Borrowing Costs 6re5d
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Gripping IFRS
Capitalisation of borrowing costs
Chapter 11 Capitalisation of Borrowing Costs Reference: IAS 23
Contents:
Page
1. Introduction and definitions 1.1 1.2 1.3 1.4
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Overview Borrowing costs Qualifying assets Qualifying borrowing costs
365 365 365 366
2. Expensing borrowing costs
366
2.1 Recognition 2.2 Measurement Example 1: expensing borrowing costs
366 366 366
3. Capitalising borrowing costs
367
3.1 Recognition
367
3.1.1 Commencement of capitalisation Example 2: capitalisation of borrowing costs: all criteria met at same time Example 3: commencement of capitalisation: criteria met at different times Example 4: commencement of capitalisation: criteria met at different times
367 367 368 368
3.1.2 Suspension of capitalisation Example 5: delays in construction
369 369
3.1.3 Cessation of capitalisation Example 6: end of construction
369 370
3.2 Measurement
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3.2.1 Measurement: specific loans Example 7: specific loans Example 8: specific loans: costs paid on specific days Example 9: specific loans: costs paid evenly over a period Example 10: specific loans: loan raised before construction begins
372 372 373 374 375
3.2.2 Measurement: general loans Example 11: general loan: costs incurred evenly Example 12: general loan: costs incurred at the end of each month Example 13: general loan: costs incurred at the start of each month
375 376 377 379
4. A comparison of the methods
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5. Disclosure
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6. Summary
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Capitalisation of borrowing costs
Introduction and definitions
1.1 Overview IAS 23 was revised in March 2007. Those of you who have studied this standard previously will notice that in the previous version of IAS 23, ants were able to choose between: • the benchmark treatment (expensing borrowing costs); and • the allowed alternative treatment (capitalising borrowing costs). In the revised version of IAS 23, however, you will notice that there is no reference at all to the benchmark or allowed alternative treatments. The revised IAS 23 has it that ants must capitalise borrowing costs (the previous allowed alternative treatment) that are incurred on qualifying assets. Thus borrowing costs on non-qualifying assets are always expensed. Therefore, IAS 23 now requires that an entity: • capitalise borrowing costs that were incurred on a qualifying asset; and • expense borrowing costs that were not incurred on a qualifying asset. Up until now you will have indirectly been exposed to borrowing costs where borrowing costs are generally expensed (i.e. the presupposition in such examples would have been that the borrowing costs were not incurred on a qualifying asset). We will now learn how and when to capitalise borrowing costs. In a nutshell, borrowing costs that relate to qualifying assets must be capitalised assuming that criteria for recognition of an asset are also met. One of the more significant reasons behind capitalising borrowing costs instead of expensing them is that the cost of financing is generally a significant cost, and is generally a necessary evil in order to bring an asset to a location and condition that makes it useable or saleable. Costs that are significant and necessary should surely form part of the asset’s cost. There are arguments against capitalizing borrowing costs as well, of course. These are discussed at the end of this chapter, but are largely academic now, given that there is no longer a choice. 1.2 Borrowing costs Borrowing costs are those costs that are incurred by the entity in connection with the borrowing of funds. Other names often used for borrowing costs include: • interest expense; and • finance charges. Borrowings costs may include: • interest incurred on loans (including bank overdraft); • amortisation of discounts (or s); • finance charges on finance leases; • exchange difference on foreign loan s; and • costs of raising debt. 1.3 Qualifying assets Qualifying assets are those that take a substantial period of time to get ready for their intended use or sale. Qualifying assets may include: • manufacturing plants; • power generation facilities; • intangible assets; • investment properties; and • inventories. 365
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1.4 Qualifying borrowing costs (IAS 23.8 - .10) Borrowing costs that must be capitalised to the cost of an asset are those that: • are directly attributable • to the acquisition, manufacture or production • of a qualifying asset; and those that • would have been avoided had the expenditure on the qualifying asset not been made. It is sometimes quite difficult to identify a direct link between borrowing costs incurred and a specific asset since: • the borrowings may not have been specifically raised for that asset, but may be general borrowings (i.e. the entity may have a range of debt instruments at a range of varying interest rates); • the borrowings may not even be denominated in your local currency (i.e. the borrowings may be foreign borrowings); and • the borrowings may be subject to hyper-inflation (borrowing costs that compensate for inflation are always expensed). The lists of complications are seemingly endless thus frequently requiring your professional judgement. These complications in calculation of the borrowing costs to be capitalised are expanded upon in the section entitled ‘measuement’. 2
Expensing borrowing costs
2.1 Recognition (IAS 23.8 - .9) Whenever borrowing costs do not meet the conditions for capitalisation, they are expensed. Expensing borrowing costs simply means to include the borrowing costs as an expense in profit or loss in the period in which they were incurred (i.e. as and when interest is charged in accordance with the of the borrowing agreement). 2.2 Measurement The amount of borrowing costs expensed is simply the amount charged by the lender in accordance with the borrowing agreement. Example 1: expensing borrowing costs Yay Limited incurred C100 000 interest (during the year ended 31 December 20X5) on a loan that was used to finance the construction of a factory plant. The factory plant was not considered to be a qualifying asset. Required: Provided the necessary journal entries for expensing the interest in Yay Limited’s books for the year ended 31 December 20X5. Solution to example 1: expensing borrowing costs Comment: When to recognise an expense: when the interest is incurred. How much to expense: the amount of interest charged by the lender in of the agreement. Debit 100 000
Finance costs (expense) Bank/ liability Interest incurred during the period is expensed
Credit 100 000
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3 3.1
Capitalisation of borrowing costs
Capitalising borrowing costs Recognition (IAS 23.8 - .9)
To capitalise borrowing costs simply means to include them in the cost of the related qualifying assets. In other words, the borrowing costs are recognised as an asset. Before the borrowing costs may be recognised as an asset, they must meet the basic recognition criteria for an asset: • future economic benefits must be probable; and • the costs must be reliably measurable. Borrowing costs that must be capitalised are those: • that are directly attributable • to the acquisition, construction or production • of a qualifying asset. Directly attributable means: if the assets had not been constructed, acquired or produced then these costs could have been avoided. An example of an acquisition is the purchase of a building. An example of the construction of an asset is the building of a manufacturing plant. An example of the production of an asset is the manufacture of inventory. When to recognise borrowing costs as part of the asset (capitalisation) is affected by: • Commencement date: capitalisation starts from the date on which certain criteria are met; • Suspension period: capitalisation must stop temporarily when certain criteria are met; • Cessation date: capitalisation must stop permanently when certain criteria are met. When borrowing costs are capitalised, the carrying amount of the asset will obviously be increased by the borrowing costs incurred. The cost of these borrowings will eventually reduce profits, but only when the qualifying asset affects profit or loss (e.g. through the depreciation expense when the qualifying asset is an item of property, plant and equipment). 3.1.1 Commencement of capitalisation (IAS 23.17 - .19) Assuming the basic recognition criteria are met, an entity must start to capitalise borrowing costs from the date that all the following criteria are met: • the entity is preparing the asset for its intended use or sale (activity is happening); • expenditure is being incurred by the entity in preparing the asset; and • borrowing costs are being incurred. The date that all three criteria are met is known as the commencement date. Example 2: capitalisation of borrowing costs - all criteria met at same time Yippee Limited incurred C100 000 interest on a loan used to finance the construction of a building during the year ended 31 December 20X5: • The building was considered to be a qualifying asset. • Construction of the building began on 1 January 20X5, when the loan was raised. • It is probable that the building would result in future economic benefits and the borrowing costs are reliably measurable. • The construction of the building began as soon as the loan was raised. Required: Provide the necessary journal entries to capitalise the borrowing costs in Yippee Limited’s books for the year ended 31 December 20X5. 367
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Solution to example 2: capitalisation of borrowing costs - all criteria met at same time Comment: Interest must be recognised as part of the cost of the qualifying asset. Interest is recognised as part of the asset (capitalisation) from the time that all criteria for capitalisation are met. All criteria are met on the same date (1 January 20X5): • a loan is raised on 1 January 20X5 on which interest is being incurred; • activities start on 1 January 20X5; and • expenditure related to the activities start on 1 January 20X5 is being incurred. The basic recognition criteria are also met and therefore the amount to be capitalised is calculated from 1 January 20X5. Debit Credit Finance costs (expense) 100 000 x 12 / 12 100 000 Bank/ liability 100 000 Interest on the loan incurred first expensed Building: cost (asset) 100 000 x 12 / 12 Finance costs (expense) Interest on the loan capitalised to the cost of the building
100 000 100 000
Example 3: commencement of capitalisation - criteria met at different times Dawdle Limited borrowed C100 000 on the 30 June 20X5 to build a factory to store its goods. The necessary building materials were only available on 31 August 20X5 and it was then that Dawdle Limited began construction. The building is considered to be a qualifying asset. Required: Discuss when Dawdle Limited may begin capitalising the interest incurred. Solution to example 3: commencement of capitalisation - criteria met at different times All three criteria must be met before the entity may begin capitalisation. From the 30 June 20X5, Dawdle Limited borrowed funds and began incurring borrowing costs, but had not yet met the other two criteria (activities were not underway and costs on the asset were not being incurred). On the 31 August 20X5, however, Dawdle both acquired the construction materials and began construction thereby fulfilling all three criteria. Dawdle Limited may therefore only begin capitalising the borrowing costs on the 31 August 20X5 (assuming that it was probable that the building would render future economic benefits and that the costs were considered reliably measurable).
