As a business owner, properly accounting for buildings on your financial statements is crucial yet complex. From recording initial purchase and construction costs to depreciating value over time, buildings significantly impact your balance sheet, income statement, and tax liability.
In this comprehensive guide, we will walk through the essential concepts, methods, and implications of building accounting under US GAAP principles. Whether you own an office tower or warehouse, apply these best practices for accurate financial reporting.
Acquiring and Initially Recording Buildings as Assets
When first acquiring buildings, proper recording as assets sets the foundation for future accounting treatment. Two key elements drive initial recognition on your balance sheet – purchase costs and construction costs.
Purchase Costs and Construction Costs
If purchasing an existing building, the acquisition cost becomes the basis for the asset value on your balance sheet. This includes the purchase price and any direct closing expenses.
Alternatively, if constructing a new building, accumulate all associated costs throughout the project. This encompasses direct construction costs like materials and labor, as well as soft costs like architectural fees, permits, and engineering studies. Treat start-up expenses and initial occupancy costs as operating expenses.
Balance Sheet Recognition Models
Under US GAAP principles, accountants employ either the cost model or revaluation model to initially record buildings on the balance sheet:
Cost Model
The simpler approach records buildings at historical cost, without adjustments for fair market value fluctuations. Any subsequent improvements or impairments do impact the recorded cost basis.
Revaluation Model
Alternatively, the revaluation method records buildings at fair value on the reporting date, reflecting changes in market conditions. This involves professional appraisals to estimate current value.
In the United States, most companies follow the cost model per ASC 360 guidelines. However, both models significantly influence depreciation calculations and financing decisions.
Depreciating Buildings to Reflect Decreasing Value
Similar to equipment and vehicles, buildings progressively lose economic value over their lifespan. We account for this diminishing utility through depreciation – allocating the asset’s cost over estimated useful years. Two key elements drive building depreciation: the selected allocation method and associated assumptions.
Purpose of Depreciation
Recording depreciation serves several interrelated purposes:
- Better represents decreasing asset value on financial statements
- Provides reserves for future asset replacement
- Enables accurate expense and profit calculations
- Offers prudent tax deductions to minimize liability
Neglecting proper depreciation distorts financials and risks significant capital gains taxes upon sale.
Depreciation Methods
Under US GAAP principles, common depreciation calculation methods include:
Straight-Line Method
Depreciates buildings at fixed amounts each year, assuming even value distribution over the lifespan. This simplistic method is widely used.
Double-Declining Balance Method
Depreciates assets more aggressively upfront, accounting for faster value deterioration earlier on. This accelerated method maximizes near-term deductions.
Units-of-Production Method
For manufacturing buildings, depreciation aligns with operational output based on estimated units produced. This approach links to usage and revenue generation.
Estimating Useful Life
All methods require estimating total useful life in years – the asset’s reasonable longevity for the business. Consider maintenance policies, usage levels, environmental conditions, and salvage value forecasts when establishing optimal useful life. Recalibrate schedules upon significant changes, like renovations. Tax authorities provide general guidelines but allow adjustments based on individual factors.
Recording Depreciation Expense on Income Statement
Under all methods, the calculated depreciation incrementally reduces the asset account on your balance sheet. Simultaneously, recognize this allocable cost as depreciation expense on your income statement, incrementally increasing total accumulated depreciation. This impacts period profits and net income accordingly. Integrate the expense into your cash flow projections as well.
Accounting for Building Improvements and Repairs
Beyond standard depreciation allocation, building improvements and repairs also periodically impact financial reporting. However, not all expenses qualify for the same balance sheet treatment. Carefully assess if expenditures extend usefulness (capitalized improvements) or simply maintain operations (repair expenses).
Capitalization Criteria
Per ASC 360 guidelines, building improvements require capitalization if all three criteria are met:
- Substantially improves or enhances utility
- Extends the original estimated useful life
- Exceeds capitalization threshold ($5,000 for buildings)
Conversely, repairs and maintenance lack lasting value, only enabling continued use.
Capitalized Improvements vs. Repairs and Maintenance Expenses
For qualifying improvements, add enhancement costs to the asset basis rather than expensing, equally extending future depreciation calculations. This avoids disproportionately reducing profits in a single year. Conversely, recognizing repair and maintenance outlays as expenses in the period incurred better matches usage and conservatively states income.
