Accounting, Financial, Taxation

Project costs are defined as “costs clearly associated with the acquisition, development, and construction of a real estate project”. In certain real estate projects, land is developed and structures are being built or refurbished. In addition to the costs of acquiring land, development and construction costs are incurred to complete the project. Other real estate projects involve property acquisition only, such as the acquisition of shopping centers that are already in operation.

Paragraph 7 of Statement 67 states the general concept for the accounting for project costs:

Project costs clearly associated with the acquisition, development, and construction of a real estate project shall be capitalized as a cost of that project. While this concept may appear straightforward, determining which costs are clearly associated with a real estate project can require significant judgment.

Direct Costs

Direct project costs are incremental costs that are directly related to the acquisition, development, and construction of the property. They may include the same types of costs as pre-acquisition costs, because certain activities can be performed before or after the acquisition. In addition to the types of costs, project costs typically include:

1. Purchase price
2. Commissions due to third parties
3. Brokerage fees due to third parties
4. Fees for title guarantee and title searches
5. Recording fees
6. Property taxes incurred during construction
7. Insurance costs incurred during construction
8. Environmental remediation costs
9. Demolition costs
10. Construction costs (materials, labor)
11. Costs of amenities
12. Donated land

All costs incurred need to be carefully evaluated to determine whether they qualify for capitalization. For example, the costs of real estate donated to governmental agencies that benefit a certain project are part of that project’s costs.

However, if donated land does not benefit (and was not made in conjunction with) a real estate project, the costs should be expensed, rather than capitalized. Similarly, demolition costs incurred within a reasonable period after the acquisition of property are generally capitalized when they are incurred, if demolition is probable at the time of acquisition. Industry practice is diverse with respect to the capitalization of demolition costs that are not incurred within a reasonable period after acquisition. The proposed SOP, if it had been issued in final form as proposed, would have required that demolition costs not incurred within a reasonable period of time after acquisition be expensed. Questions also arise with respect to the capitalization of environmental remediation costs. While environmental remediation costs incurred within a reasonable period of time after the acquisition of property are generally capitalized as part of the project costs, determining whether environmental remediation costs incurred at a later point in time are capitalizable
is more complex and involves significant judgment.

Indirect Costs

Indirect project costs are capitalized to the extent they clearly relate to the acquisition, development, or construction of a real estate project. The following are examples of indirect internal project costs:

1. Costs of planning department
2. Costs of construction administration (for example, the costs associated with a field office at a project site)
3. Internal costs incurred for cost accounting or project design
4. Depreciation of machinery and equipment used directly in construction
5. Payroll costs and employee benefi ts for employees working on the project

For internally incurred indirect costs to be capitalizable, a cost accounting system needs to be in place and adequate documentation needs to be maintained to support cost capitalization. For example: time may be recorded by the in – house designers to determine the percentage of their salaries to be allocated to a certain project. Indirect costs for which sufficient support cannot be provided, or that do not clearly relate to a project under development or construction, including general and administrative expenses, are expensed as incurred.

Statement 67 does not provide any further guidance on how to determine what costs are clearly associated with the acquisition, development, and construction of a real estate project. As a result, considerable diversity in practice exists with respect to the types of indirect project costs that are capitalized.

The proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment , limits the capitalization of indirect costs to:

1. Costs that are directly identifiable with the specific property
2. Costs incurred for property taxes and insurance for the portion of the property under construction
3. Demolition costs incurred in conjunction with the acquisition of PP & E, if demolition is probable at the time of acquisition and is expected to occur within a reasonable period after acquisition.

The proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment , provides that the capitalization of directly identifable indirect project costs should be limited to:

1. Incremental direct costs of acquiring, constructing, or installing the property
2. Payroll and payroll benefit – related costs of employees who devote time to the project
3. Depreciation of machinery and equipment used in construction or installation
4. The cost of inventory used in construction or installation

The proposed SOP does not provide for the capitalization of other indirect costs, such as occupancy costs (including rent, depreciation, and other costs associated with facilities); these costs should be charged to expense as incurred.

While the proposed SOP may prove helpful in interpreting Statement, one has to keep in mind that the FASB has not cleared that proposed SOP, and therefore, it is low - level GAAP.

General and Administrative Expenses

FASB Statement No. 67 provides that:

indirect costs that do not clearly relate to projects under development or construction, including general and administrative expenses . . . be charged to expense as incurred ” 30 without providing further guidance as to which expenses should be considered general and administrative expenses. The proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment , is more specific: “ All costs (including payroll and payroll benefit related costs) of executive management, corporate accounting, acquisitions, office management and administration, marketing, human resources, and similar costs and functions should be charged to expense as incurred.

