Accounting literature says that the cost of an asset should include all the costs necessary to get the asset set up and functioning properly for its intended use in the place it is to be used. There has long been, however, a debate about whether borrowing costs should be included in the definition of all costs necessary, or whether instead such costs should be treated as purely a period expense.
The concern is that two otherwise identical entities might report different asset costs simply due to decisions made regarding the financing of the enterprises, with the leveraged (debt issuing) entity having a higher reported asset cost. A corollary issue is whether an imputed cost of capital for equity financing should be treated as a cost to be capitalized, which would reduce or eliminate such a discrepancy in apparent asset costs.
The principal purposes to be accomplished by the capitalization of interest costs are as follows:
- To obtain a more accurate original asset investment cost
- To achieve a better matching of costs deferred to future periods with revenues of those future periods
In the US, the FASB took the position (in FAS 34) that borrowing costs, under defined conditions, are to be added to the cost of long-lived tangible assets (and inventory also, under very limited circumstances). However, the implicit cost of equity capital may not be similarly treated as an asset cost. This treatment, where defined criteria are met, is mandatory under US GAAP.
Historically, the IASB has taken a different approach, offering the US GAAP rule as one alternative treatment, optional at the reporting entity’s election, until the revised IAS 23 was issued in 2007.
Key Differences Between IAS 23 and SFAS 34
Revised IAS 23 only achieves convergence in principle to the US GAAP equivalent, SFAS 34, Capitalization of Interest Cost, and there is not full convergence of accounting treatments for borrowing costs. Key differences between IAS 23 and SFAS 34, as highlighted by IASB, include:
- Definition of borrowing costs – IAS 23 uses the term “borrowing costs,” which is broader than “interest costs” used in SFAS 34. US GAAP also provide guidance on the capitalization of derivative gains and losses that are part of the capitalized interest cost. IASB does not address derivative gains and losses.
- Definition of a qualifying asset – Some assets that meet the definition of a qualifying asset under IFRS do not meet that definition under US GAAP and vice versa. For example, in some circumstances, SFAS 34 includes as qualifying assets investment in investee accounted for under the equity method while under IAS 23 such investments are not qualifying assets. Also, SFAS 34 does not permit the capitalization of interest costs on assets acquired with gifts or grants that are restricted by the donor or grantor but IAS 23 does not address such assets.
- Measurement – Under IAS 23, an entity must capitalize the actual borrowing costs incurred on that borrowing, while SFAS 34 states that the rate of that borrowing may be used.
Additionally, several differences exist which relate to the capitalization rate and the treatment of income earned on the temporary investment of actual borrowings. In this post, you can dig this into a more deeply and more detail. Started with…
IAS 23, As Revised In 2007
In March 2007, IASB issued the revised IAS 23, Borrowing Costs, which eliminated the option of recognizing borrowing costs immediately as an expense, to the extent that they are directly attributable to the acquisition, construction, or production of a qualifying asset.
This revision was a result of the Short-Term Convergence project with the FASB. The revised standard provides that a reporting entity should capitalize those borrowing costs that are directly attributable to the acquisition, construction, or production of a qualifying asset as part of the initial carrying value of that asset, and that all other borrowing costs should be recognized as an expense in the period in which the entity incurs them.
Key changes introduced by this revised standard include:
- All borrowing costs must be capitalized if they are directly attributable to the acquisition, construction or production of a qualifying asset. The previous benchmark treatment, recognizing immediately all such financing costs as period expenses, is eliminated. Under the new approach, which was an allowable alternative treatment in the past, all these costs must be added to the carrying value of the assets, when it is probable that they will result in future economic benefits to the entity and the costs can be measured reliably, consistent with the US GAAP approach.
- Borrowing costs that do not require capitalization relate to
- Assets measured at fair value (for example, a biological asset), although an entity can present items in profit or loss as if borrowing costs had been subject to capitalization, before measuring them to their fair values.
- Inventories that are manufactured, or otherwise produced, in large quantities on a repetitive basis, even if they take a substantial period of time to get ready for their intended use or sale.
