The costs associated with the development of a project are accounted in different ways, depending on the nature of the costs and the stage of the project. Some costs are expensed as period costs, some are capitalized when incurred as costs of the project, while others are recorded as prepaid expenses and expensed in the period in which the related revenues are recognized.
There are three main stages of a development project, and accounting at these stages can be different. The three main stages are: (1) Pre-development stage; (2) Development stage; and (3) Post-development stage.
Accounting for development projects requires knowledge of regulatory requirements and pronouncements from various accounting bodies. This post aims to make these requirements and pronouncements simpler and easier to understand and also to offer a practical application of the pronouncements. Also, it discusses the accounting for costs related to acquiring, developing, constructing, selling, and leasing real estate projects.
Accounting In The Pre-Development Stage
The predevelopment stage can be described as the period prior to the start of the construction of the project. Let us start the discussion of accounting for predevelopment from the very beginning, at the inception of the entity that will own the project. Normally the sponsor(s) of a project form a legal entity that directly owns the project. The start-up costs related to the formation of this legal entity should be expensed as incurred. These start-up costs include the related filing fees, legal fees, and other regulatory fees.
In the past, the accounting for start-up costs was handled differently by different companies in different industries. Some companies expensed their start-up costs while others capitalized them and amortized them over time. As a result of these inconsistencies, in April 1998 the AICPA Statement of Position No. 98-5, Reporting on the Costs of Start-up Activities, was issued. It requires that start-up costs and organization costs are period costs and should be expensed instead of capitalized.
Some examples of predevelopment costs related to a project itself include: Acquisition options, Market studies, Traffic studies, Zoning changes, Survey costs, Costs of securing debt financing, Costs of securing equity partners, and Marketing costs.
It is important to pay particular attention to these costs to ensure that they are recorded correctly, as some are required to be expensed while others are required to be capitalized. GAAP requires that all costs associated with a project that are incurred prior to the acquisition of a property or before the entity obtains an option to acquire the property should be capitalized if all of these three conditions are met:
- The costs are directly identifiable with the specific property.
- The costs would be capitalized if the property were already acquired.
- Acquisition of the property or of an option to acquire the property is probable.
As mentioned, these three criteria have to be met for costs incurred prior to the acquisition of the property or option to acquire the property to be capitalized. The criteria require that such costs should be directly related to the property. Therefore, costs incurred at this stage should be examined carefully to make sure that they relate specifically to the property and are not general costs incurred by the entity.
Some examples of directly related types of costs include project-related travel costs and consulting fees specifically related to the property prior to acquisition or obtaining option to acquire the property.
Another criterion mentioned is whether the cost would be capitalized had the property already been acquired. Therefore, the entity needs to assess whether the nature of the cost is such that it would be capitalized.
An example is where the buyer, with the agreement of seller, decides to perform certain environmental tests prior to the decision on whether to purchase the property. Such costs clearly are costs a buyer would incur if the buyer already owned the property.
The last of the three criteria says that acquisition is probable. Here the test is both the ability of the buyer to close the deal and also that the subject property is available for sale. Therefore, even if the potential buyer is able and willing to purchase a particular property, if the property is not available for sale, this criterion is not met. Therefore, the costs should not be capitalized.
If the costs meet all three conditions mentioned, those costs are required to be capitalized; while all other costs should be expensed as incurred. It is also important to note that the cost to acquire an option to purchase a property must be capitalized. In most cases, even though all the criteria are met, there is no guarantee that the property would be acquired.
Therefore, at any time when it becomes probable that the property would not be acquired, the prior capitalized costs would have to be expensed.
Other predevelopment costs that meet the criteria for capitalization include costs incurred to change the zoning of the site and costs incurred to obtain financing, such as loan fees, points, and origination fees. In most cases, the developer starts marketing the project prior to the start or completion of construction. Therefore, marketing and other selling costs would be incurred at different stages of development.
Accounting In The Development Stage
The development stage is the period with the most activities and costs among the three stages. It is also the longest period in the project development process. The accounting during this period is very important, as both a management and a cost control tool. Adequate care should be taken to ensure that costs are recorded in the correct cost category.
Examples of costs incurred during this stage are: Site costs, Architectural and engineering, Financing, Construction, Taxes and insurance, General and administrative, Marketing, Permits and licenses, and Contingencies.
Normally in a construction project, a comprehensive budget is prepared with amounts for each of the cost categories just listed. The project’s construction, management, accounting, and finance teams meet periodically to review the budget with the actual costs incurred to ensure that costs incurred are recorded in the correct cost category or trade and also that the budget and amount left to complete the project are still reasonable.
As in other stages of the development process, some costs incurred during the development stage are capitalized while some are expensed based on the GAAP rules. According to Statement of Financial Accounting Standards No. 67, paragraph 7:
‘‘Project costs clearly associated with the acquisition, development, and construction of a real estate project shall be capitalized as a cost of that project.’’
