International Accounting Standard 23 defines finance costs as “interest and other costs that an entity incurs in connection with the borrowing of funds”.
Finance costs are also known as “financing costs” and “borrowing costs”. Companies finance their operations either through equity financing or through borrowings and loans. These funds do not come for free. The providers of funds want reward for against there funds. The equity providers want dividends and capital gains. The providers of loans seek interest payments. Interest cost is the price of obtaining loans and borrowings.
Finance costs are usually understood to be referred to interest costs. Usually they are thought to refer to interest expense on short-term borrowings (for example bank overdraft and notes payable) and long-term borrowings (for example term loans and real estate mortgages). The term “finance cost” is broader and also includes costs other than just interest expense. Finance costs also include:
- Amortization of discounts or premiums that are related to the borrowings
- Amortization of ancillary costs incurred in connection with the borrowings or arrangements
- Finance charges in respect of the finance leases
- Exchange differences arising from foreign currency borrowings to the extent that they are regarded as adjustment to the interest cost
There are two accounting treatments for finance costs under IAS 23 Borrowing Costs:
- The preferable treatment is to recognize finance costs as expense in the period in which they are incurred. When this treatment for recognizing finance cost is used, these costs should be expensed regardless of how they are applied.
- The allowed alternative treatment capitalizes finance costs as part of cost of a qualifying asset, if these costs are directly attributable to the construction, production, or acquisition of that qualifying asset. Capitalization of finance cost is allowed only if it is probable that they will result in future economic benefits and they can be reliably measured (otherwise the finance costs are expensed).
IFRS 9 Financial Instruments provides guidance on the recognition and measurement of financial assets and liabilities, including the accounting for finance costs. It requires that an entity use the effective interest method to calculate the amortized cost of a financial asset or liability and to allocate interest income or expense over the relevant period.