Chapter 11 Capitalisation of Borrowing Costs

Gripping IFRS

Capitalisation of borrowing costs

Reference: IAS 23

Chapter 11 Capitalisation of Borrowing Costs

Contents:

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1. Introduction and definitions

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1.1 Overview

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1.2 Borrowing costs

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1.3 Qualifying assets

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1.4 Qualifying borrowing costs

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2. Expensing borrowing costs

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2.1 Recognition

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2.2 Measurement

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Example 1: expensing borrowing costs

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3. Capitalising borrowing costs

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3.1 Recognition

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3.1.1 Commencement of capitalisation

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Example 2: capitalisation of borrowing costs: all criteria met at same time 367

Example 3: commencement of capitalisation: criteria met at different times 368

Example 4: commencement of capitalisation: criteria met at different times 368

3.1.2 Suspension of capitalisation

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Example 5: delays in construction

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3.1.3 Cessation of capitalisation

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Example 6: end of construction

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3.2 Measurement

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3.2.1 Measurement: specific loans

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Example 7: specific loans

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Example 8: specific loans: costs paid on specific days

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Example 9: specific loans: costs paid evenly over a period

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Example 10: specific loans: loan raised before construction begins

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3.2.2 Measurement: general loans

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Example 11: general loan: costs incurred evenly

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Example 12: general loan: costs incurred at the end of each month

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Example 13: general loan: costs incurred at the start of each month

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4. A comparison of the methods

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5. Disclosure

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6. Summary

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1 Introduction and definitions

1.1 Overview

IAS 23 was revised in March 2007. Those of you who have studied this standard previously will notice that in the previous version of IAS 23, accountants were able to choose between: ? the benchmark treatment (expensing borrowing costs); and ? the allowed alternative treatment (capitalising borrowing costs).

In the revised version of IAS 23, however, you will notice that there is no reference at all to the benchmark or allowed alternative treatments. The revised IAS 23 has it that accountants must capitalise borrowing costs (the previous allowed alternative treatment) that are incurred on qualifying assets. Thus borrowing costs on non-qualifying assets are always expensed.

Therefore, IAS 23 now requires that an entity: ? capitalise borrowing costs that were incurred on a qualifying asset; and ? expense borrowing costs that were not incurred on a qualifying asset.

Up until now you will have indirectly been exposed to borrowing costs where borrowing costs are generally expensed (i.e. the presupposition in such examples would have been that the borrowing costs were not incurred on a qualifying asset). We will now learn how and when to capitalise borrowing costs. In a nutshell, borrowing costs that relate to qualifying assets must be capitalised assuming that criteria for recognition of an asset are also met.

One of the more significant reasons behind capitalising borrowing costs instead of expensing them is that the cost of financing is generally a significant cost, and is generally a necessary evil in order to bring an asset to a location and condition that makes it useable or saleable. Costs that are significant and necessary should surely form part of the asset's cost. There are arguments against capitalizing borrowing costs as well, of course. These are discussed at the end of this chapter, but are largely academic now, given that there is no longer a choice.

1.2 Borrowing costs

Borrowing costs are those costs that are incurred by the entity in connection with the borrowing of funds.

Other names often used for borrowing costs include: ? interest expense; and ? finance charges.

Borrowings costs may include: ? interest incurred on loans (including bank overdraft); ? amortisation of discounts (or premiums); ? finance charges on finance leases; ? exchange difference on foreign loan accounts; and ? costs of raising debt.

1.3 Qualifying assets

Qualifying assets are those that take a substantial period of time to get ready for their intended use or sale.

Qualifying assets may include: ? manufacturing plants; ? power generation facilities; ? intangible assets; ? investment properties; and ? inventories.

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1.4 Qualifying borrowing costs (IAS 23.8 - .10)

Borrowing costs that must be capitalised to the cost of an asset are those that: ? are directly attributable ? to the acquisition, manufacture or production ? of a qualifying asset; and those that ? would have been avoided had the expenditure on the qualifying asset not been made.

It is sometimes quite difficult to identify a direct link between borrowing costs incurred and a specific asset since: ? the borrowings may not have been specifically raised for that asset, but may be general

borrowings (i.e. the entity may have a range of debt instruments at a range of varying interest rates); ? the borrowings may not even be denominated in your local currency (i.e. the borrowings may be foreign borrowings); and ? the borrowings may be subject to hyper-inflation (borrowing costs that compensate for inflation are always expensed).

The lists of complications are seemingly endless thus frequently requiring your professional judgement. These complications in calculation of the borrowing costs to be capitalised are expanded upon in the section entitled `measuement'.

