Borrowing costs, as understood generally, refer to interest costs. However, borrowing costs as envisaged by IAS 23 are not just interest costs on short-term borrowings, such as bank overdrafts and notes payable, or long-term borrowings, such as term loans and real estate mortgages. Rather, borrowing costs also include other related costs, such as: amortization of discounts or premiums relating to borrowings, amortization of ancillary costs incurred in connection with the arrangement or borrowings, exchange differences arising from foreign currency borrowings to the extent they are regarded as an adjustment to interest costs, finance charges in respect of finance leases recognized in accordance with IAS 17, Leases.
The issue is arisen when determining whether borrowing costs can be capitalized as part of the cost of acquiring, constructing, or producing a “qualifying asset“. This post tries to provide easy guidelines for the issue with case examples adapted from IAS 23.
IAS 23, Borrowing Costs, prescribes two alternative treatments for recognizing borrowing costs. The capitalization of borrowing costs into the cost of a qualifying asset is an “allowed alternative treatment” under the standard, while the “benchmark treatment” prescribed by the standard is to expense borrowing costs when incurred.
The Standard is to be applied in accounting for (i.e., recognizing) borrowing costs. Although the benchmark treatment under the Standard is to expense borrowing costs, the allowed alternative treatment permits capitalization of such costs. Not all kinds of borrowing costs are to be capitalized.
Borrowing costs that are directly attributable to the acquisition, construction, or production of a qualifying asset are to be capitalized as part of the cost of that asset. Furthermore, once such an accounting policy is selected, it must be used for all qualifying assets.
The standard applies only to borrowing costs relating to external borrowings and not to equity. Therefore, the Standard does not deal with the imputed or actual cost of equity, including preferred capital not classified as equity.
Definitions Of Key Terms (in accordance with IAS 23)
Borrowing costs. Include interest and other costs incurred by an entity in relation to borrowing of funds.
Qualifying asset. An asset that necessarily takes a substantial period of time to get ready for its intended use or sale.
For Your Information: The Concept of “Qualifying Asset” Is Difficult to Understand
The concept of “qualifying asset” is difficult to understand and comprehend in the spirit of the Standard. Some entities inadvertently apply (or at least insist on applying) this Standard to borrowing costs relating to assets that are expensive to purchase. These entities get confused because to them the quantum of the borrowing costs relating to the cost of the asset probably justifies such accounting treatment. For instance, if an expensive machine is bought (as opposed to being built by the entity) and the cost of the machine is quite substantial, entities inadvertently apply the Standard and argue that it is appropriate to capitalize borrowing costs along with the cost of the plant. Their justification is that since the machine is very expensive, the borrowing costs relating to the purchase of the machine are also quite significant. Thus it would not be right on their part to expense these costs. These entities further argue that in expensing such borrowing costs, they are able to capture only part of the cost of the asset. The cost of financing is to be included in the cost of the purchase of the asset because without incurring that cost, the entity would not have been in a position to purchase such an expensive asset.
In practice, auditors face such situations quite often, especially in developing countries, where the costs of borrowing are quite high compared to other economies.
Next, let’s have a look at the following case example. Move on…
On December 1, 20X8, LieDharma Inc. began construction of homes for those families that were hit by the tsunami disaster and were homeless. The construction is expected to take 3.5 years. It is being financed by issuance of bonds for $7 million at 12% per annum. The bonds were issued at the beginning of the construction. The bonds carry a 1.5% issuance cost. The project is also financed by issuance of share capital with a 14% cost of capital. LieDharma Inc. has opted under IAS 23 to capitalize borrowing costs.
The question is: What is the total borrowing costs that need to be capitalized under IAS 23?
