Accounting treatment of borrowing costs is the subject matter of IAS 23. IAS 16 which deals on property, plant and equipment (PPE) made provisions surrounding how tangible non-current assets (TNCAs) are treated.
It among other things states that borrowing costs MUST be included in the initial cost of an item of property plant and equipment.
Note that capitalisation of borrowing costs is not exclusive to PPE only. It equally applies to any asset that takes substantial amount of time to be made ready for use or sale. IAS 23 did not unfortunately define what substantial amount of time is but this is where best of judgement and professionalism can be applied. All other borrowing costs for non qualifying assets are expensed in the profit or loss for the period which they relate.
The problem however is determining what constitutes qualifying borrowing costs. A lot of preparers of financial statements have in the past engaged in all sorts of shady deals when capitalising borrowed costs. And that is why there is an accounting standard that ensures uniformity in this area.
This article is in response to an email asking for an article on the accounting treatment of borrowing costs as per IFRS and IAS. I don’t usually delve into technical writings as it involves frequent updates to accommodate the changes made to relevant IASs (not that I am a lazy accountant…lol). Maybe I will do more of technical accounting articles after this, who knows. Ok, let’s get started.
How to Treat Borrowing Costs In Accordance With IAS 23 Borrowing Costs
I would like to start by saying that SMEs are not allowed to capitalise borrowing costs as they have their own IFRS.
The treatment of borrowing costs as per IAS 23 is quite simple and straight forward. IAS 23 Borrowing costs regulates and controls the extent to which organizations are permitted to capitalize borrowing costs incurred as a result of borrowing money from financial instructions to fund the acquisition of qualifying tangible non-current assets.
Qualifying TNCAs are assets that take substantial time to get ready for its intended use or sale. I have used the term capitalization a few times without explaining its contextual meaning. So let us quickly get over that.
Capitalization in the context of borrowing costs simply means adding to or being included to. if I add the cost of installing my newly purchased state of the art equipment to the cost of buying and bring the asset to site, it simply means I have capitalized the installation cost. I hope this is clear enough.
The accounting treatment of borrowing costs will be covered under 4 different headings below.
(A). When to start capitalising borrowing costs
Capitalisation of borrowing costs can only commence when all the following 3 conditions are met:
1. Expenditure for the asset(s) has being incurred
2. Borrowing costs are being incurred
3. All necessary activities or tasks required to put the asset to its intended use or sale are in progress. This is to say that you cannot capitalise borrowing cost when you are still planning to start a project(s).
(B). Interest Rate to be used
Only borrowing costs that are actually incurred less any investment income from temporarily investing the fund before eventually using them may be capitalised.
Chinweike LTD borrowed £85m from Me-and-Me bank for a period of one year to finance the acquisition of a qualifying asset costing a total of £85m. The borrowing interest rate is at 3%. The company invested in a short term investment with yield of 1% for a period of one month (before the start) that the company experienced some computer glitch which halted operation.
The amount of borrowing costs that can be capitalised in the above example is £2,479,167 (£85m X 0.03) – (£85 X (1/12 X 0.01)).
(C). Where funds are taken from general borrowing
Sometimes companies borrow lots of money (say from 3 different banks) for general purpose and then use some of the funds to finance a qualifying asset. The interest rate to be used in calculating the borrowing cost is the weighted average cost of the general borrowing.
Continuing from example 2 above, assuming that Chinweike Ltd borrows £35m 4% loan from XYZ bank and another £65million 5% loan from ABC bank (all in the same period). The amount to be capitalised would be the amount spent on the qualifying asset multiplied by the weighted average cost of all the borrowing in this case is £3.3m which 3.89% multiplied by £85m.
(£85m X 3% + £35m X 4% + £65m X 5%) /£185m) = 3.89%
(D). When to stop capitalising borrowing costs
Capitalisation of borrowing costs should stop when either:
• Substantially all the activities or tasks necessary to prepare the qualifying asset for its intended use or sale is complete, or
• When work is suspended due to art of God or industrial strike for example
IAS 23 stipulates that borrowing costs on qualifying assets must be capitalised. This however does not apply if your company is a SME. I have also used simple example to illustrate how borrowing costs under IAS 23 should be treated.
Do not hesitate to ask your question in the comment box below if you have any question regarding this.