3.5.3.A Borrowing costs on borrowings related to completed qualifying assets

As noted at 3.5.3 above, determining general borrowings will not always be straightforward and, as a result, the determination of the amount of borrowing costs that are directly attributable to the acquisition of a qualifying asset is difficult and the exercise of judgement is required.

A question that arises is whether a specific borrowing undertaken to obtain a qualifying asset ever changes its nature into a general borrowing. Differing views exist as to whether or not borrowings change their nature throughout the period they are outstanding. Some consider that once the asset for which the borrowing was incurred has been completed, and the entity chooses to use its funds on constructing other assets rather than repaying the loan, this changes the nature of the loan into a general borrowing. However, to the extent that the contract links the repayment of the loan to specific proceeds generated by the entity, its nature as a specific borrowing would be preserved. Others take the view that once the borrowing has been classified as specific, its nature does not change while it remains outstanding.

Entities may wish to consider using the related guidance in IFRS as permitted by Section 10 (see Chapter 9 at 3.2). In December 2017, the IASB issued the Annual Improvements to IFRSs 2015-2017 Cycle which amended paragraph 14 of IAS 23. The amendments clarified that when a qualifying asset is ready for its intended use or sale, an entity treats any outstanding borrowings made specifically to obtain that qualifying asset as part of general borrowings. [IAS 23.BC14D]. These amendments apply to accounting periods beginning on or after 1 January 2019.

Refer also to further discussion in 3.6.3 below to determine when all the activities necessary to prepare the qualifying asset for its intended use or sale are ‘substantially’ complete.

3.5.3.B General borrowings related to specific non-qualifying assets

Another question that arises is regarding the treatment of general borrowings used to purchase a specific asset other than a qualifying asset for the purpose of capitalising borrowing costs.

Section 25 explicitly states that the capitalisation rate to be used should be the weighted average of rates applicable to the entity's ‘general borrowings that are outstanding during the period’. [FRS 102.25.2C]. This means that any specific borrowings related to obtaining either qualifying assets or non-qualifying assets would be excluded. Therefore, only the general borrowings are included in the computation of capitalisation rate.

3.5.3.C Expenditure on the asset

Section 25 explicitly states that for purposes of applying the capitalisation rate to the expenditure on the qualifying asset, ‘the expenditure on the asset is the average carrying amount of the asset during the period, including borrowing costs previously capitalised’. [FRS 102.25.2C].

Accordingly, unlike in IFRS (see 2.3 above), expenditure is not restricted to that resulting in the payment of cash, the transfer of other assets or the assumption of interest-bearing liabilities. Therefore, in principle, costs of a qualifying asset that have only been accrued but have not yet been paid in cash would also be included although, by definition, no interest can have been incurred on an accrued payment. The same principle can be applied to non-interest bearing liabilities e.g. non-interest-bearing trade payables or retention money that is not payable until the asset is completed.

A related issue that can arise in practice is about whether an entity includes expenditures on a qualifying asset incurred before obtaining general borrowings in determining the amount of borrowing costs eligible for capitalisation. Consider the fact pattern below:

• an entity constructs a qualifying asset;
• the entity has no borrowings at the start of the construction of the qualifying asset;
• partway through construction, it borrows funds generally and uses them to finance the construction of the qualifying asset; and
• the entity incurs expenditures on the qualifying asset both before and after it incurs borrowing costs on the general borrowings.

An entity applies paragraph 25.2D(a) of FRS 102 to determine the commencement date for capitalising borrowing costs. This paragraph requires an entity to begin capitalising borrowing costs when it meets all of the following conditions:

• it incurs expenditures on the asset;
• it incurs borrowing costs; and
• it undertakes activities necessary to prepare the asset for its intended use or sale (see also 3.6.1 below). [FRS 102.25.2D(a)].

Applying paragraph 25.2D(a) of FRS 102 to the fact pattern described above, the entity would not begin capitalising borrowing costs until it incurs borrowing costs.

Once the entity incurs borrowing costs and therefore satisfies all the three conditions described above, it then applies paragraph 25.2C of FRS 102 to determine the expenditures on a qualifying asset to which it applies the capitalisation rate. In doing so, we believe, the entity does not disregard expenditures on the qualifying asset incurred before the entity obtains the general borrowings. For this purpose, the expenditure on the asset is the average carrying amount of the asset during the period, including borrowing costs previously capitalised.

The above issue was also discussed by the International Financial Reporting Interpretations Committee (the ‘Interpretations Committee’) in its June 2018¹ and September 2018² meetings and a similar conclusion was reached.

3.5.3.D Assets carried below cost in the statement of financial position

An asset may be recognised in the financial statements during the period of production on a basis other than cost, i.e. it may have been written down below cost as a result of being impaired. An asset may be impaired when its carrying amount or expected ultimate cost, including costs to complete and the estimated capitalised interest thereon, exceeds its estimated recoverable amount or net realisable value (see 3.6.2.A below).

