Resolved: start-up costs are not assets.
The conclusion seems simple enough: The costs of start-up activities, including organization costs, should be expensed as they are incurred. But how easy will entities find it to apply this new rule by the AICPA's AcSEC? In April 1998, AcSEC issued SOP 98-5, Reporting on the Costs of Start-Up Activities, which applies to all nongovernment entities. Most entities are required to adopt the SOP for fiscal years beginning after December 15, 1998, except for certain investment companies, which were required to adopt it as of June 30, 1998. (See Official Releases, page 99, for the text of the SOP). This article addresses some of the possible confusion about what SOP 98-5 does and does not cover.
START-UP ACTIVITIES DEFINED
SOP 98-5 defines start-up activities as one-time activities an entity undertakes when it opens a new facility, introduces a new product or service, conducts business in a new territory or with a new class of customer or beneficiary, initiates a new process in an existing facility or commences some new operation. After considerable research and discussion, that's the best definition anyone could come up with.
That said, the final definition is broad and might appear to overlap with activities related to buying or building certain assets, such as fixed assets and inventory--comments on the exposure draft of the SOP highlighted some of the confusion. One provision of the SOP is worth stressing: Costs that entities previously capitalized as start-up costs should now be expensed as they are incurred. So, if Joe's Retail Co. has start-up costs of $1 million on its balance sheet, it should expense the entire $1 million immediately upon adopting SOP 98-5 and then expense all such costs as they are incurred in the future.
START-UP COSTS VS. FIXED ASSETS
Certain costs an entity incurs in conjunction with start-up activities may, in fact, be costs related to the construction of, say, a plant. How should a CPA distinguish between one-time activities related to opening a new facility (startup) and activities to get a plant constructed and ready for its intended use (fixed asset)? The distinction should not be based on a timeline of when certain activities take place, but, rather, on the nature of the activities and the costs. This, however, leads to other questions, such as whether test runs of a new plant are start-up costs or costs to get the fixed asset ready for its intended use. SOP 98-5 says CPAs should look to an entity's policy of accounting for fixed assets. In other words, the SOP is not intended to override level-A GAAP issued by the FASB.
What is GAAP for fixed assets? For most entities, the primary level-A GAAP sources for fixed asset accounting include chapter 9, section C, of Accounting Research Bulletin (ARB) no. 43, Depreciation, and FASB Statement no. 34, Capitalization of Interest Cost, which refers to the notion of capitalization up to the point that an asset is ready for its intended me. Neither source provides complete details about what costs are capitalizable. Instead, CPAs often must use textbooks and industry practice to determine detailed fixed asset accounting policies.
Intermediate financial accounting textbooks include the following expenditures as fixed assets: (1) the cost of building--materials, labor and overhead incurred during construction; professional fees; and building permits and (2) the cost of purchasing--purchase price, freight and handling; insurance during transit, assembly and installation; and the cost of trial runs.
START-UP COSTS VS. INVENTORY COSTS
Certain costs an entity incurs in conjunction with start-up activities may relate to the acquisition or manufacture of inventory. A CPA may encounter problems similar to those of fixed assets--how to distinguish between one-time activities that are related to introducing a new product (start-up) and activities related to getting the inventory ready for sale (inventory). Again, SOP 98-5 is not intended to override an entity's inventory accounting policy.
What is GAAP for inventory? For most entities, chapter 4 of ARB no. 43 is the primary level-A GAAP source for inventory accounting. Although that chapter does not give CPAs an all-inclusive list of the costs that should be capitalized as inventory, paragraph 5 does provide some guidance. As in fixed asset accounting, many entities use textbooks and established industry practice to determine capitalizable inventory costs.
Accounting textbooks include these expenditures as inventory: the cost of manufacturing--raw materials, labor and overhead, such as indirect materials and indirect labor, and the cost of purchasing--purchase price, freight and other costs that are directly related to bringing goods to the purchaser and converting them to salable condition.
THE BOTTOM LINE
Two important items in SOP 98-5 are "bottom-line" concerns for CPAs:
1. Entities should expense start-up costs as they are incurred.
2. To determine what kinds of costs--which seem like start-up costs--may actually be capitalized, CPAs must focus on other sources of GAAP. AcSEC does not have the authority to provide further guidance on level-A topics, such as fixed asset and inventory accounting.
CPAs who work for entities that must implement SOP 98-5 would be wise to meet with their outside CPA firms before the end of a reporting period to decide how costs are to be categorized--as start-up, fixed assets or inventory, for example. As a CPA's individual judgment is required to make some of these decisions, entities should take steps to prevent last-minute disagreements.
Given the difficulty of more precisely defining start-up costs, it is no wonder SOP 98-5 requires them to be expensed as incurred. It appears that U.S. financial reporting will not be alone in this requirement. The latest available draft of the International Accounting Standards Committee standard on intangibles requires entities to expense start-up costs as incurred. Can the world be so wrong?
RELATED ARTICLE: EXECUTIVE SUMMARY
* IN APRIL 1998, THE AICPA ISSUED SOP 98-5, Reporting on the Costs of Start-Up activities. It applies to all nongovernment entities, most of which are required to adopt it for fiscal years beginning after December 15, 1998.
* START-UP COSTS--ONE-TIME ACTIVITIES an entity undertakes when it introduces a new product or service, conducts business in a new territory or with a new class of customer or beneficiary, initiates a new process in an existing facility or commences some new operation--must be expensed, according to the new SOP, as the entity incurs them.
* SOP 98-5 IS NOT INTENDED TO OVERRIDE level-A GAAP. In determining whether an expense is a start-up cost or a fixed asset, CPAs should look to an entity's policy of accounting for fixed assets for guidance.
* AS THEY IMPLEMENT SOP 98-5, ENTITIES should meet with their outside CPA firms before the end of a reporting period to decide which costs are start-up, fixed assets or inventory. This will help prevent last-minute disagreements.
CHARLES L. McDONALD, CPA, PhD, is associate professor of accounting, Fisher School of Accounting, University of Florida, Gainesville. DANIEL NOLL, CPA, is a technical manager in the AICPA accounting standards division. Mr. Noll is an employee of the American Institute of CPAs and his views of the AICPA. Official positions are determined through specific committee procedures, due process and deliberation.