FSA - Capitalization of Interest

The argument for interest capitalization is that a self-constructed asset should cost the same as a purchased asset, which will include vendor interest costs. However, interest capitalization, the result of a financing decision, is allowed only for leveraged companies. A leveraged company and a debt-free company, each constructing an identical asset, will record a different asset cost. Which of the following statements concerning accounting for capitalized interest costs is least accurate? a. Total assets will be lower in the initial period for a debt-free company. b. A leveraged company will record higher net income in the initial period. c. The interest coverage ratio of a leveraged company will be higher during the initial period. d. A company capitalizing interest will have a higher asset turnover ratio going forward. D is the correct answer, and I agree that this statement is not accurate, however I believe that B would also work here. If we are comparing a leveraged company with a debt-free company, neither will record an interest expense (debt-free company will finance with equity), therefore net income will should be the same.

The question asks , “Which of the following statements concerning accounting for capitalized interest costs is least accurate” I think letter B is not correct (meaning it is accurate) because if you compare a leveraged company only to itself it will have a higher net income in the period of capitalization because interest expense will be reduced. The way the question is worded it makes you want to compare / contrast levered versus non levered company in which case I see your point that B is also not accurate and I would think result in lower net income for levered firm (higher depreciation as a result of higher assets) than a debt-free firm. Again, wording is tricky here.

A - Correct, as capitalizing interest creates a prepaid asset, which adds to the assets of a levered company. B - True since you’re in essence amortizing interest at a moderated pace over time (in the beginning you’re payments generate a prepaid asset, so no expenses are recorded) C - B and C go in tandem–higher net income resulting from lower interest expense would also result in higher interest coverage because of that lower interest expense. D - TAT is by definition Revenue / Avg Total Assets. Avg Total Assets–and not revenue–is affected by capitalization. A greater denominator results in lower turnover. Hence D is least accurate. The key is to answer the actual question. In fact, you could answer the question by just reading the last sentence. Every thing else is ancillary.