The question then arises as to whether the calculation of interest to be capitalised should be based on the cost or carrying amount of the impaired asset. It could be argued that in this case, cost should be used, as this is the amount that the entity or group has had to finance. However, Section 25 explicitly states that the expenditure on the asset is the average carrying amount (not the cost) of the asset during the period. Nevertheless, in the case of an impaired asset, the continued capitalisation based on cost (instead of average carrying value) of the asset may well necessitate a further impairment. Accordingly, although the amount capitalised will be different, this should not affect net profit or loss as this is simply an allocation of costs between finance costs and impairment expense.

3.5.3.E Calculation of capitalisation rate

As noted at 3.5.3 above, determining general borrowings will not always be straightforward, it will be necessary to exercise judgement to meet the main objective – a reasonable measure of the directly attributable finance costs.

The following example illustrates the practical application of the method of calculating the amount of finance costs to be capitalised:

In this example, all borrowings are at fixed rates of interest and the period of construction extends at least until the end of the period, simplifying the calculation. The same principle is applied if borrowings are at floating rates i.e. only the interest costs incurred during that period, and the weighted average borrowings for that period, will be taken into account.

Note that the company's shareholders' equity (i.e. equity instruments – see further discussion at 3.5.5.D below) cannot be taken into account. Also, at least part of the outstanding general borrowings is presumed to finance the acquisition or construction of qualifying assets. Regardless of whether they are financing qualifying or non-qualifying assets, all of the outstanding borrowings are presumed to be general borrowings – unless they are specific borrowings (see discussions at 3.5.3.A and 3.5.3.B above).

The above example also assumes that loans are drawn down to match expenditure on the qualifying asset. If, however, a loan is drawn down immediately and investment income is received on the unapplied funds, then the calculation differs from that in Example 22.1 above. This is illustrated in Example 22.2 below.

3.5.5.A Derivative financial instruments

Many derivative financial instruments such as interest rate swaps, floors, caps and collars are commonly used to manage interest rate risk on borrowings. The most straightforward and commonly encountered derivative financial instrument used to manage interest rate risk is a floating to fixed interest rate swap, as in the following example.

Section 25 is silent on the use of hedging instruments in determining directly attributable borrowing costs. Section 12 – Other Financial Instruments Issues – sets out the basis on which derivatives are recognised and measured. Accounting for hedges is discussed in Chapter 10 at 10.

An entity may consider that a specific derivative financial instrument, such as an interest rate swap, is directly attributable to the acquisition, construction or production of a qualifying asset. If the instrument does not meet the conditions for hedge accounting then the effects on income will be different from those if it does, and they will also be dissimilar from year to year. What is the impact of the derivative on borrowing costs eligible for capitalisation? In particular, does the accounting treatment of the derivative financial instrument affect the amount available for capitalisation? If hedge accounting is not adopted, does this affect the amount available for capitalisation?

The following examples illustrate the potential differences.

In our view, all these methods are valid interpretations of Section 25; however, the preparer will need to consider the most appropriate method in the particular circumstances after taking into consideration the discussion below.

In particular, if using method (ii), it is necessary to demonstrate that the gains or losses on the derivative financial instrument are directly attributable to the construction of a qualifying asset. In making this assessment it is necessary to consider the term of the derivative and this method may not be appropriate if the derivative has a different term to the underlying directly attributable borrowing.

Based on the facts in this example, and assuming that entering into the derivative financial instrument is considered to be related to the borrowing activities of the entity, method (iii) may not be an appropriate method to use because it appears to be inconsistent with the underlying principle of Section 25 – that the costs eligible for capitalisation are those costs that would have been avoided if the expenditure on the qualifying asset had not been made. [FRS 102.25.2A]. However, method (iii) may be an appropriate method to use in certain circumstances where it is not possible to demonstrate that the gains or losses on a specific derivative financial instrument are directly attributable to a particular qualifying asset, rather than being used by the entity to manage its interest rate exposure on a more general basis.

Note that method (i) appears to be permitted under US GAAP for fair value hedges. IAS 23 makes reference in its basis of conclusion that under US GAAP, derivative gains and losses (arising from the effective portion of a derivative instrument that qualifies as a fair value hedge) are considered to be part of the capitalised interest cost. IAS 23 does not address such derivative gains and losses. [IAS 23.BC21].

Whichever policy is chosen by an entity, it needs to be consistently applied in similar situations.

3.5.5.B Gains and losses on derecognition of borrowings

If an entity repays borrowings early, in whole or in part, then it may recognise a gain or loss on the early settlement. Such gains or losses include amounts attributable to expected future interest rates; in other words, the settlement includes an estimated prepayment of the future cash flows under the instrument. The gain or loss is a function of relative interest rates and how the interest rate of the instrument differs from current and anticipated future interest rates. There may be circumstances in which a loan is repaid while the qualifying asset is still under construction. Section 25 does not address this issue.

