IAS 23 Borrowing Costs

Core principle:

Borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset form part of the cost of that asset. Other borrowing costs are recognised as an expense.

(IAS 23: para. 1)

Examples of qualifying assets (substantial time to get ready for its intended use or sale):

• Inventories. For large quantities of inventories which are produced in large quantities on a repetitive basis such as cheese, wine and aircrafts (substantial time to produce). The standard allows an option (accounting policy) for the entity to either to capitalise the borrowing cost or not capitalising it. But inventories produced/manufactured over a short period of time are not qualifying assets.

(IAS 23: para. 4)

• Manufacturing plants
• Power generation facilities
• Intangible assets such as development costs
• Investment properties
• Bearer plants
• For biological asset (if it is a qualifying asset) acquired at fair value, the entity is not required to apply this standard to borrowing cost.

(IAS 23: para. 4)

Financial assets are not qualifying assets.

Assets that are ready for their intended use or sale when purchased are not qualifying assets. This means that management should assess the intention of the use and sale of the asset when it is acquired. Management should combine assets together to determine whether it is ready for their intended use or sale.

(IAS 23: para.5)

Example 1: The intention of management 1

A telecom company acquired a 5G licence. The licence could be sold or licensed to a third party. However, management intends to use it to operate a wireless network. Development of the network starts when the licence is acquired.

Required:

Should borrowing costs on the acquisition of the 5G licence be capitalised until the network is ready for its intended use?

Answer:

The answer is yes. This is because the licence has been exclusively acquired to operate the wireless network.

The acquisition of the licence is the first step in a wider investment project (developing the network). It is part of the network investment, which meets the definition of a qualifying asset.

The fact that the licence can be used or licensed to a third party when purchased is irrelevant.

Example 2: The intention of management 2

A company incurred borrowing costs regarding the government permit to build a building and an equipment which can be used to build lots of buildings in the future.

Required:

Whether the borrowing costs for the government permit and equipment can be capitalised per IAS 23?

Answer:

• Yes for the building because this is the necessary step for the building to be built and the building is a qualifying asset. Therefore, we should consider the permit and building together, and the borrowing costs on the permit can be capitalised.
• No for the equipment. Because the equipment will be used to build future buildings, hence at the time that the equipment was acquired, it is ready for its intended use.

1. Interest expense

2. Finance charges for leases. For example, a crane or a dockyard is leased for the purpose of constructing a ship. The ship is a qualifying asset. The interest on the lease of the crane or dockyard is capitalised as borrowing costs.

3. Exchange differences from foreign currency loan* (accounting policy)

Example for exchange differences from foreign currency loan:

A business based in the USA took a foreign currency loan in Japanese Yen of 100 million at the year start for the construction of its own factory and the loan is for one year.

The interest expense in Yen translated back to the US dollar is $0.45 million during the year.

The Japanese Yen of 100m translated back to the USD at the time that the loan was taken out and as at the Financial Statements year end are $0.9 million and $0.8 million.

Required:

Accounting treatment.

Answer:

The borrowing costs include:

* This is an exchange gain because instead of owing $0.9m to the bank but now it only owes $0.8m to the bank because of exchange rate differences. Hence the gain from foreign exchange rate differences should offset the interest expense. If there are foreign exchange losses, the interest expense should increase by the loss on retranslation.

An entity shall capitalise borrowing costs that are directly attributable to the acquisition (such as the interest expense on the loan in order to get the government permit or license before producing outputs), construction or production of a qualifying asset as part of the cost of that asset.

This means that entities must capitalise all eligible borrowing costs except in some situations such as the optional treatment for large and repetitive quantities of inventories to be produced.

Capitalised borrowing costs should be added to the cost of the asset. Other borrowing costs which are not eligible should be recognised as expenses.

Example:

As at the year start, a business began to construct a building with an estimated useful life of 40 years. The building costs are $35 million. The construction was completed in 9 months and brought into use in 12 months.

To complete the project, the business borrowed $20 million at the year start with the loan interest rate being 10%. The loan will be repaid in 12 months.

Required:

Accounting treatment.

Answer:

First 9 months: capitalise the borrowing costs: $20m x 10% x 9/12 = $1.5m

Last 3 months: expense the borrowing costs: $20m x 10% x 3/12 = $0.5m

Borrowing costs available for capitalisation = Actual borrowing costs LESS investment income

Example:

On 1 January, the business borrowed $1.5 million to finance the production of its two ships and each is expected to be completed in one year. Work has started during this year and the loan facility was drawn down and incurred on 1 January. The remaining funds are invested temporarily.

The loan rate was 10% and the business can invest surplus funds at 8%.

Required:

Calculate the capitalised borrowing costs for each asset. Ignore compound interest in the calculation.

Answer:

Borrowings are obtained generally and applied in part to obtain a qualifying asset, we should use the ‘capitalisation rate’

Exclude borrowings for specific qualifying assets.

Example:

The business has three types of loans during the year:

The 7.5% loan notes was issued to fund the construction of a building and the construction has begun this year.

At the start of this year, the business began construct a piece of equipment which is a qualifying asset using the existing borrowings. Expenditure drawn down for the construction was: $40 million at the start of this year and $30 million in October.

Required:

Calculate the capitalised borrowing costs.

Answer:

Capitalisation rate = 9% x (130/220*) + 8.5% x (90/220) = 8.8%

*This is calculated using the average bank loan during the year: $130 million and $90 million together to be a total $220 million.