Examples help illustrate the distinction:
Capital Improvements: New HVAC system, backup generator installation, electrical overhaul, structural reinforcements.
Repairs and Maintenance: Brick repointing, gutter replacement, parking lot pothole patching, stair tread replacement.
Leasehold Accounting for Buildings
Many businesses opt to lease rather than purchase buildings to conserve capital and enable flexibility. While eliminating ownership responsibilities, leased premises still impact operations, costs, risk exposure, and financial reporting – requiring rigorous accounting practices. Specifically, properly treat tenant improvements under lease clauses, rent payments, and balance sheet disclosures.
Leasehold Improvements
Unlike building owners, tenants cannot capitalize on improvement costs for accounting purposes due to the limited economic benefit period per ASC 840 guidelines. Instead, established leasehold improvement accounts enable systematic amortization over the shorter lease term, not the asset’s extended life. These balance sheets and income statement impacts better match expenses to the operational period benefited.
Accounting for Leased Buildings
All lease agreements involve complex legal terminology and clauses dictating use rights, restrictions, termination options, rent schedules, operating expense allocations, renewal terms, and security deposit handling. Thoroughly review contracts to structure accurate accounting treatment regarding:
Lease Contract Clauses
Classify agreements as operating leases or capital leases based on key provisions and risk exposure, significantly impacting balance sheet presentation. Consult professionals to ensure appropriate conclusions under ASC 840 principles for your situation.
Rent Expense
Systematically recognize contractual rent outflows as operating expenses over the lease period on your income statement rather than upfront, incrementally reducing earnings each period benefited.
Disclosure Requirements
Future minimum lease payment commitments require footnote disclosure on financial statements or supplementary schedules per ASC requirements, informing stakeholders of long-term cash flow obligations. An auditor can help ensure compliance.
Impact on Financial Statements and Additional Considerations
As demonstrated, buildings substantially impact your core financial statements in interrelated ways, warranting rigorous accounting. Further contextual factors also deserve consideration when owning, improving, or leasing buildings.
Balance Sheet, Income Statement, Cash Flow Statement
Tracing the impact across statements provides a comprehensive perspective:
Balance Sheet: Buildings represent substantial asset cost bases reduced by accumulated depreciation and outstanding mortgages. Leased premises require limited disclosure.
Income Statement: Depreciation allocation and repair expenses reduce margins while leased premises generate rent expenses. These collectively diminish net income.
Cash Flow Statement: Constructing or acquiring buildings constitutes investing outflows while mortgage principal payments require ongoing financing outflows. Operations generate inflows to finance expenses reflected on the income statement.
Notes to Financial Statements
Within supplementary financial statement notes, business entities must disclose building accounting policies, depreciation methods, capitalization thresholds, lease obligations, and other relevant assumptions or commitments. This qualitatively contextualizes quantitative reporting. External auditors often guide note preparation.
Property Taxes and Insurance
Beyond accounting treatments, as owners, companies must budget for recurring building-related fees like property tax levies and insurance premiums to occupy or operate facilities. Model expected costs early in planning processes to comprehensively project overhead expenses and cash outlays. Consult specialists to minimize expenses if possible.
International Accounting Differences
While most American companies follow US GAAP-based guidance explained here, globally, many countries use International Financial Reporting Standards (IFRS). Under IFRS 16 for leases and IAS 16 for buildings, some specific calculations differ. Multinational businesses must integrate appropriate frameworks across geographies.
Internal Controls and Audit Procedures
Due to buildings’ materiality, strengthen associated internal controls for sound governance. Customize audit procedures to thoroughly validate reporting treatments, calculations, assumptions, and note disclosures regarding buildings. This promotes data integrity for decision-making. Independent external examination also enhances credibility for investors and stakeholders.
Valuation Methods
Beyond accounting rule compliance, evaluating building assets periodically or when events trigger impairment testing often provides a meaningful perspective for shareholders and leadership. Common valuation approaches include cost, income capitalization, and sales comparison methods. Consult accredited appraisers for formal estimates.
Conclusion
In summary, properly recording and depreciating owned buildings as well as rigorously tracking leasehold premises requires comprehensive policies, calculations, analysis, and disclosures spanning far beyond one financial metric or report.
Master these building accounting best practices to genuinely understand and benchmark performance over time. Treat this as an ongoing operating priority with continuous enhancement opportunities rather than a one-time project for sustainable success.