Borrowing costs are defined as interest and other costs that an entity incurs in connection with the borrowing of funds. Such costs may include interest on bank overdrafts and short-term as well as long-term borrowings, amortization of discounts and premiums related to borrowings as well as any ancillary costs incurred in connection with the transaction of borrowings, finance charges related to finance leases (in accordance with IAS 17, Leases) and exchange differences arising from foreign currency borrowings to the extent they are treated as an adjustment to interest costs.
Borrowing costs eligible for capitalization, directly attributable to the acquisition, construction or production of a qualifying asset, are those borrowing costs that would have been avoided if the expenditure on this asset had not been made. They include actual borrowing costs incurred less any investment income on the temporary investment of those borrowings.
The amount of borrowing costs eligible for capitalization is determined by applying a capitalization rate to the expenditures on that asset. The capitalization rate is the weighted-average of the borrowing costs applicable to the borrowings of the entity that are outstanding during the period, other than borrowings made specifically for the purpose of obtaining a qualifying asset. The amount of borrowing costs capitalized during a period cannot exceed the amount of borrowing costs incurred.
A qualifying asset is an asset that necessarily takes a substantial period of time to get ready for its intended use and may include inventories, manufacturing plants, power generation facilities, intangible assets, properties that will become self-constructed investment properties once their construction or development is complete, and investment properties measured at cost that are being redeveloped. Other investments, and inventories that are routinely manufactured or otherwise produced in large quantities on a repetitive basis over a short period of time, as well as assets that are ready for their intended use or sale when acquired, are not qualifying assets.
IAS 23 does not deal with the actual or imputed cost of equity, including preferred capital not classified as a liability.
Qualifying assets are those that normally take an extended period of time to prepare for their intended uses. While IAS 23 does not give further insight into the limitations of this definition, many years’ experience with SFAS 34 provided certain insights that may prove germane to this matter.
In general, interest capitalization has been applied to those asset acquisition and construction situations in which:
- Assets are being constructed for an entity’s own use or for which deposit or progress payments are made
- Assets are produced as discrete projects that are intended for lease or sale
- Investments are being made that are accounted for by the equity method, where the investee is using funds to acquire qualifying assets for its principal operations which have not yet begun.
Generally, inventories and land that are not undergoing preparation for intended use are not qualifying assets. When land is in the process of being developed, it is a qualifying asset. If land is being developed for lots, the capitalized interest cost is added to the cost of the land. The related borrowing costs are then matched against revenues when the lots are sold. If, on the other hand, the land is being developed for a building, the capitalized interest cost should instead be added to the cost of the building. The interest cost is then matched against future revenues as the building is depreciated.
The capitalization of interest costs would probably not apply to the following situations:
- The routine production of inventories in large quantities on a repetitive basis
- For any asset acquisition or self-construction, when the effects of capitalization would not be material, compared to the effect of expensing interest
- When qualifying assets are already in use or ready for use
- When qualifying assets are not being used and are not awaiting activities to get them ready for use
- When qualifying assets are not included in a consolidated statement of financial position
- When principal operations of an investee accounted for under the equity method have already begun
- When regulated investees capitalize both the cost of debt and equity capital
- When assets are acquired with grants and gifts restricted by the donor to the extent that funds are available from those grants and gifts
If funds are borrowed specifically for the purpose of obtaining a qualified asset, the interest costs incurred thereon should be deemed eligible for capitalization, net of any interest earned from the temporary investment of idle funds. It is likely that there will not be a perfect match between funds borrowed and funds actually applied to the asset production process, at any given time, although in some construction projects funds are drawn from the lender’s credit facility only as vendors’ invoices, and other costs, are actually paid. Only the interest incurred on the project should be included as a cost of the project, however.
Interest Of Credit Facilities Used To Generate Pool Of Funds
In other situations, a variety of credit facilities may be used to generate a pool of funds, a portion of which is applied to the asset construction or acquisition program. In those instances, the amount of interest to be capitalized will be determined by applying an average borrowing cost to the amount of funds committed to the project. Interest cost could include the following:
- Interest on debt having explicit interest rates
- Interest related to finance leases
- Amortization of any related discount or premium on borrowings, or of other ancillary borrowing costs such as commitment fees
The amount of interest to be capitalized is that portion that could have been avoided if the qualifying asset had not been acquired. Thus, the capitalized amount is the incremental amount of interest cost incurred by the entity to finance the acquired asset.
