Why Cost related to Preferred Shares cannot be capitalised?

Question

Hi All,

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Question:

Q. On 1 January, a company that prepares its financial statements according to International Financial Reporting Standards (IFRS) arranged financing for the construction of a new plant. The company

borrowed NZ$5,000,000 at an interest rate of 8%,
 	issued NZ$5,000,000 of preferred shares with a cumulative dividend rate of 6%, and
 	temporarily invested NZ$2,000,000 of the loan proceeds during the first six months of construction and earned 7% on that amount.

The amount of financing costs to be capitalized to the cost of the plant in the first year is closest to:

NZ$400,000.
 	NZ$630,000.
 	NZ$330,000.

Solution
C is correct. The interest costs can be capitalized during the construction phase; however, under IFRS any amounts earned by temporarily investing the funds are deducted from the capitalized amount. The costs related to the preferred shares cannot be capitalized.

Capitalized Costs

NZ$

Interest costs
0.08 × 5,000,000
400,000

Minus interest income
0.07 × 2,000,000 × 0.5 year
−70,000

Total capitalized costs

330,000

A is incorrect because it fails to deduct the temporary interest earned (US GAAP): 400,000.

B is incorrect because it does deduct the temporary interest earned, but also capitalized the dividends.

330,000 + 0.06 × 5,000,000 = 330,000 + 300,000 = 630,000

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Thank you!

Zee Tan · Answer

A capitalized cost is an expense that is added to the cost basis of a fixed asset on a company's balance sheet. Capitalized costs are incurred when building or purchasing fixed assets - the new plant in the case of your question.

Preferred shares are not capitalized since they are not assigned specifically to the construction of the new plant, but is financing the company in general.