Property, plant, and equipment (PP&E) is reported at its historical cost, which is the amount of cash, or its equivalent, paid to acquire an asset, and is commonly adjusted subsequently for amortization, depreciation, and/or impairment. The guidance for the costs to be capitalized when acquiring PP&E can be found in ASC 360-10.
Excerpt from ASC 360-10-30-1
[T]he historical cost of acquiring an asset includes the costs necessarily incurred to bring it to the condition and location necessary for its intended use.
Activities necessary to acquire PP&E and bring it to the condition and location necessary for its intended use are defined in ASC 360-10-20.
Definition from ASC 360-10-20
Activities: The term activities is to be construed broadly. It encompasses physical construction of the asset. In addition, it includes all the steps required to prepare the asset for its intended use. For example, it includes administrative and technical activities during the preconstruction stage, such as the development of plans or the process of obtaining permits from governmental authorities. It also includes activities undertaken after construction has begun in order to overcome unforeseen obstacles, such as technical problems, labor disputes, or litigation.
When determining which costs should be capitalized for assets that are self-constructed, it is important to distinguish between those costs that are “necessarily incurred” and those that could have been avoided by the reporting entity. For example, penalties or fines from the mismanagement of a capital project would not qualify for capitalization as such amounts are not “necessarily incurred” to bring the asset to its intended use. Alternatively, costs relating to unforeseen obstacles encountered during construction (such as additional excavation costs, or additional required permitting) would likely qualify for capitalization. Determining which costs are “necessarily incurred” for a capital project requires judgment.
Generally, costs incurred for replacements or betterments of property, plant, and equipment can be capitalized when they extend the life or increase the functionality of the asset in question; otherwise, they should be expensed as incurred (e.g., repairs and maintenance). See PPE 1.4 for information on accounting for maintenance costs.
Capital costs may include labor, materials and supplies, transportation, engineering services, certain overhead costs, insurance, employee benefits, taxes, and interest. Similarly, an expenditure that adds to the productive capacity or improves the efficiency of an existing asset can be considered a capital item. Costs incurred during construction that are directly attributable to placing it into service should be capitalized. Costs that are not necessary in readying an asset for use should be recognized as an expense as incurred.
ASC 970, Real Estate - General, includes incremental guidance on capitalizing the costs of real estate developed for sale or rental. That guidance explicitly excludes capital projects constructed for a reporting entity’s own use. However, in the absence of other authoritative guidance, reporting entities often apply the guidance in ASC 970 by analogy in developing their overall capitalization policies. See PPE 1.7 for information on specific considerations for capital projects built for sale or rental.
The cost of acquiring an asset includes the costs necessarily incurred to bring it to the condition and location necessary for its intended use. The unissued PPE SOP identified four stages during which costs may be incurred related to long-lived assets: the preliminary stage, the pre-acquisition stage, the construction stage, and the in-service stage.
Figure PPE 1-1 in PPE 1.2.2 contains a summary of the accounting for common types of costs incurred during all stages of construction of a capital project. The following sections discuss what costs can be capitalized during each of the stages.
The first stage during which costs are incurred related to long-lived assets is the preliminary stage. During the preliminary stage, the project is not considered probable of being constructed. Accordingly, given the high degree of uncertainty about the future economic benefits, costs incurred during this stage are expensed as incurred.
The preliminary stage commences at the beginning of a project and lasts until the acquisition or construction of the specific long-lived asset is considered probable, as defined in ASC 450, Contingencies. In assessing probability, the reporting entity should consider whether (1) management, having the requisite authority, has implicitly or explicitly authorized and committed to funding the acquisition or construction of a specific asset, (2) the financial resources are available consistent with such authorization, and (3) the ability exists to meet the necessary local and other governmental regulations.
