When obtaining a loan for operations or the purchase of assets. There are certain costs related to the loan other than the principal amount. The two most common fees are loan or origination fees and the interest charged on the outstanding principal itself. On construction or similar loans that are associated with an underlying asset these two costs are treated very differently.
Loan origination fees refer to all fees charged for the initiation and completion of the loan process, and can be calculated differently depending on the lending institution. However, there is usually an element of the fees that are associated with the principal value of the loan. While these are a one-time cost incurred at the beginning of a loan, they are related to the loan and thus benefit the borrower for the entire loan term, in most cases several months or years. If these fees are insignificant they can be expensed at the time incurred. On larger loans these fees can be materially significant. In these cases, the origination fees associated with the loan can be capitalized and amortized over the life of the loan. These costs cannot be capitalized as part of the cost basis for any related assets, but they can be spread out over several months as an expense.
Interest, on the other hand, can be capitalized as part of an associated asset in certain circumstances. If the related assets require a period of time to be ready for actual use – for example extended construction periods on real property, equipment, or ships – and the assets are intended for sale or lease, the interest can be capitalized as part of the cost basis for the assets themselves. However, if the assets are meant for construction and use by the company building it, the interest must be expensed as incurred. Additionally, if the underlying assets are inventory items that are routine and produced in large quantities, the interest must also be expensed.
The costs associated with a loan can have a material impact on asset values or monthly expenses if they are recorded incorrectly. It is especially important to handle the accounting treatment of loan origination fees and interest correctly on large projects that span several months or years as it can paint a misleading picture of a the health of a business. TGG Accounting professionals can help you understand the proper accounting treatment of loan fees and interest for your particular situation.Written by: