Self Constructed Assets

When companies decide to build their own assets, like equipment or production plants, unique accounting challenges arise. Self-constructed assets require an organization to assess various costs associated with construction and to determine which of these costs should be capitalized. Let’s dive into the major components of accounting for self-constructed assets.

Key Components of Self-Construction Costs

Direct Costs of Construction
- Includes materials, labor, and engineering expenses that are directly tied to building the asset.
- Also encompasses variable manufacturing overhead costs incurred as part of the production process.
Indirect Costs of Construction
- Fixed manufacturing overhead costs: These can include electricity, depreciation on equipment, property taxes, and supervision.
- Assigning indirect costs is particularly complex and often debated due to the unique characteristics of each construction project.
Interest Costs
- When a company borrows funds for construction, the interest accrued during the construction period may be capitalized.
- Internal debates exist over whether to include imputed interest when the company uses its own funds instead of borrowed funds.

Capitalization of Interest During Construction

Accounting authorities, like the Financial Accounting Standards Board (FASB), provide guidelines on capitalizing interest during asset construction. There are three main approaches considered:

Approach (a): No Interest Capitalization
- Under this approach, any interest on borrowed funds during construction is immediately expensed.
- This method is straightforward but does not align with matching principles, as it does not allocate costs to the revenue periods in which they are expected to generate income.
Approach (b): Capitalize Interest for All Funds Used in Construction
- This method requires the capitalization of an interest cost, regardless of whether the funds are borrowed or internally sourced.
- Although this provides a comprehensive view of construction costs, it raises challenges in accurately determining the cost of imputed interest.
Approach (c): Capitalize Interest on Borrowed Funds Only
- This approach treats the interest on borrowed funds as part of the construction costs, equivalent to material or labor.
- It ensures that the cost reflects only necessary expenditures, while aligning closely with the matching principle, as the interest is directly tied to asset acquisition.

Methods for Allocating Fixed Overhead Costs

There are two primary methods for handling fixed overhead costs:

No Overhead Allocation
- This method excludes fixed overheads, like insurance and general utilities, from the construction cost.
- Proponents argue that these overheads do not increase due to asset construction and should therefore not be capitalized, which results in more accurate period expenses.
Full-Costing Approach
- In this approach, a portion of fixed overhead is assigned to the construction project.
- This approach reflects a more comprehensive allocation of costs, ensuring that indirect expenses associated with construction are properly accounted for.

Important Considerations

Excess Overhead Allocation: If allocating indirect costs results in costs exceeding the probable fair value of the constructed asset, the excess should be treated as a loss in the current period rather than capitalized.
Capitalization Limitations: To avoid overvaluing an asset, it’s critical to set boundaries on the costs capitalized, ensuring they align with the expected economic benefits of the asset.

Conclusion

Accounting for self-constructed assets demands a careful assessment of costs. By evaluating which costs are essential to the creation of the asset and understanding the implications of interest capitalization and overhead allocation, companies can ensure accurate and fair asset valuation on their financial statements.