Question

   Langer Airline is converting from piston-type planes to jets. Delivery time for the jets is 3 years, during which substantial progress payments must be made. The multimillion-dollar cost of the planes cannot be financed from working capital; Langer must borrow funds for the payments.

Because of high interest rates and the large sum to be borrowed, management estimates that interest costs 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, Langer’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-year service life.

Instructions

Give your recommendation concerning the proper accounting for interest during the conversion period. Support your recommendation with reasons and suggested accounting treatment. (Disregard income tax implications.)

Answer 1

In the above case we should follow the principle of GAAP that capitalize actual cost during construction. We must capitalize actual cost during the constructuction period as interest on borrowing is similar to labour cost and material which is incurred during the conversion period. Under this approach, company may face higher cost of debt than that on raising equity as multimillion cost of the planes is to be financed. GAAP followsmthe concept that the historical cost of acquiring the asset includes all type of cost and interest of debt is a part of it which must not be ignored. As during the conversion period asset is not generating the revenue. Thus, we must capitalize the interest for that period. Langer Airline must report these interest as expense and match it with the revenue when asset is ready to use.

We will show the capitalized interest on the income statement as follows:

Income from operations		xxxx
other expenses and losses	xxxx
less: capitalized interest	xxx	xxxx
Income before taxes		xxxx
Income taxes		xxx
Net income		xxxx