February 29, 2016
Can you capitalize demolition costs?
A question has arose multiple times in my career at different organizations regarding the types of costs that are capitalizable. This questions intrigues me because of the fact that it seems very basic and straightforward, but surprisingly, I’ve seen a lot of time spent attempting to research and support a particular position on this, one way or another.
The two most common situations I’ve seen is where you a) need to perform demolition costs to remove whatever is in a particular location in order have the space available to build or install a new asset in that location, and b) where you have two very similar assets, and therefore you tear down the old one, to install a new one in a different location (think of a office remodel where you tear down demising walls to expand the space and reinstall another one in a different location.
What does the codification say?
ASC 360-10-30 discusses the generic rules around the definition of historical cost (emphasis added):
Historical Cost Including Interest
30-1 Paragraph 835-20-05-1 states that the historical cost of acquiring an asset includes the costs necessarily incurred to bring it to the condition and location necessary for its intended use. As indicated in that paragraph, if an asset requires a period of time in which to carry out the activities necessary to bring it to that condition and location, the interest cost incurred during that period as a result of expenditures for the asset is a part of the historical cost of acquiring the asset.
30-2 See the glossary for a definition of activities necessary to bring an asset to the condition and location necessary for its intended use.
The ASC Glossary further defines these activities, as alluded to in paragraph 30-2 above.
The term activities is to be construed broadly. It encompasses physical construction of the asset. In addition, it includes all the steps required to prepare the asset for its intended use. For example, it includes administrative and technical activities during the preconstruction stage, such as the development of plans or the process of obtaining permits from governmental authorities. It also includes activities undertaken after construction has begun in order to overcome unforeseen obstacles, such as technical problems, labor disputes, or litigation.
So at this point, most of you already have a predefined notion of what the guidance is trying to say here, and it seems pretty clear. Either you are thinking a) “I have to enter into some sort of demolition project/incur some demolotion costs in order for a new asset to be ready for its intended use, so clearly this would be a a capitalizable cost.” Or b) “the guidance above is clearly all around the new asset, but does not speak to costs of OTHER assets. If the FASB was so specific as to include references to construction costs, they would have also been equally as specific about de-construction costs or demolition costs. The fact that they didn’t mention it should be interpreted to mean that this was a specific omission, and therefore the demolition costs should be treated as any other period costs, the same as if there was an absence of the construction of a new asset.”
Either way you are thinking about it right now, you have to least see that the guidance isn’t as specific as it could be.
Next we turn to other available guidance. The questions is whether or not to expense costs associated with demolition of a space or existing asset at a location, vs capitalize those related costs to the ultimate asset. When framing the question in this way, we find that there is some guidance out there.
First, here is an excerpt from EY “Real Estate Acquisition, development and construction costs”, revised June 2015.
2.3.2 – Accounting for demolition costs
An entity may purchase property with the intention of demolishing the existing structure and replacing it with a new structure or with the intention of reconstructing the interior of the building (e.g., gutting the interior of a warehouse in preparation for reconstructing the interior as office space). Alternatively, an entity may purchase property with the intention of operating the property, but later decide to demolish and replace the property with a new structure. When there is a change in the use of real estate (e.g., when a golf course is converted to an office building complex), the guidance for real estate project costs (ASC 970-360-35-2) indicates that the previously capitalized development and construction costs need not be written off if certain conditions are met (see Section 2.10). However, the guidance for real estate project costs does not address demolition costs or the accounting for previously capitalized development and construction costs when there is no change in use (i.e., a 20-year old hotel is demolished and replaced with a new hotel).
Demolition costs incurred in conjunction with the acquisition of real estate may be capitalized as part of the cost of the acquisition if the demolition (a) is contemplated as part of the acquisition and (b) occurs within a reasonable period of time after the acquisition, or is delayed, but the delay is beyond the entity’s control (e.g., demolition cannot commence until the end of an existing tenant’s lease term, which will expire shortly after acquisition or demolition is subject to governmental permitting processes). If an entity purchases property with the intention of demolishing the existing structure and replacing it with a new structure, the entire purchase price and the costs of demolition should be allocated to the cost of the land.
If an entity purchases a property with the intention of demolishing and rebuilding the interior of the building only, the purchase price and costs of demolition should be allocated between the land and building with the demolition component assigned solely to the building.
If a demolition was not contemplated as part of an acquisition of real estate or the demolition does not occur within a reasonable period of time after the acquisition, the costs of the demolition should be charged to expense as incurred, unless the demolition is accounted for as an asset retirement obligation (ARO) in accordance with ASC 410-20.
The key, per EY, appears to be whether or not the demolition is contemplated at the outset of obtaining control over the item to demolish. (i.e., if you purchase a parking lot with a huge statue in the middle of it, but intend at the outset to demolish and remove the statue, then these costs are really costs contemplated in getting your new parking lot ready for it’s intended use. However, if you begin operating your parking lot without removing the statue, but realize that it is taking up valuable space a year or so later, then this wouldn’t be considered a cost to get your parking lot ready for its intended use, evidenced by the fact that you would have already been using it).
