Determining the time period for capitalization of borrowing costs

An entity should begin capitalizing borrowing costs on the commencement date.

Three conditions must be met before the capitalization period should begin :

1. Expenditures for the asset are being incurred
2. Borrowing costs are being incurred
3. Activities that are necessary to prepare the asset for its intended use are in progress

As long as these conditions continue, borrowing costs can be capitalized.

Expenditures incurred for the asset include only those that have resulted in payments of cash, transfer of other assets or the assumption of interest-bearing liabilities, and are reduced by any progress payments and grants received for that asset.

(The principle in IAS 23 par. 17(a) is that borrowing costs are capitalized only when the entity requires funding for its expenditures on the qualifying asset. IAS 23 par. 18 states that expenditures on a qualifying asset include only those expenditures that have resulted in payments of cash, transfers of other assets or the assumption of interest-bearing liabilities (reduced by progress payments and certain grants). Accordingly, capitalization of borrowing costs is deferred until this condition is met).

Necessary activities are interpreted in a very broad manner. They start with the planning process and continue until the qualifying asset is substantially complete and ready to function as intended. These activities may include technical and administrative work prior to actual commencement of physical work, such as obtaining permits and approvals, and may continue after physical work has ceased. Brief, normal interruptions do not stop the capitalization of interest cost. However, if the entity intentionally suspends or delays the activities for some reason, interest costs should not be capitalized from the point of suspension or delay until substantial activities in regard to the asset resume.

If the asset is completed in a piecemeal fashion, the capitalization of interest cost stops for each part as it becomes ready to function as intended. An asset that must be entirely complete before the parts can be used as intended can continue to capitalize interest costs until the total asset becomes ready to function (Hrd).

Guidebook to IAS 23 Borrowing Costs

The International Accounting Standards Board (IASB) issued a revised version of IAS 23 Borrowing Costs (IAS 23) in March 2007. In the revised standard, the previous benchmark treatment of recognising borrowing costs as an expense has been eliminated. Instead, borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset will form part of the cost of that asset. The revised IAS 23 is effective for annual periods beginning on or after 1 January 2009 with earlier application permitted.

The new standard will represent a change in accounting policy for entities that applied the benchmark treatment under the previous standard. These entities will now need to develop procedures to calculate the amount of borrowing costs to be capitalised. Although the concept of capitalising borrowing costs is simple and familiar to many, putting that concept into practice frequently leads to questions.

Issues that often take up management time, and may therefore need to be considered early, include :

• which of the entity’s loans are specific borrowings?
• how does an entity reflect the fluctuation of borrowings and interest rates during the period when calculating the borrowing costs to capitalise?
• how does an entity take into account the effect of exchange differences in determining the amount of borrowing costs to capitalise?

These and many other common questions are considered in : Grant Thornton – Capitalisation of Borrowing Costs, from theory to practice.

This guidebook is available to be downloaded in here.  Another valuable guidebook published by PWC also available in here. 

IAS 23 versus SFAS 34 – several main differences

The Basis for Conclusions on IAS 23 Borrowing Costs which accompanies, but not as part of IAS 23, revealed out several major differences between IAS 23 and FASB Statement of Financial Accounting Standards (SFAS) No. 34 Capitalization of Interest Cost.

Definition of borrowing costs

IAS 23 uses the term ‘borrowing costs’ whereas SFAS 34 uses the term ‘interest costs’. ‘Borrowing costs’ reflects the broader definition in IAS 23, which encompasses interest and other costs, such as : (a) exchange differences arising from foreign currency borrowings to the extent that they are regarded as an adjustment to interest costs; and (b) amortization of ancillary costs incurred in connection with the arrangement of borrowings.

EITF issues No. 99-9 concludes that derivative gains and losses (arising from the effective portion of a derivative instrument that qualifies as a fair value hedge) are part of the capitalized interest cost. IAS 23 does not address such derivative gains and losses.

Definition of a qualifying asset

The main differences are as follows:

(a) IAS 23 defines a qualifying asset as one that takes a substantial period of time to get ready for its intended use or sale. The SFAS 34 definition does not include the term substantial.

(b) IAS 23 excludes from its scope qualifying assets that are measured at fair value. SFAS 34 does not address assets measured at fair value.

(c) SFAS 34 includes as qualifying assets investments in investees accounted for using the equity method, in some circumstances. Such investments are not qualifying assets according to IAS 23.

(d) SFAS 34 does not permit the capitalization of interest costs on assets acquired with gifts or grants that are restricted by the donor or grantor in some situations. IAS 23 does not address such assets.

Measurement

When an entity borrows funds specifically for the purpose of obtaining a qualifying asset:

(a) IAS 23 requires an entity to capitalize the actual borrowing costs incurred on that borrowing. SFAS 34 states that an entity may use the rate of that borrowing.

(b) IAS 23 requires an entity to deduct any income earned on the temporary investment of actual borrowings from the amount of borrowing costs to be capitalized. SFAS 34 does not generally permit this deduction, unless particular tax-exempt borrowings are involved.

SFAS 34 requires an entity to use judgement in determining the capitalization rate to apply to the expenditures on the asset-an entity selects the borrowings that it considers appropriate to meet the objective of capitalizing the interest costs incurred that otherwise could have been avoided.

When an entity borrows funds generally and uses them to obtain a qualifying assets, IAS 23 permits some flexibility in determining the capitalization rate, but requires an entity to use all outstanding borrowings other than those made specifically to obtain a qualifying asset.

Disclosure requirements

IAS 23 requires disclosure of the capitalization rate used to determine the amount of borrowing costs eligible for capitalization. SFAS 34 does not require this disclosure.

