Self Constructed Assets

Fundamental Concepts of Self Constructed Assets

The premise of self constructed assets is intrinsic to businesses and their financial operations. But to uncover what these assets are, let's delve further into this business phenomena.

These assets might include office buildings, machinery, or software systems developed in-house. The cost of the self constructed assets consists of both direct and indirect costs.

• Direct costs: These costs can be directly associated with the production of the assets. For example, cost of raw materials, direct labour, etc.
• Indirect costs: These costs are not directly associated with production but are still needed for the creation of the asset. This includes costs such as depreciation, factory overhead, etc.

Definition and Importance of Self Constructed Assets

Self constructed assets could be referred to as 'internally developed assets'.

They help in minimizing operational costs, enhancing financial resource utilization and allow businesses to tailor them according to their specific needs. Therefore, proper recording and management of these assets should be a priority for any business.

Main Characteristics of Self Constructed Assets

The self constructed assets have some unique characteristics that set them apart from other types of assets:

Being aware of these characteristics provides businesses comprehensive insights about the impact, risks, benefits, and functions related to self constructed assets.

Accounting for Self Constructed Assets

Unravelling the intricacies of accounting for self constructed assets presents a dynamic challenge which requires your understanding of the basic principles of finance, cost-accounting, and a sound knowledge of related accounting standards. Let's delve deeper into this attribute, which is an integral part of business studies.

Exploring the Accounting Process for Self Constructed Assets

Self constructed assets require meticulous accounting as they directly impact a company's financial statements. While resources like raw materials and labour are consumed during the creation of these assets, these costs are technically not 'expenses' in the traditional sense. Instead, they increase the value of the asset under construction, and so, must be capitalised.

The capitalisation of costs is based on the concept that these costs provide benefits beyond the current period and must therefore be matched to income of later periods.

Crucially, aligning with the matching principle in accounting, the costs of a self constructed asset should be capitalised until the asset is substantially complete and ready for use. Among these, direct costs such as material and labour costs and those indirect costs that are directly attributable to the asset’s production are considered.

MOvevover, note that it is not every indirect cost that should be capitalised. According to accounting standards, only those indirect costs that increase during the construction period due to the construction effort should be capitalised. The logic behind this is that these increased costs would not have been incurred if the asset was not being constructed.

The general formula for the cost of self constructed assets is as follows:

\[ \text{Cost of Self Constructed Assets} = \text{Direct Materials} + \text{Direct Labour} + \text{Allocated Overheads} \]

Key Steps in Accounting for Self Constructed Assets

Accounting for these assets involves the understanding of a few key steps.

1. Allocation of Costs: Allocate all direct and indirect costs incurred during production to the appropriate asset account.
2. Period of Capitalisation: Determine the period over which costs should be capitalised, generally from the decision to make the asset until it is substantially complete and ready for use.
3. Stopping Capitalisation: Stop capitalising costs when the asset is ready for use, even if it is not yet in use.

Role of GAAP in Accounting for Self Constructed Assets

In line with the Generally Accepted Accounting Principles (GAAP), the costs associated with self constructed assets must be classified as capital expenditures rather than operational expenses. Capitalising these costs helps to spread them out over the useful life of the asset, thereby enhancing the accuracy of financial statement over time.

This principle is dictated by GAAP under "Property, Plant and Equipment" (US GAAP's ASC 360 or IFRS's IAS 16). Here, direct and indirect costs that are clearly attributable to the acquisition, construction or production of assets are required to be capitalised, if it's probable that the asset will generate economic benefit.

It is therefore important that firms adhere to the GAAP standards while accounting for their self constructed assets to promote comparability and transparency in their financial reporting.

Capitalisation of Self Constructed Assets

Capitalisation is an essential aspect of accounting for self constructed assets. It involves attributing the costs associated with the production of the asset, including certain interest costs, to the value of the asset. This process allows the firm to recover the expenditure over the service life of the asset by processing it as a depreciation expense.

Interest Capitalization on a Self-Constructed Asset

If you undertake a project that involves significant expenditure and spans over a lengthy period of time, it's not uncommon to borrow funds for the project. The interest that arises during the construction period enhances the cost of the asset. Neglecting to capitalise this interest as part of the production cost often leads to an understatement of the asset's cost and an overstatement of the net income in the period.

Understanding the Concept of Interest Capitalization

The process of interest capitalisation commences when three conditions are met:

• The expenditures for the asset have been made.
• The activities that are necessary to prepare the asset for its intended use are in progress.
• Interest costs are being incurred.

