Accrual Accounting for Capital Projects
The accrual method of accounting recognizes transactions as they happen, regardless of when cash is received or paid. Using this basis, businesses capitalize transactions related to large projects, such as construction costs. Capitalized projects are presented in the balance sheet as assets -- not all costs are shown as expenses in the income statement.
Capital projects are usually expensive and are to be utilized for many years. The accrual basis of accounting requires that items to be used long term be considered assets, i.e. be capitalized. A major remodeling of a building, new construction, and creation and implementation of a large computerized system are all examples of capital projects. Many businesses have policies and procedures regarding transactions that must be capitalized, including a minimum cost limit, usually $5,000, for projects to be capitalized. Capitalization is complex, requiring depreciation and maintenance of accounts, which may not be worthwhile for small projects.
When an item is deemed to be a capital asset within a project, businesses may set up separate accounts within the project. With long-term projects, phases may be implemented and accounts are created within each phase of the project. For example, in a construction situation, the first phase could be to demolish existing buildings, and the firm may create accounts for contractors, hauling and inspections costs within this phase. Another balance sheet account that needs to be set up is the accumulated depreciation, a contra-asset account that collects depreciation costs throughout the years.
Some companies show separate depreciation expense accounts for each item, such as equipment, furniture, and construction expenses, while others use only one account to recognize all depreciation expenses. Once depreciation is calculated, it's recognized with entries to this account by debiting the depreciation expense and crediting the accumulated depreciation in the balance sheet. As part of the normal accounting cycle, the depreciation expense is closed along with all other accounts in the income statement at a period end. Since depreciation transactions don't involve cash, accountants using the indirect method to prepare cash flows statements adjust net income for depreciation.
The accounting for project capitalization and depreciation involve many details. In the case of a construction project, all costs, including payroll, need to be identified and recognized as assets. The next step in this process is to recognize depreciation expense based on the cost of the items, useful lives, salvage values and methodologies, such as straight-line, where the same amount is depreciated throughout the asset's life. For example, the cost of a project may be $100,000 as of Jan. 1 with no salvage value and a life of 10 years. Using the straight-line method, the depreciation expense would be $10,000 per year.