During the preliminary stage, activities are performed exploring the opportunities for acquisition or construction of property, plant, and equipment. A reporting entity may conduct feasibility studies and other activities related to asset selection. The reporting entity may incur costs to obtain an option to acquire one or more items of PP&E during this stage. Some examples of other costs that may be incurred during this stage include those related to surveying, zoning, engineering studies, design layouts, traffic studies, and obtaining management’s approval to move forward with a particular capital project. Some of these costs may be incurred in one or more of the stages of a project. Therefore, the assessment of probability of a project when the costs are incurred is key to the capitalization decision.
Accounting for costs during the preliminary stage is consistent with guidance in ASC 720-15, Other Expenses, Start-up Costs, which addresses costs associated with start-up activities, including those related to new capital projects, and states that such costs should be expensed as incurred.
The accounting for costs to arrange financing for the construction of a new capital project is specifically addressed by ASC 835, Interest. See PPE 1.3 for further discussion regarding capitalized interest.
The pre-acquisition stage begins when the construction of specific property, plant, or equipment is probable but prior to the start of construction. The unissued PPE SOP differentiates between costs that are directly identifiable with the specific PP&E and those that are an allocated or overhead cost. Directly identifiable costs should be capitalized in the pre-acquisition stage whereas allocated and other overhead costs should be expensed as incurred. Similarly, in the general guidance on real estate, ASC 970-340-25-3 states that costs that meet specified criteria should be capitalized once the project is probable.
Excerpt from ASC 970-340-25-3
All other costs related to a property that are incurred before the entity acquires the property, or before the entity obtains an option to acquire it, shall be capitalized if all of the following conditions are met and otherwise shall be charged to expense as incurred:
General and administrative costs and overhead costs should be charged to expense as incurred, regardless of whether those costs are incurred internally or outsourced to a third party. Those costs include all costs (including payroll and payroll benefit-related costs) of support functions, which include executive management, corporate accounting, acquisitions, purchasing, legal, office management and administration, marketing, human resources, and information systems. Similarly, a reporting entity that outsources its acquisitions department to a third party should charge the costs to expense as incurred because an acquisitions department represents a support function and the reporting entity could choose to establish its own internal acquisitions department.
If during the pre-acquisition stage the construction or acquisition of the specific long-lived asset is determined to no longer be probable, the capitalized costs related to the project should be assessed for impairment under ASC 360. When evaluating whether the capitalized costs of a project that is no longer probable of being completed are impaired, a reporting entity will need to determine whether the asset will be sold, abandoned, or held and used (e.g., to potentially be completed in the future). When determining the fair value of an impaired project, a rebuttable presumption exists that the fair value of costs incurred before the acquisition or construction stage is zero. Refer to PPE 6.3.1 for further discussion on assets to be abandoned. Refer to PPE 5.3 for additional information on the held for sale model. Refer to PPE 5.2 for additional information on the held and used model.
Similar to the pre-acquisition stage, costs incurred during the construction stage that are directly identifiable should be capitalized. Directly identifiable costs include:
Rent, depreciation, and other occupancy costs associated with the physical space occupied by employees are not directly identifiable costs and should be expensed as incurred, consistent with the accounting for those types of costs within the pre-acquisition stage. General and administrative and overhead costs should also be expensed as incurred, whether the costs are internal or paid to third parties.
Directly identifiable costs should be distinguished from allocated or overhead costs. Directly identifiable costs should be capitalized, while other costs should be expensed as incurred. Overhead costs are not directly related to the construction of the asset and should be expensed as incurred. Overhead costs should be expensed even when they relate to employees who are specifically involved in the construction of the asset (e.g., occupancy costs specific to internal engineers who are directly involved in the internal construction of PP&E are expensed). This is consistent with the conclusion in ASC 350-40-30-3 for internal-use software, which precludes the capitalization of overhead costs.
In addition, lease costs associated with ground or building operating leases that are incurred during a construction period should be recognized as lease expense if a company is developing a property for its own use.