A weighted-average of the rates of the borrowings of the entity should be used. The selection of borrowings to be used in the calculation of the weighted-average of rates requires judgment. In resolving this problem, particularly in the case of consolidated financial statements, the best criterion to use is the identification and determination of that portion of interest that could have been avoided if the qualifying assets had not been acquired.
The base (which should be used to multiply the weighted-average rate by) is the average amount of accumulated net capital expenditures incurred for qualifying assets during the relevant reporting period. Capitalized costs and expenditures are not synonymous terms.
Theoretically, a capitalized cost financed by a trade payable for which no interest is recognized is not a capital expenditure to which the capitalization rate should be applied. Reasonable approximations of net capital expenditures are acceptable, however, and capitalized costs are generally used in place of capital expenditures unless there is a material difference.
If the average capitalized expenditures exceed the specific new borrowings for the time frame involved, the excess expenditures amount should be multiplied by the weighted-average of rates and not by the rate associated with the specific debt. This requirement more accurately reflects the interest cost that is actually incurred by the entity in bringing the long-lived asset to a properly functioning condition and location. The interest being paid on the underlying debt may be either simple or subject to compounding.
Simple interest is computed on the principal alone, whereas compound interest is computed on principal and on any accumulated interest that has not been paid. Compounding may be yearly, monthly, or daily. Most long-lived assets will be acquired with debt having interest compounded, and that feature should be considered when computing the amount of interest to be capitalized.
The total amount of interest actually incurred by the entity during the relevant time frame is the ceiling for the amount of interest cost capitalized. Thus, the amount capitalized cannot exceed the amount actually incurred during the period. On a consolidated financial reporting basis, this ceiling is defined as the sum of the parent’s interest cost plus that incurred by its consolidated subsidiaries.
If financial statements are issued separately, the interest cost capitalized should be limited to the amount that the separate entity has incurred, and that amount should include interest on inter-company borrowings, which of course would be eliminated in consolidated financial statements. The interest incurred is a gross amount and is not netted against interest earned except in rare cases.
SIC 2 states that if interest cost is capitalized, this fact must not result in the asset being reported at an amount in excess of recoverable amount. Any excess interest cost is thus an impairment, to be recognized immediately in expense.
Example Of Accounting For Capitalized Interest Costs
Assume the following: On January 1, 2011, Lie Dharma Putra Corp. contracted with Leo Company to construct a building for $20,000,000 on land that Lie Dharma Putra had purchased years earlier. Lie Dharma Putra Corp. was to make five payments in 2011, with the last payment scheduled for the date of completion. The building was completed December 31, 2011.
Lie Dharma Putra Corp. made the following payments during 2011:
January 1, 2011 $ 2,000,000
March 31, 2011 $ 4,000,000
June 30, 2011 $ 6,100,000
September 30, 2011 $ 4,400,000
December 31, 2011 $ 3,500,000
Lie Dharma Putra Corp. had the following debt outstanding at December 31, 2011:
- A 12%, 4-year note dated 1/1/2011 with interest compounded quarterly. Both principal and interest due 12/31/11 (relates specifically to building project) $8,500,000
- A 10%, 10-year note dated 12/31/2007 with simple interest and interest payable annually on December 31 $6,000,000
- A 12%, 5-year note dated 12/31/2009 with simple interest and interest payable annually on December 31 $7,000,000
The amount of interest to be capitalized during 2011 is computed as follows:
Average Accumulated Expenditures
Date Expenditure Cap. Accumulated
1/1/2011 $ 2,000,000 12/12 $2,000,000
3/31/2011 $ 4,000,000 9/12 $3,000,000
6/30/2011 $ 6,100,000 6/12 $3,050,000
9/30/2011 $ 4,400,000 3/12 $1,100,000
12/31/2011 $ 3,500,000 0/12 –
$ 20,000,000 $9,150,000
Note: * The number of months between the date when expenditures were made and the date on which interest capitalization stops (December 31, 2011).
Potential Interest Cost to Be Capitalized
($8,500,000 × 1.12551)* – $8,500,000 = $1,066,840
$ 650,000 × 0.1108** = $ 72,020
$9,150,000 = $1,138,860
* The principal, $8,500,000, is multiplied by the factor for the future amount of $1 for 4 periods at 3% to determine the amount of principal and interest due in 2011.
