Case1: Herb Construction Company is building a hotel for speculativepurposes. That is, the Company has not yet found a buyer for thehotel, but expects to do so within a few months. Herb, who expects tospend about another two years to complete construction of the hotel,asks his accountant if interest and property taxes associated withthis construction site should be capitalized or expensed. At whatrate of interest should Herb use, if any, to capitalize any interestcosts?
ProblemIdentification: How should a property owner know whether propertytaxes and interest should be expensed or capitalized?
Keywords:property taxes capitalization
Conclusion:For an asset to be able to enjoy the benefits of interestcapitalization, the intended asset must have a period of time toprepare it for its intended use. An example is a firm constructing abuilding for its use either for lease or sale, as in the case ofHerb Construction Company. The cost used to put up an asset is whatis referred to as capitalized cost. So as not to be considered aninterest expense, it is added to the cost and thus treated as part ofthe asset and computed together with the asset’s depreciation. Itappears as an item on the balance sheet of the company and asexpenditure it appears in the income statement as a depreciationexpense and not interest expense. It is a complicated process and assuch should be applied to large sums of capital as it may make theresults of the company look better with regards to cash flow analysiswhich might not be the case.
Interestis capitalized to offer a clear picture of the cost of the asset, inour case it would better help the company when it comes to valuationof the hotel during its sale. This would ensure that the interestexpense incurred by Herb Construction Company isn’t borne by thecompany alone, but rather it is transferred to the buyer in the longrun. Assets that qualify for interest capitalization include assetconstructed for own use, assets built by a supplier with partialpayments already made, and assets for leasing or sale created asdiscrete projects such as cruise ships.
Afew things have to be looked at carefully before an asset qualifiesfor interest capitalization. These are
Does the asset qualify? – For an asset to qualify, the asset must have a time period during which it is prepared for use. Assets that are mass produced e.g. cars, refrigerators do not qualify.
What is the beginning and ending of the capitalization period? - A few conditions must be met with regards to the period of interest capitalization. They are to name a few
Expenses for the asset must have been incurred.
Preparations to get it ready for intended use must be ongoing.
Interest expense must be incurred.
What interest should be capitalized? – This means what amount of interest could be avoided if the funds to put up the hotel were used to offset the debt.
Case2: Inorder to help induce Jill Gregory to remain as president of the ReedCompany, in 2000 it promises to pay her (or her estate) $200,000 peryear for the next 15 years even if she leaves the company or dies.Reed wants to properly record this transaction as deferredcompensation, but is unsure of how many years it should use toamortize this cost. Moreover, Reed also purchased a whole lifeinsurance policy for Jill, naming the company as the solebeneficiary. Reed wants to ascertain if it can offset the cashsurrender value of the policy against the above deferred compensationliability.
ProblemIdentification: How should a life insurance policy be offset againsta deferred compensation liability?
Keywords:deferred compensation life insurance amortization
Conclusion:Deferredcompensation is a share of an employee’s compensation which is setaside to be paid out at a later time rather than the period for whichit is due [ CITATION Ell141 l 1033 ].It can fall into either one of these categories
Qualified Plan – It allows the employer to recognize an expense now and for the employee to pay taxes only when the payment is made to them or their estate. In order to qualify as a deferred compensation plan, there are some Internal Revenue Service’s rules that it must comply with, including the viability of it being offered to a large number of employees and not just highly paid executives.
Rabbi Trust – It is set up using company stocks and can be claimed by creditors in the event of the company going under or defaulting on its obligation. Payments are made to employees in the future as agreed on in the plan that set up the trust. The expense recognized by the accountants of the firm are the initial cost of stocks and not the value when paid out.
Secular Trust – It is a type of trust that protects assets placed in trust for the future benefit of employees from creditors in case of any default in obligations of the firm. The employees are however taxed in the present which offers a substantial challenge for those who may lack cash on hand to offset the taxes.
Aplan that does not satisfy the Internal Revenue Service’s rules isconsidered as nonqualified plans. In the case of Jill Gregory, thiswould be the category in which it falls into. It happens whenemployers only offer the compensation to a small group of highlycompensated employees. The employer only need recognize the expensewhen the compensation is made. The company can amortize thecompensation based on the life expectancy of the employee.Corporate-OwnedLife Insurance (COLI) is a type of life insurance policy that isowned by the employer that insures the life of one of its employees.It is a form of a grantor Rabbi Trust.
Ellig, B. (2014). The Complete Guide to Executive Compensation. McGraw-Hill Professional.