Property Taxes and Insurance

Property taxes, insurance, and interest are commonly referred to as holding costs. Taxes and insurance are capitalized as part of the property ’ s cost during the period in which activities necessary to get the property ready for its intended use are in progress. The capitalization period for property taxes and insurance (beginning, end, and suspension) coincides with the capitalization period for interest set forth in FASB Statement No. 34, Capitalization of Interest Cost. After the real estate property is ready for its intended use, property taxes and insurance are charged to expense as incurred. Special considerations are necessary when development activities occur only on a portion of a real estate property. For example: a company may own a 50 - acre parcel of land and is constructing a building on 5 of these 50 acres. The capitalization of property taxes and insurance would only be appropriate for interest and taxes relating to the fi ve acres under construction.

Insurance and taxes are capitalized during the construction period irrespective of whether the real estate is newly acquired or whether it has been used subsequent to its acquisition, with construction activities starting at a later point in time. For example: a hotel building may be redeveloped (refurbished) after it has been operating for many years. The proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment, uses the “ voidable cost concept” to determine whether property taxes and insurance should be capitalized. If the property has been used in the past as an operating asset, but is removed from operations for purposes of construction, property taxes and insurance are avoidable costs of construction, even though they are not incremental to the entity, since the entity could avoid the property taxes and insurance by choosing to dispose of the property.

However, for properties under construction that remain in operation while construction takes place, the proposed SOP suggests that costs incurred for property taxes and insurance should be capitalized only if they are incremental and directly attributable to the construction activities.

Interest

Undertaking real estate projects requires significant capital, and financing cost is a major cost factor. If real estate is acquired that is not ready for its intended use, interest expense incurred during the development and construction period is part of a project ’ s costs that is capitalized. FASB believes that through interest capitalization, a measure of acquisition cost is obtained that reflects the company ’ s investment in the real estate asset. Accordingly, interest capitalization is not discontinued when a real estate project is impaired; any write - down is increased by interest expected to be capitalized in future accounting periods.

There may be a period of time in which a company generates interest income from the investment of unused funds on project fi nancing obtained. Generally, such interest income is recognized as income when earned. It is not offset against interest cost when determining the amount of interest cost to be capitalized, except in the case of certain tax - exempt borrowings.

The determination of the amount of interest to be capitalized in a real estate project is a four - step process:

Step 1. Determine Whether The Real Estate Project Qualifies For Interest Capitalization

The following assets qualify for interest capitalization:

1. Assets that are constructed or otherwise produced for a company ’s own use
2. Assets intended for sale or lease that are constructed or otherwise produced as discrete projects, such as real estate developments.

Additionally, investments in equity method investees may be qualifying assets.

FASB Statement No. 34, Capitalization of Interest Cost, precludes interest capitalization for certain types of assets, including (1) assets that are in use or ready for their intended use, and (2) assets that, although not in use, are not undergoing activities to get them ready for their use.

Land that is not undergoing activities necessary to get it ready for its intended use is not an asset qualifying for interest capitalization. Once activities are undertaken for the purpose of developing land for a particular use, the acquisition and development expenditures qualify for interest capitalization while those activities are in progress. If a structure is built on the land, such as a plant or an office building, interest capitalized on the land expenditures is part of the cost of the structure. If a tract of land is developed and subdivided to be sold as developed lots, interest capitalized on the land expenditures becomes part of the cost of the land.

Step 2. Determine The Types Of Expenditures That Qualify For Interest Capitalization

After it has been determined that a project qualifi es for interest capitalization, the expenditures incurred for that project have to be evaluated to determine whether they qualify for interest capitalization. As a general rule, expenditures that do not require the transfer of cash or other assets or the incurrence of liabilities on which interest is accrued do not qualify for interest capitalization. As such, capitalized amounts financed through trade payables, retainages, or progress payment collections from customers may lead to differences between capitalized project costs and the amount of expenditures that qualify for interest capitalization. Paragraph of FASB Statement No. 34 provides, however, that capitalized expenditures for an asset may be used as a reasonable approximation of expenditures on which interest is capitalized, unless the difference is material.

Step 3. Determine The Capitalization Period

Interest is capitalized when the following three conditions are present: Expenditures for the asset (that qualify for interest capitalization) have been made.

Activities that are necessary to get the asset ready for its intended use are in progress.

Interest cost is being incurred.