Example 4: commencement of capitalisation - criteria met at different times Hoorah Limited incurred C100 000 interest for the year ended 31 December 20X5 on a loan of C1 000 000, raised on 1 January 20X5. The loan was raised to finance the construction of a building during the year ended 31 December 20X5. The building is a qualifying asset. Construction began on 1 February 20X5. Required: Provide the necessary journal entries to capitalise the borrowing costs in Hoorah Limited’s books for the year ended 31 December 20X5. Solution to example 4: commencement of capitalisation - criteria met at different times Comment: Borrowing costs are being incurred from 1 January 20X5, but activities and related expenditure are only incurred from 1 February 20X5: all three criteria for capitalisation are therefore only met from 1 February 20X5 and therefore capitalisation may only occur from this date:
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20X5 Finance costs (expense) 100 000 x 12 / 12 Bank/ liability Interest on the loan incurred first expensed: total interest incurred for the year (given: 100 000) Building: cost (asset) 100 000 x 11 / 12 Finance costs (expense) Interest on the loan capitalised to the cost of the building; from commencement date (1 February 20X5)
Debit 100 000
Credit 100 000
91 667 91 667
3.1.2 Suspension of capitalisation (IAS 23.20 - .21) If the active development of the qualifying asset is interrupted or delayed for a long period of time, the capitalisation of the borrowing costs must be suspended. Capitalisation of borrowing costs must not be suspended, however, if: • the delay is only temporary; • if the delay is due to substantial technical or istrative work; or • if the delay is a necessary part of getting the asset ready for its intended use. A typical example of when borrowing costs should continue to be capitalised despite a delay is a wine farm that has to wait for its inventory of wine to mature in order to ensure a saleable condition. In this case, borrowing costs that are incurred during this period of maturation would continue to be capitalised to the cost of the inventory of wine. Example 5: delays in construction A hotel is under construction in 20X5. Borrowing costs of C300 000 are incurred on a loan during 20X5. The loan was specifically raised on 1 January 20X5 for the sole purpose of the construction of the hotel. Required: Discuss how much of the interest may be capitalised assuming that: A. The builders go on strike for a period of two months, during which no progress is made. B. The builders of the hotel had to wait for five days for the cement in the foundations to dry. Solution to example 5: delays in construction A. During these two months, the interest incurred may not be capitalised to the asset as it is a substantial and unnecessary interruption to the construction process. B. The borrowing costs must still be capitalised as it is merely a temporary delay and is a normal part of the construction process.
3.1.3 Cessation of capitalisation The entity must stop capitalising borrowing costs when the asset: • is ready for its intended use or sale; or • is substantially complete and capable of being used or sold. By way of example, capitalisation would cease if routine istration work or minor modifications are all that remains to be done (e.g. decoration of a new building to the client’s specifications) in order to bring the asset to a useable or saleable condition. If an asset is completed in parts where each part is capable of being used separately from the other parts, then capitalisation of borrowing costs ceases on each part as and when each part is completed. An example of such an asset would be an office park: as office blocks are 369
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completed, these office blocks may begin to be used by tenants. An example of an asset that would not be capable of being used or sold in parts is a factory plant that requires parts to be made in sequence and where the plant becomes operational only when all parts are completed. Example 6: end of construction Flabby Limited began construction of a block of flats on 1 January 20X5. The block of flats is to be leased out to tenants in the future. On 1 January 20X5, Flabby Limited correctly began capitalising borrowing costs (on a C2 000 000 loan raised for the construction) to the cost of the property. On 30 September 20X5, the building of the block was complete but no tenants could be found. On 15 November 20X5, however, after lowering the rentals, the entire building was rented out to tenants. Interest of C200 000 (at 10% on the loan) was incurred during the 12-month period ended 31 December 20X5. Required: Discuss when Flabby Limited should stop capitalising the interest expense to the asset (building) and show the journal entries relating to interest. Solution to example 6: end of construction Capitalisation should cease when: • the asset is ready for its intended use or sale. On the 30 September 20X5 the construction was completed. Although the asset was not being leased it was ready to be leased to tenants on 30 September 20X5, and therefore capitalisation must cease on 30 September 20X5 (because one of the three criteria for capitalisation is no longer met: activity has ceased). All subsequent interest incurred must be expensed. Journals in 20X5: Finance costs (expense) Bank/ liability Interest incurred: 200 000 (given)
Debit 200 000
Building (asset) Finance costs (expense) Interest capitalised: 200 000 x 9 / 12 (to completion date: 30/9/20X5)
150 000
3.2
Credit 200 000
150 000
Measurement (IAS 23.10 - .15)
Not all borrowing costs may be capitalised. The list of borrowing costs that may be capitalised are given in IAS 23 and are included under paragraph 1.2 above. Notice that this list excludes certain costs associated with raising funds or otherwise financing a qualifying asset. This suggests that costs that do not appear on this list may not be capitalised. Borrowing costs therefore exclude: • cost of raising share capital that is recognised as equity, for example: - dividends on ordinary share capital; - dividends on non-redeemable preference share capital (dividends on redeemable preference share capital may be capitalised because redeemable preference shares are recognised as liabilities and not equity); • cost of using internal funds (e.g. if one uses existing cash resources instead of borrowing more funds, there is a indirect cost being the lost income, often measured using the 370
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Capitalisation of borrowing costs
companies weighted average cost of capital or the market interest rates that could otherwise have been earned); foreign exchange differences that are incurred as a result of acquiring the qualifying asset on credit with no interest charged (e.g. if an asset is purchased for $ 1 000 on 1 January 20X1 when the exchange rate is C7: $1, then the entity owes C7 000 on the transaction date, but if the payment is only necessary on 30 June 20X1 and if the payment is made on this date, and if the exchange rate is C10: $1 on this date, then the entity will have to pay C10 000: the asset will be recorded at C7 000 and the C3 000 exchange difference will have to be expensed since it does not relate to a borrowing cost).
The formula used to measure the borrowing costs that may be capitalised depends on the source of the borrowings. There are two sources of borrowings, which include: • specific borrowings and • general borrowings. Unfortunately IAS 23 does not define what is meant by specific and general borrowings. The difference between specific and general borrowings can, however, be explained as follows: • specific borrowings are taken out for the sole purpose of financing the construction, acquisition or production of a qualifying asset; whereas • general borrowings are those funds that are entered into for a ‘general’ purpose. These funds may be utilised for buying inventory, paying off creditors and a multitude of other purposes in addition to the construction, acquisition or production of a qualifying asset. When determining whether your borrowings are either general or specific, it is useful to that whilst a bank overdraft facility is often used as general purpose borrowings, it is also possible for a bank overdraft facility to be arranged specifically for a qualifying asset. The particular circumstances should, therefore, always be considered when deciding whether the borrowing is specific or general. Measuring the borrowing costs to be capitalised is sometimes more complicated that it first appears. The basic questions that one needs to answer when measuring the borrowing costs to be capitalised include: • are the borrowings specific or general or is there a mix of both specific and general? • is the borrowing a precise amount (e.g. a loan) or does it increase as expenditure is paid for (e.g. a bank overdraft)? • are the expenditures (on which interest is incurred) incurred evenly or at the beginning or end of a period or at haphazard times during a period? • how long are the periods during which capitalisation is allowed? In considering whether the borrowings specific or general or is there a mix of both specific and general, that: • where the borrowings are specific: - you will need the actual rate of interest/s charged on the borrowing/s; and - you will need to ascertain whether any surplus borrowings were invested upon which interest income was earned (if so, to reduce the interest expense by the interest income); • where the borrowings are general: - you will need the weighted average rate of interest charged (assuming there is more than one general borrowing outstanding during the period); In considering whether the borrowing is a precise amount (e.g. a loan) or whether it increase as expenditure is paid for (e.g. a bank overdraft), bear in mind that: • if the borrowing is a loan ( a precise amount), you will use the capital sum; and • if the borrowing is an overdraft (a fluctuating amount), you will use the relevant expenditures and will need to know when they were incurred (or whether they were incurred relatively evenly).
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In assessing whether the expenditures (on which interest is incurred) are incurred evenly or at the beginning or end of a period or at haphazard times during a period, bear in mind that: • interest expense can be measured using average borrowing balances if the costs are incurred evenly, whereas actual borrowing balances should be used (whether specific or general borrowings) if costs are incurred at the beginning or end of a period; and • interest income should be measured using average investment balances if the costs are incurred evenly, whereas actual investment balances should be used (if it is a specific borrowing) if costs are incurred at the beginning or end of a period,. In determining the periods during which capitalisation must occur, you will need to know: • the commencement date: borrowings may be outstanding (and incurring interest) before commencement date in which case interest expense (and interest income on any surplus funds invested) up to commencement date must be ignored when calculating the portion to be capitalised; • the cessation date: borrowings may be outstanding (and incurring interest) after cessation date in which case interest expense (and interest income on any surplus funds invested) after cessation date must be ignored when calculating the portion to be capitalised; and • whether there was a suspension period between these two dates: borrowings may be outstanding (and incurring interest) during a suspension period in which case interest expense (and interest income on any surplus funds invested) during this period must be ignored when calculating the portion to be capitalised. 3.2.1 Measurement: specific loans (IAS 23.12 - .13) All of the borrowing costs incurred on a specific loan are capitalised to the asset. If these funds are invested prior to the date they were utilised then any interest earned must be subtracted from the interest incurred (borrowing costs), in which case only the net amount may be capitalised. Example 7: specific loans Yahoo Limited borrowed C500 000 from the bank on 1 January 20X5 to begin the construction of a building. The interest payable on the loan during 20X5 was C50 000 (calculated at 10%). The company invested all surplus funds raised in a fixed deposit and earned C24 000 interest during 20X5. No capital portion of the loan was repaid during the year ended 31 December 20X5. All criteria for capitalisation of borrowing costs were met on 1 January 20X5. The building is a qualifying asset. Required: Calculate the amount of borrowing costs that must be capitalised in of IAS 23 and show the necessary journal entries. Solution to example 7: specific loans Comment: this example shows that interest income is used to reduce the amount of borrowings that may be capitalised when the borrowing is a specific borrowing.
