10
Borrowing Costs
Introduction
The crux of the standard is that borrowing costs incurred as a result of the construction, manufacturing or acquiring of specific assets should form part of the cost of those assets, i.e., they should be capitalised. The standard refers to these particular assets as “Qualifying assets,” the definition of which is explained in the next section of this chapter. The standard then qualifies that other borrowing costs, those not attributable to qualifying assets, must be expensed.
The standard specifically excludes qualifying assets measured at fair value and inventories which are produced in large quantities on a repetitive basis. The thought behind these exclusions was as follows.
The determination of fair value, and thus the measurement of the asset, is not affected by the amount of borrowing costs incurred. Thus, there is no need for specific requirements for accounting for the borrowing cost; they are simply treated as all other borrowing costs are and expensed. The excluding of inventories produced in large quantities on a repetitive basis was an acknowledgement that it would be difficult for preparers to collect the information required to monitor and allocate the borrowing costs to inventory items produced in such a manner. The Board determined that the cost would outweigh the benefit of the information provided to the users and thus excluded such inventories from the scope.
Definitions of Terms
Borrowing costs. Interest and other costs that an entity incurs in connection with the borrowing of funds. Borrowing costs that are directly attributable to the acquisition, construction or production of qualifying assets (defined as those taking a substantial period of time to prepare for intended use or sale) are capitalised to the cost of those assets. Borrowing costs may include interest expense calculated using the effective interest method (IFRS 9), finance charges in respect of finance leases (IAS 17) or certain exchange differences arising from foreign currency borrowings.
Carrying amount (book value). The value reported for an asset or liability in the statement of financial position. For assets, this is either cost, revalued amount or cost minus valuation adjustments such as depreciation or allowance for bad debts. Carrying amount of property, plant and equipment is the amount at which an asset is recognised after deducting any accumulated depreciation and accumulated impairment losses. Carrying amount is often different from market value because depreciation is a cost allocation rather than a means of valuation. For liabilities, the carrying amount is the amount of the liability minus adjustments such as any sums already paid or bond discounts.
Qualifying asset. An asset that necessarily requires a substantial period of time to get ready for its intended use or sale. Qualifying assets can be inventories, plant and equipment, intangibles, investment properties and bearer plants, unless the assets are accounted for at fair value. Financial assets or inventories produced over a very short period of time in a repetitive process are not qualifying assets. Assets that are acquired and that are already in the condition for their intended use or sale are not qualifying assets.
Recognition and Measurement
Capitalisation of Borrowing Costs
IAS 23 provides that a reporting entity should capitalise borrowing costs as defined that are directly attributable to the acquisition, construction or production of a qualifying asset as part of the initial carrying amount of that asset, and that all other borrowing costs should be recognised as an expense in the period in which the entity incurs them. The following questions then need to be answered and the standard provides us with the answers:
- From when should capitalisation of the borrowing costs start?
- How much should we capitalise?
- When do we stop capitalising borrowing costs?
When do we Start Capitalising?
An entity should begin capitalising borrowing costs on the commencement date. Three conditions must be met before the capitalisation period should begin:
- Expenditures for the asset are being incurred;
- Borrowing costs are being incurred; and
- Activities that are necessary to prepare the asset for its intended use or sale are in progress.
As long as these conditions continue, borrowing costs can be capitalised. 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 capitalisation of interest costs. However, if the entity intentionally suspends or delays the activities for some reason, interest costs should not be capitalised 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 capitalisation 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 capitalise interest costs until the total asset becomes ready to function.
How much should we Capitalise?
Borrowing costs eligible for capitalisation, those directly attributable to the acquisition, construction or production of a qualifying asset, are borrowing costs which would have been avoided if the expenditure on the qualifying asset had not been made. They include actual borrowing costs incurred less any investment income on the temporary investment of those borrowings.
In determining the amount of borrowing costs eligible for capitalisation the standard makes reference to borrowing costs which result from funds borrowed specifically for the purpose of purchasing or producing the qualifying asset (specific borrowings) as opposed to situations where an entity uses funds it has borrowed generally (to be used as is necessary and not specifically borrowed with the qualifying asset in mind) to fund the acquisition or production of the qualifying asset (general borrowings).
