Financial Reporting

Question: A company is considering buying a building for $1.0 million on January 1, Year One so that a retail

store can be opened immediately. The company can borrow the money from a bank that requires payment of

$100,000 in interest (an assumed annual rate of 10 percent) at the end of each year starting with Year One. As

a second possibility, the company can borrow the same $1.0 million on the first day of the current year and use

it to build a similar store to be completed and opened on December 31. Again, $100,000 in interest (10 percent

annual rate) must be paid every year, starting at the end of Year One. In each case, the same amount of money

is expended to acquire this structure. If money is borrowed and a building constructed, is financial reporting the

same as if the money had been used to buy property suitable for immediate use?

Answer: A payment of $1 million is made in both cases for the building. However, the interest is handled

differently from an accounting perspective. If a building is purchased, the structure can be used immediately to

generate revenue. Payment of the $100,000 interest charge allows the company to open the store and start making

sales at the beginning of the year. The matching principle requires this cost to be reported as interest expense for

Year One. Expense is matched with the revenue it helps create.

In contrast, if company officials choose to construct the building, no revenue is generated during all of Year One.

Because of the decision to build rather than buy, revenues are postponed. Without any corresponding revenues,

expenses are not normally recognized. Choosing to build this structure means that the interest paid during Year

One is a normal and necessary cost to get the building ready to use. Thus, the $100,000 interest is capitalized

rather than expensed. It is reported as part of the building’s historical cost to be expensed over the useful life—as

depreciation—in the years when revenues are earned.