Interest incurred Interest earned Total to be capitalised
Calculations: 500 000 x 10% given
C 50 000 (24 000) 26 000 Debit 50 000
Finance costs (expense) Bank/ liability Interest incurred on the loan first expensed
Credit 50 000
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Bank/ liability Interest income Interest income earned on investment of surplus loan funds Building: cost (asset) 50 000 – 24 000 Finance costs (expense) Portion of interest on the loan capitalised to the cost of the building
Debit 24 000
Credit 24 000
26 000 26 000
When calculating the interest income you may find that actual amounts invested can be used. This happens when, for example, the expenditures are infrequent and/ or happen at the start or end of a period. This will mean that the investment balance will remain unchanged for a period of time. The calculation of the amount of borrowing costs on specific borrowings that must be capitalised is therefore: • total interest incurred on specific borrowings: capital borrowed x interest rate x period borrowed • less interest income earned from investment of surplus borrowings: amount invested x interest rate x period invested. Very often, however, average amounts invested need to be used instead of actual amounts invested. This happens more frequently when the borrowing is a general borrowing, but can apply to a specific borrowing where, for example, the expenditure is paid relatively evenly over a period of time, with the result that the balance on the investment (being the surplus borrowings that are invested) is constantly changing. In this case, it is normally acceptable to calculate the interest earned on the average investment balance over a period of time (rather than on the actual balance on a specific day). The calculation of the amount of borrowing costs on specific borrowings that must be capitalised could therefore be: • total interest incurred on specific borrowings: capital borrowed x interest rate x period borrowed • less interest income earned from investment of surplus borrowings: (investment o/ balance + investment c/ balance) / 2 x interest rate x period invested Example 8: specific loans – costs paid on specific days Haha Limited borrowed C500 000 from the bank on 1 January 20X5 to begin the construction of a building (a qualifying asset). Construction began on 1 January 20X5 (i.e. all criteria for capitalisation of borrowing costs were met). The interest rate payable on the loan was 10%. The company paid construction costs of C400 000 on 1 March 20X5. Surplus funds were invested in a fixed deposit and earned interest at 6% per annum. No capital portion of the loan was repaid during the year ended 31 December 20X5. Required: Calculate the amount of borrowing costs that must be capitalised. Solution to example 8: specific loans – costs paid on specific days Comment: The borrowings are raised two months before they were required. These surplus funds are invested for January and February and the balance on this for these two months remains stable at C500 000. On March, however, payments totaling C400 000 are made, thus reducing the investment balance to C100 000. This balance remains stable for the remaining ten months of the year. Since the expenditure is not incurred evenly over a period but is incurred on a specific day, the interest income for the purposes of the calculation of the borrowing costs to be capitalised should be calculated using the actual investment balances (C500 000 for 2 months and C100 000 for 10 months). Calculations: Borrowing costs incurred Interest earned Capitalised borrowing costs
500 000 x 10% x 12 / 12 500 000 x 6% x 2 / 12 + (500 000 – 400 000) x 6% x 10/ 12
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Debit 50 000
Finance costs (expense) Bank/ liability Interest incurred on the loan is first expensed
Credit 50 000
Bank/ liability Interest income Interest income earned on investment of surplus loan funds
10 000
Building: cost (asset) Finance costs (expense) Portion of interest on the loan capitalised to the cost of the building
40 000
10 000
40 000
Example 9: specific loans – costs paid evenly over a period Hooray Limited borrowed C500 000 from the bank on 1 January 20X5 to begin the construction of a building (a qualifying asset). Construction begins on 1 January 20X5 (all criteria for capitalisation of borrowing costs were met on this date). The interest rate payable on the loan was 10%. The company paid construction costs of C400 000 evenly between 1 March 20X5 and 31 December 20X5. Surplus funds are invested in a fixed deposit and earned interest at 6% per annum. No capital portion of the loan was repaid during the year ended 31 December 20X5. Required: Calculate the amount of borrowing costs that must be capitalised. Solution to example 9: specific loans – costs paid evenly over a period Comment: The borrowings are raised two months before they were required. These surplus funds are invested for January and February and the balance on this for these two months remains stable at C500 000. From March, however, the amount invested gradually reduces as payments are made (the balance of C500 000 on 1 March gradually decreases to a balance of C100 000 (C500 000 – C400 000) on 31 December. Since the payments are incurred evenly over this ten-month period, the interest income for the purposes of the calculation of the borrowing costs to be capitalised may be calculated using the average of these two balances (C500 000 and C100 000).
Interest incurred Interest earned Capitalised borrowing costs
Calculations: 500 000 x 10% x 12 / 12 (500 000 x 6% x 2 / 12) + (500 000 + 100 000) / 2 x 6% x 10/ 12
Debit 50 000
Finance costs (expense) Bank/ liability Interest incurred on the loan is first expensed
C 50 000 (20 000) 30 000 Credit 50 000
Bank/ liability Interest income Interest income earned on investment of surplus loan funds
20 000
Building: cost (asset) Finance costs (expense) Portion of interest on the loan capitalised to the cost of the building
30 000
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20 000
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Example 10: specific loans – loan raised before construction begins Yeeha Limited borrowed C500 000 from the bank on 1 January 20X5 to begin the construction of a building (a qualifying asset). Construction began on 1 February 20X5 (i.e. all criteria for capitalisation of borrowing costs were met on this date). The interest rate payable on the loan is 10%. The company paid construction costs of C400 000 on 1 March 20X5. Surplus funds are invested in a fixed deposit and earned interest at 6% per annum. No capital portion of the loan was repaid during the year ended 31 December 20X5. Required: Calculate the amount of borrowing costs that may be capitalised. Solution to example 10: specific loans – loan raised before construction begins Compare this to example 8, in which the construction began on 1 January 20X5. In this example, the loan is taken out before construction begins. All criteria for capitalisation are therefore only met on 1 February 20X1 (commencement date) and therefore the interest that is incurred/ earned before this date must be ignored for the purpose of calculating the portion of interest to be capitalised.
Interest incurred after commencement date Interest earned after commencement date Capitalised borrowing costs
Calculations: 500 000 x 10% x 11 / 12 (i.e. excludes January interest expense) (500 000 x 6% x 1 / 12) + (500 000 - 400 000) x 6% x 10 / 12 (i.e. excludes January interest income)
(7 500) 38 333
Finance costs (expense) Bank/ liability Interest incurred on the loan first expensed: 500 000 x 10% x 12/ 12 Bank/ liability Interest income Interest income earned on investment of surplus loan funds: (500 000 x 6% x 2 / 12) + (500 000 – 400 000) x 6% x 10 / 12 Building: cost (asset) Finance costs (expense) Portion of interest on the loan capitalised to the cost of the building
3.2.2
C 45 833
Debit 50 000
Credit 50 000
10 000 10 000
38 333 38 333
Measurement: general loans (IAS 17.14 - .15)
General loans are used for many purposes and therefore it cannot be said that all the interest incurred thereon was ‘directly attributable to the qualifying asset’. Therefore, not all the interest incurred on a general loan may be capitalised to the asset. If the entity has used a general loan for a qualifying asset, the costs eligible for capitalisation are the weighted average cost of borrowings, calculated as follows: • capitalisation rate x the average expenditure relating to the qualifying asset. • The capitalisation rate is: the weighted average interest rate on the loans borrowed by the entity. • The average expenditure is: expenditure for the period / 2 The total amount of interest capitalised may not exceed the total interest paid or incurred.
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Example 11: general loans – costs incurred evenly Bizarre Limited had a C500 000 7% existing general loan outstanding on 1 January 20X5. It raised an additional general loan of C600 000 on 1 January 20X5 at an interest rate of 12.5%. Bizarre Limited did not make any repayments on either loan during the year. Construction began on 1 January 20X5. The company spent the following amounts per month on the construction of a building, a qualifying asset: C per month 50 000 30 000 100 000
1 January – 31 July (7 months) 1 August – 30 November (4 months) 1 – 31 December (1 month)
Required: Calculate the amount of borrowing costs that must be capitalised and provide the necessary journal entries for the year ended 31 December 20X5, assuming that the amounts were spent evenly during each month. Solution to example 11: general loans – costs incurred evenly Comment: There are two borrowings, both of which are general borrowings and therefore the borrowing costs to be capitalised is based on the expenditures incurred and the weighted average interest rate. Since the expenditures are incurred evenly, average expenditures are used. Since the borrowings are general, one does not consider interest income in the calculation of the amount to be capitalised. W1: Borrowing costs to be capitalised The loans are general loans and therefore the formula is: ‘Capitalisation rate x Average expenditure’. Capitalisation rate (weighted average interest rate): = interest incurred on general borrowings/ borrowings outstanding during the period = [(C500 000 x 7% x 12 / 12) + (C600 000 x 12.5% x 12 / 12)] / 1 100 000 total borrowings = 10% Cumulative expenditure 1 January 20X5 January – July 31 July 20X5 August - November 30 November 20X5 December 31 December 20X5
Opening balance 50 000 x 7 months Closing balance 30 000 x 4 months Closing balance 100 000 x 1 month Closing balance
Capitalisation rate x average expenditure: Jan – July (0 + 350 000) / 2 x 10% x 7 / 12 months;
C 0 350 000 350 000 120 000 470 000 100 000 570 000 C 10 208
OR: (50 000 x 7 months) / 2 x 10 % x 7 / 12 months
Aug – Nov (350 000 + 470 000) / 2 x10% x 4 / 12 months; Dec
OR: {(30 000 x 4 months) / 2 + 50 000 x 7} x 10 % x 4 / 12 months (470 000 + 570 000) / 2 x 10% x 1 / 12 months; OR {(100 000 x 1) / 2 + 50 000 x 7 + 30 000 x 4 }x 10% x 1/ 12
Total to be capitalised:
13 667 4 333 28 208
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The above calculation can be done the long way around, if preferred: Expense incurred evenly during each month Balance (A) Expense (B) Balance (C ) January 0 50 000 50 000 February 50 000 50 000 100 000 March 100 000 50 000 150 000 April 150 000 50 000 200 000 May 200 000 50 000 250 000 June 250 000 50 000 300 000 July 300 000 50 000 350 000 August 350 000 30 000 380 000 September 380 000 30 000 410 000 October 410 000 30 000 440 000 November 440 000 30 000 470 000 December 470 000 100 000 570 000
Balance (D ) 25 000 75 000 125 000 175 000 225 000 275 000 325 000 365 000 395 000 425 000 455 000 520 000