2 Expensing borrowing costs

2.1 Recognition (IAS 23.8 - .9)

Whenever borrowing costs do not meet the conditions for capitalisation, they are expensed.

Expensing borrowing costs simply means to include the borrowing costs as an expense in profit or loss in the period in which they were incurred (i.e. as and when interest is charged in accordance with the terms of the borrowing agreement).

2.2 Measurement

The amount of borrowing costs expensed is simply the amount charged by the lender in accordance with the borrowing agreement.

Example 1: expensing borrowing costs

Yay Limited incurred C100 000 interest (during the year ended 31 December 20X5) on a loan that was used to finance the construction of a factory plant.

The factory plant was not considered to be a qualifying asset.

Required: Provided the necessary journal entries for expensing the interest in Yay Limited's books for the year ended 31 December 20X5.

Solution to example 1: expensing borrowing costs

Comment: When to recognise an expense: when the interest is incurred. How much to expense: the amount of interest charged by the lender in terms of the agreement.

Finance costs (expense) Bank/ liability

Interest incurred during the period is expensed

Debit 100 000

Credit 100 000

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3 Capitalising borrowing costs

3.1 Recognition (IAS 23.8 - .9)

To capitalise borrowing costs simply means to include them in the cost of the related qualifying assets. In other words, the borrowing costs are recognised as an asset.

Before the borrowing costs may be recognised as an asset, they must meet the basic recognition criteria for an asset: ? future economic benefits must be probable; and ? the costs must be reliably measurable.

Borrowing costs that must be capitalised are those: ? that are directly attributable ? to the acquisition, construction or production ? of a qualifying asset.

Directly attributable means: if the assets had not been constructed, acquired or produced then these costs could have been avoided.

An example of an acquisition is the purchase of a building. An example of the construction of an asset is the building of a manufacturing plant. An example of the production of an asset is the manufacture of inventory.

When to recognise borrowing costs as part of the asset (capitalisation) is affected by: ? Commencement date: capitalisation starts from the date on which certain criteria are met; ? Suspension period: capitalisation must stop temporarily when certain criteria are met; ? Cessation date: capitalisation must stop permanently when certain criteria are met.

When borrowing costs are capitalised, the carrying amount of the asset will obviously be increased by the borrowing costs incurred. The cost of these borrowings will eventually reduce profits, but only when the qualifying asset affects profit or loss (e.g. through the depreciation expense when the qualifying asset is an item of property, plant and equipment).

3.1.1 Commencement of capitalisation (IAS 23.17 - .19)

Assuming the basic recognition criteria are met, an entity must start to capitalise borrowing costs from the date that all the following criteria are met: ? the entity is preparing the asset for its intended use or sale (activity is happening); ? expenditure is being incurred by the entity in preparing the asset; and ? borrowing costs are being incurred.

The date that all three criteria are met is known as the commencement date.

Example 2: capitalisation of borrowing costs - all criteria met at same time

Yippee Limited incurred C100 000 interest on a loan used to finance the construction of a building during the year ended 31 December 20X5: ? The building was considered to be a qualifying asset. ? Construction of the building began on 1 January 20X5, when the loan was raised. ? It is probable that the building would result in future economic benefits and the borrowing

costs are reliably measurable. ? The construction of the building began as soon as the loan was raised.

Required: Provide the necessary journal entries to capitalise the borrowing costs in Yippee Limited's books for the year ended 31 December 20X5.

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Solution to example 2: capitalisation of borrowing costs - all criteria met at same time

Comment: Interest must be recognised as part of the cost of the qualifying asset. Interest is recognised

as part of the asset (capitalisation) from the time that all criteria for capitalisation are met. All criteria

are met on the same date (1 January 20X5):

? a loan is raised on 1 January 20X5 on which interest is being incurred;

? activities start on 1 January 20X5; and

? expenditure related to the activities start on 1 January 20X5 is being incurred.

The basic recognition criteria are also met and therefore the amount to be capitalised is calculated from

1 January 20X5.

Debit

Credit

Finance costs (expense)

100 000 x 12 / 12

100 000

Bank/ liability

100 000

Interest on the loan incurred first expensed

Building: cost (asset)

100 000 x 12 / 12

Finance costs (expense)

Interest on the loan capitalised to the cost of the building

100 000

100 000

Example 3: commencement of capitalisation - criteria met at different times

Dawdle Limited borrowed C100 000 on the 30 June 20X5 to build a factory to store its goods. The necessary building materials were only available on 31 August 20X5 and it was then that Dawdle Limited began construction. The building is considered to be a qualifying asset.