The term “activities that are necessary to get the asset ready for its intended use” is interpreted broadly in practice. Such activities include administrative and technical activities before ground is broken, such as the development of plans or the process of obtaining permits from governmental authorities. If a company suspends substantially all activities related to the development of the property, the company has to evaluate the reason and duration of the suspension and determine whether interest capitalization during such period of suspension is appropriate.

An interruption that is brief or inherent in the asset development process, such as labor strikes or weather conditions, would not lead to a cessation of interest capitalization, whereas a company - induced suspension in construction activities due to a decline in the real estate market would preclude interest capitalization.

The capitalization period ends when the asset is substantially complete and ready for its intended use. By requiring that the capitalization period end when the asset is “substantially complete”, the FASB intended to prohibit the continuation of interest capitalization in situations in which the fi nal completion of assets is intentionally delayed. For example: a developer may choose to defer installing fixtures and fittings until condominium units are being sold to give buyers a choice of styles and colors.

Paragraph 22 of FASB Statement No. 67 allows for a maximum period of one year after cessation of major construction activities, over which a developer may assert that the project is not substantially completed, by requiring that:

….a real estate project shall be considered substantially completed and held available for occupancy upon completion of tenant improvements by the developer but no later than one year from cessation of major construction activity . . .

Real estate projects may need to be divided into separate assets or parts for purposes of determining whether they are ready for their intended use. For example: a condominium building is comprised of individual condominiums, which can be used independently from each other. 47 Each such condominium constitutes a separate asset, and interest ceases to be capitalized on condominiums that have been completed and are ready for use. Other real estate assets must be completed in their entirety before any part of the asset can be used, such as the construction of a manufacturing facility.

Judgment must be exercised when determining whether a real estate project should be divided into separate parts for purposes of interest capitalization.

Step 4. Determine The Amount Of Interest Cost To Be Capitalized

The amount of interest cost to be capitalized is intended to be that portion of the interest cost incurred during the asset’s acquisition and construction period that theoretically could have been avoided if expenditures for the asset had not been made.

The total amount of interest cost that may be capitalized in an accounting period is limited to the total amount of interest cost incurred by the company in that period. For purposes of FASB Statement No. 34, interest cost incurred by a company includes:

1. Interest recognized on obligations with explicitly stated interest rates (including the amortization of discount or premium and debt issue costs).
2. Interest imputed on certain types of payables, in accordance with Accounting Principles Board (APB) Opinion No. 21, Interest on Receivables and Payables.
3. Interest on capital leases determined in accordance with FASB Statement No. 13, Accounting for Leases.

The amount of interest cost to be capitalized in an accounting period is determined by applying an interest rate to the average amount of accumulated expenditures for the asset during the period. In determining what interest rate to use, the objective is to determine a reasonable measure of the cost of financing the acquisition and development of the asset. The interest rate or interest rates used should be based on the rates applicable to borrowings outstanding during the period. If a company has obtained a specifi c loan for a qualifying asset, the company may use the rate on that borrowing as the capitalization rate for the expenditures for the asset. If the average accumulated expenditures for the asset exceed the amounts of that loan, the capitalization rate applied to any excess is a weighted average of the rates applicable to other borrowings of the company.

Paragraph 14 of Statement 34 provides with respect to the weighted average interest rate to be used:

In identifying the borrowings to be included in the weighted average rate, the objective is a reasonable measure of the cost of financing the acquisition of the asset in terms of the interest cost incurred that otherwise could have been avoided. Accordingly, judgment will be required to make a selection of borrowings that best accomplishes that objective in the circumstances.

 

Further worth reading: Cost Allocation

Most businesses carry some debt and most pay interest on that debt. Some businesses loan money or other assets and receive interest payments. Do you know how to calculate, pay, collect and record interest? Here are some basic knowledge I am going to reveal in brief: Exploring types of interest, delving into credit interest, booking interest, paying long-term debt interest, recording interest income. So read on

Determining Interest Types

Financial institutions use two different types of interest calculations when determining how much to pay you in interest for money on deposit or calculating how much you will pay them on a loan or credit card — simple interest and compound interest.