Interest % 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10%
Months 1 1 1 1 1 1 1 1 1 1 1 1
Capitalise 208 625 1 042 1 458 1 875 2 292 2 708 3 042 3 292 3 542 3 792 4 333
570 000
28 209
Balance (A): first day of the month Expense (B): incurred on the last day of the month Balance (C): last day of the month Balance (D): average balance = (A + C) / 2 Capitalise: interest expense that may be capitalised: Balance (A) x interest rate x 1 / 12 Capitalisation rate (weighted average interest rate): see calculation above Journals in 20X5: Building (asset) Bank/ liability Construction costs incurred: 50 000 x 7 + 30 000 x 4 + 100 000 x 1 This journal would actually be processed separately for each and every payment but is shown here as a cumulative journal for ease Finance costs (expense) Bank/ liability Finance costs incurred: 500 000 x 7% + 600 000 x 12.5%
Debit 570 000
Credit 570 000
110 000
Building (asset) Finance costs (expense) Finance costs capitalised: (W1)
110 000 28 209 28 209
Example 12: general loans – costs incurred at the end of each month Bizarre Limited had a C500 000 7% existing general loan outstanding on 1 January 20X5. It raised an additional general loan of C600 000 on 1 January 20X5 at an interest rate of 12.5%. Bizarre Limited did not make any repayments on either loan during the year. Construction began on 1 January 20X5. The company spent the following amounts per month on the construction of a building, a qualifying asset: C per month 50 000 30 000 100 000
1 January – 31 July 1 August – 30 November 1 – 31 December
Required: Calculate the amount of borrowing costs that must be capitalised and provide the necessary journal entries for the year ended 31 December 20X5, assuming that the amounts were paid at the end of each month. 377
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Solution to example 12: general loans – costs incurred at the end of each month Comment: There are two borrowings, both of which are general borrowings and therefore the interest to be capitalised is based on the expenditures incurred and the weighted average interest rate. Since the expenditures are incurred at the end of the month, actual expenditures should be used instead (assuming the difference between using actual and average expenses is considered by the entity to be material). The interest is calculated as follows: the opening balance at the beginning of each month multiplied by the weighted average interest rate multiplied by 1/ 12. W1: Borrowing costs to be capitalised The loans are general loans and therefore the formula is: ‘Capitalisation rate x Average expenditure’. Expense incurred at end of each month Balance (A) Expense (B) January 0 50 000 February 50 000 50 000 March 100 000 50 000 April 150 000 50 000 May 200 000 50 000 June 250 000 50 000 July 300 000 50 000 August 350 000 30 000 September 380 000 30 000 October 410 000 30 000 November 440 000 30 000 December 470 000 100 000
Balance (C ) 50 000 100 000 150 000 200 000 250 000 300 000 350 000 380 000 410 000 440 000 470 000 570 000
Interest 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10%
Months 1 1 1 1 1 1 1 1 1 1 1 1
570 000
Capitalise (D) 0 417 833 1 250 1 667 2 083 2 500 2 917 3 167 3 417 3 667 3 917 25 835
Balance (A): balance on the first day of the month Expense (B): incurred on the last day of the month Balance (C): balance on the last day of the month Capitalise (D): interest expense that may be capitalised: A x interest rate x 1 / 12 Capitalisation rate (weighted average interest rate): = interest incurred on general borrowings/ borrowings outstanding during the period = [(C500 000 x 7% x 12 / 12) + (C600 000 x 12.5% x 12 / 12)] / 1 100 000 total borrowings = 10% Journals in 20X5: Building (asset) Bank/ liability Construction costs incurred: 50 000 x 7 + 30 000 x 4 + 100 000 x 1 This journal would actually be processed separately for each and every payment but is shown here as a cumulative journal for ease Finance costs (expense) Bank/ liability Finance costs incurred: 500 000 x 7% + 600 000 x 12.5% Building (asset) Finance costs (expense) Finance costs capitalised: (W1)
Debit 570 000
Credit 570 000
110 000 110 000 25 835 25 835
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Example 13: general loans – costs incurred at the start of each month Bizarre Limited had a C500 000 7% existing general loan outstanding on 1 January 20X5. It raised an additional general loan of C600 000 on 1 January 20X5 at an interest rate of 12.5%. Bizarre Limited did not make any repayments on either loan during the year. Construction began on 1 January 20X5. The company spent the following amounts per month on the construction of a building, a qualifying asset: C per month 50 000 30 000 100 000
1 January – 31 July 1 August – 30 November 1 – 31 December
Required: Calculate the amount of borrowing costs that must be capitalised and provide the necessary journal entries for the year ended 31 December 20X5, assuming that the amounts were paid at the beginning of each month. Solution to example 13: general loans – costs incurred at the start of each month Comment: There are two borrowings, both of which are general borrowings and therefore the interest to be capitalised is based on the expenditures incurred and the weighted average interest rate. Since the expenditures are incurred at the beginning of each month, actual expenditures should be used instead (assuming that the difference between using actual and average expenses is considered by the entity to be material). The interest is calculated as: the opening balance at the beginning of each month multiplied by the weighted average interest rate multiplied by 1/ 12. W1: Borrowing costs to be capitalised The loans are general loans and therefore the formula is: ‘Capitalisation rate x Average expenditure’. Expense incurred at beginning of each month Balance (A) Expense (B) January 0 50 000 February 50 000 50 000 March 100 000 50 000 April 150 000 50 000 May 200 000 50 000 June 250 000 50 000 July 300 000 50 000 August 350 000 30 000 September 380 000 30 000 October 410 000 30 000 November 440 000 30 000 December 470 000 100 000
Balance (C ) 50 000 100 000 150 000 200 000 250 000 300 000 350 000 380 000 410 000 440 000 470 000 570 000
570 000
Interest % 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10%
Months 1 1 1 1 1 1 1 1 1 1 1 1
Capitalise 417 833 1 250 1 667 2 083 2 500 2 917 3 167 3 417 3 667 3 917 4 750 30 585
Balance (A): balance on the first day of the month before payment of expense Expense (B): incurred on the first day of the month Balance (C): adjusted balance on the first day of the month after payment of expense Capitalise: interest expense that may be capitalised: C x interest rate x 1 / 12 Capitalisation rate (weighted average interest rate): = interest incurred on general borrowings/ borrowings outstanding during the period = [(C500 000 x 7% x 12 / 12) + (C600 000 x 12.5% x 12 / 12)] / 1 100 000 total borrowings
= 10%
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Journals in 20X5: Building (asset) Bank/ liability Construction costs incurred: 50 000 x 7 + 30 000 x 4 + 100 000 x 1 This journal would actually be processed separately for each and every payment but is shown here as a cumulative journal for ease Finance costs (expense) Bank/ liability Finance costs incurred: 500 000 x 7% + 600 000 x 12.5% Building (asset) Finance costs (expense) Finance costs capitalised: 30 585 (W1)
4
Debit 570 000
Credit 570 000
110 000 110 000 30 585 30 585
A comparison of the methods
It is interesting to note that many ants expected the revised IAS 23 to make the expensing of borrowing costs compulsory and to outlaw the capitalisation thereof – not the other way around! There are arguments both for and against the capitalisation of borrowing costs. Some argue that the capitalisation of borrowing costs is more appropriate than the expensing them because: • interest should not be treated any differently to the other directly attributable costs that are capitalised in of IAS 16: Property, Plant and Equipment (improves consistency); • if the entity had purchased the qualifying asset, the construction company (seller) would have included any borrowing costs that they incurred into the purchase price: it therefore improves comparability between companies that purchase assets and those that construct their own (improves comparability); and • if the entity does not capitalise the borrowing costs, it will result in a decrease in their profit, merely because they decided to self-construct the asset. A better approach, it is argued, would be to recognise the borrowing costs as part of the cost of the asset and then recognise these costs as an expense (e.g. depreciation) over the period that the asset is used and earns revenue (improves matching of expense to income). Some of the arguments against capitalizing borrowing costs include: • borrowing costs incurred when constructing an asset should be expensed in the period in which they are incurred, just as any other finance costs would be (improves consistency and matching of expenses to the period in which they were incurred); • the calculation of the portion of the borrowing costs to be capitalised is, in practice, very subjective and could therefore result in errors and manipulation and therefore expensing the actual borrowing costs incurred is less prone to error (improves reliability); and • when interest is treated as an expense, cash flows for the period will approximate the profit for the period, which is more useful to the (improves relevance) since it helps to predict cash flows. 5
Disclosure (IAS 23.26)
The entity must disclose the following in the financial statements: • the total amount of borrowing costs capitalised; • the amount of borrowing costs expensed as finance costs in the statement of comprehensive income (this is an IAS 1 requirement – not a requirement of IAS 21); • the capitalisation rate used to calculate the borrowing costs for a general loan.
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Company name Statement of comprehensive income (extracts) For the year ended 31 December Note Profit before finance costs Finance costs Profit before tax Other comprehensive income Total comprehensive income
3.
20X5 C x X x x x
20X4 C x X x x x
20X5 C Z (Y) X
20X4 C Z (Y) X
Company name Notes to the financial statement (extracts) For the year ended 31 December 3. Finance costs Interest incurred Less interest capitalised Finance cost expense
IAS 23 requirement IAS 1 requirement
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6. Summary IAS 23 Borrowing costs Expense
Capitalise
If not related to a qualifying asset
If it relates to a qualifying asset and meets all criteria for capitalisation
Qualifying borrowing costs
Capitalise borrowing costs that relate to costs: • directly attributable to the • acquisition, construction or production of • a qualifying asset and if • future economic benefits are probable and • costs can be reliably measured
Qualifying asset
•
those that take a long time to get ready
Measurement General borrowings
•
• •
Start
• •
•
Specific borrowings
Capitalise borrowing costs using the following formula: Capitalisation rate (CR) x the expenditure; but limit to the actual borrowing costs incurred CR = weighted average borrowing costs divided by the general outstanding borrowings
Interest is being incurred; Expenditure on the production of the asset is being incurred; and Activities are in progress
• •
Pause
Capitalise the total amount of borrowing costs actually incurred Less any interest income earned on the temporary investment of any surplus borrowings
the construction of the asset is interrupted or delayed for a long period of time; (do not pause if the delay is necessary).
Stop
the asset is ready for its intended use or sale; (or if it is substantially ready).