In certain circumstances, there may be depreciation costs directly related to the construction project, such as depreciation of equipment used to build a long-lived asset for internal use. The depreciation costs of the equipment used to build a long-lived asset are considered directly identifiable and should be capitalized. On the other hand, depreciation related to the company's headquarters would be considered an indirect cost and should be charged to expense as incurred.
As discussed in PPE 1.7, ASC 970 provides specific guidance for the construction of real estate assets for sale or rental whereby certain overhead and other costs may be capitalized.
Constructing or acquiring a new asset may result in other incremental costs that would have been avoided if the asset had not been constructed or acquired. These should not be capitalized if they do not contribute to bringing the asset into the location and condition necessary for it to be capable of operating in the manner intended by management. For example, a mobile phone operator may be setting up a new network in a new territory, involving the construction of the network system (new transmitter towers, etc.). Costs that do not relate to the construction of the physical assets, such as marketing the cellular service and hiring incremental store employees to establish the territory, do not qualify as part of the cost of the asset even though they are incurred during the construction stage of the new network.
Demolition costsAccording to the unissued PPE SOP, “demolition costs incurred by an owner or lessor should be charged to expense as incurred and included in results of operations, except when incurred in conjunction with an acquisition or lease of real estate and the demolition (a) is contemplated as part of the acquisition or at lease inception and (b) occurs within a reasonable period of time thereafter or is delayed, but the delay is beyond the reporting entity’s control (e.g., if demolition cannot commence until the end of an existing tenant’s lease term or demolition is subject to governmental permitting processes).”
For example, if a reporting entity purchases land that includes a building but upon acquisition, the reporting entity plans to demolish the structure to construct a new building and demolition occurs within a reasonable period of time subsequent to acquisition, the costs incurred to demolish the property are part of preparing the site and thus should be capitalized as part of the land. If the building is to be renovated rather than razed, any demolition costs would be capitalized as part of the building renovations.
If the demolition is not done in connection with the acquisition of a structure, the incremental costs incurred to demolish the building should be expensed as incurred.
ContributionsMunicipalities and other government entities sometimes require entities to construct additional assets or infrastructure unrelated to the project as a condition of obtaining a construction permit. For example, if a company’s project plan eliminates trees or green space, the government entity may require that the company build a park or plant a certain number of trees along the municipality’s roads or make a charitable contribution to an environmental not-for-profit organization. ASC 720-25-20 defines a contribution, including characteristics that distinguishes a contribution from an exchange transaction.
Partial definition from ASC 720-25-20
Contribution: An unconditional transfer of cash or other assets, as well as unconditional promises to give, to an entity or a reduction, settlement, or cancellation of its liabilities in a voluntary nonreciprocal transfer by another entity acting other than as an owner. Those characteristics distinguish contributions from:
In a contribution transaction, the resource provider often receives value indirectly by providing a societal benefit although that benefit is not considered to be of commensurate value.
Contributions should be expensed in the period made, unless the contribution is for the in-substance purchase of a good or service. Payments made or other services provided to a municipality or governmental entity to obtain a permit, zoning change, or other licenses necessary for construction are not contributions. Instead, such amounts are paid in exchange for the ability to construct a facility, meaning that they represent an exchange transaction. Therefore, capitalization of any required charitable contribution or cost of a municipal improvement project as part of the capital project is generally appropriate if the payment is made once the project is probable or is in construction and can be directly identified with the receipt of the permit or license.
Asset ready for intended use / operating levelsCosts incurred during the construction stage before the plant can operate are capitalized. For example, the cost to run machinery and equipment in order to test that the output meets certain regulatory specifications would be considered costs of the construction stage and should be capitalized.
The construction stage ends when long-lived assets are ready for their intended use. Long-lived assets are considered ready for their intended use when they are first capable of producing a unit of product that is saleable or usable internally by the reporting entity. Refer to PPE 4.3.1 for additional information on the commencement of depreciation.
