Recently, the IRS issued guidance related to the interpretation of the interest capitalization regulations under uniform capitalization. Significant differences between this income tax guidance and that of SFAS 34 related to financial accounting and reporting will have an impact on the calculation of deferred income taxes. In this article we describe some of the major differences related to:

* assets that qualify for interest capitalization;

* The length of the capitalization period, including interim delays; and

* Use of simple and compound interest.

Tax Rules Contrasted with GAAP

There are significant differences between the income tax capitalization rules and the requirements of GAAP. Most of these differences result from the differing perspectives of the IRS and the FASB.

In the first half of this century, business enterprises tended to expense interest charges on the income statement instead of capitalizing them as part of the associated assets on the balance sheet. During the 1960s, however, the acquisition and construction of productive assets accelerated. Companies found it necessary to report higher earnings to attract greater amounts of debt and equity financing. Capitalization of interest on the new and existing debt, therefore, became a way to obtain higher earnings. Unfortunately, there was no authoritative guidance on how to capitalize interest. As a result, various approaches were followed as to which assets were allowed to attract interest, which interest rate was used, etc. Consequently, in 1974, the sEC suspended capitalization for most companies. The suspension remained in effect until the FASB issued SFAS 34 in October 1979. That document provides the standard for interest capitalization for financial accounting and reporting.

There are several examples of how these financial accounting requirements differ from the newly enacted tax regulations. One, quite correctly, would expect tax regulations to be designed to minimize interest expense and maximize capitalization of interest charges, thereby maximizing taxable income. On the other hand, the principle of conservatism inherent in GAAP generally results in prescribed financial accounting methods that minimize income.

Accumulated Production

Expenditures--Qualifying Assets

Interest is to be capitalized for tax purposes on "accumulated production expenditures" and for financial accounting purposes on "average accumulated expenditures" during the period in which the asset is being constructed. Under GAAP, average accumulated expenditures include only those made on the following qualifying assets:

1. Assets that are being constructed by the entity for its own use or on which progress payments are being made;

2. Assets being built through discrete projects for subsequent lease or sale (precludes routine inventories);

3. Investments accounted for under the equity method when the investor is acquiring qualifying assets for pending operations.

Tax regulations take a broader view of which expenditures qualify for interest capitalized. IRS Notice 88-89 adds expenditures for pre- production planning and design activities and pre-production acquisition of land and raw materials. Moreover, a relevant percentage of the non- depreciated cost of equipment used to produce qualifying assets is included in accumulated production expenditures.

FASB requirements appear to be based on cash flow, while tax regulations are based on capitalized amounts. Thus, if a contractor performs services and the economic performance test is satisfied, the accrual basis taxpayer must add the accrued costs to accumulated production expenditures.

The book value of property used to produce other property is treated as an investment in a project for tax purposes, but not under GAAP. For example, assume that during April, Applique Company began constructing a building on property it purchased several years earlier for $40,000. Two backhoes, purchased in January of last year for $60,000 each and being depreciated for tax purposes using the double-declining balance method over five years, were used for 30% of their operating hours to help dig a foundation. Planning costs in February and March are estimated as being $10,000. The contractor was paid 10% of the total contract price of $800,000 on April 1.

Average accumulated expenditures in April, for GAAP purposes, total $80,000. For tax purposes, however, accumulated production expenditures are computed as follow:

Contract payment ($800,000 x .10) $ 80,000 Property cost 40,000 Planning cost 10,000 Backhoe usage 720 Total accumulated production expenditures $130,720

The difference of $50,720 between the financial and tax amounts represents the non-depreciated cost of the property plus previously recognized expenses for financial accounting purposes. For income tax purposes, the difference represents the capitalizable asset cost that will be depreciated over future periods. Thus, interest on $50,720 of eligible debt will be capitalized for income tax computations but expensed for financial accounting--a temporary difference in income.

Accumulated Production

Expenditures--Period

Computations

GAAP require that average accumulated expenditures be based on the actual payment schedule; tax regulations require that averages be computed at least monthly (unless an alternative method results in no significant difference in results). To see the effect, consider the following expenditures pattern in which expenditures for GAAP purposes do not differ from those for tax purposes:

April 1 $ 80,000 May 1 60,000 July 1 100,000 October 1 500,000 December 1 (project completion) 60,000 Total expenditures $320,000

Under GAAP, the average accumulated expenditures would be computed as shown in Figure 1.

Under income tax rules, however, monthly averages must be taken and then averaged again, as follows (note that depreciation and pre- production costs, as given earlier, are also included). For April, the beginning expenditure level is $130,720, as computed earlier. The accumulated expenditure level at April 30 is the sum given by the following:

Beginning expenditure level $130,720 Expenditures in April 60,000 Backhoe depreciation for April 720

Ending accumulated expenditures $191,420

The average production expenditures for the month, then, are calculated as ($130,720 + $191,420)/2 = $161,080. Remaining averages are computed in a similar fashion. Note that not all months show additional expenditures, but the relevant percentage of depreciation on the production equipment (backhoes) is included for each month. (See Figure 2.)