This is the commencement date
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Chapter 11 Capitalisation of Borrowing Costs Reference: IAS 23
Contents:
Page
1. Introduction and definitions 1.1 1.2 1.3 1.4
365
Overview Borrowing costs Qualifying assets Qualifying borrowing costs
365 365 365 366
2. Expensing borrowing costs
366
2.1 Recognition 2.2 Measurement Example 1: expensing borrowing costs
366 366 366
3. Capitalising borrowing costs
367
3.1 Recognition
367
3.1.1 Commencement of capitalisation Example 2: capitalisation of borrowing costs: all criteria met at same time Example 3: commencement of capitalisation: criteria met at different times Example 4: commencement of capitalisation: criteria met at different times
367 367 368 368
3.1.2 Suspension of capitalisation Example 5: delays in construction
369 369
3.1.3 Cessation of capitalisation Example 6: end of construction
369 370
3.2 Measurement
370
3.2.1 Measurement: specific loans Example 7: specific loans Example 8: specific loans: costs paid on specific days Example 9: specific loans: costs paid evenly over a period Example 10: specific loans: loan raised before construction begins
372 372 373 374 375
3.2.2 Measurement: general loans Example 11: general loan: costs incurred evenly Example 12: general loan: costs incurred at the end of each month Example 13: general loan: costs incurred at the start of each month
375 376 377 379
4. A comparison of the methods
380
5. Disclosure
380
6. Summary
382
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1
Capitalisation of borrowing costs
Introduction and definitions
1.1 Overview IAS 23 was revised in March 2007. Those of you who have studied this standard previously will notice that in the previous version of IAS 23, ants were able to choose between: • the benchmark treatment (expensing borrowing costs); and • the allowed alternative treatment (capitalising borrowing costs). In the revised version of IAS 23, however, you will notice that there is no reference at all to the benchmark or allowed alternative treatments. The revised IAS 23 has it that ants must capitalise borrowing costs (the previous allowed alternative treatment) that are incurred on qualifying assets. Thus borrowing costs on non-qualifying assets are always expensed. Therefore, IAS 23 now requires that an entity: • capitalise borrowing costs that were incurred on a qualifying asset; and • expense borrowing costs that were not incurred on a qualifying asset. Up until now you will have indirectly been exposed to borrowing costs where borrowing costs are generally expensed (i.e. the presupposition in such examples would have been that the borrowing costs were not incurred on a qualifying asset). We will now learn how and when to capitalise borrowing costs. In a nutshell, borrowing costs that relate to qualifying assets must be capitalised assuming that criteria for recognition of an asset are also met. One of the more significant reasons behind capitalising borrowing costs instead of expensing them is that the cost of financing is generally a significant cost, and is generally a necessary evil in order to bring an asset to a location and condition that makes it useable or saleable. Costs that are significant and necessary should surely form part of the asset’s cost. There are arguments against capitalizing borrowing costs as well, of course. These are discussed at the end of this chapter, but are largely academic now, given that there is no longer a choice. 1.2 Borrowing costs Borrowing costs are those costs that are incurred by the entity in connection with the borrowing of funds. Other names often used for borrowing costs include: • interest expense; and • finance charges. Borrowings costs may include: • interest incurred on loans (including bank overdraft); • amortisation of discounts (or s); • finance charges on finance leases; • exchange difference on foreign loan s; and • costs of raising debt. 1.3 Qualifying assets Qualifying assets are those that take a substantial period of time to get ready for their intended use or sale. Qualifying assets may include: • manufacturing plants; • power generation facilities; • intangible assets; • investment properties; and • inventories. 365
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1.4 Qualifying borrowing costs (IAS 23.8 - .10) Borrowing costs that must be capitalised to the cost of an asset are those that: • are directly attributable • to the acquisition, manufacture or production • of a qualifying asset; and those that • would have been avoided had the expenditure on the qualifying asset not been made. It is sometimes quite difficult to identify a direct link between borrowing costs incurred and a specific asset since: • the borrowings may not have been specifically raised for that asset, but may be general borrowings (i.e. the entity may have a range of debt instruments at a range of varying interest rates); • the borrowings may not even be denominated in your local currency (i.e. the borrowings may be foreign borrowings); and • the borrowings may be subject to hyper-inflation (borrowing costs that compensate for inflation are always expensed). The lists of complications are seemingly endless thus frequently requiring your professional judgement. These complications in calculation of the borrowing costs to be capitalised are expanded upon in the section entitled ‘measuement’. 2
Expensing borrowing costs
2.1 Recognition (IAS 23.8 - .9) Whenever borrowing costs do not meet the conditions for capitalisation, they are expensed. Expensing borrowing costs simply means to include the borrowing costs as an expense in profit or loss in the period in which they were incurred (i.e. as and when interest is charged in accordance with the of the borrowing agreement). 2.2 Measurement The amount of borrowing costs expensed is simply the amount charged by the lender in accordance with the borrowing agreement. Example 1: expensing borrowing costs Yay Limited incurred C100 000 interest (during the year ended 31 December 20X5) on a loan that was used to finance the construction of a factory plant. The factory plant was not considered to be a qualifying asset. Required: Provided the necessary journal entries for expensing the interest in Yay Limited’s books for the year ended 31 December 20X5. Solution to example 1: expensing borrowing costs Comment: When to recognise an expense: when the interest is incurred. How much to expense: the amount of interest charged by the lender in of the agreement. Debit 100 000
Finance costs (expense) Bank/ liability Interest incurred during the period is expensed
Credit 100 000
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3 3.1
Capitalisation of borrowing costs
Capitalising borrowing costs Recognition (IAS 23.8 - .9)
To capitalise borrowing costs simply means to include them in the cost of the related qualifying assets. In other words, the borrowing costs are recognised as an asset. Before the borrowing costs may be recognised as an asset, they must meet the basic recognition criteria for an asset: • future economic benefits must be probable; and • the costs must be reliably measurable. Borrowing costs that must be capitalised are those: • that are directly attributable • to the acquisition, construction or production • of a qualifying asset. Directly attributable means: if the assets had not been constructed, acquired or produced then these costs could have been avoided. An example of an acquisition is the purchase of a building. An example of the construction of an asset is the building of a manufacturing plant. An example of the production of an asset is the manufacture of inventory. When to recognise borrowing costs as part of the asset (capitalisation) is affected by: • Commencement date: capitalisation starts from the date on which certain criteria are met; • Suspension period: capitalisation must stop temporarily when certain criteria are met; • Cessation date: capitalisation must stop permanently when certain criteria are met. When borrowing costs are capitalised, the carrying amount of the asset will obviously be increased by the borrowing costs incurred. The cost of these borrowings will eventually reduce profits, but only when the qualifying asset affects profit or loss (e.g. through the depreciation expense when the qualifying asset is an item of property, plant and equipment). 3.1.1 Commencement of capitalisation (IAS 23.17 - .19) Assuming the basic recognition criteria are met, an entity must start to capitalise borrowing costs from the date that all the following criteria are met: • the entity is preparing the asset for its intended use or sale (activity is happening); • expenditure is being incurred by the entity in preparing the asset; and • borrowing costs are being incurred. The date that all three criteria are met is known as the commencement date. Example 2: capitalisation of borrowing costs - all criteria met at same time Yippee Limited incurred C100 000 interest on a loan used to finance the construction of a building during the year ended 31 December 20X5: • The building was considered to be a qualifying asset. • Construction of the building began on 1 January 20X5, when the loan was raised. • It is probable that the building would result in future economic benefits and the borrowing costs are reliably measurable. • The construction of the building began as soon as the loan was raised. Required: Provide the necessary journal entries to capitalise the borrowing costs in Yippee Limited’s books for the year ended 31 December 20X5. 367
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Solution to example 2: capitalisation of borrowing costs - all criteria met at same time Comment: Interest must be recognised as part of the cost of the qualifying asset. Interest is recognised as part of the asset (capitalisation) from the time that all criteria for capitalisation are met. All criteria are met on the same date (1 January 20X5): • a loan is raised on 1 January 20X5 on which interest is being incurred; • activities start on 1 January 20X5; and • expenditure related to the activities start on 1 January 20X5 is being incurred. The basic recognition criteria are also met and therefore the amount to be capitalised is calculated from 1 January 20X5. Debit Credit Finance costs (expense) 100 000 x 12 / 12 100 000 Bank/ liability 100 000 Interest on the loan incurred first expensed Building: cost (asset) 100 000 x 12 / 12 Finance costs (expense) Interest on the loan capitalised to the cost of the building
100 000 100 000
Example 3: commencement of capitalisation - criteria met at different times Dawdle Limited borrowed C100 000 on the 30 June 20X5 to build a factory to store its goods. The necessary building materials were only available on 31 August 20X5 and it was then that Dawdle Limited began construction. The building is considered to be a qualifying asset. Required: Discuss when Dawdle Limited may begin capitalising the interest incurred. Solution to example 3: commencement of capitalisation - criteria met at different times All three criteria must be met before the entity may begin capitalisation. From the 30 June 20X5, Dawdle Limited borrowed funds and began incurring borrowing costs, but had not yet met the other two criteria (activities were not underway and costs on the asset were not being incurred). On the 31 August 20X5, however, Dawdle both acquired the construction materials and began construction thereby fulfilling all three criteria. Dawdle Limited may therefore only begin capitalising the borrowing costs on the 31 August 20X5 (assuming that it was probable that the building would render future economic benefits and that the costs were considered reliably measurable).
