This article, "Interest and Wages During Construction – Capitalize!," originally appeared on BDO.com.
There are a variety of costs related to constructing a new location. Some expenses will hit the profit and loss (P&L) as incurred and others will be capitalized and depreciated over time. If your company is planning to open a new location, it is important to note that interest and wages related to the construction process are capital expenditures and should be depreciated over the life of the asset to which they relate. These capital expenditures are typically classified as a component of leasehold improvements.
In determining the amount of interest to be capitalized, multiply the applicable borrowing rate by the amount of borrowed money spent on the project. The applicable borrowing rate is calculated one of two ways:
- If you acquire debt specifically for the project, use the interest rate explicit in the loan agreement.
- If you use funds from existing debt (i.e., draw on existing line of credit) an average interest rate is used, calculated by dividing total interest paid by total debt outstanding.
Once you have determined the correct rate to use, multiply that rate by the total amount of borrowed funds expended on the project. Capitalize the lesser of that amount or the actual amount of interest incurred.
Important items to note:
- Any excess cash spent on the project is not included; only consider funds borrowed.
- If you borrow $10 million specifically for the project but end up spending $6 million, only money actually spent ($6 million in this example) is used when calculating capitalized interest.
- Projects funded through equity capital do not qualify. Money spent must be acquired as debt.
- A company doesn’t actually have to borrow money to fund construction in order to capitalize interest. If there is existing debt, but working capital is used to fund the build, you would still capitalize the interest on the existing debt under the theory that if you were not doing the build, the debt would have been repaid and therefore you are indirectly borrowing.
In determining the amount of wages to be capitalized, allocate costs based on the percentage of time employees spend on the project. Make sure you have support for the percentage you use. This could be in the form of time cards with specific project names assigned to time recorded.
Bonuses paid to employees are included in the allocation. Even if a bonus is based on completion of a project, it is still subject to the allocation percentage. For example, John spends 85 percent of his time on a project. He receives a $10,000 bonus when the project is complete. The entire bonus relates to the project, but only $8,500 is capitalized since John only spent 85 percent of his time on the project.
Important items to note:
- If construction activities are continuous, overhead costs (not including G&A) are also allocated to the project.
- If construction activities are intermittent, only direct labor costs are allocated to the project.
Q: What is the capitalization period?
A: Construction does not need to be in progress for these costs to be capitalized. Interest and wages incurred during the planning stage are included. Capitalization should cease on the date the restaurant is ready for use.
You cannot stop capitalization to avoid impairment. Even if the carrying amount of the asset exceeds its recoverable amount, continue capitalization until the restaurant is ready for use.
Q: When am I exempt from these capitalization rules?
A: You do not need to capitalize interest and wages during routine improvements with short construction periods.
You do not need to capitalize these costs if the effects are immaterial. If you have 100 locations, the amount that would be capitalized for the construction of one location is probably insignificant when compared to the total fixed assets of the other restaurants. However, failure to capitalize interest also creates an income statement error (overstated interest expense). Thus, consider materiality as it relates to interest expenses and other P&L metrics.
Q: Are there different rules for my income tax return?
A: There are no differences in the tax law regarding capitalized interest and wages. Capitalize the costs as discussed above and depreciate the asset over the life used for income tax purposes.