitalized = $35,000,000
2. Interest to be capitalized as per US GAAP
Under US GAAP, interest on borrowed funds is capitalised on the basis of expenditures made on the construction of the qualifying asset. Specific funds are capitalised on the interest expense of specific borrowing cost.
Interest Expense = (1,000,000,000 x 2% x 1 year) + [($1,000,000,000 + $500,000,000) x 2% 1 year]
= $20,000,000 + $30,000,000 = $50,000,000
Income on spare Amount = (1,000,000,000 x 3%) + (500,000,000 x 3%) = $45,000,000
Interest cost to be capitalized = $50,000,000 - 45,000,000 = $5,000,000