You are a financial analyst charged with evaluating the asset efficiency of companies in the airline industry. The financial statements for Air Canada include the following note:
U) INTEREST CAPITALIZED
Borrowing costs are expensed as incurred, except for interest attributable to the acquisition, construction, or production of an asset that necessarily takes a substantial period of time to get ready for its intended use, in which case they are capitalized as part of the cost of that asset. Capitalization of borrowing costs commences when expenditures for the asset and borrowing costs are being incurred and the activities to prepare the asset for its intended use are in progress. Borrowing costs are capitalized up to the date when the project is completed and the related asset is available for its intended use.
Required:
1. Assume that Air Canada followed this policy for a major construction project this year. What is the direction of the effect of Air Canada’s policy on the following? Use 1 for increase, 2 for decrease, and NE for no effect.
a. Cash flows
b. Fixed asset turnover ratio
2. Normally, how would your answer to (1 b) affect your evaluation of Air Canada’s effectiveness in utilizing property, plant, and equipment?
3. If the fixed asset turnover ratio changes because of interest capitalization, does this change indicate a real change in efficiency? Why or why not?