Improper capitalisation of costs, or where mistakes are made most often

Not every investment project qualifies for capitalisation

In practice, we often encounter the argument that if an expenditure is related to a significant company project, it should be capitalised. However, this is not the case either under Czech accounting rules or under IFRS.

The key question is not whether the cost relates to a long-term project, but whether it contributes to the acquisition or creation of a specific non-current asset that the company will subsequently use. In the case of development activities, compliance with National Accounting Board Interpretation I-40, Recognition of Intangible Development Outputs, is crucial.

Five key questions

• Is a specific non-current asset being created?
• Is the cost directly related or causally attributable to that asset?
• Is it highly probable that the non-current asset will be completed and will generate economic benefits for the company?
• Was the cost incurred before the asset was ready for use?
• Is the cost free from any of the express exclusions from valuation listed in Section 47 of Decree No. 500/2002 Coll. for entrepreneurs (the “Decree”)?

If the answer to any of these questions is no, the appropriate treatment will generally be to recognise the costs as an expense in the period or, where the applicable conditions are met, to defer them (as deferred expenses or complex deferred expenses) (see, for example, Czech Accounting Standard No. 017: Accounting Relationships).

What may form part of the valuation of non-current assets

When an asset is acquired from a supplier, its valuation includes the acquisition cost, i.e. the purchase price and acquisition-related costs. For assets created internally, valuation is based on own costs. Nowadays, projects are often mixed, with part acquired from suppliers and part performed by the company’s own employees. The specific items included in valuation are governed primarily by Section 47 of the Decree.

Error No. 1: Capitalising training and change management costs in erp projects

Implementation of ERP (Enterprise Resource Planning) systems typically includes services of various types. While licences, software modifications, configuration work and certain pre-implementation tests may form part of the valuation of software, user training is excluded from valuation under Section 47(2) of the Decree. Change management, communications and organisational redesign generally do not create software but rather prepare the organisation for change. Another cost that is not included in the value of a new ERP system is the cost of data conversion.

Error No. 2: Indiscriminate capitalisation of internal employee salaries

Only direct personnel costs and demonstrably attributable indirect costs may be included in the own costs of internally generated assets. It is not sufficient to decide that a certain percentage of the costs of the IT, investment or ESG organisational unit will automatically be capitalised. The entity must be able to demonstrate who worked on a specific asset, what work they performed and how the amount was calculated. Ideally, detailed records of hours worked (timesheets) broken down by individual activities should be available.

Error No. 3: Capitalising costs incurred before the decision to acquire a specific asset

The decisive moment is when the entity’s management makes the decision to acquire a specific asset. Costs incurred before that point cannot be included in the valuation of the investment and must be recognised in profit or loss for the relevant period. Examples include costs incurred in selecting a suitable type of equipment, feasibility studies, market and demand assessment studies, reviews of available technologies or suppliers, or analyses of the expected return on different variants of the proposed investment project.

Error No. 4: Treating an ESG project as an automatic reason for capitalisation

An environmental or transformational objective does not change the valuation rules. In most cases, an energy audit, ESG strategy, carbon footprint calculation or management training cannot be capitalised as part of non-current assets.

Error No. 5: Confusing development with routine innovation

Not every project described as development results in the creation of an intangible asset. It is necessary to distinguish the research phase, unsuccessful alternatives and general innovation activities from development activities that lead to the creation of a specific asset. National Accounting Board Interpretation I-40 may be used as supporting guidance in this assessment.

Error No. 6: Project management unconnected with a specific investment

External project management may form part of an asset’s valuation if it is directly and demonstrably connected with the acquisition of a specific asset. General project portfolio management, reporting to senior management or coordination of a transformation programme do not meet this condition.

For example, imagine an investment manager simultaneously managing the construction of a production hall, the implementation of an ERP system and the relocation of a warehouse. Without a demonstrable allocation of work, the manager’s annual personnel costs of CZK 2 million cannot be allocated among individual projects based merely on an estimate.

Error No. 7: An unsuccessful project left on the construction-in-progress account

Assets under construction must be reviewed regularly from the perspective of appropriate valuation and the likelihood of completion. If a project has been permanently discontinued or its completion and future economic benefits can no longer be expected, its write-off as an abandoned investment must be addressed. A lack of financial resources may also be a reason for a write-off.

Consider a situation in which a company incurred CZK 4 million of costs for project documentation and surveys relating to the construction of a new facility. After a change in strategy, the company abandoned the project but left the amount recorded in account 042. A general assertion that the project might one day be resumed or that the materials might prove useful for other investment projects is not a sufficient reason for retaining the asset under construction on the balance sheet.

Conclusion

For many projects, it is not easy to distinguish between investment and operating activities without a more detailed analysis. Development and construction projects very often include organisational, training and operational costs as well. The mere fact that a cost is connected with a project is not sufficient justification for capitalising it as an asset under construction. It is necessary to demonstrate which specific future asset the cost relates to, why it was necessary for its acquisition, and whether it was incurred after the decision to acquire the asset was made but before the asset was ready for use.