When the asset is ready for use, even if demand does not support operating the asset at its normal capacity, costs should no longer be capitalized. For example, a new hotel may be available for 100% occupancy almost as soon as it has been constructed. As demand usually builds slowly, there may be initial operating losses due to low occupancy. In such a case, the initial operating losses are not costs that may be capitalized. Similarly, marketing costs associated with generating demand for the hotel may not be capitalized.
Example PPE 1-1 and Example PPE 1-2 illustrate the treatment of operating costs and production costs incurred during the construction stage.
EXAMPLE PPE 1-1An amusement park has a “soft” opening to the public to conduct a trial run of its attractions. Tickets are sold at a 50% discount during this period and the park is running at 40% operating capacity. The amusement park will officially open in three months. Management asserts that the soft opening is necessary for the amusement park to ensure it is capable of operating in its intended manner.
Should the operating costs during the soft opening be capitalized? AnalysisNo. The soft opening operating costs should not be capitalized but instead should be expensed as incurred. Even though the amusement park is running at less than full operating capacity, it is clear that the amusement park is capable of operating in the intended manner.
EXAMPLE PPE 1-2Manufacturing Corp is a manufacturing company with various plants across the world. Manufacturing Corp is expanding its manufacturing footprint by constructing a facility in China. The facility has been completed and is producing prototype parts, which are being tested to ensure they are in accordance with the customer’s quality specifications.
Should Manufacturing Corp capitalize the costs associated with producing the prototype? AnalysisYes. Costs associated with preproduction test runs to prepare the long-lived asset to be ready for its intended use should be accounted for within the construction stage. Since the prototype parts are not yet saleable by the reporting entity, the costs of producing these parts should be capitalized. Costs incurred after the quality control testing has been completed (i.e., when the parts can be sold to customers), would be accounted for in accordance with the requirements for the in-service stage.
Once the asset has reached the in-service stage, depreciation on the long-lived asset should commence. Refer to PPE 4 for additional information on depreciation.
The in-service stage of long-lived assets begins when the asset is substantially complete and ready for its intended use. Costs during this stage include:
Costs incurred to acquire additional components of PP&E or replace existing components of PP&E should be capitalized. The costs of normal, recurring, or periodic repairs and maintenance activities and all other costs related to PP&E incurred during this stage should be expensed as incurred. In other words, costs during the in-service stage that extend the existing service potential of the long-lived asset or replace significant components of the long-lived asset should be capitalized. All other costs, including normal repairs and maintenance activities, should be expensed as incurred. See PPE 1.4 for additional information on maintenance activities.
Example PPE 1-3 illustrates the accounting for remodeling costs. EXAMPLE PPE 1-3Supermarket Corp, a supermarket chain, is renovating one of its stores. The store will increase in size, have more available space for in-store promotion outlets, and will include a restaurant. Management expects the store renovations to attract new customers and result in a more than nominal increase in sales.
Should the costs incurred to renovate the existing store be capitalized by Supermarket Corp? AnalysisYes. The store remodel will create additional available space for in-store promotion outlets and a restaurant. Since the renovation will create additional space and future economic benefits, the cost of remodeling the store should be capitalized.
Costs that are incurred to enhance the productivity of the long-lived asset (such as those intended to increase the long-lived asset’s daily output) should be capitalized. However, costs that are incurred to change the long-lived asset from one intended use to another (such as to change a tire manufacturing machine from one model tire to a different model), would generally not be capitalized.
When a reporting entity relocates in-service assets, the costs of dismantling, transporting, and reassembling the assets should usually be expensed as incurred. These types of costs generally do not extend the useful life of the asset or improve the quantity or quality of goods produced by the asset.
Example PPE 1-4 illustrates the determination of incremental costs to be capitalized for a capital project.
EXAMPLE PPE 1-4PPE Corp has an existing factory that it intends to demolish and redevelop. During the redevelopment period, the company will move its production facilities to another temporary site. The following costs will be incurred for the project:
No. Even though the costs are incremental, they are not directly attributable to the new building and not necessary for it to be capable of operating in the manner intended by management. The costs related to the temporary facility should be expensed as incurred.