** Weighted-average interest rate
10%, 10-year note $ 6,000,000 $ 600,000
12%, 5-year note $ 7,000,000 $ 840,000
Total interest / Total principal = $1,440,000/$13,000,000
The actual interest is:
12%, 4-year note [($8,500,000 × 1.12551) – $8,500,000] = $1,066,840
10%, 10-year note ($6,000,000 × 10%) = $ 600,000
12%, 5-year note ($7,000,000 × 12%) = $ 840,000
Total interest = $2,506,840
The interest cost to be capitalized is the lesser of $1,138,860 (avoidable interest) or $2,506,840 (actual interest). The remaining $1,367,980 (= $2,506,840 – $1,138,860) must be expensed.
Determining The Time Period For Capitalization Of Borrowing Costs
An entity should begin capitalizing borrowing costs on the commencement date. Three conditions must be met before the capitalization period should begin:
- Expenditures for the asset are being incurred
- Borrowing costs are being incurred
- Activities that are necessary to prepare the asset for its intended use are in progress
As long as these conditions continue, borrowing costs can be capitalized. Expenditures incurred for the asset include only those that have resulted in payments of cash, transfers of other assets or the assumption of interest-bearing liabilities, and are reduced by any progress payments and grants received for that asset.
Necessary activities are interpreted in a very broad manner. They start with the planning process and continue until the qualifying asset is substantially complete and ready to function as intended.
These activities may include technical and administrative work prior to actual commencement of physical work, such as obtaining permits and approvals, and may continue after physical work has ceased. Brief, normal interruptions do not stop the capitalization of interest costs. However, if the entity intentionally suspends or delays the activities for some reason, interest costs should not be capitalized from the point of suspension or delay until substantial activities in regard to the asset resume.
If the asset is completed in a piecemeal fashion, the capitalization of interest costs stops for each part as it becomes ready to function as intended. An asset that must be entirely complete before the parts can be used as intended can continue to capitalize interest costs until the total asset becomes ready to function.
Suspension And Cessation Of Capitalization
If there is an extended period during which there is no activity to prepare the asset for its intended use, capitalization of borrowing costs should be suspended. As a practical matter, unless the break in activity is significant, it is usually ignored.
Also, if delays are normal and to be expected given the nature of the construction project (such as a suspension of building construction during the winter months), this would have been anticipated as a cost and would not warrant even a temporary cessation of borrowing cost capitalization.
Capitalization would cease when the project has been substantially completed. This would occur when the asset is ready for its intended use or for sale to a customer. The fact that routine minor administrative matters still need to be attended to would not mean that the project had not been completed, however. The measure should be substantially complete, in other words, not absolutely finished.
Costs In Excess Of Recoverable Amounts
When the carrying amount or the expected ultimate cost of the qualifying asset, including capitalized interest cost, exceeds its recoverable amount (if property, plant, or equipment) or net realizable value (if an item held for resale), it will be necessary to record an adjustment necessary to write the asset carrying value down. Any excess interest cost is thus an impairment, to be recognized immediately in expense.
In the case of plant, property, and equipment, a later write-up may occur due to use of the allowed alternative (i.e., revaluation) treatment, recognizing fair value increases, in which case, as described earlier, recovery of a previously recognized loss will be reported in earnings.
With respect to an entity’s accounting for borrowing costs, the financial statements must disclose (1) the amount of borrowing costs capitalized during the period, and (2) the capitalization rate used to determine the amount of borrowing costs eligible for capitalization.
As noted, this rate will be the weighted-average of rates on all borrowings included in an allocation pool or the actual rate on specific debt identified with a given asset acquisition or construction project.
Revised IAS 23 should be applied for annual periods beginning on or after January 1, 2012, with earlier application permitted. If an entity applies this Standard from an earlier date, it should apply to all qualifying assets for which the commencement date for capitalization of borrowing costs is on or after that date.
Companies that currently apply the benchmark treatment of recognizing borrowing costs as an expense will need changes in systems and processes in order to collect relevant information and calculate the amount of borrowing costs to be capitalized. Other transactions, such as foreign currency borrowings and hedging activities, may also impact the amount of borrowing costs subject to capitalization. In addition, US Foreign Private Issuers may need to maintain two sets of capitalization information—one set under IFRS and one under US GAAP.