Financial Reporting (F7/FR)

BORROWING COSTS (IAS 23)

IAS 23, Borrowing Costs, prescribes the criteria for determining whether borrowing costs can be
capitalized as part of the cost of acquiring, constructing, or producing a “qualifying asset.” The
Standard prescribes the capitalization of borrowing costs into the cost of a qualifying asset.

Borrowing costs in relation to a qualifying asset such as a building or major construction

contract should therefore be capitalised and included in the cost of the asset, provided that the
borrowing costs can be directly related to it.

• The cost of the asset will be more accurately stated by the inclusion of these costs.
• The borrowing costs will be more accurately matched to future revenues when they are
depreciated as part of the cost of the asset.

DEFINITIONS OF KEY TERMS

• Borrowing costs.

Include interest and other costs incurred by an entity in relation to borrowing of funds.

• Qualifying asset.

An asset that necessarily takes a substantial period of time to get ready for its intended use or
sale.

Assets that are ready for their intended use or sale when acquired are not qualifying assets as
envisioned by this Standard. Qualifying assets, for the purposes of this Standard, are assets that
take a substantial period of time to get ready for their intended use. Examples of qualifying
assets include

• A toll bridge that takes a couple of years to construct before it is ready for use and is opened
to the public

• A power plant that takes a substantial period of time to get ready for its intended use

• A hydroelectric dam that services the needs of a village and takes a considerable period of
time to construct

Inventories that are routinely manufactured or are produced on a repetitive basis over a short
period of time are obviously not qualifying assets. However, inventories that require a

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substantial period of time to bring to a saleable condition can be regarded as qualifying assets
for the purposes of this Standard.

Example
On December 1, 2009, Compassionate Inc. began construction of homes for those families that
were hit by the tsunami disaster and were homeless. The construction is expected to take 3.5
years. It is being financed by issuance of bonds for $7 million at 12% per annum. The bonds were
issued at the beginning of the construction. The bonds carry a 1.5% issuance cost. The project is
also financed by issuance of share capital with a 14% cost of capital.

Compassionate Inc. is required under IAS 23 to capitalize borrowing costs.

Required

Compute the borrowing costs that need to be capitalized under IAS 23.

Solution

Since these homes are “qualifying assets,” borrowing costs can be capitalized and are computed
thus:

Interest on 7m bond = 7m ×12% = $840000

Amortization of issuance cost = 0.015×7m/3.5 = 30000

Total= 870000

COMMENCEMENT OF CAPITALIZATION
Capitalization of borrowing costs shall commence when

• Expenditures for the asset are being incurred.

• Borrowing costs are being incurred.

• Activities necessary to prepare the asset for its intended use or sale are in progress.

Specific borrowing
If loan is specifically taken for qualifying asset, capitalization start from start whether amount of
loan is utilized or not

Amount to be capitalized= total interest- investment income generated from extra funds

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Financial Reporting (F7/FR)
Example
On 1 January 20X6 Stremans Co borrowed $1.5m to finance the production of two assets, both
of which were expected to take a year to build. Work started during 20X6. The loan facility was
drawn down and incurred on 1 January 20X6, and was utilised as follows, with the remaining
funds invested temporarily.

Asset A Asset B

$'000 $'000

1 January 20X6 250 500

1 July 20X6 250 500

The loan rate was 9% and Stremans Co can invest surplus funds at 7%.

Required

Ignoring compound interest, calculate the borrowing costs which may be capitalised for each of
the assets and consequently the cost of each asset as at 31 December 20X6.

Answer

Asset A Asset B

$ $

Borrowing costs

To 31 December 20X6 $500,000/$1,000,000 ×9% 45,000 90,000

Less investment income

To 30 June 20X6 $250,000/$500,000 × 7% × 6/12 (8,750) (17,500)

36,250 72,500

Cost of assets

Expenditure incurred 500,000 1,000,000

Borrowing costs 36,250 72,500

536,250 1,072,5001

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Financial Reporting (F7/FR)
General borrowing
• Interest is capitalized when payment is made
• When there are multiple loans available weighted average interest is used

Example
Acruni Co had the following loans in place at the beginning and end of 20X6.

