What Costs Are Capitalized During Construction?

Understanding Capitalization in Construction

Capitalization in accounting refers to recording an expenditure as an asset on the balance sheet rather than an immediate expense on the income statement. This practice is particularly relevant for construction projects, which involve significant outlays to create long-term assets. When costs are capitalized, they are recognized over the asset’s useful life through depreciation, aligning the expense with the periods in which the asset generates revenue. This approach provides a more accurate representation of the company’s financial position and performance.

The fundamental accounting principle guiding capitalization is the matching principle, which aims to match expenses with the revenues they help generate. For construction, this means the costs incurred to build an asset, such as a building or a new facility, are treated as part of the asset’s value because they contribute to its ability to provide economic benefits over many years. Instead of being fully expensed in the year they are paid, these capitalized costs become part of the asset’s book value and are systematically allocated as depreciation expense over the asset’s estimated useful life. This contrasts with expensed costs, which are reported on the income statement immediately and reduce current period income.

Direct and Indirect Capitalizable Costs

Construction projects involve various costs that can be capitalized, broadly categorized into direct and indirect expenditures. Direct costs are those expenses directly traceable to the physical construction of the asset. These include the cost of materials, such as lumber, concrete, steel, wiring, and fixtures, which are incorporated into the structure. Additionally, the wages and benefits paid to workers directly involved in the physical construction, including craftspeople and on-site laborers, are considered direct costs.

Indirect costs, while not physically part of the structure, are necessary to bring the asset to its intended condition and location. These often encompass a range of professional fees and project-related expenses. Examples include architectural and engineering fees for design and planning, as well as costs for obtaining necessary permits and licenses from regulatory bodies. Site preparation costs, such as demolition of existing structures, excavation, and land clearing, are also typically capitalized as they prepare the ground for the new construction. Further indirect costs include expenses for construction management and on-site supervision, which oversee the project’s progress and quality. Insurance premiums for policies like builder’s risk insurance, which protect against damage during the construction period, are also capitalized. Property taxes levied on the land during the construction phase, before the asset is ready for its intended use, are another capitalizable indirect cost. Finally, testing and inspection costs to ensure compliance and quality, along with legal fees directly related to the construction project, such as those for zoning approvals or contract drafting, contribute to the asset’s capitalized cost.

Capitalization of Interest Costs

Under specific accounting standards, such as ASC 835-20, interest costs incurred on funds borrowed to finance the construction of certain assets must be capitalized. This requirement applies to what are known as “qualifying assets,” which are assets that require a substantial period of time to get ready for their intended use, such as buildings, large machinery, or infrastructure projects. The rationale behind capitalizing interest is that it is considered a cost of getting the asset ready, similar to the costs of materials or labor.

The amount of interest capitalized is generally the actual interest incurred on specific borrowings used for the construction project. This capitalized amount is limited to the amount of interest that could have been avoided if the construction expenditures had not been made.

Defining the Capitalization Period

The capitalization of construction costs begins only when specific conditions are simultaneously met, marking the start of the capitalization period. This period commences when expenditures for the asset have been made, indicating financial commitment to the project. Concurrently, activities necessary to get the asset ready for its intended use, such as physical construction or development work, must be underway. Additionally, if applicable, interest costs must be actively incurred during the period.

Capitalization of costs ceases when the asset is substantially complete and ready for its intended use. This signifies that all necessary activities to prepare the asset for its operational purpose have been fully finished. It is important to note that the asset does not need to be actually in use; rather, it simply needs to be in a condition where it can be effectively used as intended. Minor finishing touches, such as painting or landscape work, or deferred maintenance, typically do not extend the capitalization period once the asset is functionally ready. Any costs incurred after the asset is ready for its intended use, such as routine maintenance, repairs, or operational expenses, are generally expensed as incurred rather than capitalized.