IAS 23 - Borrowing Costs (detailed review)

Thursday, January 23, 2014 Print Email

Objective

This standard prescribes the accounting treatment of borrowing cost, the circumstance in which the borrowing cost will be capitalized and when it will be recognized as expense.

Scope

The requirements of this Standard are applicable to deal with the accounting treatment of borrowing cost. However this standard does not applies to the actual or imputed cost related to the equity instruments.

Definitions

1. Borrowing Cost:
It is interest cost and any other cost which arises, in order to borrow the funds. It includes:

  • Interest
  • Discount on issuance of loan note or debenture
  • Premium on redemption of loan note debenture
  • Any interest cost included in finance lease
  • Interest on overdraft
  • Any Issuance cost on loan instruments

2. Qualifying Asset:
An asset, that essentially takes a long or substantial time period to get ready for sale or intended use by the entity.
For example Inventory, Investment property, or any self constructed asset which takes a long time period to get complete.

  • Qualifying asset does not include assets which are ready for sale or use, at the time when these are acquired and the assets which are completed in the short interval.

Recognition of Borrowing Cost

The borrowing cost which is incurred for the construction or acquisition of a Qualifying Asset will be capitalized as part of cost of such asset. Any other borrowing cost will be treated as expense and will be charged to the statement of profit and loss.

  • The borrowing cost which relates to a qualifying asset is called ‘Eligible Borrowing Cost’ as it becomes eligible to be capitalized in the cost of asset.

 

  • The borrowing cost related to qualifying asset, which becomes eligible to be capitalized, is that borrowing cost that can be avoided if that asset is not produced or constructed.
  • The cost of qualifying asset including the capitalized borrowing cost should not exceed the Recoverable value of the asset, if exceeded then the asset will be written down to its recoverable value as per the requirements of IAS 36.

Measurement of Eligible Borrowing Cost to be Capitalized

The measurement of the borrowing cost related to the qualifying asset which is capitalize as part of the cost of such asset, depends upon:

1.  Specific Loan/Fund:

The loan which is specifically borrowed for the construction or acquisition of a qualifying asset only is called specific loan. In such situation the borrowing cost eligible for capitalization will be calculated as, actual borrowing cost incurred on the asset less any income from temporary investment of funds during the period of construction.

2.  General Loan/Funds:

The loan which is borrowed for the qualifying asset and general use in business both is called general loan. In such situation the borrowing cost eligible for capitalization will be calculated as, the expenditure on the qualifying asset during the accounting period will be multiplied with weighted average borrowing cost percentage of the entity in respect of the loans which were outstanding during the accounting period.

Commencement of Capitalization:

The capitalization of borrowing cost will start right from the date when entity will meet all the following conditions:

  • The expenditure on the asset has been started;
  • Borrowing cost is being incurred;
  • The activities necessary to complete the asset are in progress.
  • The expenditure on a qualifying asset includes the expenditure in the form of payments for the material, associated labor cost and related overheads.
  • The activities necessary to complete the asset includes not only the physical construction of the asset, it also encompasses any technical working, administrative work and taking planning permission from related authorities before the start of physical construction work.
  • The borrowing cost can only be capitalized, during the period when activities necessary to complete the asset are in progress. And the borrowing cost during the period when activities necessary to complete the asset are interrupted will not be capitalized and such borrowing cost will be charged to the statement of profit & loss as an expense.

Suspension of Capitalization of Borrowing Cost:

If during the period of construction, the activities necessary to complete the asset are interrupted or suspended due to particular reasons, the borrowing cost of such period will be accounted for as follows:

  • If the period of interruption is material, the borrowing cost of such period will not be capitalized and will be charged to statement of profit and loss as an expense.
  • If the period of interruption is immaterial or temporary such as (Material shortage or labor strikes), then entity may continue to capitalize the borrowing cost during such period. 

Cessation of Capitalization:

  • The capitalization of the borrowing cost will cease, when activities necessary to complete the asset are finished i.e. the completion of the physical structure of the qualifying asset, although some administrative or decorative work may still continue.
  • If a qualifying asset contains different component parts such as (Industrial plant which has several processes) and the entity will complete the construction of such qualifying asset by constructing each part or component on individual basis in a sequence, where each part or component can be used individually while the construction work is in progress on other parts or components, the capitalization of the borrowing cost will cease when activities necessary to complete that part for its intended use or sale has been finished.

Disclosure

The standard requires the entity to disclose the following:

Application Examples:

Example 1:

AB Ltd. started the construction of an asset on 1 January 2013 with a loan of $40,000 borrowed at an interest rate of 9% per annum.
The loan was used on the asset as follows:

 

$’000

1 January 2013

15,000

1 May 2013

20,000

1 October 2013

5,000

The construction of the asset was completed on 31 December 2013. However, during the accounting period AB Ltd. has invested the surplus funds at an interest rate of 3% on temporary basis before these were required for spending.