Capitalised borrowing costs = ($40m x 8.8% x 12/12)+ ($30m x 8.8% x 3/12) = $4.18m

The maximum borrowing costs to be capitalised should not exceed actual borrowing costs incurred. This happens when the expenditure on qualifying asset is greater than its borrowings.

Example:

Expenditure spent on the building is $100m but it only took $80m debt with the interest rate being 10%. The loan is for one year.

Required:

Determine the amount to be capitalised.

Answer:

Only $8m to be capitalised.

The maximum borrowing costs ($100m x 10% = $10m) should not exceed actual borrowing costs incurred ($80m x 10% = $8m).

Sometimes, the qualifying assets may be impaired (PP&E impairment or inventories where costs are lower than the net realisable value), the calculation of the capitalised borrowing costs should be based on the impaired qualifying asset.

(IAS 23: para.16)

All three events/transactions happen:

1. Incur expenditure
2. Incur borrowing costs
3. Activities to prepare the asset for its intended use or sale such as obtaining permits but do not include holding an asset when no production or development that changes the asset’s condition is taking place such as the land is held without any associated development activity – does not meet with the third criteria.

(IAS 23: para. 17)

IAS 23 allows the average carrying amount of the asset during a period to be used as an approximation to the expenditure to which the capitalisation rate is applied in the period.

(IAS 23: para. 14)

Example:

The capitalisation rate may be applied to the weighted average carrying amount above of $875 instead of the simple average carrying amount of $850 (($300+$1,400)/2).

If the reason is normal, we should continue to capitalise the borrowing costs:

• Factory closed down during holiday season
• Production process is slow
• High water levels delay construction of a bridge (if such high water levels are common during the construction period in the geographical region involved) then capitalisation of borrowing costs should not be suspended
• Periods when engineers improve the technical specifications of the asset

If the reason is abnormal, we should suspend to capitalise the borrowing costs:

• Workers go on strike
• Fire damage
• Flood

(IAS 23: para. 20-21)

Substantially all the activities to prepare the qualifying asset for its intended use or sale are completed.

Normally when physical construction of the asset is completed, although minor modifications may still be outstanding.

Assets completed in parts or stages (capitalisation should cease for each part as it is completed such as business part consisting of many buildings).

(IAS 23: para. 22-25)

Example:

1. Investment property for sale:

Investment property has been completed but the business needs time to find new tenants. Hence when the investment property is completed, the borrowing costs should cease to be capitalised.

1. Building complete - fire safety approval is outstanding:

An entity has completed the physical construction of a building but is not permitted to use it until fire approval is obtained. Often it is a formality to obtain the necessary approval for fire safety. In such cases it is appropriate to cease capitalisation on physical completion. If the building fails the inspection, and substantial additional work is then required, it may be necessary to resume capitalisation of borrowing costs.

1. Shopping centre:

Major construction work on the shopping centre is completed first but the fit-out work (which is essential for the intended use) continues. At this stage the building is not ready for use and the entity continues to capitalise borrowing costs. When the fit-out is substantially complete the entity ceases to capitalise borrowing costs on the shopping centre.

1. Late completion of the car park:

The multi-storey car park is capable of being used independently. If construction of the car park continues after work on the shopping centre is complete, borrowing costs continue to be capitalised on the car park. The treatment of the shopping centre is not affected by the later completion of the car park.

Amount of borrowing costs capitalised during the period

Capitalisation rate

Exam rehearsal question – Emcee – June 2016 Q3 (a)

Emcee, a public limited company, is a sports organisation which owns several football and basketball teams. It has a financial year end of 31 May 2016. Emcee needs a new stadium to host sporting events which will be included as part of Emcee’s property, plant and equipment. Emcee therefore commenced construction on a new stadium on 1 February 2016, and this continued until its completion which was after the year end of 31 May 2016. The direct costs were $20 million in February 2016 and then $50 million in each month until the year end. Emcee has not taken out any specific borrowings to finance the construction of the stadium, but it has incurred finance costs on its general borrowings during the period, which could have been avoided if the stadium had not been constructed. Emcee has calculated that the weighted average cost of borrowings for the period 1 February–31 May 2016 on an annualised basis amounted to 9% per annum. Emcee needs advice on how to treat the borrowing costs in its financial statements for the year ending 31 May 2016. (6 marks)

Answer:

IAS 23 requirement:

IAS 23 Borrowing Costs requires such borrowing costs to be capitalised if the asset takes a substantial period of time to be prepared for its intended use or sale.

The definition of borrowing costs includes interest expense calculated by the effective interest method, finance charges on finance leases and exchange differences arising from foreign currency borrowings relating to interest costs.

Borrowing costs should be capitalised during construction and include the costs of funds borrowed for the purpose of financing the construction of the asset, and general borrowings which would have been avoided if the expenditure on the asset had occurred.

The general borrowing costs are determined by applying a capitalisation rate to the expenditure on that asset. The capitalisation rate will be the weighted average of the borrowing costs applicable to the general pool.

Application:

The weighted-average carrying amount of the stadium during the period is $(20 + 70 + 120 + 170) million/4, that is $95 million.

The capitalisation rate of the borrowings of Emcee during the period of construction is 9% per annum, therefore the total amount of borrowing costs to be capitalised is the weighted-average carrying amount of the stadium multiplied by the capitalisation rate. That is ($95 million x 9% x 4/12) $2·85 million.

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