Section 11 requires that gains and losses on extinguishment of debt should be recognised in profit or loss (see Chapter 10 at 9.4.3). Accordingly, in our view, gains and losses on derecognition of borrowings are not eligible for capitalisation. Decisions to repay borrowings early are not usually directly attributable to the qualifying asset but to other circumstances of the entity.

The same approach would be applied to gains and losses arising from a refinancing when there is a substantial modification of the terms of borrowings as this is accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability (see Chapter 10 at 9.4.2 to 9.4.3).

3.5.5.C Gains or losses on termination of derivative financial instruments

If an entity terminates a derivative financial instrument, for example, an interest rate swap, before the end of the term of the instrument, it will usually have to either make a payment or receive a payment, depending on the fair value of the instrument at that time. The fair value is typically based on expected future interest rates; in other words it is an estimated prepayment of the future cash flows under the instrument.

The treatment of the gain or loss for the purposes of capitalisation will depend on the following:

• the basis on which the entity capitalises the gains and losses associated with derivative financial instruments attributable to qualifying assets (see 3.5.5.A above); and
• whether the derivative is associated with a borrowing that has also been terminated.

Entities must adopt a treatment that is consistent with their policy for capitalising the gains and losses from derivative financial instruments that are attributable to qualifying investments (see 3.5.5.A above).

The accounting under Section 12 will differ depending on whether the instrument has been designated as a hedge or not. Assuming the instrument has been designated as a cash flow hedge and that the borrowing has not also been repaid, the entity will usually maintain the cumulative gain or loss on the hedging instrument, subject to reclassification to profit or loss during the same period that the hedged cash flows affect profit or loss. In such a case, the amounts that are reclassified from other comprehensive income will be eligible for capitalisation for the remainder of the period of construction.

Similarly, assuming the instrument has been designated as a fair value hedge and that the borrowing has not also been repaid, entities would continue to recognise the cumulative gain or loss on the hedging instrument in the carrying amount of the hedged item and would form part of the ongoing determination of amortised cost of the financial liability using the effective interest rate method. Interest expense calculated using the effective interest method is eligible for capitalisation for the remainder of the period of construction (see 3.2 above).

If the entity is not hedge accounting for the derivative financial instrument, but considers it to be directly attributable to the construction of the qualifying asset then it will have to consider whether part of the gain or loss relates to a period after construction is complete.

If the underlying borrowing is also terminated then the gain or loss will not be capitalised and the treatment will mirror that applied on derecognition of the borrowing, as described at 3.5.5.B above.

3.5.5.D Dividends payable on shares classified as financial liabilities

An entity might finance its operations in whole or in part by the issue of preference shares and in some circumstances these will be classified as financial liabilities (see Chapter 10). In some circumstances the dividends payable on these instruments would meet the definition of borrowing costs. For example, an entity might have funded the development of a qualifying asset by issuing redeemable preference shares that are redeemable at the option of the holder and so are classified as financial liabilities under Section 22. In this case, the ‘dividends’ would be treated as interest and meet the definition of borrowing costs and so could be capitalised following the principles on specific borrowings discussed at 3.5.2 above.

Companies with outstanding preference shares which are treated as liabilities under Section 22 might subsequently obtain a qualifying asset. In such cases, these preference share liabilities would be considered to be part of the company's general borrowings. The related ‘dividends’ would meet the definition of borrowing costs and could be capitalised following the principles on general borrowings discussed at 3.5.3 above – i.e. that they are directly attributable to a qualifying asset.

If these shares were both irredeemable, but still treated as liabilities under Section 22 (see Chapter 10), and the only general borrowings, it would generally be difficult to demonstrate that such borrowings would have been avoided if the expenditure on the qualifying asset had not been made. In such a case capitalisation of related ‘dividends’ would not be appropriate, unless the qualifying asset is demonstrably funded (at least partly) by such borrowings. In cases where such instruments were just a part of a general borrowing ‘pool’, it would be appropriate to include applicable ‘dividends’ in determining the borrowing costs eligible for capitalisation (see 3.5.3 above), notwithstanding the fact that these instruments are irredeemable, provided that:

• at least part of any of the general borrowings in the pool was applied to obtain the qualifying asset; or
• it can be demonstrated that at least part of the fund specifically allocated for repaying any of the redeemable part of the pool was used to obtain the qualifying asset.

Capitalisation of dividends or other payments made in respect of any instruments that are classified as equity in accordance with Section 22 is not appropriate as these instruments would not meet the definition of financial liabilities. In addition, as discussed at 3.2 above, Section 25 does not deal with the actual or imputed cost of equity, including preferred capital not classified as a liability.