Required:

(a) The Borrowing Cost eligible for capitalization at 31.12.2013.
(b) The Cost of Asset to be reported in the statement of financial position at 31.12.2013.

Solution:

(W1) Determination of the Purpose Nature & of the Loan/Funds

  • The loan in the scenario is specific loan as the whole amount of the loan $40,000 is used for the construction the asset.
  • The asset is a Qualifying Asset as the asset in scenario is completed in a period of 1 year which is substantial time period.
  • As the borrowing Cost is related to the qualifying asset, the whole amount of borrowing cost will be capitalized in the cost of qualifying asset.

(w2) Calculation of Eligible Borrowing Cost:

As the loan is specific loan, so the Eligible Borrowing Cost will be calculated as follows:

Eligible Borrowing Cost = Actual Borrowing Cost – Income from temporary investment      of funds.

  = ($40,000 * 9%) – $288

Eligible Borrowing Cost   = $3,312

(W3) Income from temporary Investment of Surplus funds:

(25,000 * 3%) * 4/12 + (5,000 * 3%) * 3/12   =   $288

(W4) Cost of the asset at 31.12.2013

($15,000+$25,000+$5,000) + $3,312 = $43,312

 

Example 2:

AB Ltd. started the construction of an asset on 1 January 2013. For this purpose three loans were outstanding at the start of the year as follows:

 

Amount, $’000

Interest Rate, %

Loan 1

80,000

11

Loan 2

70,000

15

Loan 3

40,000

17

The funds were used on the asset as follows:


            

$’000

1 January 2013

25,000

1 May 2013

20,000

1 October 2013

15,000

The construction of the asset was completed on 31 December 2013.

Required:

(a) The Borrowing Cost eligible for capitalization at 31.12.2013.
(b) The Cost of Asset to be reported in the statement of financial position at 31.12.2013

 

Solution:

(W1) Determination of the Purpose Nature & of the Loan/Funds

  • The loan in the scenario is General loan as only $60,000 is used for the construction the asset out of total loans of $190,000.
  • The asset is a Qualifying Asset as the asset in scenario is completed in a period of 1 year which is substantial time period.
  • As the borrowing Cost is related to the qualifying asset, therefore the whole amount of borrowing cost will be capitalized in the cost of qualifying asset.

(w2) Calculation of Eligible Borrowing Cost:

As the loan is General loan, so the Eligible Borrowing Cost will be calculated as follows:

Eligible Borrowing Cost = Average amount invested   *   Weighted Average
Into asset                                 borrowing Cost Rate

= $49,583  *  13.72%

Eligible Borrowing Cost = $6,545 

(W3) Average Amount Invested into Asset:

 

$’000

$25,000 * 12/12   =

25,000

$20,000 *   8/12   =

13,333

$15,000 *   9/12   =

11,250

 

49,583

(W4) Weighted Average Borrowing Cost Rate:

($80,000 / $190,000) * 11%  + ($70,000 / $190,000) *  15%  +  ($40,000 / $190,000) * 17% = 13.72%

(W5)Cost of the Asset at 31.12.2013

(25,000+$20,000+$15,000) + 6,545 = $66,545

Example 3:

AB Ltd. raised a $20 million loan having interest rate of 7.5% on 1 January 2013.The loan was specifically raised for the construction of an office building which meets the definition of aqualifying asset under IAS 23. The construction of the office building started on 1 February 2013 and the construction was completed on 30 November 2013. However, the construction of the office building was suspended for two months period because of the shortage of material and labor strikes during July and August 2013. The loan was temporarily invested for the month of January 2013 and earned interest of $80,000.

Required
Calculate the eligible borrowing cost that will be capitalized as part of the cost of the office building and the finance cost that should be reported in profit or loss for the year ended 31 December 2013.

Solution:

The total Borrowing cost for the year is $1,500,000 ($20m x 7.5%).

However, the capitalization of borrowing cost will commence when:

  • The expenditure on the asset has been started;
  • Borrowing cost is being incurred;
  • The activities necessary to complete the asset are in progress

But borrowing cost will not be capitalized, when development of the asset is suspended, or when the construction is completed, therefore:

The borrowing cost for the period of four months will not be capitalized and will be charged to profit and loss as expense as follows:
- January (the construction was not started in this month)
-  July & August(the period when development was suspended) and 
-  December (the construction was completed in November)

  • Borrowing Cost to be charge to profit or loss = $1,500,000 x 4/12 = $500,000
  • The borrowing cost that relates to the qualifying asset and which will be capitalized, in case of specific loan, will be calculated as follows:

Borrowing cost to be capitalized = Actual borrowing cost – Income from temporary investment

= ($1,500,000 x 8/12) – 0 = $1,000,000

As the interest income is earned during the period (January) when borrowing cost was not being capitalized. Therefore the interest received of $80,000 will be charged to statement of profit or loss as income and will not be deducted from the capitalized borrowing costs.

  • Cost of the Asset in the Statement of Financial Position = $20,000,000 + $1,000,000  = $3,000,000.

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