The determination of eligible borrowing costs in instances where specific borrowings are utilised is a very simple exercise. In these situations one simply has to calculate the actual borrowing costs incurred during the period on those specific borrowings. If the full amount of the borrowing is not used immediately in the acquisition of the qualifying asset, any investment income earned on the unutilised borrowings must be subtracted from the borrowing costs to be capitalised. Thus, the following formula could be used to summarise the above:
Eligible specific borrowing cost = Actual borrowing costs incurred (on the specific borrowings) – Investment income (earned on temporary investment of surplus specific borrowings)
For general borrowings, the calculation of the eligible borrowing costs is a little more involved. The amount of borrowing costs eligible for capitalisation, in these instances, is determined by applying a capitalisation rate to the expenditures on that asset. The capitalisation 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 (i.e., the weighted-average borrowing cost applicable to general borrowings). This is qualified by the fact that the amount of borrowing costs capitalised during a period cannot exceed the amount of borrowing costs incurred. IAS 23 does not deal with the actual or imputed cost of equity, including preferred capital not classified as a liability.
The selection of borrowings to be used in the calculation of the weighted-average of rates requires judgement. 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. Capitalised costs and expenditures are not synonymous terms. Theoretically, a capitalised cost financed by a trade payable for which no interest is recognised is not a capital expenditure to which the capitalisation rate should be applied. Reasonable approximations of net capital expenditures are acceptable, however, and capitalised costs are generally used in place of capital expenditures unless there is a material difference.
If the average capitalised 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 capitalised.
The total amount of interest actually incurred by the entity during the relevant time frame is the ceiling for the amount of interest cost capitalised. Thus, the amount capitalised 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 capitalised should be limited to the amount that the separate entity has incurred, and that amount should include interest on intercompany 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.
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 capitalised 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.
When do we Stop Capitalising Borrowing Costs?
The capitalisation of borrowing costs must be temporarily suspended during extended periods during which there is no activity to prepare the asset for its intended use. 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 capitalisation.
Capitalisation 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.
The capitalisation of interest costs would probably not apply to the following situations:
- 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 regulated investees capitalise both the cost of debt and equity capital; or
- When assets are acquired with grants and gifts restricted by the donor to the extent that funds are available from those grants and gifts.
Costs in Excess of Recoverable Amounts
When the carrying amount or the expected ultimate cost of the qualifying asset, including capitalised interest cost, exceeds its recoverable amount (if property, plant or equipment) or net realisable value (if an item is held for resale), it will be necessary to record an adjustment to write the asset carrying amount down. Any excess interest cost is thus an impairment, to be recognised immediately in expenses.
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, recognising fair value increases, in which case, as described earlier, recovery of a previously recognised loss will be reported in earnings.
Disclosure Requirements
With respect to an entity's accounting for borrowing costs, the financial statements must disclose:
- The amount of borrowing costs capitalised during the period; and
- The capitalisation rate used to determine the amount of borrowing costs eligible for capitalisation.
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.
Future Development
In January of 2017 the IASB issued the exposure draft of the Annual Improvements to IFRS 2015–2017. One of the amendments recommended in the exposure draft was a clarification to IAS 23 Borrowing Costs. The amendment aims to bring increased clarity to the calculation of borrowing costs eligible for capitalisation. The amendment clarifies that when calculating the capitalisation rate to be applied to general borrowings the weighted average borrowings for the year should include specific borrowings in certain circumstances. The following circumstances need to be present to include specific borrowings:
- The acquisition, production or construction of the qualifying asset is complete, or very near complete. The standard refers to a situation where “substantially all the activities necessary to prepare the asset for its intended use or sale are complete”; AND
- The specific borrowings must still be outstanding (i.e., the portion which has not yet been repaid).
At its July meeting the Board agreed to accept the amendment as set out in the exposure draft. No effective date has been set as yet.
US GAAP Comparison
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 FAS 34 provided certain insights that may prove germane to this matter. In general, interest capitalisation 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; or
- 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 capitalised 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 capitalised 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.
US GAAP and IFRS are nearly identical with regard to capitalised interest. Both have essentially the same definition of eligible assets, when the capitalisation can begin and when it ends. However, there are also some differences regarding what borrowings are included to compute a capitalisation rate, and costs do not include exchange rate differences. US GAAP does not require that all borrowings be included in the determination of the weighted-average capitalisation rate. Only a reasonable measure of cost for financing the acquisition must be capitalised. A reasonable interest cost is the interest incurred that otherwise would have been avoided if not for constructing the eligible asset. With the exception of tax-exempt borrowings, US GAAP does not permit offsetting of interest income against interest expense to determine the amount to capitalise. The interest income can only be that which was earned on the tax-exempt borrowing. US GAAP does not permit capitalisation of interest for inventories that are routinely manufactured or otherwise produced in large quantities on a repetitive basis (ASC 835-20-15-6[g]).