Since these homes are “qualifying assets” borrowing costs can be capitalized and are computed with two steps:
Step-1: Interest on $7 million bond = $7,000,000 ×12% = $840,000
Step-2: Amortization of issuance costs of the bond (using the straight-line method)
= [(0.015 × $7,000,000 ) / 3.5 years]
Total borrowing to be capitalized = $840,000 + $30,000 = $870,000
Assets that are ready for their intended use or sale when acquired are not qualifying assets as envisioned by this standard. Qualifying assets, for the purposes of this standard, are assets that take a substantial period of time to get ready for their intended use. Examples of qualifying assets include:
- A toll bridge that takes a couple of years to construct before it is ready for use and is opened to the public
- A power plant that takes a substantial period of time to get ready for its intended use
- A hydroelectric dam that services the needs of a village and takes a considerable period of time to construct
Inventories that are routinely manufactured or are produced on a repetitive basis over a short period of time are obviously not qualifying assets. However, inventories that require a substantial period of time to bring to a salable condition can be regarded as qualifying assets for the purposes of this standard.
For better understanding about the “qualifying assets” concept, let’s have a look another case example below. Read on…
LieDharma Inc. engaged a consulting firm to advise it on many projects that it had been planning to undertake in order to diversify its operations and enhance its public image and ratings. With this mandate, the consulting firm set out to prepare a feasibility study for the construction of a shopping mall that would house anchor tenants such as world-class international designers and well-known global retail chains. The consulting firm advised LieDharma Inc. that this kind of a project would do wonders to its corporate image. This shopping mall had certain distinguishing features that were unique in many respects, and it could easily win the coveted title of the most popular commercial complex in the country. Based on this advice, LieDharma Inc. began construction of the shopping mall on a huge plot of land in the heart of the city. Substantial amounts were spent on its construction. Architects from around the globe competed for the project, and the construction was entrusted to the best construction firm in the country. The construction took over two years from the date the project was launched. The total cost of construction was financed by a term loan from an international bank.
The consulting firm also advised LieDharma Inc. to launch a car dealership that deals only in world-renowned, expensive brand names, such as Rolls-Royce and Alfa Romeo. According to the research study undertaken by the consulting firm, this would be yet another business to diversify and invest in order to enhance the corporate image of LieDharma Inc. with people who matter, as such an exclusive car dealership would cater only to the needs of the top management of multinational corporations (MNCs) operating in the country. LieDharma Inc. invested in this business by borrowing funds from major local banks. Besides the corporate guarantees LieDharma Inc. gave to the banks, they also insisted on depositing with the banks title deeds of the cars as security for the loans until the entire loan amounts remain unpaid.
The Questions are:
(a) Would the shopping mall be considered a qualifying asset under the Standard? Would the interest expense on the term loan borrowed for the construction of the shopping mall qualify as eligible borrowing costs?
(b) Would the expensive cars purchased by the car dealership be considered qualifying assets under the Standard, thereby making it possible for LieDharma Inc. to capitalize the borrowing costs, which are substantial compared to the costs of the cars? Would borrowing costs include guarantee commission paid to banks for arranging corporate guarantees in addition to interest expense on bank loans?
(a) Yes, the shopping mall would be considered a qualifying asset as envisaged by the standard because construction took a substantial period of time. Furthermore, the interest expense on the funds borrowed for the construction of the shopping mall would qualify as eligible borrowing costs.
(b) Although the cars purchased are expensive assets, because they are ready for use when purchased (and do not take a substantial period of time to get ready for their intended use), they are not qualifying assets. Neither the interest expense on bank borrowings nor the guarantee fees for corporate guarantees given to banks by LieDharma Inc. would be capitalized with the cost of cars and would be expensed in the year of acquisition of the cars.
Recognition Of The Borrowing Costs
Under the benchmark treatment, borrowing costs shall be recognized as an expense in the period in which they are incurred.
When the benchmark treatment for recognizing borrowing costs is used, these costs are expensed regardless of how they are applied.
Allowed Alternative Treatment
Under the allowed alternative treatment, borrowing costs that are directly attributable to the acquisition, construction, or production of a qualifying asset shall be capitalized as part of the cost of that asset.
Capitalization of borrowing costs that are directly attributable to the acquisition, construction, or production of a qualifying asset as part of the cost of the asset is possible only if both these conditions are met:
- It is probable that they will result in future economic benefits to the entity.
- The costs can be measured reliably.
[If borrowing costs do not meet these criteria, then they are expensed].
