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Property Taxes Herb Construction Company Essay

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Updated: May 4th, 2022

Businesses incur various expenses in the course of their operations. It is critical to determine whether to capitalize or expense various financial operations of the business. Inappropriate accounting of financial transactions would make it difficult for an organization to determine its real financial position. This may pose several problems in planning. Whether to capitalize or expense interests and property taxes is one of the most contentious issues in accounting.

Interests and property taxes constitute the holding costs of the property. Companies usually capitalize taxes that a property may accrue while undergoing preparation to match its intended use. Therefore, taxes form part of the property costs. Companies should capitalize property taxes if the incremental increase in taxes is directly due to the construction activities. This is regardless of whether the property was operational before development (Nikolai, Bazley, and Jones 479). Therefore, Herb Construction Company should capitalize on the property taxes of the hotel it is constructing. This is because the taxes of the property are directly due to the development of the property.

Herb Construction Company has three alternatives on how to treat interests during construction. It may opt not to capitalize interest during construction, capitalize a certain amount of interest, or capitalize interest on all funds used in developing the property. If the company opts not to capitalize interest during construction, then it should treat all interest as total costs of borrowing funds. Herb Construction Company should treat interest as an expense during the entire period of the interest (Nikolai, Bazley and Jones 480). The company should record other interests – such as interest on funds borrowed to purchase property, plant, or equipment – similarly.

Herb Construction Company may also capitalize certain amounts of interest. In this option, the company would assign a certain interest to all funds, regardless of whether the company borrows the funds borrowed or not. The company would assign and capitalize interests on equity and borrowed funds that it uses in developing the property. This option provides the best economic costs of the development of the property. However, the major limitation of this option is that there is no definite rate that the company may assign the equity (Nikolai, Bazley, and Jones 480).

Herb Construction Company may also capitalize interest on all funds that it borrows to develop the property. This option requires companies to treat borrowed funds as part of the cost of the acquisition of the property. Therefore, the cost of borrowed funds is similar to other construction costs. Since the asset is not generating any revenue while under construction, the matching principle necessitates capitalization of the cost of interest of the property (Nikolai, Bazley, and Jones 480).

A company should capitalize an asset that is for its own use, or if it intends to sell or lease the property after its completion. Therefore, Herb Construction Company should capitalize interest and property taxes of the hotel under construction. However, not all properties merit capitalization. A company cannot capitalize a property that is ready for its intended use, or if the company does use the property in its earning activities (Nikolai, Bazley and Jones 480).

The amount of interest that Herb Construction Company may capitalize depends on the funds that the company borrows and the cost of borrowing the funds. The company should determine the interest rate by allocating a certain interest rate on the average cost of the investment for the property during the capitalization period. If expenditure on the asset outweighs cost of borrowing or there is no precise borrowing, Herb Construction Company should assign a weighted average interest rate on all other borrowings (Nikolai, Bazley and Jones 480).

Reference

Nikolai, Loren A., Bazley, John D. and Jones, Jefferson P. Intermediate accounting. Belmont, CA: Cengage Learning, 2009. Print.

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