Required: Discuss when Dawdle Limited may begin capitalising the interest incurred.

Solution to example 3: commencement of capitalisation - criteria met at different times

All three criteria must be met before the entity may begin capitalisation. From the 30 June 20X5, Dawdle Limited borrowed funds and began incurring borrowing costs, but had not yet met the other two criteria (activities were not underway and costs on the asset were not being incurred). On the 31 August 20X5, however, Dawdle both acquired the construction materials and began construction thereby fulfilling all three criteria. Dawdle Limited may therefore only begin capitalising the borrowing costs on the 31 August 20X5 (assuming that it was probable that the building would render future economic benefits and that the costs were considered reliably measurable).

Example 4: commencement of capitalisation - criteria met at different times

Hoorah Limited incurred C100 000 interest for the year ended 31 December 20X5 on a loan of C1 000 000, raised on 1 January 20X5. The loan was raised to finance the construction of a building during the year ended 31 December 20X5. The building is a qualifying asset. Construction began on 1 February 20X5.

Required: Provide the necessary journal entries to capitalise the borrowing costs in Hoorah Limited's books for the year ended 31 December 20X5.

Solution to example 4: commencement of capitalisation - criteria met at different times

Comment: Borrowing costs are being incurred from 1 January 20X5, but activities and related expenditure are only incurred from 1 February 20X5: all three criteria for capitalisation are therefore only met from 1 February 20X5 and therefore capitalisation may only occur from this date:

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20X5

Finance costs (expense)

100 000 x 12 / 12

Bank/ liability

Interest on the loan incurred first expensed: total interest incurred for

the year (given: 100 000)

Building: cost (asset)

100 000 x 11 / 12

Finance costs (expense)

Interest on the loan capitalised to the cost of the building; from

commencement date (1 February 20X5)

Debit 100 000

91 667

Credit 100 000

91 667

3.1.2 Suspension of capitalisation (IAS 23.20 - .21)

If the active development of the qualifying asset is interrupted or delayed for a long period of time, the capitalisation of the borrowing costs must be suspended.

Capitalisation of borrowing costs must not be suspended, however, if: ? the delay is only temporary; ? if the delay is due to substantial technical or administrative work; or ? if the delay is a necessary part of getting the asset ready for its intended use.

A typical example of when borrowing costs should continue to be capitalised despite a delay is a wine farm that has to wait for its inventory of wine to mature in order to ensure a saleable condition. In this case, borrowing costs that are incurred during this period of maturation would continue to be capitalised to the cost of the inventory of wine.

Example 5: delays in construction

A hotel is under construction in 20X5. Borrowing costs of C300 000 are incurred on a loan during 20X5. The loan was specifically raised on 1 January 20X5 for the sole purpose of the construction of the hotel.

Required: Discuss how much of the interest may be capitalised assuming that: A. The builders go on strike for a period of two months, during which no progress is made. B. The builders of the hotel had to wait for five days for the cement in the foundations to dry.

Solution to example 5: delays in construction

A. During these two months, the interest incurred may not be capitalised to the asset as it is a substantial and unnecessary interruption to the construction process.

B. The borrowing costs must still be capitalised as it is merely a temporary delay and is a normal part of the construction process.

3.1.3 Cessation of capitalisation

The entity must stop capitalising borrowing costs when the asset: ? is ready for its intended use or sale; or ? is substantially complete and capable of being used or sold.

By way of example, capitalisation would cease if routine administration work or minor modifications are all that remains to be done (e.g. decoration of a new building to the client's specifications) in order to bring the asset to a useable or saleable condition.

If an asset is completed in parts where each part is capable of being used separately from the other parts, then capitalisation of borrowing costs ceases on each part as and when each part is completed. An example of such an asset would be an office park: as office blocks are

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completed, these office blocks may begin to be used by tenants. An example of an asset that would not be capable of being used or sold in parts is a factory plant that requires parts to be made in sequence and where the plant becomes operational only when all parts are completed.

Example 6: end of construction

Flabby Limited began construction of a block of flats on 1 January 20X5. The block of flats is to be leased out to tenants in the future.

On 1 January 20X5, Flabby Limited correctly began capitalising borrowing costs (on a C2 000 000 loan raised for the construction) to the cost of the property.

On 30 September 20X5, the building of the block was complete but no tenants could be found. On 15 November 20X5, however, after lowering the rentals, the entire building was rented out to tenants.