Thus, by averaging monthly and including equipment depreciation and pre-production expenses, the average expenditure level is larger for tax purposes than for financial accounting purposes. This, of course, leads to smaller interest expense and larger capitalized interest for income tax computations than for financial calculations. Before-tax financial income is less than taxable income by nearly $100,000 because of the difference between the amounts for tax purposes and for financial reporting purposes.

Accumulated Production

Expenditures--Interim Delays

Tax rules do not allow interruptions in capitalization for delays or suspensions once construction activities have begun. SFAS 34 specifically dictates that capitalization be delayed when they are not "normal." This obviously could affect the amount of capitalized interest cost. For example, assume $100,000 was borrowed at 12% to apply to $100,000 in construction costs. The construction planning and financing take place during March, and construction itself occurs from May 1 through July 31. The expenditure pattern is as follows:

March 1 $ 10,000 May 31 15,000 June 30 30,000 July 31 45,000

Total $ 100,000

Average accumulated expenditures and the associated interest cost to be capitalized in the financial statements are computed as shown in Figure 3. Accumulated production expenditures and tax-related interest capitalization are computed as shown in Figure 4. Interest accrued during April is expensed in the financial statements, resulting in a temporary difference income tax paid and expensed.

Traced and Avoidable Interest

Interest on debt that is incurred in order to finance a construction project, (hence it can be "traced" to the project), is included in capitalized interest under both tax rules and GAAP. If accumulated expenditures exceed the amount of such traceable debt, a weighted average interest rate on any remaining but apparently unrelated debt is applied against the additional expenditures. The rationale is that this debt could have been retired and the interest cost thereby "avoided" if the construction project had not used available funds. This rationale is applied to both tax and financial reporting.

Nonetheless, there is a major difference in application between the IRS and the FASB. Under Notice 88-89, taxpayers applying the accrual method would include accounts payable and other such non-interest bearing debt in the computation of traced or avoided cost debt. SFAS 34 specifically requires that only liabilities on which interest is recognized should be included in the computations.

To illustrate, consider the following scenario. Lodet Corporation had accumulated production expenditures equalling (to facilitate comparison) average accumulated expenditures of $600,000. Outstanding debt is as follows:

Traced debt (interest rate = 10%) $400,000 Other interest-bearing debt (interest rate = 12%) 300,000 Trade accounts payable 100,000

Under the tax rules, capitalized interest would be computed as follows:

Traced debt ($400,000 x .10) $ 40,000 Avoided debt ($200,000 x .09) 18,000

Capitalized interest $ 58,000

Under GAAP, capitalized interest would be:

Specific interest ($400,000 x .10) $ 40,000 Avoided interest ($200,000 x .12) 24,000

Capitalized interest $ 64,000

Thus, there is a $6,000 difference between interest capitalized for tax and financial statement purposes. This results from a smaller average interest rate for tax computations due to including zero interest rate debt in the calculation. Consequently, the income figure for computing taxes payable is larger than that for computing tax expense.

Simple versus Compound Interest

SFAS 34 does not preclude using either simple or compound interest rates in financial capitalization computations. Tax regulations, however, only recognize compound interest. This represents another potential source of difference between taxed income and financial income. Even if accumulated production expenditures and average accumulated expenditures are the same amount, the capitalized interest can vary by the difference between simple and compound interest. For instance, suppose $21,000,000 was borrowed at 12%, and eligible accumulated expenditures over the 14-month construction period beginning December 1, 19X1, were $21,000,000 for both income tax and financial accounting purposes. If simple interest is compounded for financial accounting, $2,940,000 in interest will be capitalized. For tax purposes, using annual compounding, the capitalized interest cots is computed as follows:

December 19X1 ($21,000,000 x .12 x 1/12) $ 210,000 All of 19X2 ($21,210,000 x .12) 2,545,200 January 19X3 ($23,755,200 x .12 x 1/12) 237,552

Total interest subject to capitalization $2,992,752

Thus, taxable income is $52,752 greater than pre-tax accounting income, assuming the interest difference was expensed for financial accounting purposes.

Summary and Conclusion

Preliminary guidance from the IRS suggests there will be several differences in the calculation of capitalized construction period interest for income tax purposes and financial reporting purposes. These differences result from the opposing perspectives of the IRS and the FASB.

This article has illustrated potential income differences resulting from alternative approaches to calculation of the accumulated expenditures that provide the basis for interest calculations; and for contrasting methods of interest accrual. Tax rules are written to provide for a greater amount of interest capitalization than GAAP. This is especially true for definitions of the capitalization period and the asset expenditures that are accumulated.

The result of these differences will be a more complicated income tax computation and additional temporary credits to the deferred tax account for affected companies.