It’s always good to look at international standards as well, as it is well known that there is an overall desire to generally converge. Also, there are many publications which specifically highlight the differences between US GAAP and IFRS, so if, in general, you are taking a position that clearly is in opposition to the treatment applied under IFRS, then it is a good idea to see if others acknowledge the divergence between the accounting standards.
First, note the similarities in the actual IFRS guidance to ASC 360 posted above. The following is from IAS 16.16,
16.16 – The cost of an item of property, plant and equipment comprises:
a. its purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates.
b. any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management.
c. the initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located, the obligation for which an entity incurs either when the item is acquired or as a consequence of having used the item during a particular period for purposes other than to produce inventories during that period.
“Location and condition necessary for it to be capable of operating in a manner intended by management” sounds a lot like “costs necessarily incurred to bring it to the condition and location necessary for its intended use.”
Deloitte has the following Q&A on the subject (technically covering the IAS standard, not ASC), Q&A IAS 16: 16-8.
Question: Should the costs incurred to demolish pre-existing structures in order to build on a site be capitalised in the costs of the new asset?
Answer: It depends. The costs that may be included in the carrying amount of an asset are limited to those that arise directly from the construction or acquisition of the asset. When, for example, costs are incurred to demolish existing structures in order to build on a site, the cost of demolition may be incremental to the construction cost or it may be associated with derecognition of a previously held asset. It depends on whether the existing structures were previously used in the entity’s business, or were acquired as part of the site with the specific intention of demolishing them. In the latter case, the demolition costs are clearly incremental and should be included in the cost of the new asset. In the former case, the cost of the old asset should be written off to profit or loss through accelerated depreciation once the decision to demolish is made; the demolition costs incurred relate to the derecognition of the old asset and should also be expensed when incurred.
It appears that Deloitte (technically Deloitte Touche Tohmatsu) believes that the IAS guidance should be applied in a similar fashion as EY believes that the Codification should be. PwC on the other hand, refers to the fact that most companies will refer to a SOP that was never actually finalized, due to the lack of availability of more specific US guidance. Back in 2001, the Accounting Standards Executive Committee of the AICPA prepared an exposure draft of a Statement of Position: “ACCOUNTING FOR CERTAIN COSTS AND ACTIVITIES RELATED TO PROPERTY, PLANT, AND EQUIPMENT.” Although this exposure draft was never adopted, PwC’s guidance to its clients has been to look to this exposure draft for additional guidance when other more specific guidance doesn’t exist.
Per this exposure draft,
Demolition costs incurred by an owner or lessor should be charged to expense as incurred and included in results of operations, except when incurred in conjunction with an acquisition or lease of real estate and the demolition (a) is contemplated as part of the acquisition or at lease inception and (b) occurs within a reasonable period of time thereafter or is delayed, but the delay is beyond the entity’s control (for example, if demolition cannot commence until the end of an existing tenant’s lease term or demolition is subject to governmental permitting processes). Demolition costs meeting the above conditions should be capitalized as part of the cost of the real estate; whether the demolition costs are capitalized as land or building depends on the nature of the costs. For example, costs related to the demolition of a building in preparation for new construction would be capitalized as part of the land, whereas costs related to gutting the interior of a warehouse in preparation for reconstructing the interior as office space would be capitalized as part of the building.
Although EY doesn’t appear to state the source of their information, it does seem that PwC and EY are on the same page in terms of the source of their conclusions as some of the wording used in EY’s guide looks like it taken almost directly from the SOP exposure draft.
Conclusion: I believe that based on the above, there is clear agreement in the industry as to which demolition costs are able to be capitalized as part of the construction or acquisition of a new asset, and which ones are not. If the demolition is contemplated during the acquisition of the property, then these are capitalizable. Else, these should be expensed as incurred unless already accounted for under ASC 410 as an asset retirement obligation. If there is a difference between actual costs and ARO accrued, then those differences should be accounted for in accordance with ASC 410 as well.
Lastly, this post was specific to demolition costs, however, the treatment of a carrying value of an asset is a linked concept. I could write another post specific to this, but know that the conclusion would be that the concept of carrying value is that it meets the definition of an asset. An asset must have a probable future benefit to an entity per FASB Concept Statement 6. It does not logically follow that one asset that is demolished to make room for another asset can meet this definition post demolition, and therefore, capitalizing the remaining NBV into another asset is not appropriate. Instead, once a plan to demolish an asset has been created, an entity should reassess their depreciation estimates and adjust so that the depreciation will reduce NBV to its residual/salvage value as of the planned date of demolition (which is most likely zero).
Please send any clarification questions, and/or challenges on any of the above to me. I always enjoy a healthy discourse and won’t be offended if someone else disagrees, or has additional information that I should be adding to the above.
Disclaimer: Be smart, the above information was taken at a point in time, and the interpretations of guidance can change day to day based on additional conversations with the FASB or actions taken by the SEC. You should always consult with your external auditors or regulators before concluding on your specific situation, as every situation is different. The information provided in this publication should not be interpreted as providing accounting advice. The content is intended for general informational purposes only, and you should consult your CPA or CPA firm if you have specific accounting questions. Last updated 8/2/2015.
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