The aim of this standard is to provide guidance regarding the treatment of borrowing costs in an entity’s financials. Borrowing costs include finance charges/ cost on leases, interest on borrowings and bank overdraft, and exchange differences on funds borrowed in foreign currency, where they are considered as an adjustment to finance or interest costs.
Borrowing costs that can directly be attributed to the purchase, production, or construction of a qualifying asset would then be made part of that asset’s cost.
- IAS 23 basically covers the accounting treatment of borrowing costs.
- The standard does not deal with the imputed or actual cost of equity including preferred shares not classified as a liability in an entity’s accounts.
A company or any other entity is not required to apply the standard for borrowing costs that are directly related to the acquisition, production, or construction of a qualifying asset that is measured at fair value (for example, a biological asset falling within the scope of IAS 41 Agriculture) or inventories that are produced or manufactured in large numbers on a repetitive basis.
Definitions of Relevant Terms
These are costs that a company or any other entity incurs when raising funds through borrowing from financial institutions or other entities. These costs may include the following:
- Finance cost on lease liabilities recognized in accordance with IFRS 16;
- Interest cost calculated by using the effective rate of interest method described in IFRS 9;
- Exchange differences resulting from borrowing of foreign currency where they are considered as an adjustment to finance or interest costs.
Any asset that takes time to be prepared or made available for either sale or use. The following may be classified as qualifying assets:
- Manufacturing plants
- Investment properties
- Intangible assets
- Bearer plants
- Power generation facilities
However, inventories are not considered to be qualifying assets. Inventories can be defined as all those assets that are produced or manufactured in a short span of time. Assets that are readily available for their intended sale or use at the time of acquisition are not considered as qualifying assets.
An entity should capitalize all the borrowing costs it has incurred in connection with the production, acquisition, or construction of a qualifying asset as part of that asset’s cost if it is probable that economic benefits associated with the said asset will flow to the entity and its cost can reliably be measured. An entity should recognize all other costs of borrowing funds as expenses in its accounts in the financial period in which they have been incurred.
Borrowing Costs that are Eligible for Capitalization
The borrowing costs that directly relate to the purchase, production, or construction of a qualifying asset are those costs that could have been avoided if no expense on the said asset had been incurred by the entity. When an entity specifically borrows funds for acquiring or producing/ constructing a qualifying asset then the cost of borrowing such funds will be made part of that qualifying asset as these costs are directly related to making that asset ready for its intended purpose.
In some cases, it may be very difficult to identify a direct relation between a qualifying asset and the funds borrowed specifically for that qualifying asset and to separate the borrowings that could have been avoided if no expense was incurred on the qualifying asset. Such a difficulty usually occurs when an entity’s financing activity is centrally co‑ordinated. Complications also arise when a group uses multiple debt instruments to obtain funds at different interest rates and lends the said funds on different bases to other group entities. Other difficulties arise through when an entity makes use of loans linked to or denominated in foreign currencies, especially when the group of which the said entity is a part of operates in highly inflationary economies, and from changes in rates of exchange. As a result, determining the costs of borrowing that relate directly to the acquisition, production, or construction of a qualifying asset, becomes rather difficult and therefore requires judgment.
In some instances, arrangements made to finance the acquisition or production of a qualifying asset may result in an entity borrowing funds and incurring related borrowing costs before all or part of the said funds are used for expenditure on the qualifying asset. In such situations, the funds are usually invested on a temporary basis before they are utilized for obtaining or manufacturing a qualifying asset. In determining the borrowing costs eligible to be capitalized during a specific period, any income earned from investing the borrowed funds would be deducted from the borrowing costs incurred to obtain the funds in the first place.
If an entity generally borrows funds and then uses the borrowed funds for acquiring or constructing a qualifying asset then in such a scenario the entity should determine the borrowing cost that can be capitalized as part of the asset’s cost through using a rate of capitalization and applying it to the expenses incurred on the qualifying asset. The rate will be the weighted average of all the borrowing costs applicable to the funds borrowed by the entity that is still outstanding other than the funds that were specifically borrowed for the acquiring or producing/ constructing an asset.
The borrowing costs in which an entity makes part of the cost of an asset during a specific period should not exceed the borrowing costs which were actually incurred by the entity during that specific period.
Commencement of Capitalization
An entity will commence capitalizing the costs associated with borrowing of funds for a qualifying asset from the date the entity meets the below-mentioned conditions:
- Incurs expenditure on the asset;
- Incurs borrowing cost; and
- Undertakes activities or perform tasks which are necessary for getting an asset ready either for use or sale
Expenditures incurred on an asset only include expenditures that resulted in cash payment, transfer of assets, or the assumption of interest-bearing liabilities.
The activities that are necessary for getting the asset ready for its intended sale or use include activities prior to the physical construction of the asset. These include technical as well as administrative work carried out before the commencement of the physical construction of the asset. However, such activities do not include the holding of an asset when no development or production that changes the condition of the asset is taking place.
Excess of the Carrying Value of the Qualifying Asset Over Its Recoverable Value
When the carrying amount of a qualifying asset exceed its net realizable value or recoverable amount, the carrying amount is written down as per the requirements of other standards such as IAS 2 Inventories and IAS 36 Impairment of Assets.
Suspension of Capitalization
An entity should suspend capitalizing costs associated with borrowing of funds during periods in which production or acquisition of a qualifying asset has been suspended by the entity.
However, entities normally do not suspend or stop the capitalization of borrowing costs during a period in which it carries out substantial administrative or technical work. In addition, capitalization of borrowing costs is also not suspended when temporary delays are part of the process of making an asset ready/ available for its intended purpose.
Cessation of Capitalization
An entity should cease the capitalization of all costs incurred for borrowing funds for a qualifying asset when all the activities/ tasks necessary for getting the asset ready for its intended sale or use, are complete.
When an entity has the task of preparing/ constructing an asset in parts and each part can be used when complete while construction continues on other parts then in such a scenario, the entity should cease capitalizing borrowing costs allocated to a part when the entity completes all the activities necessary to get that part ready for its intended purpose.
Disclosure Requirements in IAS 23
As per IAS 23, an entity is required to disclose the following:
- The amount of cost associated with borrowing funds (borrowing costs) capitalized during the period; and
- The capitalization rate used for determining the costs of borrowing that are to be capitalized as part of the qualifying asset.