Companies that require additional long-term assets, such as factories, buildings and machinery, have several options. They can purchase new or used assets from others, lease the required assets or build the assets themselves. Construction in process, also known as construction is progress or CIP, is a general ledger account that companies use to record the costs of constructing long-term assets. The primary issue in accounting for CIP is separating expenses from capital costs.
The CIP account is a fixed, or long-term, balance sheet asset account that is usually reported as a part of the Property, Plant and Equipment subsection. As an asset account, CIP has a natural debit balance. Only costs that a company doesn't immediately expense reside in the CIP account. These are capital costs, which a company must depreciate over a set number of years. However, depreciation doesn't begin until the company places the asset into service, which means that the CIP account is not depreciated. Conversely, companies can immediately deduct expenses from income.
Capital costs include the direct materials, direct overhead and direct labor used to construct a long-term asset, which is an asset the company will hold for more than a year. The typical accounting entry is a debit to the CIP account and a credit to cash or accounts payable. This would apply, for example, to the concrete poured for a building. Expense entries include certain project-related indirect overhead costs that don't meet the company's capitalization requirements, such as accounting and personnel service costs. The accounting entries for these are a debit to the appropriate expense account and a credit to cash or accounts payable.
Companies often want to see the total costs associated with the construction of an asset. The solution is to set up CIP as a summary account with two sub-accounts. One sub-account carries the capital costs and the other sub-account holds items to be expensed. The company transfers the items in the CIP expense sub-account to the appropriate expense account, which creates an audit trail of project expenses. This approach helps companies avoid incorrectly characterizing project expenses as capital costs.
When the project asset finally enters into service, the company debits the appropriate long-term asset account, such as buildings or machines, and credits the project CIP account to bring its balance to zero. Once this transfer occurs, the company can begin depreciating the asset over its productive lifetime. The Internal Revenue Service has detailed guidelines specifying the number of years companies should use for depreciation purposes. These numbers do not necessarily bear any relation to the actual service lifetime of the asset.