Accounting for capital projects involves determining which costs can be capitalized and which must be expensed. This guide provides an overview of accounting for capital projects, focusing on the capitalization of costs according to US GAAP. The core question revolves around identifying costs “necessarily incurred” to bring an asset to its intended use.
Property, plant, and equipment (PP&E) is recorded at its historical cost, which includes the cash or its equivalent paid to acquire the asset, adjusted for amortization, depreciation, or impairment. ASC 360-10 provides guidance on which costs to capitalize when acquiring PP&E.
ASC 360-10-30-1 states that the historical cost of acquiring an asset includes the costs necessarily incurred to bring it to the condition and location necessary for its intended use. These activities, defined in ASC 360-10-20, encompass the physical construction of the asset and all steps required to prepare it for its intended use. This includes administrative and technical activities during the preconstruction stage, such as developing plans or obtaining permits, and activities undertaken after construction begins to overcome unforeseen obstacles.
Distinguishing Capitalizable Costs
When determining which costs to capitalize for self-constructed assets, it’s crucial to distinguish between costs that are “necessarily incurred” and those that could have been avoided. Penalties or fines from mismanagement are not capitalizable, while costs relating to unforeseen obstacles like additional excavation or permitting likely qualify. Determining which costs are “necessarily incurred” requires judgment.
Generally, costs incurred for replacements or betterments of PP&E can be capitalized if they extend the asset’s life or increase its functionality. Otherwise, they should be expensed as incurred, such as repairs and maintenance (see PPE 1.4 for more details).
Capital costs can include labor, materials, transportation, engineering services, overhead, insurance, employee benefits, taxes, and interest. Expenditures that add to productive capacity or improve efficiency can also be considered capital items. Costs directly attributable to placing an asset into service should be capitalized, while those not necessary for readying the asset should be expensed as incurred.
ASC 970, Real Estate – General, provides incremental guidance on capitalizing costs for real estate developed for sale or rental. While explicitly excluding capital projects for a reporting entity’s own use, entities often apply ASC 970 by analogy when developing their overall capitalization policies. See PPE 1.7 for specific considerations for capital projects built for sale or rental.
Stages of Capital Project Cost Accounting
The unissued PPE SOP identifies four stages during which costs may be incurred: preliminary, pre-acquisition, construction, and in-service.
Preliminary Stage
During the preliminary stage, the project isn’t considered probable, and costs are expensed as incurred due to the uncertainty of future economic benefits. This stage begins at the project’s outset and lasts until acquisition or construction is considered probable, as defined in ASC 450, Contingencies. Probability assessment involves evaluating management authorization and commitment to funding, availability of financial resources, and the ability to meet regulations.
Activities in this stage include feasibility studies, asset selection, and obtaining options to acquire PP&E. Costs related to surveying, zoning, engineering studies, and obtaining management approval are also common. The assessment of project probability is key to the capitalization decision.
Accounting for costs during the preliminary stage aligns with ASC 720-15, Other Expenses, Start-up Costs, which states that such costs should be expensed as incurred. Financing costs are addressed by ASC 835, Interest.
Pre-Acquisition Stage
The pre-acquisition stage begins when construction is probable but before it starts. The unissued PPE SOP differentiates between directly identifiable costs and allocated or overhead costs. Directly identifiable costs are capitalized, while allocated and overhead costs are expensed.
ASC 970-340-25-3 states that costs incurred before property acquisition are capitalized if they are directly identifiable with the specific property, would be capitalized if the property were already acquired, and acquisition is probable.
Directly identifiable costs include incremental direct costs of pre-acquisition activities with independent third parties, payroll and benefit-related costs for employees directly involved, and payments to obtain an option to acquire PP&E. General and administrative costs and overhead costs are expensed as incurred.
If construction or acquisition is no longer probable, capitalized costs are assessed for impairment under ASC 360. A rebuttable presumption exists that the fair value of costs incurred before the acquisition or construction stage is zero.
Construction Stage
The construction stage begins when the entity obtains ownership or the right to use the PP&E. Costs are incurred to acquire, construct, or install the PP&E before it’s available for its intended use. Activities include planning for construction, constructing or installing PP&E, and supervising construction.
Similar to the pre-acquisition stage, directly identifiable costs are capitalized, including incremental direct costs and costs directly related to activities performed by the entity, and preproduction test runs.
Rent, depreciation, and occupancy costs are not directly identifiable and should be expensed. General and administrative and overhead costs should also be expensed. Directly identifiable costs should be distinguished from allocated or overhead costs.
Lease costs during a construction period for a company developing property for its own use should be recognized as lease expense. Depreciation costs directly related to the construction project, like equipment depreciation, are considered directly identifiable and should be capitalized.
ASC 970 provides specific guidance for real estate assets for sale or rental, where certain overhead and other costs may be capitalized.
Incremental costs that would have been avoided if the asset hadn’t been constructed shouldn’t be capitalized if they don’t contribute to bringing the asset into the necessary condition for operation.
Demolition costs are expensed unless incurred with an acquisition or lease of real estate where demolition is contemplated. Contributions to municipalities as a condition of obtaining a construction permit are expensed unless they are exchange transactions.
Costs incurred during the construction stage before the plant can operate are capitalized. The construction stage ends when assets are ready for their intended use, capable of producing a unit of product that is saleable or usable internally.
When the asset is ready for use, costs should no longer be capitalized, even if demand doesn’t support operating at normal capacity.
In-Service Stage
The in-service stage begins when the asset is substantially complete and ready for its intended use. Costs include repairs and maintenance, replacement of existing components, and purchase of additional components.
Costs to acquire additional components or replace existing components should be capitalized. Normal repairs and maintenance and other costs should be expensed. Costs that extend the asset’s service potential or replace significant components should be capitalized.
Costs to enhance productivity should be capitalized, while costs to change the asset from one intended use to another generally aren’t capitalized. Relocating in-service assets generally results in expensing dismantling, transporting, and reassembling costs.
Capitalization Thresholds
US GAAP doesn’t permit establishing a capitalization threshold, but many entities do so for ease of recordkeeping. The assumption is that the difference between capitalizing and depreciating or expensing such amounts immediately wouldn’t be material to the financial statements.
It’s important that the use of a threshold doesn’t have a material effect. Management should consider the amount and types of costs expected to be incurred to evaluate the impact. Materiality should be assessed on both a qualitative and quantitative basis.
Changes to the capitalization threshold should be applied prospectively. Assets capitalized under a previous threshold shouldn’t be adjusted.
Conclusion
Determining whether “Can Travel Be Capitalized” and other costs related to capital projects can be a complex process that requires careful consideration of accounting standards and professional judgment. This guide provides a comprehensive overview of the principles involved, but it is essential to consult with accounting professionals to ensure compliance with specific requirements and facts. Understanding these principles will enable businesses to make informed decisions about cost capitalization, ensuring accurate financial reporting and effective management of capital projects.