The capitalisation period ends when the asset is substantially complete and ready for use. It's important to note that the asset doesn't have to be in use for interest capitalisation to stop; it just needs to be ready for use.

Application of Interest Capitalization on a Self-Constructed Asset

Interest capitalisation applies to assets that are self constructed for a company's own use and assets intended for sale or lease provided the activities necessary to get them ready for sale or lease are in progress.

Furthermore, the specific interest that is to be capitalised is determined by the lesser of the actual interest costs incurred during the capitalisation period or the potential interest that could have been avoided if the expenditure for the asset had not been made i.e., "avoidable interest".

Here's how you calculate:

\[ \text{Avoidable Interest} = \text{Weighted-average expenditure amount} \times \text{Interest rate} \]

In the equation above, the weighted average expenditure amount is the sum of the expenditures for the asset weighted by the amount of time (fraction of a year or accounting period) that an expenditure is outstanding.

Self Constructed Assets Capitalization Process

The capitalisation process of self constructed assets involves recognising and recording costs associated with their construction and production in the financial statements correctly. It allows the company to spread the costs incurred on the asset's creation over the asset's useful life, rather than treating them as expenses in the period they were identified.

How to Capitalise the Costs of Self Constructed Assets

The capitalization process is a systematic step to ensuring that all direct and indirect costs related to the asset's production are duly accounted for:

1. Identify all Direct Costs: Determine all the costs that are directly associated with the production of the asset. This includes raw materials and labour costs.
2. Identify all Indirect Costs: Determine all the costs not directly associated with the production but are needed for the creation of the asset. This includes costs such as depreciation, factory overhead, etc. Only those indirect costs that increase during the construction period due to construction effort should be capitalised.
3. Start Capitalisation: Capitalise these costs from the time you decide to create the asset and continue until the asset is substantially complete and ready for use.
4. Include Interest Costs (if any): The capitalisation of interest is an important aspect to consider in cases where funds are borrowed to finance the construction of assets.
5. Stop Capitalisation: It's imperative to stop capitalising costs when the asset is ready for use, even if it is not yet in use.

Understanding these steps will provide a clear foundation for the capitalisation of self constructed assets, keeping your accounting books accurate and compliant with standard accounting principles.

Self Constructed Assets According to International Standards

When navigating through the world of self constructed assets, understanding the international accounting standards becomes of utmost importance. The Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS) are two critical frameworks that guide the recognition and valuation of such assets. As global standards, they define how self constructed assets should be calculated, reported and disclosed in financial reporting.

Self Constructed Assets under GAAP

In the U.S., GAAP is the standard framework of guidelines for financial accounting. It includes the standards, conventions, and rules accountants follow in recording and summarising transactions and in the preparation of financial statements. It's crucial to understand the GAAP-specific rules and approaches required to accurately account for self constructed assets.

GAAP Guidelines for Self Constructed Assets

According to the GAAP, self constructed assets should include all costs directly associated with the creation of assets such as material and labor costs, as well as a proportional share of indirect costs that are incurred in creating the asset.

The GAAP recognizes costs such as administration and general overheads as a period expense and not part of the production cost. However, it does allow for the capitalisation of interest on borrowings for the construction, as a part of the asset cost. This is in accordance with the Interest Capitalization standard (Section 835-20 of the FASB Accounting Standards Codification). Accordingly, the interest capitalisation begins when the construction starts and ends when construction is substantially complete or production is suspended.

Furthermore, under GAAP rules, the costs of assets manufactured for the purpose of being sold are considered inventory and not capitalised.

Differences in Self Constructed Assets: GAAP vs. IFRS

While both GAAP and IFRS provide standards for accounting for self constructed assets, a few key distinctions exist.

Unlike the GAAP, the IFRS doesn't require companies to capitalise interest for self constructed assets. Furthermore, the IFRS requires the capitalisation of 'directly attributable costs', which includes a wider range of expenses such as direct labour costs, cost of site preparation, initial delivery, handling costs, installation costs, and professional fees.

An additional difference lies in how each framework handles the classification of self constructed assets destined for sale. Unlike the GAAP that deems it inventory, the IFRS requires this to be capitalised as a non-current asset until the point of sale.

Self Constructed Assets under IFRS

A much broader standard than GAAP, the IFRS is used in many parts of the world, including the European Union, Australia, and India. The IFRS standards for self constructed assets diverge from GAAP in a few areas providing a different set of guidelines for the valuation of such assets.