Borrowings Eligible For Capitalization
When borrowings are taken specifically to acquire, construct, or produce an asset, the borrowing costs that relate to that particular qualifying asset are readily identifiable. In such circumstances, it is easy to quantify the borrowing costs that would need to be capitalized by using the process of elimination, that is, capitalizing the borrowing costs that would have been avoided had the expenditure on the qualifying asset not been made.
Difficulties arise, however, if borrowings and funding are organized centrally, say, within a group of companies. In such cases, a weighted-average capitalization rate may be applied to the expenditures on the qualifying asset.
When funds borrowed specifically to finance a qualifying asset are not utilized immediately, and instead the idle funds are invested temporarily until required, the borrowing costs that are capitalized should be reduced by any investment income resulting from the investment of idle funds. Borrowing costs capitalized in a period cannot exceed the amount of borrowing costs incurred by the entity during that period.
For better understanding of the issue, read on the following case example…
A socially responsible multinational corporation (MNC) decided to construct a tunnel that will link two sides of the village that were separated by a natural disaster years ago. Realizing its role as a good corporate citizen, the MNC has been in this village for a couple of years exploring oil and gas in the nearby offshore area. The tunnel would take two years to build and the total capital outlay needed for the construction would be not less than $20 million. To allow itself a margin of safety, the MNC borrowed $22 million from three sources and used the extra $2 million for its working capital purposes.
Financing was arranged in this way:
- Bank term loans: $5 million at 7% per annum
- Institutional borrowings: $7 million at 8% per annum
- Corporate bonds: $10 million at 9% per annum
In the first phase of the construction of the tunnel, there were idle funds of $10 million, which the MNC invested for a period of six months. Income from this investment was $500,000.
Issues: If the MNC decided to opt for the “allowed alternative treatment” under IAS 23, how would it treat the borrowing costs? How would it capitalize the borrowing costs, and what would it do with the investment income?
Under the allowed alternative treatment under IAS 23, borrowing costs would be capitalized as part of the cost of the asset.
(a) In order to capitalize the borrowing costs, a weighted-average cost of funds borrowed is computed:
= ($5 million × 7%) + ($7 million × 8%) + ($10 million × 9%) / ($5 million + $7 million + $10 million)
= ($1.81 million / $22 million) × 100
= 8.22 % per annum
(b) Total borrowing cost = $20 million × 8.22 % per annum × 2 years
= $1.644 million × 2 years
= $3.288 million
(c) Borrowing costs to be capitalized = Interest expense – investment income [resulting from investment of idle funds]
= $3,288,000 – $500,000
Excess Of Carrying Amount Of The Qualifying Asset Over The Recoverable Amount
When the carrying amount or the expected ultimate cost of the qualifying asset exceeds its recoverable amount or net realizable value, the carrying amount is to be written down or written off in accordance with the requirements of other Standards, such as IAS 36, Impairment of Assets.
Commencement Of Capitalization
Capitalization of borrowing costs shall commence when:
- Expenditures for the asset are being incurred;
- Borrowing costs are being incurred; and
- Activities necessary to prepare the asset for its intended use or sale are in progress.
Suspension Of Capitalization
Capitalization shall be suspended during extended periods in which active development is interrupted unless that period is a necessary part of the process for the production of the asset. For example: capitalization would be suspended during an interruption to the construction of a bridge during very high water levels, which are common in the area where construction is taking place.
However, capitalization of borrowing costs should not be suspended when there is only a temporary delay that is caused by certain expected and anticipated reasons, such as while an asset is getting ready for its intended use.
Cessation Of Capitalization
Capitalization of borrowing costs shall cease when substantially all the activities necessary to prepare the asset for its intended use or sale are complete. If all that is left are minor modifications, such as decoration or routine administrative work, then the asset is considered to be substantially complete. In some instances, such as a business park or extensive development, parts may become ready for use in stages. In such cases, capitalization ceases on those parts that are ready for use.
An entity shall disclose its accounting policy for the recognition of borrowing costs, the amount of borrowing costs capitalized during the period, and the capitalization rate used to determine the amount of borrowing costs eligible for capitalization.