3.5.7.A Borrowings in one company and development in another

A question that can arise in practice is whether it is appropriate to capitalise interest in the group financial statements on borrowings that appear in the financial statements of a different group entity from that carrying out the development. Based on the underlying principle of Section 25, capitalisation in such circumstances would only be appropriate if the amount capitalised fairly reflected the interest cost of the group on borrowings from third parties that could have been avoided if the expenditure on the qualifying asset were not made.

Although it may be appropriate to capitalise interest in the group financial statements, the entity carrying out the development should not capitalise any interest in its own financial statements as it has no borrowings. If, however, the entity has intra-group borrowings then interest on such borrowings may be capitalised in its own financial statements.

3.5.7.B Qualifying assets held by joint ventures

A number of sectors carry out developments through the medium of joint ventures (see Chapter 13) – this is particularly common with property developments. In such cases, the joint venture may be financed principally by equity and the joint venturers may have financed their participation in this equity through borrowings.

In situations where the joint venture is classified as a jointly controlled entity (JCE) in accordance with Section 15 – Investments in Joint Ventures, it is not appropriate to capitalise interest in the JCE on the borrowings of the venturers as the interest charge is not a cost of the JCE. Neither would it be appropriate to capitalise interest in the financial statements of the venturers, whether in separate or consolidated financial statements, because the qualifying asset does not belong to them. The investing entities have an investment in a financial asset (i.e. an equity instrument of another entity) which is excluded by Section 25 from being a qualifying asset (see 3.4 above).

In situations where the joint venture is classified as a jointly controlled operation (JCO) or jointly controlled assets (JCA) in accordance with Section 15 and the venturers are accounting for their own and their share of the assets, liabilities, revenue and expenses of the JCO or JCA, then the venturers could capitalise borrowing costs incurred that relate to their own qualifying asset or their share of any qualifying asset. Borrowing costs eligible for capitalisation would be based on the venturer's obligation for the loans of such JCO or JCA together with any direct borrowings of the venturer itself if the venturer funds part of the acquisition of such joint venture's qualifying asset.

3.6.2.A Impairment considerations

When it is determined that capitalisation is appropriate, an entity continues to capitalise borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset as part of the cost of the asset even if the capitalisation causes the expected ultimate cost of the asset to exceed its net realisable value (for inventories that are qualifying assets) or recoverable amount (for all other qualifying assets).

When the carrying amount of the qualifying asset exceeds its recoverable amount or net realisable value (depending on the type of asset), the carrying amount of the asset must be written down or written off in accordance with the Section 27 (see Chapter 24). In certain circumstances, the amount of the write-down or write-off is written back in accordance with Section 27. Section 25 does not have specific guidance in instances where an asset is incomplete thus, an entity may wish to consider the related guidance in IFRS. Under IAS 23, if the asset is incomplete, the impairment assessment is performed by considering the expected ultimate cost of the asset. [IAS 23.16]. The expected ultimate cost, which will be compared to recoverable amount or net realisable value, must include costs to complete and the estimated capitalised interest thereon.

3.6.3.A Borrowing costs on ‘land expenditures’

An issue may arise about when an entity ceases capitalising borrowing costs on land, for example, consider the fact pattern below:

• an entity acquires and develops land and thereafter constructs a building on that land – the land represents the area on which the building will be constructed;
• both the land and the building meet the definition of a qualifying asset; and
• the entity uses general borrowings to fund the expenditures on the land and construction of the building.

The issue is whether the entity ceases capitalising borrowing costs incurred in respect of expenditures on the land (‘land expenditures’) once it starts constructing the building or whether it continues to capitalise borrowing costs incurred in respect of land expenditures while it constructs the building.

In our view, in applying Section 25 to determine when to cease capitalising borrowing costs incurred on land expenditures, an entity considers:

• the intended use of the land; and
• in applying paragraph 25.2D(c) of FRS 102, whether the land is capable of being used for its intended purpose while the construction continues on the building.

Land and buildings are used for owner-occupation (and therefore recognised as property, plant and equipment applying Section 17); rent or capital appreciation (and therefore recognised as investment property applying Section 16 – Investment Property); or for sale (and therefore recognised as inventory applying Section 13). The intended use of the land is not simply for the construction of a building on the land, but rather to use it for one of these three purposes.

If the land is not capable of being used for its intended purpose while construction continues on the building, the entity considers the land and the building together to assess when to cease capitalising borrowing costs on the land expenditures. In this situation, the land would not be ready for its intended use or sale until substantially all the activities necessary to prepare both the land and building for that intended use or sale are complete (see 3.6.3 above).

The above issue was also discussed by the Interpretations Committee in its June 2018³ and September 2018⁴ meetings and a similar conclusion was reached.