IFRS Rules for Self Constructed Assets

As per IFRS (IAS 16 and IAS 23 to be precise), the cost of self constructed assets includes directly attributable costs, which incorporates all direct costs and any directly attributable costs necessary to bring the asset to working condition for its intended use. The standard allows companies to select the method of allocating fixed overheads to the cost of conversion, but the allocation should be based on the normal operating capacity.

Moving on to interest capitalisation, IFRS also provides guidance on the capitalisation of borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset. Generally, IFRS requires more interests to be capitalised, compared to GAAP.

Under IFRS, similar to GAAP, interest capitalisation commences when the entity incurs borrowing costs and ceases when substantially all the activities necessary to prepare the qualifying asset for its intended use or sale are complete.

Similarities in Self Constructed Assets: GAAP vs. IFRS

Despite their differences, GAAP and IFRS share some common ground when it comes to self constructed assets. Both standards agree that costs directly associated with the production of the asset, such as materials and labour costs, should be capitalised.

Similarly, both GAAP and IFRS permit the capitalisation of interest cost on borrowings attributed to the construction of the assets. Nevertheless, the amount and period of capitalised interest may differ between the two standards due to their different rules for determining capitalisation rates and period.

Finally, under both frameworks, the capitalisation ceases when the asset is ready for its intended use, irrespective of whether it is put into operation or not. In other words, both standards tie the cessation of capitalisation to the physical completion of the asset, not its operational phase.

Practical Application: Self Constructed Assets Example

Putting theory into practice is an effective approach for a comprehensive understanding of self constructed assets. A practical example would pinpoint the specifics of the asset cost identification, allocation and capitalisation processes. It will enhance your insight into these assets' conceptual framework and assist in honing your managerial and financial decision-making skills.

Understanding Self Constructed Assets with Real-Life Examples

A retail company intending to expand its operations plans to construct a new warehouse. The construction of the warehouse is considered a project, and the warehouse itself is a self constructed asset. It will be used to store inventory to supply stores across a region, directly influencing the company’s sales generation.

The self constructed warehouse incurs a series of associated costs such as direct materials (bricks, cement, steel), direct labour (construction workers’ wages), directly attributable overheads (equipment rental), and indirect costs (general site management).

Additionally, let's say the company borrowed $1,000,000 at a yearly interest rate of 5% to fund the construction project. The construction period lasts for 2 years, during which the company incurs interest costs. In accordance with the interest capitalisation rules, these costs should be capitalised and added to the cost of the warehouse.

Breakdown of a Self Constructed Assets Example

• Cost of Direct Materials: The cost of raw materials including the bricks, cement, steel and others are categorised as direct materials costs.
• Cost of Direct Labour: The wages paid to the construction workers are designated as direct.labor costs.
• Directly Attributable Overheads: Costs such as equipment rental that are directly attributable to the construction of the warehouse are categorised as directly attributable overheads.
• Cost of Indirect Costs: Costs like general site management that don't directly contribute to the construction but are necessary for the project are considered indirect costs.
• Interest Costs: Interest costs are capitalised according to the rules for capitalisation of borrowing costs. Using the formula for calculating the avoidable interest cost: \[ \text{Avoidable Interest} = \text{Weighted-average expenditure amount} \times \text{Interest rate} \] The total cost of interest over the two-year construction period will be \( $1,000,000 \times 5\% \times 2 = $100,000 \).

The sum of these costs will constitute the total cost of the warehouse recorded in the company accounts as a self constructed asset.

Learning from a Self Constructed Assets Case Study

Let's take a deeper dive into this case and understand its implications on the company's financial statements. On completion of the warehouse construction, the company will add the total cost calculated above to its balance sheet as a non-current asset under 'Property, Plant and Equipment'. Depreciation expense will be recorded every accounting period to evenly distribute the cost of this asset over its useful life, following the matching principle of accounting.

This capitalisation of the warehouse as an asset instead of expensing its costs in the periods they were incurred, leads to higher profits in the financial periods during the construction. Consequently, it also results in higher assets, and potentially higher equity, depending on the financing of the warehouse's construction. These would not have been the case if the company simply expensed all the costs as and when incurred.

From this case study, it's clear that understanding the handling of self constructed assets in accounting is not just about recording the correct figures in financial statements. It also influences the analysis and interpretation of these financial statements, affecting the perceived financial health and performance of the company.