 
Simple interest

Simple interest is easy to calculate. Here’s the formula for calculating simple interest:

Principal × Interest rate × n = Interest

Example:

You have a $10,000 savings account earning 3 percent interest per year. If you want to know what the total interest earned over three years, here how it is simply calculated:

Interest = $10,000 × .03 × 3 = $900

Compound Interest

Compound interest is more complicated to calculate because interest is not only charged on the amount you have on deposit, it is also calculated on the interest earned during the time you have it on deposit. So when you calculate compound interest you must add the interest earned the previous period to the balance before calculating the interest earned during the new period. Here’s the formula for calculating compound interest for a three-year deposit:

Interest for Year one = Principal × Interest rate
Interest for year two = (Principal + Interest earned) × Interest rate
Interest for year three = (Principal + Interest earned) × Interest rate

Note: You would repeat this method of calculation for the life of the deposit.

Example:

To Calculate the compound interest on a $10,000 deposit at 3% for three years, are as follows:

Year one: $10,000 × .03 = $300
Year two: $10,300 × .03 = $309
Year three: $10,609 × .03 = $318.27
——————————————————-
Total interest earned in three years = $927.27

When you are taking a loan, you always want to be sure you will be paying simple interest. When you are opening a savings account or any other type of savings instrument with a financial institution you always want to be sure you will earn compound interest.

Even compound interest can be paid differently. Some banks will compound your earnings monthly, which means interest earned will be added to your balance before the next monthly interest calculation. For other types of accounts interest is only compounded annually. So always look for a bank that compounds your savings monthly.

Determining Interest on Debt

Businesses borrow money for both short-term (less than 12 months) and long-term business needs.

Short-term debt usually includes credit cards and lines of credit.

Long term debt can include a multi-year loan for a vehicle or 15 or more year loan for a mortgage. Any money paid toward interest in the current year is shown as an interest expense on the Income Statement.

Credit cards

As you know from your personal credit cards, if you pay the bill in full at the end of each month, you don’t have any interest charges. But, if you don’t pay the balance in full each month, interest is charged based on a daily periodic interest rate, which means you start paying interest from the day you make a purchase. The daily periodic rate is calculated by dividing the annual rate by 365 days. Here is a table shows you a typical credit card interest charge:

You will find a similar table on your credit card bills, but the actual interest rates may be different depending on your credit card agreement

Example: Using the Table, Here is how to calculate the interest for a purchase of $150 made on April 15, andthe month closes on April 30. Assume the bill is not paid in full each month.

Interest: $150 × 0.034076 = $5.114

So, now you can see that interest compounded daily can be a lot more expensive than a simple annual interest rate. Credit cards are definitely the most expensive way to carry a loan. You won’t be calculating interest. Instead you’ll be using the amount of interest charged shown on the monthly credit card bill as your interest expense.

Most businesses seek better rates for short-term borrowing by using lines of credit. When using this type of credit line, you draw cash when needed and pay interest on the amount of the loan balance, but it is not compounded daily like a credit card.

Example:

A businessman draws $1,000 from his line of credit with an 8% interest rate. Here is how to calculate interest he will pay each month that he has the loan (assume he pays the total interest due each month, which means the balance will stay constant each month).

Annual Interest = $1,000 × .08 = $80
Monthly Interest Due = 80/12 = $6.67

Recording Interest on Short-term Debt

Recording interest on short-term debt is simple. When the cash is initially taken out of the account, you would record the cash receipt and the increase in a liability this way:

[Debit]. Cash = $1,500
[Credit]. Credit Line Payable = $1,500

As you make interest payments, you would record the decrease in Cash and an Interest Expense. If you also paid toward the balance of the loan you would add that to the entry this way:

[Debit]. Credit Line Payable = $150
[Debit]. Interest Expense = $10
[Credit]. Cash = $160

Example:

You would record a cash payment on a line of credit of $500 plus $35 interest as follows:

[Debit]. Credit Line Payable = $500
[Debit]. Interest Expense = $35
[Credit]. Cash = $535

Separating and Paying Interest on Debt

When a company takes on long-term debt, which means debt to be paid over more than 12 months, then the debt must be separated into current and long-term debt. The current debt will be the amount of cash that must be paid during the current year, which will include both interest and principal payments. Any amount remaining would be long-term debt. You would need to ask your bank for an amortization chart in order to determine how much of each payment on the long-term debt goes toward interest and how much goes toward principal.

Recording (booking) Interest Income

Many businesses earn interest from money in savings accounts, money market accounts or certificates of deposit or other investment vehicles. You need to record any interest earned for the business in an Interest Income account, which will appear on the Income Statement.

Luckily you shouldn’t have to calculate that interest. Your bank statement will indicate the amount of interest earned.

Example:

When you get the statement from the bank you find that your business account earned $25 in interest income. How would you record that transaction in the books?

Here is the entry would look like:

[Debit]. Cash = $25
[Credit]. Interest Income = $25