Example 4: commencement of capitalisation - criteria met at different times Hoorah Limited incurred C100 000 interest for the year ended 31 December 20X5 on a loan of C1 000 000, raised on 1 January 20X5. The loan was raised to finance the construction of a building during the year ended 31 December 20X5. The building is a qualifying asset. Construction began on 1 February 20X5. Required: Provide the necessary journal entries to capitalise the borrowing costs in Hoorah Limited’s books for the year ended 31 December 20X5. Solution to example 4: commencement of capitalisation - criteria met at different times Comment: Borrowing costs are being incurred from 1 January 20X5, but activities and related expenditure are only incurred from 1 February 20X5: all three criteria for capitalisation are therefore only met from 1 February 20X5 and therefore capitalisation may only occur from this date:
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20X5 Finance costs (expense) 100 000 x 12 / 12 Bank/ liability Interest on the loan incurred first expensed: total interest incurred for the year (given: 100 000) Building: cost (asset) 100 000 x 11 / 12 Finance costs (expense) Interest on the loan capitalised to the cost of the building; from commencement date (1 February 20X5)
Debit 100 000
Credit 100 000
91 667 91 667
3.1.2 Suspension of capitalisation (IAS 23.20 - .21) If the active development of the qualifying asset is interrupted or delayed for a long period of time, the capitalisation of the borrowing costs must be suspended. Capitalisation of borrowing costs must not be suspended, however, if: • the delay is only temporary; • if the delay is due to substantial technical or istrative work; or • if the delay is a necessary part of getting the asset ready for its intended use. A typical example of when borrowing costs should continue to be capitalised despite a delay is a wine farm that has to wait for its inventory of wine to mature in order to ensure a saleable condition. In this case, borrowing costs that are incurred during this period of maturation would continue to be capitalised to the cost of the inventory of wine. Example 5: delays in construction A hotel is under construction in 20X5. Borrowing costs of C300 000 are incurred on a loan during 20X5. The loan was specifically raised on 1 January 20X5 for the sole purpose of the construction of the hotel. Required: Discuss how much of the interest may be capitalised assuming that: A. The builders go on strike for a period of two months, during which no progress is made. B. The builders of the hotel had to wait for five days for the cement in the foundations to dry. Solution to example 5: delays in construction A. During these two months, the interest incurred may not be capitalised to the asset as it is a substantial and unnecessary interruption to the construction process. B. The borrowing costs must still be capitalised as it is merely a temporary delay and is a normal part of the construction process.
3.1.3 Cessation of capitalisation The entity must stop capitalising borrowing costs when the asset: • is ready for its intended use or sale; or • is substantially complete and capable of being used or sold. By way of example, capitalisation would cease if routine istration work or minor modifications are all that remains to be done (e.g. decoration of a new building to the client’s specifications) in order to bring the asset to a useable or saleable condition. If an asset is completed in parts where each part is capable of being used separately from the other parts, then capitalisation of borrowing costs ceases on each part as and when each part is completed. An example of such an asset would be an office park: as office blocks are 369
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completed, these office blocks may begin to be used by tenants. An example of an asset that would not be capable of being used or sold in parts is a factory plant that requires parts to be made in sequence and where the plant becomes operational only when all parts are completed. Example 6: end of construction Flabby Limited began construction of a block of flats on 1 January 20X5. The block of flats is to be leased out to tenants in the future. On 1 January 20X5, Flabby Limited correctly began capitalising borrowing costs (on a C2 000 000 loan raised for the construction) to the cost of the property. On 30 September 20X5, the building of the block was complete but no tenants could be found. On 15 November 20X5, however, after lowering the rentals, the entire building was rented out to tenants. Interest of C200 000 (at 10% on the loan) was incurred during the 12-month period ended 31 December 20X5. Required: Discuss when Flabby Limited should stop capitalising the interest expense to the asset (building) and show the journal entries relating to interest. Solution to example 6: end of construction Capitalisation should cease when: • the asset is ready for its intended use or sale. On the 30 September 20X5 the construction was completed. Although the asset was not being leased it was ready to be leased to tenants on 30 September 20X5, and therefore capitalisation must cease on 30 September 20X5 (because one of the three criteria for capitalisation is no longer met: activity has ceased). All subsequent interest incurred must be expensed. Journals in 20X5: Finance costs (expense) Bank/ liability Interest incurred: 200 000 (given)
Debit 200 000
Building (asset) Finance costs (expense) Interest capitalised: 200 000 x 9 / 12 (to completion date: 30/9/20X5)
150 000
3.2
Credit 200 000
150 000
Measurement (IAS 23.10 - .15)
Not all borrowing costs may be capitalised. The list of borrowing costs that may be capitalised are given in IAS 23 and are included under paragraph 1.2 above. Notice that this list excludes certain costs associated with raising funds or otherwise financing a qualifying asset. This suggests that costs that do not appear on this list may not be capitalised. Borrowing costs therefore exclude: • cost of raising share capital that is recognised as equity, for example: - dividends on ordinary share capital; - dividends on non-redeemable preference share capital (dividends on redeemable preference share capital may be capitalised because redeemable preference shares are recognised as liabilities and not equity); • cost of using internal funds (e.g. if one uses existing cash resources instead of borrowing more funds, there is a indirect cost being the lost income, often measured using the 370
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•
Capitalisation of borrowing costs
companies weighted average cost of capital or the market interest rates that could otherwise have been earned); foreign exchange differences that are incurred as a result of acquiring the qualifying asset on credit with no interest charged (e.g. if an asset is purchased for $ 1 000 on 1 January 20X1 when the exchange rate is C7: $1, then the entity owes C7 000 on the transaction date, but if the payment is only necessary on 30 June 20X1 and if the payment is made on this date, and if the exchange rate is C10: $1 on this date, then the entity will have to pay C10 000: the asset will be recorded at C7 000 and the C3 000 exchange difference will have to be expensed since it does not relate to a borrowing cost).
The formula used to measure the borrowing costs that may be capitalised depends on the source of the borrowings. There are two sources of borrowings, which include: • specific borrowings and • general borrowings. Unfortunately IAS 23 does not define what is meant by specific and general borrowings. The difference between specific and general borrowings can, however, be explained as follows: • specific borrowings are taken out for the sole purpose of financing the construction, acquisition or production of a qualifying asset; whereas • general borrowings are those funds that are entered into for a ‘general’ purpose. These funds may be utilised for buying inventory, paying off creditors and a multitude of other purposes in addition to the construction, acquisition or production of a qualifying asset. When determining whether your borrowings are either general or specific, it is useful to that whilst a bank overdraft facility is often used as general purpose borrowings, it is also possible for a bank overdraft facility to be arranged specifically for a qualifying asset. The particular circumstances should, therefore, always be considered when deciding whether the borrowing is specific or general. Measuring the borrowing costs to be capitalised is sometimes more complicated that it first appears. The basic questions that one needs to answer when measuring the borrowing costs to be capitalised include: • are the borrowings specific or general or is there a mix of both specific and general? • is the borrowing a precise amount (e.g. a loan) or does it increase as expenditure is paid for (e.g. a bank overdraft)? • are the expenditures (on which interest is incurred) incurred evenly or at the beginning or end of a period or at haphazard times during a period? • how long are the periods during which capitalisation is allowed? In considering whether the borrowings specific or general or is there a mix of both specific and general, that: • where the borrowings are specific: - you will need the actual rate of interest/s charged on the borrowing/s; and - you will need to ascertain whether any surplus borrowings were invested upon which interest income was earned (if so, to reduce the interest expense by the interest income); • where the borrowings are general: - you will need the weighted average rate of interest charged (assuming there is more than one general borrowing outstanding during the period); In considering whether the borrowing is a precise amount (e.g. a loan) or whether it increase as expenditure is paid for (e.g. a bank overdraft), bear in mind that: • if the borrowing is a loan ( a precise amount), you will use the capital sum; and • if the borrowing is an overdraft (a fluctuating amount), you will use the relevant expenditures and will need to know when they were incurred (or whether they were incurred relatively evenly).
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Capitalisation of borrowing costs
In assessing whether the expenditures (on which interest is incurred) are incurred evenly or at the beginning or end of a period or at haphazard times during a period, bear in mind that: • interest expense can be measured using average borrowing balances if the costs are incurred evenly, whereas actual borrowing balances should be used (whether specific or general borrowings) if costs are incurred at the beginning or end of a period; and • interest income should be measured using average investment balances if the costs are incurred evenly, whereas actual investment balances should be used (if it is a specific borrowing) if costs are incurred at the beginning or end of a period,. In determining the periods during which capitalisation must occur, you will need to know: • the commencement date: borrowings may be outstanding (and incurring interest) before commencement date in which case interest expense (and interest income on any surplus funds invested) up to commencement date must be ignored when calculating the portion to be capitalised; • the cessation date: borrowings may be outstanding (and incurring interest) after cessation date in which case interest expense (and interest income on any surplus funds invested) after cessation date must be ignored when calculating the portion to be capitalised; and • whether there was a suspension period between these two dates: borrowings may be outstanding (and incurring interest) during a suspension period in which case interest expense (and interest income on any surplus funds invested) during this period must be ignored when calculating the portion to be capitalised. 3.2.1 Measurement: specific loans (IAS 23.12 - .13) All of the borrowing costs incurred on a specific loan are capitalised to the asset. If these funds are invested prior to the date they were utilised then any interest earned must be subtracted from the interest incurred (borrowing costs), in which case only the net amount may be capitalised. Example 7: specific loans Yahoo Limited borrowed C500 000 from the bank on 1 January 20X5 to begin the construction of a building. The interest payable on the loan during 20X5 was C50 000 (calculated at 10%). The company invested all surplus funds raised in a fixed deposit and earned C24 000 interest during 20X5. No capital portion of the loan was repaid during the year ended 31 December 20X5. All criteria for capitalisation of borrowing costs were met on 1 January 20X5. The building is a qualifying asset. Required: Calculate the amount of borrowing costs that must be capitalised in of IAS 23 and show the necessary journal entries. Solution to example 7: specific loans Comment: this example shows that interest income is used to reduce the amount of borrowings that may be capitalised when the borrowing is a specific borrowing.