SFAS 34 requires disclosure of the total amount of interest cost incurred during the period, including the amount capitalized and the amount recognized as an expense. IAS 23 requires disclosure only of the amount of borrowing costs capitalized during the period. IAS 1 Presentation of Financial Statements requires the disclosure of finance costs for the period.

(Source of this article : IAS 23 BC - Basis for Conclusions on IAS 23 Borrowing Costs)

The Core Principles of IAS 23 Borrowing Costs

IAS 23 (revised March 2007) uses the following terms with the meanings specified :

Borrowing costs are interest and other costs that an entity incurs in connection with the borrowing of funds.

A qualifying asset is an asset that necessarily takes a substantial period of time to get ready for its intended use or sale.

An entity shall capitalize borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset as part of the cost of that asset. An entity shall recognize other borrowing costs as an expense in the period in which it incurs them (par. 8).

To the extent that an entity borrows funds specifically for the purpose of obtaining a qualifying asset, the entity shall determine the amount of borrowing costs eligible for capitalization as the actual borrowing costs incurred on that borrowing during the period less any investment income on the temporary investment of those borrowings (par. 12).

To the extent that an entity borrows funds generally and uses them for the purpose of obtaining a qualifying asset, the entity shall determine the amount of borrowing costs eligible for capitalization by applying a capitalization rate to the expenditures on that asset. The capitalization rate shall be the weighted average of the borrowing costs applicable to the borrowings of the entity that are outstanding during the period, other than borrowings made specifically for the purpose of obtaining a qualifying asset. The amount of borrowing costs that an entity capitalizes during a period shall not exceed the amount of borrowing costs it incurred during that period (par. 14).

An entity shall begin capitalizing borrowing costs as part of the cost of a qualifying asset on the commencement date. The commencement date for capitalization is the date when the entity first meets all of the following conditions :

1. It incurs expenditures for the assets;

2. It incurs borrowing costs; and

3. It undertakes activities that are necessary to prepare the asset for its intended use or sale.

The activities necessary to prepare the asset for its intended use or sale encompass more than the physical construction of the asset. They include technical and administrative work prior to the commencement of physical construction, such as the activities associated with obtaining permits prior to the commencement of the physical construction. However, such activities exclude the holding of an asset when no production or development that changes the asset’s condition is taking place.

For example, borrowing costs incurred while land is under development are capitalized during the period in which activities related to the development are being undertaken. However, borrowing costs incurred while land acquired for building purposes is held without any associated development activity do not qualify for capitalization.

An entity shall suspend capitalization of borrowing costs during extended periods in which it suspends active development of a qualifying asset (par. 20).

An entity shall cease capitalizing borrowing costs when substantially all the activities necessary to prepare the qualifying asset for its intended use or sale are complete (par. 22).

An asset is normally ready for its intended use or sale when the physical construction of the asset is complete even though routine administrative work might still continue. If minor modifications, such as the decoration of a property to the purchaser’s or user’s specification, are all that are outstanding, this indicates that substantially all the activities are complete.

When an entity completes the construction of a qualifying asset in parts and each part is capable of being used while construction continues on other parts, the entity shall cease capitalizing borrowing costs when it completes substantially all the activities necessary to prepare that part for its intended use or sale (par. 24).

An entity shall apply this standard for annual periods beginning on or after 1 January 2009.

This standard supersedes IAS 23 Borrowing Costs revised in 1993.

The Chronology of IAS 23 Borrowing Costs and why it was revised

IAS 23 Borrowing Costs was issued by the International Accounting Standards Committee in December 1993. It replaced IAS 23 Capitalisation of Borrowing Costs (issued March 1984).

In April 2001 the International Accounting Standards Board resolved that all Standards and Interpretation issued under previous Constitutions continued to be applicable unless and until they were amended or withdrawn.

IAS 23 was amended by IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors (issued December 2003).

In March 2007 the IASB issued a revised IAS 23.

The following Interpretations refer to IAS 23 :

· IFRIC 1 Changes in Existing Decommissioning, Restoration and Similar Liabilities (issued May 2004 and subsequently amended)

· IFRIC 12 Service Concession Arrangements (issued November 2006 and subsequently amended)

The revisions to IAS 23 result from the International Accounting Standards Board’s Short-term Convergence project.

The project is being conducted jointly with the United States standard-setter, the Financial Accounting Standards Board (FASB).

The objective of the project is to reduce differences between IFRSs and US generally accepted accounting principles (GAAP) that are capable of resolution in a relatively short time and can be addressed outside major projects.

The revisions to IAS 23 are principally concerned with the elimination of one of the two treatments that exist for borrowing costs directly attributable to the acquisition, construction or production of a qualifying asset.

The application of only one method will enhance comparability.

For the reasons set out below, the Board decided to eliminate the option of immediate recognition of such borrowing costs as an expense. It believes this will result in an improvement in financial reporting as well as achieving convergence in principle with US GAAP.

The Board considered whether to seek convergence on the detailed requirements for the capitalization of borrowing costs directly attributable to the acquisition, construction or production of a qualifying asset.

However, the Board noted statements by the US Securities and Exchange Commission (SEC) and the European Commission that the IASB and FASB should focus their short-term convergence effort on eliminating major differences of principle between IFRSs and US GAAP.

For their purposes, convergence on the detailed aspects of accounting treatments is not necessary.

The Board further noted that both IAS 23 and SFAS 34 Capitalization of Interest Cost were developed some years ago. Consequently, neither set of specific provisions may be regarded as being of a clearly higher quality than the other.

Therefore, the Board concluded that if should not spend time and resources considering aspects of IAS 23 beyond the choice between capitalization and immediate recognition as an expense.

(This article was excerpted from IAS 23 Borrowing Costs)