1 January 31 December 20X6 20X6

$m $m

10% Bank loan repayable 20X8 120 120

9.5% Bank loan repayable 20X9 80 80

8.9% debenture repayable 20X7 – 150

The 8.9% debenture was issued to fund the construction of a qualifying asset (a piece of mining
equipment), construction of which began on 1 July 20X6

On 1 January 20X6, Acruni Co began construction of a qualifying asset, a piece of machinery for
a hydroelectric plant, using existing borrowings. Expenditure drawn down for the construction
was: $30m on 1 January 20X6, $20m on 1 October 20X6.

Required

Calculate the borrowing costs that can be capitalised for the hydro-electric plant machine.

SUSPENSION OF CAPITALIZATION
Capitalization shall be suspended during extended periods in which active development is
interrupted unless that period is a necessary part of the process for the production of the asset.
For example, capitalization would be suspended during an interruption to the construction of a
bridge during very high water levels, which are common in the area where construction is taking
place. However, capitalization of borrowing costs should not be suspended when there is only a

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temporary delay that is caused by certain expected and anticipated reasons, such as while an
asset is getting ready for its intended use.

CESSATION OF CAPITALIZATION
Capitalization of borrowing costs shall cease when substantially all the activities necessary to
prepare the asset for its intended use or sale are complete. If all that is left are minor
modifications, such as decoration or routine administrative work, then the asset is considered to
be substantially complete.

In some instances, such as a business park or extensive development, parts may become ready
for use in stages. In such cases, capitalization ceases on those parts that are ready for use.

RECOGNITION
Borrowing costs that are directly attributable to the acquisition, construction, or production of a
qualifying asset shall be capitalized as part of the cost of that asset.

Capitalization of borrowing costs that are directly attributable to the acquisition, construction,
or production of a qualifying asset as part of the cost of the asset is possible only if both these
conditions are met:

• It is probable that they will result in future economic benefits to the entity.

• The costs can be measured reliably.

(If borrowing costs do not meet these criteria, then they are expensed.)

BORROWINGS ELIGIBLE FOR CAPITALIZATION

When borrowings are taken specifically to acquire, construct, or produce an asset, the
borrowing costs that relate to that particular qualifying asset are readily identifiable. In such
circumstances, it is easy to quantify the borrowing costs that would need to be capitalized by
using the process of elimination, that is, capitalizing the borrowing costs that would have been
avoided had the expenditure on the qualifying asset not been made.

Difficulties arise, however, if borrowings and funding are organized centrally, say, within a
group of companies. In such cases, a weighted-average capitalization rate may be applied to the
expenditures on the qualifying asset.

When funds borrowed specifically to finance a qualifying asset are not utilized immediately, and
instead the idle funds are invested temporarily until required, the borrowing costs that are

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capitalized should be reduced by any investment income resulting from the investment of idle
funds.

Borrowing costs capitalized in a period cannot exceed the amount of borrowing costs incurred
by the entity during that period

Example
A socially responsible multinational corporation (MNC) decided to construct a tunnel that will
link two sides of the village that were separated by a natural disaster years ago. Realizing its
role as a good corporate citizen, the MNC has been in this village for a couple of years exploring
oil and gas in the nearby offshore area. The tunnel would take two years to build and the total
capital outlay needed for the construction would be not less than $20 million. To allow itself a
margin of safety, the MNC borrowed $22 million from three sources and used the extra $2
million for its working capital purposes. Financing was arranged in this way:

• Bank term loans: $5 million at 7% per annum

• Institutional borrowings: $7 million at 8% per annum

• Corporate bonds: $10 million at 9% per annum

In the first phase of the construction of the tunnel, there were idle funds of $10 million, which
the MNC invested for a period of six months. Income from this investment was $500,000.

Required

When MNC capitalizes borrowing costs under IAS 23, how would it treat the borrowing costs?
How would it capitalize the borrowing costs, and what would it do with the investment income?

Solution

Under IAS 23, borrowing costs would be capitalized as part of the cost of the asset.