Interest incurred Interest earned Total to be capitalised
Calculations: 500 000 x 10% given
C 50 000 (24 000) 26 000 Debit 50 000
Finance costs (expense) Bank/ liability Interest incurred on the loan first expensed
Credit 50 000
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Capitalisation of borrowing costs
Bank/ liability Interest income Interest income earned on investment of surplus loan funds Building: cost (asset) 50 000 – 24 000 Finance costs (expense) Portion of interest on the loan capitalised to the cost of the building
Debit 24 000
Credit 24 000
26 000 26 000
When calculating the interest income you may find that actual amounts invested can be used. This happens when, for example, the expenditures are infrequent and/ or happen at the start or end of a period. This will mean that the investment balance will remain unchanged for a period of time. The calculation of the amount of borrowing costs on specific borrowings that must be capitalised is therefore: • total interest incurred on specific borrowings: capital borrowed x interest rate x period borrowed • less interest income earned from investment of surplus borrowings: amount invested x interest rate x period invested. Very often, however, average amounts invested need to be used instead of actual amounts invested. This happens more frequently when the borrowing is a general borrowing, but can apply to a specific borrowing where, for example, the expenditure is paid relatively evenly over a period of time, with the result that the balance on the investment (being the surplus borrowings that are invested) is constantly changing. In this case, it is normally acceptable to calculate the interest earned on the average investment balance over a period of time (rather than on the actual balance on a specific day). The calculation of the amount of borrowing costs on specific borrowings that must be capitalised could therefore be: • total interest incurred on specific borrowings: capital borrowed x interest rate x period borrowed • less interest income earned from investment of surplus borrowings: (investment o/ balance + investment c/ balance) / 2 x interest rate x period invested Example 8: specific loans – costs paid on specific days Haha Limited borrowed C500 000 from the bank on 1 January 20X5 to begin the construction of a building (a qualifying asset). Construction began on 1 January 20X5 (i.e. all criteria for capitalisation of borrowing costs were met). The interest rate payable on the loan was 10%. The company paid construction costs of C400 000 on 1 March 20X5. Surplus funds were invested in a fixed deposit and earned interest at 6% per annum. No capital portion of the loan was repaid during the year ended 31 December 20X5. Required: Calculate the amount of borrowing costs that must be capitalised. Solution to example 8: specific loans – costs paid on specific days Comment: The borrowings are raised two months before they were required. These surplus funds are invested for January and February and the balance on this for these two months remains stable at C500 000. On March, however, payments totaling C400 000 are made, thus reducing the investment balance to C100 000. This balance remains stable for the remaining ten months of the year. Since the expenditure is not incurred evenly over a period but is incurred on a specific day, the interest income for the purposes of the calculation of the borrowing costs to be capitalised should be calculated using the actual investment balances (C500 000 for 2 months and C100 000 for 10 months). Calculations: Borrowing costs incurred Interest earned Capitalised borrowing costs
500 000 x 10% x 12 / 12 500 000 x 6% x 2 / 12 + (500 000 – 400 000) x 6% x 10/ 12
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C 50 000 (10 000) 40 000 Chapter 11
Gripping IFRS
Capitalisation of borrowing costs
Debit 50 000
Finance costs (expense) Bank/ liability Interest incurred on the loan is first expensed
Credit 50 000
Bank/ liability Interest income Interest income earned on investment of surplus loan funds
10 000
Building: cost (asset) Finance costs (expense) Portion of interest on the loan capitalised to the cost of the building
40 000
10 000
40 000
Example 9: specific loans – costs paid evenly over a period Hooray Limited borrowed C500 000 from the bank on 1 January 20X5 to begin the construction of a building (a qualifying asset). Construction begins on 1 January 20X5 (all criteria for capitalisation of borrowing costs were met on this date). The interest rate payable on the loan was 10%. The company paid construction costs of C400 000 evenly between 1 March 20X5 and 31 December 20X5. Surplus funds are invested in a fixed deposit and earned interest at 6% per annum. No capital portion of the loan was repaid during the year ended 31 December 20X5. Required: Calculate the amount of borrowing costs that must be capitalised. Solution to example 9: specific loans – costs paid evenly over a period Comment: The borrowings are raised two months before they were required. These surplus funds are invested for January and February and the balance on this for these two months remains stable at C500 000. From March, however, the amount invested gradually reduces as payments are made (the balance of C500 000 on 1 March gradually decreases to a balance of C100 000 (C500 000 – C400 000) on 31 December. Since the payments are incurred evenly over this ten-month period, the interest income for the purposes of the calculation of the borrowing costs to be capitalised may be calculated using the average of these two balances (C500 000 and C100 000).
Interest incurred Interest earned Capitalised borrowing costs
Calculations: 500 000 x 10% x 12 / 12 (500 000 x 6% x 2 / 12) + (500 000 + 100 000) / 2 x 6% x 10/ 12
Debit 50 000
Finance costs (expense) Bank/ liability Interest incurred on the loan is first expensed
C 50 000 (20 000) 30 000 Credit 50 000
Bank/ liability Interest income Interest income earned on investment of surplus loan funds
20 000
Building: cost (asset) Finance costs (expense) Portion of interest on the loan capitalised to the cost of the building
30 000
374
20 000
30 000
Chapter 11
Gripping IFRS
Capitalisation of borrowing costs
Example 10: specific loans – loan raised before construction begins Yeeha Limited borrowed C500 000 from the bank on 1 January 20X5 to begin the construction of a building (a qualifying asset). Construction began on 1 February 20X5 (i.e. all criteria for capitalisation of borrowing costs were met on this date). The interest rate payable on the loan is 10%. The company paid construction costs of C400 000 on 1 March 20X5. Surplus funds are invested in a fixed deposit and earned interest at 6% per annum. No capital portion of the loan was repaid during the year ended 31 December 20X5. Required: Calculate the amount of borrowing costs that may be capitalised. Solution to example 10: specific loans – loan raised before construction begins Compare this to example 8, in which the construction began on 1 January 20X5. In this example, the loan is taken out before construction begins. All criteria for capitalisation are therefore only met on 1 February 20X1 (commencement date) and therefore the interest that is incurred/ earned before this date must be ignored for the purpose of calculating the portion of interest to be capitalised.
Interest incurred after commencement date Interest earned after commencement date Capitalised borrowing costs
Calculations: 500 000 x 10% x 11 / 12 (i.e. excludes January interest expense) (500 000 x 6% x 1 / 12) + (500 000 - 400 000) x 6% x 10 / 12 (i.e. excludes January interest income)
(7 500) 38 333
Finance costs (expense) Bank/ liability Interest incurred on the loan first expensed: 500 000 x 10% x 12/ 12 Bank/ liability Interest income Interest income earned on investment of surplus loan funds: (500 000 x 6% x 2 / 12) + (500 000 – 400 000) x 6% x 10 / 12 Building: cost (asset) Finance costs (expense) Portion of interest on the loan capitalised to the cost of the building
3.2.2
C 45 833
Debit 50 000
Credit 50 000
10 000 10 000
38 333 38 333
Measurement: general loans (IAS 17.14 - .15)
General loans are used for many purposes and therefore it cannot be said that all the interest incurred thereon was ‘directly attributable to the qualifying asset’. Therefore, not all the interest incurred on a general loan may be capitalised to the asset. If the entity has used a general loan for a qualifying asset, the costs eligible for capitalisation are the weighted average cost of borrowings, calculated as follows: • capitalisation rate x the average expenditure relating to the qualifying asset. • The capitalisation rate is: the weighted average interest rate on the loans borrowed by the entity. • The average expenditure is: expenditure for the period / 2 The total amount of interest capitalised may not exceed the total interest paid or incurred.
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Gripping IFRS
Capitalisation of borrowing costs
Example 11: general loans – costs incurred evenly Bizarre Limited had a C500 000 7% existing general loan outstanding on 1 January 20X5. It raised an additional general loan of C600 000 on 1 January 20X5 at an interest rate of 12.5%. Bizarre Limited did not make any repayments on either loan during the year. Construction began on 1 January 20X5. The company spent the following amounts per month on the construction of a building, a qualifying asset: C per month 50 000 30 000 100 000
1 January – 31 July (7 months) 1 August – 30 November (4 months) 1 – 31 December (1 month)
Required: Calculate the amount of borrowing costs that must be capitalised and provide the necessary journal entries for the year ended 31 December 20X5, assuming that the amounts were spent evenly during each month. Solution to example 11: general loans – costs incurred evenly Comment: There are two borrowings, both of which are general borrowings and therefore the borrowing costs to be capitalised is based on the expenditures incurred and the weighted average interest rate. Since the expenditures are incurred evenly, average expenditures are used. Since the borrowings are general, one does not consider interest income in the calculation of the amount to be capitalised. W1: Borrowing costs to be capitalised The loans are general loans and therefore the formula is: ‘Capitalisation rate x Average expenditure’. Capitalisation rate (weighted average interest rate): = interest incurred on general borrowings/ borrowings outstanding during the period = [(C500 000 x 7% x 12 / 12) + (C600 000 x 12.5% x 12 / 12)] / 1 100 000 total borrowings = 10% Cumulative expenditure 1 January 20X5 January – July 31 July 20X5 August - November 30 November 20X5 December 31 December 20X5
Opening balance 50 000 x 7 months Closing balance 30 000 x 4 months Closing balance 100 000 x 1 month Closing balance
Capitalisation rate x average expenditure: Jan – July (0 + 350 000) / 2 x 10% x 7 / 12 months;
C 0 350 000 350 000 120 000 470 000 100 000 570 000 C 10 208
OR: (50 000 x 7 months) / 2 x 10 % x 7 / 12 months
Aug – Nov (350 000 + 470 000) / 2 x10% x 4 / 12 months; Dec
OR: {(30 000 x 4 months) / 2 + 50 000 x 7} x 10 % x 4 / 12 months (470 000 + 570 000) / 2 x 10% x 1 / 12 months; OR {(100 000 x 1) / 2 + 50 000 x 7 + 30 000 x 4 }x 10% x 1/ 12
Total to be capitalised:
13 667 4 333 28 208
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Gripping IFRS
Capitalisation of borrowing costs
The above calculation can be done the long way around, if preferred: Expense incurred evenly during each month Balance (A) Expense (B) Balance (C ) January 0 50 000 50 000 February 50 000 50 000 100 000 March 100 000 50 000 150 000 April 150 000 50 000 200 000 May 200 000 50 000 250 000 June 250 000 50 000 300 000 July 300 000 50 000 350 000 August 350 000 30 000 380 000 September 380 000 30 000 410 000 October 410 000 30 000 440 000 November 440 000 30 000 470 000 December 470 000 100 000 570 000
Balance (D ) 25 000 75 000 125 000 175 000 225 000 275 000 325 000 365 000 395 000 425 000 455 000 520 000
Interest % 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10%