Interest of C200 000 (at 10% on the loan) was incurred during the 12-month period ended 31 December 20X5.

Required: Discuss when Flabby Limited should stop capitalising the interest expense to the asset (building) and show the journal entries relating to interest.

Solution to example 6: end of construction

Capitalisation should cease when: ? the asset is ready for its intended use or sale.

On the 30 September 20X5 the construction was completed. Although the asset was not being leased it was ready to be leased to tenants on 30 September 20X5, and therefore capitalisation must cease on 30 September 20X5 (because one of the three criteria for capitalisation is no longer met: activity has ceased). All subsequent interest incurred must be expensed.

Journals in 20X5: Finance costs (expense)

Bank/ liability Interest incurred: 200 000 (given)

Debit 200 000

Credit 200 000

Building (asset) Finance costs (expense)

Interest capitalised: 200 000 x 9 / 12 (to completion date: 30/9/20X5)

150 000

150 000

3.2 Measurement (IAS 23.10 - .15)

Not all borrowing costs may be capitalised. The list of borrowing costs that may be capitalised are given in IAS 23 and are included under paragraph 1.2 above.

Notice that this list excludes certain costs associated with raising funds or otherwise financing a qualifying asset. This suggests that costs that do not appear on this list may not be capitalised. Borrowing costs therefore exclude: ? cost of raising share capital that is recognised as equity, for example:

- dividends on ordinary share capital; - dividends on non-redeemable preference share capital (dividends on redeemable

preference share capital may be capitalised because redeemable preference shares are recognised as liabilities and not equity); ? cost of using internal funds (e.g. if one uses existing cash resources instead of borrowing more funds, there is a indirect cost being the lost income, often measured using the

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companies weighted average cost of capital or the market interest rates that could otherwise have been earned); ? foreign exchange differences that are incurred as a result of acquiring the qualifying asset on credit terms with no interest charged (e.g. if an asset is purchased for $ 1 000 on 1 January 20X1 when the exchange rate is C7: $1, then the entity owes C7 000 on the transaction date, but if the payment is only necessary on 30 June 20X1 and if the payment is made on this date, and if the exchange rate is C10: $1 on this date, then the entity will have to pay C10 000: the asset will be recorded at C7 000 and the C3 000 exchange difference will have to be expensed since it does not relate to a borrowing cost).

The formula used to measure the borrowing costs that may be capitalised depends on the source of the borrowings. There are two sources of borrowings, which include: ? specific borrowings and ? general borrowings.

Unfortunately IAS 23 does not define what is meant by specific and general borrowings. The difference between specific and general borrowings can, however, be explained as follows: ? specific borrowings are taken out for the sole purpose of financing the construction,

acquisition or production of a qualifying asset; whereas ? general borrowings are those funds that are entered into for a `general' purpose. These

funds may be utilised for buying inventory, paying off creditors and a multitude of other purposes in addition to the construction, acquisition or production of a qualifying asset.

When determining whether your borrowings are either general or specific, it is useful to remember that whilst a bank overdraft facility is often used as general purpose borrowings, it is also possible for a bank overdraft facility to be arranged specifically for a qualifying asset. The particular circumstances should, therefore, always be considered when deciding whether the borrowing is specific or general.

Measuring the borrowing costs to be capitalised is sometimes more complicated that it first appears. The basic questions that one needs to answer when measuring the borrowing costs to be capitalised include: ? are the borrowings specific or general or is there a mix of both specific and general? ? is the borrowing a precise amount (e.g. a loan) or does it increase as expenditure is paid

for (e.g. a bank overdraft)? ? are the expenditures (on which interest is incurred) incurred evenly or at the beginning or

end of a period or at haphazard times during a period? ? how long are the periods during which capitalisation is allowed?

In considering whether the borrowings specific or general or is there a mix of both specific and general, remember that: ? where the borrowings are specific:

- you will need the actual rate of interest/s charged on the borrowing/s; and - you will need to ascertain whether any surplus borrowings were invested upon which

interest income was earned (if so, remember to reduce the interest expense by the interest income); ? where the borrowings are general: - you will need the weighted average rate of interest charged (assuming there is more than one general borrowing outstanding during the period);

In considering whether the borrowing is a precise amount (e.g. a loan) or whether it increase as expenditure is paid for (e.g. a bank overdraft), bear in mind that: ? if the borrowing is a loan ( a precise amount), you will use the capital sum; and ? if the borrowing is an overdraft (a fluctuating amount), you will use the relevant

expenditures and will need to know when they were incurred (or whether they were incurred relatively evenly).

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