1. In order to capitalize the borrowing costs, a weighted-average cost of funds borrowed is

computed:

1. In order to capitalize the borrowing costs, a weighted-average cost of funds borrowed is

computed:

= ($5 million × 7%) + ($7 million × 8%) + ($10 million × 9%)/($5 million + $7 million + $10 million)

= ($1.81 million/$22 million) × 100

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Financial Reporting (F7/FR)

= 8.22 % per annum

2. Total borrowing cost = $20 million × 8.22 % per annum × 2 years

= $1.644 million × 2 years

= $3.288 million

3. Borrowing costs to be capitalized = Interest expense – Investment income (resulting from

investment of idle funds)

= $3,288,000 – $500,000

= $2,788,000

EXCESS OF CARRYING AMOUNT OF THE QUALIFYING ASSET OVER THE RECOVERABLE AMOUNT
When the carrying amount or the expected ultimate cost of the qualifying asset exceeds its
recoverable amount or net realizable value, the carrying amount is to be written down or
written off in accordance with the requirements of other Standards, such as IAS 36, Impairment
of Assets.

Disclosure
The following should be disclosed in the financial statements in relation to borrowing costs.

(a) Amount of borrowing costs capitalised during the period

(b) Capitalisation rate used to determine the amount of borrowing costs eligible for
capitalization

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Financial Reporting (F7/FR)

Chapter end exercise

Q1 Under what conditions can an entity capitalise borrowing costs?

A The borrowing costs are incurred for purchases of inventory items

B The borrowing costs are directly attributable to the acquisition, construction, or production of
a qualifying asset

C The borrowing costs are directly attributable to the acquisition, construction, or production of
routinely manufactured assets

D The borrowing costs are incurred for purchases of property, plant and equipment

Q2 Which of the following would qualify as a borrowing cost as defined in IAS 23 Borrowing
Costs?

(1) Premium on redemption of preference share capital

(2) Discount on the issue of convertible debt

(3) Interest expense calculated using the effective interest rate

(4) Finance charges related to finance leases

A 1, 2 and 3 only

B 2, 3 and 4 only

C 1 and 4 only

D 1, 2, 3 and 4

Q3 For which of the following categories of funds used to construct a factory, that is a
qualifying asset, can borrowing costs NOT be capitalised?

A Funds borrowed specifically to construct the factory

B Funds borrowed in advance of expenditure on the factory

C General borrowed funds used to finance the building of the factory

D Funds borrowed that have been applied to the construction of a new office

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Financial Reporting (F7/FR)

Q4 Which qualitative characteristic is applied by IAS 23 Borrowing Costs to the

capitalisation of borrowing costs?

A Consistency

B Timeliness

C Materiality

D Understandability

Q5 QI is incurring expenditure on project 275 which meets the definition of a qualifying

asset, in accordance with IAS 23 Borrowing Costs. The company has the following debt
components:

(1) 6% $100,000 debt used specifically to finance project 274

(2) 7% $500,000 preference share capital

(3) 10% $80,000 short-term loan

(4) 4% $200,000 convertible debt

What capitalisation rate would QI apply to expenditure incurred on project 275?

A 7%

B 6.75%

C 6.54%

D 4%

Q6 Details relating to construction of Apex’s new store:

Apex issued a $10 million unsecured loan with a coupon (nominal) interest rate of 6% on 1 April
2016. The loan is redeemable at a premium which means the loan has an effective finance cost
of 7·5% per annum. The loan was specifically issued to finance the building of the new store
which meets the definition of a qualifying asset in IAS 23. Construction of the store commenced
on 1 May 2017 and it was completed and ready for use on 28 February 2017, but did not open
for trading until 1 April 2017. During the year trading at Apex’s other stores was below
expectations so Apex suspended the construction of the new store for a two month period

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during July and August 2016. The proceeds of the loan were temporarily invested for the month
of April 2016 and earned interest of $40,000.

Required:

Calculate the net borrowing cost that should be capitalised as part of the cost of the new store
and the finance cost that should be reported in the statement of profit or loss for the year ended
31 March 2017.

Q7 Which of the following assets would NEVER qualify for capitalisation of borrowing costs
under IAS 23 Borrowing Costs?

A Intangible assets

B Financial assets

C Manufacturing plants

D Power generation facilities

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