Months 1 1 1 1 1 1 1 1 1 1 1 1
Capitalise 208 625 1 042 1 458 1 875 2 292 2 708 3 042 3 292 3 542 3 792 4 333
570 000
28 209
Balance (A): first day of the month Expense (B): incurred on the last day of the month Balance (C): last day of the month Balance (D): average balance = (A + C) / 2 Capitalise: interest expense that may be capitalised: Balance (A) x interest rate x 1 / 12 Capitalisation rate (weighted average interest rate): see calculation above Journals in 20X5: Building (asset) Bank/ liability Construction costs incurred: 50 000 x 7 + 30 000 x 4 + 100 000 x 1 This journal would actually be processed separately for each and every payment but is shown here as a cumulative journal for ease Finance costs (expense) Bank/ liability Finance costs incurred: 500 000 x 7% + 600 000 x 12.5%
Debit 570 000
Credit 570 000
110 000
Building (asset) Finance costs (expense) Finance costs capitalised: (W1)
110 000 28 209 28 209
Example 12: general loans – costs incurred at the end of each month Bizarre Limited had a C500 000 7% existing general loan outstanding on 1 January 20X5. It raised an additional general loan of C600 000 on 1 January 20X5 at an interest rate of 12.5%. Bizarre Limited did not make any repayments on either loan during the year. Construction began on 1 January 20X5. The company spent the following amounts per month on the construction of a building, a qualifying asset: C per month 50 000 30 000 100 000
1 January – 31 July 1 August – 30 November 1 – 31 December
Required: Calculate the amount of borrowing costs that must be capitalised and provide the necessary journal entries for the year ended 31 December 20X5, assuming that the amounts were paid at the end of each month. 377
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Gripping IFRS
Capitalisation of borrowing costs
Solution to example 12: general loans – costs incurred at the end of each month Comment: There are two borrowings, both of which are general borrowings and therefore the interest to be capitalised is based on the expenditures incurred and the weighted average interest rate. Since the expenditures are incurred at the end of the month, actual expenditures should be used instead (assuming the difference between using actual and average expenses is considered by the entity to be material). The interest is calculated as follows: the opening balance at the beginning of each month multiplied by the weighted average interest rate multiplied by 1/ 12. W1: Borrowing costs to be capitalised The loans are general loans and therefore the formula is: ‘Capitalisation rate x Average expenditure’. Expense incurred at end of each month Balance (A) Expense (B) January 0 50 000 February 50 000 50 000 March 100 000 50 000 April 150 000 50 000 May 200 000 50 000 June 250 000 50 000 July 300 000 50 000 August 350 000 30 000 September 380 000 30 000 October 410 000 30 000 November 440 000 30 000 December 470 000 100 000
Balance (C ) 50 000 100 000 150 000 200 000 250 000 300 000 350 000 380 000 410 000 440 000 470 000 570 000
Interest 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10%
Months 1 1 1 1 1 1 1 1 1 1 1 1
570 000
Capitalise (D) 0 417 833 1 250 1 667 2 083 2 500 2 917 3 167 3 417 3 667 3 917 25 835
Balance (A): balance on the first day of the month Expense (B): incurred on the last day of the month Balance (C): balance on the last day of the month Capitalise (D): interest expense that may be capitalised: A x interest rate x 1 / 12 Capitalisation rate (weighted average interest rate): = interest incurred on general borrowings/ borrowings outstanding during the period = [(C500 000 x 7% x 12 / 12) + (C600 000 x 12.5% x 12 / 12)] / 1 100 000 total borrowings = 10% Journals in 20X5: Building (asset) Bank/ liability Construction costs incurred: 50 000 x 7 + 30 000 x 4 + 100 000 x 1 This journal would actually be processed separately for each and every payment but is shown here as a cumulative journal for ease Finance costs (expense) Bank/ liability Finance costs incurred: 500 000 x 7% + 600 000 x 12.5% Building (asset) Finance costs (expense) Finance costs capitalised: (W1)
Debit 570 000
Credit 570 000
110 000 110 000 25 835 25 835
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Gripping IFRS
Capitalisation of borrowing costs
Example 13: general loans – costs incurred at the start of each month Bizarre Limited had a C500 000 7% existing general loan outstanding on 1 January 20X5. It raised an additional general loan of C600 000 on 1 January 20X5 at an interest rate of 12.5%. Bizarre Limited did not make any repayments on either loan during the year. Construction began on 1 January 20X5. The company spent the following amounts per month on the construction of a building, a qualifying asset: C per month 50 000 30 000 100 000
1 January – 31 July 1 August – 30 November 1 – 31 December
Required: Calculate the amount of borrowing costs that must be capitalised and provide the necessary journal entries for the year ended 31 December 20X5, assuming that the amounts were paid at the beginning of each month. Solution to example 13: general loans – costs incurred at the start of each month Comment: There are two borrowings, both of which are general borrowings and therefore the interest to be capitalised is based on the expenditures incurred and the weighted average interest rate. Since the expenditures are incurred at the beginning of each month, actual expenditures should be used instead (assuming that the difference between using actual and average expenses is considered by the entity to be material). The interest is calculated as: the opening balance at the beginning of each month multiplied by the weighted average interest rate multiplied by 1/ 12. W1: Borrowing costs to be capitalised The loans are general loans and therefore the formula is: ‘Capitalisation rate x Average expenditure’. Expense incurred at beginning of each month Balance (A) Expense (B) January 0 50 000 February 50 000 50 000 March 100 000 50 000 April 150 000 50 000 May 200 000 50 000 June 250 000 50 000 July 300 000 50 000 August 350 000 30 000 September 380 000 30 000 October 410 000 30 000 November 440 000 30 000 December 470 000 100 000
Balance (C ) 50 000 100 000 150 000 200 000 250 000 300 000 350 000 380 000 410 000 440 000 470 000 570 000
570 000
Interest % 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10%
Months 1 1 1 1 1 1 1 1 1 1 1 1
Capitalise 417 833 1 250 1 667 2 083 2 500 2 917 3 167 3 417 3 667 3 917 4 750 30 585
Balance (A): balance on the first day of the month before payment of expense Expense (B): incurred on the first day of the month Balance (C): adjusted balance on the first day of the month after payment of expense Capitalise: interest expense that may be capitalised: C x interest rate x 1 / 12 Capitalisation rate (weighted average interest rate): = interest incurred on general borrowings/ borrowings outstanding during the period = [(C500 000 x 7% x 12 / 12) + (C600 000 x 12.5% x 12 / 12)] / 1 100 000 total borrowings
= 10%
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Capitalisation of borrowing costs
Journals in 20X5: Building (asset) Bank/ liability Construction costs incurred: 50 000 x 7 + 30 000 x 4 + 100 000 x 1 This journal would actually be processed separately for each and every payment but is shown here as a cumulative journal for ease Finance costs (expense) Bank/ liability Finance costs incurred: 500 000 x 7% + 600 000 x 12.5% Building (asset) Finance costs (expense) Finance costs capitalised: 30 585 (W1)
4
Debit 570 000
Credit 570 000
110 000 110 000 30 585 30 585
A comparison of the methods
It is interesting to note that many ants expected the revised IAS 23 to make the expensing of borrowing costs compulsory and to outlaw the capitalisation thereof – not the other way around! There are arguments both for and against the capitalisation of borrowing costs. Some argue that the capitalisation of borrowing costs is more appropriate than the expensing them because: • interest should not be treated any differently to the other directly attributable costs that are capitalised in of IAS 16: Property, Plant and Equipment (improves consistency); • if the entity had purchased the qualifying asset, the construction company (seller) would have included any borrowing costs that they incurred into the purchase price: it therefore improves comparability between companies that purchase assets and those that construct their own (improves comparability); and • if the entity does not capitalise the borrowing costs, it will result in a decrease in their profit, merely because they decided to self-construct the asset. A better approach, it is argued, would be to recognise the borrowing costs as part of the cost of the asset and then recognise these costs as an expense (e.g. depreciation) over the period that the asset is used and earns revenue (improves matching of expense to income). Some of the arguments against capitalizing borrowing costs include: • borrowing costs incurred when constructing an asset should be expensed in the period in which they are incurred, just as any other finance costs would be (improves consistency and matching of expenses to the period in which they were incurred); • the calculation of the portion of the borrowing costs to be capitalised is, in practice, very subjective and could therefore result in errors and manipulation and therefore expensing the actual borrowing costs incurred is less prone to error (improves reliability); and • when interest is treated as an expense, cash flows for the period will approximate the profit for the period, which is more useful to the (improves relevance) since it helps to predict cash flows. 5
Disclosure (IAS 23.26)
The entity must disclose the following in the financial statements: • the total amount of borrowing costs capitalised; • the amount of borrowing costs expensed as finance costs in the statement of comprehensive income (this is an IAS 1 requirement – not a requirement of IAS 21); • the capitalisation rate used to calculate the borrowing costs for a general loan.
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Capitalisation of borrowing costs
Company name Statement of comprehensive income (extracts) For the year ended 31 December Note Profit before finance costs Finance costs Profit before tax Other comprehensive income Total comprehensive income
3.
20X5 C x X x x x
20X4 C x X x x x
20X5 C Z (Y) X
20X4 C Z (Y) X
Company name Notes to the financial statement (extracts) For the year ended 31 December 3. Finance costs Interest incurred Less interest capitalised Finance cost expense
IAS 23 requirement IAS 1 requirement
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Capitalisation of borrowing costs
6. Summary IAS 23 Borrowing costs Expense
Capitalise
If not related to a qualifying asset
If it relates to a qualifying asset and meets all criteria for capitalisation
Qualifying borrowing costs
Capitalise borrowing costs that relate to costs: • directly attributable to the • acquisition, construction or production of • a qualifying asset and if • future economic benefits are probable and • costs can be reliably measured
Qualifying asset
•
those that take a long time to get ready
Measurement General borrowings
•
• •
Start
• •
•
Specific borrowings
Capitalise borrowing costs using the following formula: Capitalisation rate (CR) x the expenditure; but limit to the actual borrowing costs incurred CR = weighted average borrowing costs divided by the general outstanding borrowings
Interest is being incurred; Expenditure on the production of the asset is being incurred; and Activities are in progress
• •
Pause
Capitalise the total amount of borrowing costs actually incurred Less any interest income earned on the temporary investment of any surplus borrowings
the construction of the asset is interrupted or delayed for a long period of time; (do not pause if the delay is necessary).
Stop
the asset is ready for its intended use or sale; (or if it is substantially ready).
This is the commencement date
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Chapter 11
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