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
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The key distinction is that buying enables the company to generate revenue right away whereas constructing the building means that no revenue will be earned during Year One. Assume, for example, that this building is expected to generate revenues for twenty years with no expected residual value and that the straight-method is used for depreciation purposes. Notice the difference in many of the reported figures. Store Bought on January 1, Year One—Revenues Generated Immediately Historical cost: $1 million Interest expense reported for Year One: $100,000 Interest expense reported for Year Two: $100,000. Depreciation expense reported for Year One: $50,000 ($1 million/20 years).
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