Question

(Accounting for Pre-Opening Costs) After securing lease commitments from several major stores, Auer Shopping Center, Inc. was organized and built a shopping center in a growing suburb.

The shopping center would have opened on schedule on January 1, 2017, if it had not been struck by a severe tornado in December. Instead, it opened for business on October 1, 2017. All of the additional construction costs that were incurred as a result of the tornado were covered by insurance.

In July 2016, in anticipation of the scheduled January opening, a permanent staff had been hired to promote the shopping center, obtain tenants for the uncommitted space, and manage the property.

A summary of some of the costs incurred in 2016 and the first nine months of 2017 follows.

	2016	January 1, 2017, through September 30, 2017
Interest on mortgage bonds	\(720,000	\)540,000
Cost of obtaining tenants	300,000	360,000
Promotional advertising	540,000	557,000

The promotional advertising campaign was designed to familiarize shoppers with the center. Had it been known in time that the center would not open until October 2017, the 2016 expenditure for promotional advertising would not have been made. The advertising had to be repeated in 2017.

All of the tenants who had leased space in the shopping center at the time of the tornado accepted the October occupancy date on the condition that the monthly rental charges for the first 9 months of 2017 be canceled.

Instructions

Explain how each of the costs for 2016 and the first 9 months of 2017 should be treated in the accounts of the shopping center corporation. Give the reasons for each treatment.

Short answer

Interest must be capitalized because the building requires a period of time to get ready for its intended use. Both the 2016 and 2017 costs of obtaining tenants should be expensed as incurred. The costs should be expensed as incurred or the first time the advertising takes place.

Step-by-step solution

Meaning of Pre-Opening Costs 

Pre-opening costs are the funds spent by an entrepreneur or a company sponsor prior to the launch of a new endeavor. Pre-opening costs, also known as start-up costs, include anything from incorporation and legal fees to money spent on company plan development, permits, and registrations.

Explaining how each of the costs for 2016 and the first 9 months of 2017 should be treated in the accounts of the shopping center corporation 

Interest on mortgage bonds: An amount equal to the intrigued cost brought about in 2016 ($720,000) is a cost that can be related to the ordinary construction period and can be Treated as a typical component of the cost of the physical assets of the shopping center since the construction period would have finished at the end of the year in the event that the tornado had not occurred.

The choice to utilize debt capital to finance the shopping center was made with full information that would collect during the construction period and including the full cost of building the center, bringing it to the point at which it would create income.The retail center's future income must have been calculated to be more than enough to pay all of the planned expenses of development and preparation for occupancy, including interest during the construction period.

Instead of classifying interest as part of the cost of the physical assets, it may be argued that it is part of the overall cost of getting the firm to a stage where it can generate income and hence should be recognized as organization expenditure. Interest during construction, in this view, is merely one of the numerous costs associated with acquiring and organizing a new business's physical assets, but it is not attached to any specific assets.

The amount of interest expense for the first nine months of 2017 is used to calculate the 2017 tornado loss. Because of the tornado, the construction time was extended to October 2017. This does not deserve capitalization as construction period interest. It is, in effect, an uninsured tornado-related loss. The full sum would have been a typical operational expenditure chargeable against the rental income received during the first nine months of 2017 if it hadn't been for the disaster.

Cost of obtaining tenants: The expenditures of finding renters in 2016 and 2017 should be expensed when they are incurred. The cost of finding renters is a one-time expense. Start-up expenditures are simple to account for, so expense them when they are incurred. These expenses are made with the prospect of improved revenues or efficiency in the future. However, estimating the quantity and timing of future benefits is so difficult that a conservative approach is required—expense these expenditures as they occur.

Promotional advertising: Future gains from advertising are not sufficiently specified or quantified with the degree of certainty necessary to recognize these expenses as an asset, according to the profession, except in restricted circumstances. As a result, the expenditures should be expensed as they are incurred or when the advertising is initially done. The advertising expenditures incurred in 2017 might be represented as a loss to highlight that this was a one-time occurrence.