When a firm constructs its own buildings or equipment, what costs are capitalized?

Answer 1

Self-Constructed Asset

When a firm constructs its own buildings or equipment, it recognizes the labor, material, and overhead costs incurred as an asset. U.S. GAAP and IFRS require firms to include, or capitalize, interest costs during construction in the cost of a self-constructed asset. The rationale for capitalization is that firms must incur financing costs in self-constructing an asset just as they must incur labor and material costs.

Firms base the amount of interest costs capitalized on the amount borrowed to self-construct the asset. The amount represents the interest cost incurred during periods of construction that the firm could have avoided by not constructing the asset. If the costs of self-construction exceed the amount of any new borrowing, the firm uses the weighted-average rate it pays for its other borrowings to measure the amount capitalized. The total amount capitalized cannot exceed total interest costs for the period. Interest capitalization stops when construction ends.

The capitalization of interest in the acquisition cost of assets during construction results in recognizing total expense over the life of the asset equal to the cash expenditure; capitalizing interest delays expense recognition from the time periods of borrowing to the time periods of using the asset.