The implication here is that for a cost to be capitalized as a project cost, there has to be a clear indication that it is directly related to a project.
Many costs incurred at this stage are mostly capitalized, such as site acquisition costs, architectural, engineering, and construction. However, certain other costs incurred during this stage that are not directly associated with the project should be expensed; these costs include general and administrative and marketing costs.
The invoices and other supporting documents related to these costs should be properly reviewed to determine the nature of the costs and to decide whether they should be capitalized or expensed.
In some instances, costs might be related to more than one project. For example, say a developer is developing an office complex with multiple individual buildings, and bills for certain costs, such as surveys or architects for the whole complex, are billed together. Such costs are still capitalized, but they would have to be allocated among the individual buildings. The developer should use any reasonable method to allocate the costs among the individual projects.
Amortization of Costs
Financing costs such as origination fees, points, and guaranty fees should be capitalized as prepaid assets and amortized to periodic project costs.
Assume an entity obtained a construction loan of $100 million for an office development project due at the completion of the project in 3 years with an interest rate of 8 percent. At closing, the borrower paid 1 percent origination fee, 1 percent point, .05 percent debt guaranty fee, and other loan closing costs of $525,000.
Therefore, the total costs incurred by the borrower at closing, which are usually disbursed from the loan principal, would be:
Origination fee (1%) = $1,000,000
Point (1%) = $1,000,000
Guaranty fee (.05%) = $ 500,000
Other loan closing costs = $ 525,000
Total loan closing costs = $3,025,000
At the day of closing, the entity would record this accounting journal entry:
[Debit]. Cash = $96,975,000
[Debit]. Prepaid assets = $3,025,000
[Credit]. Loans payable = $100,000,000
Note, however, that in most cases the borrower would not take the cash up front at closing but will draw on the amount periodically (usually once a month) as bills are received from contractors and vendors through a process called the submission of draw. On the amortization of the $3,025,000 total loan closing costs, each month the company reduces the prepaid asset by $84,028 ($3,025,000/36 months).
Therefore, each month, the journal entry to record this amount as project cost would be:
[Debit]. Loan financing cost = $84,028
[Credit]. Prepaid assets—loan cost = $84,028
This entry will be recorded each month over the 36-month loan term. If for any reason the loan term is extended, the monthly amortization will have to be adjusted.
Assume that six months prior to the loan expiration, the company realized that the project would not be timely completed due to a construction workers’ union strike. Management assessment indicates that the project will take an additional six months from the prior expected completion date. The borrower therefore approaches the lender, which agrees to extend the loan for the additional six months. The unamortized prepaid balance would now be amortized over the remaining loan term of one year, which is determined as the six months left on the original agreement plus the additional six-month extension.
The new monthly amortization would be determined as:
Unamortized balance prior to loan-
extension ($84,028 x 6) = $504,167
New amortization period = 12 months
($504,167/12 months) = $42,014
Therefore, after the extension, the monthly journal entry to record the cost amortization would be:
[Debit]. Loan financing cost = $42,014
[Credit]. Prepaid asset—loan cost = $42,014
Real Estate and Income Taxes
During construction, the entity may be required to pay taxes to the government. The most common taxes are the real estate taxes and income taxes. These two taxes are treated very differently in a construction project. For GAAP financial reporting purposes, costs incurred for real estate taxes from the inception of the project through the time at which the property is ready for its intended use should be capitalized as project costs. Real estate taxes after this period should be expensed.
The second type of taxes mentioned was income taxes. During the development stage, companies can still earn income through interest income on funds deposited at a bank or through parking revenues. Therefore, an entity might owe the government income taxes related to this income. These income taxes are expenses of the period and should be expensed.
Often some companies net their interest expense against interest income on their project budget; however, financial reporting under GAAP does not allow the netting of these two costs in financial statements.
As mentioned earlier, interest expense incurred through the time at which the property is ready for its intended use should be capitalized; interest income should be reported separately on the income statement when earned. The only exception in which interest income can be netted against interest expense is when the interest expense is from tax-exempt borrowings.
Another common error in financial reporting by some entities is the accounting for audit fees paid to the entity’s auditors for the audit of its financial statements. Audit fees are expenses of the period and not directly related to the project. Therefore, they should be expensed as incurred. In general, all expenses should be thoroughly reviewed to determine whether they should be expensed or capitalized.
Accounting In The Post-Development Stage
The post-development stage is the period when the project is substantially complete and is ready for its intended use. For example, if this is a condo project, the buyers can now move in; if it is a rental property, the lessees, if any, can now take possession of the spaces.
Most expenses incurred during this stage, such as salaries and wages, cleaning, security, utilities, water, and real estate taxes, are expensed as incurred. In addition, certain capital improvements performed after the completion of the project normally are capitalized and depreciated over the project’s useful life. Also, certain costs incurred in leasing the space (if a rental property), such as brokers’ fees and attorney’s fees, are also capitalized and amortized over the related lease term.