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General rules for recognising borrowing costs

Leszek WOZIŃSKI
Audit Manager at RSM Poland

The company's activity, including the acquisition and production of assets, is often financed from external sources (loans or credits). Such type of financing involves the payment of interest and other costs associated with the borrowing of the funds, i.e. the borrowing costs.

Capitalization of borrowing costs

The possibility of capitalising financial costs is regulated by IAS 23 Borrowing Costs (further IAS 23). If a given fixed asset fulfils the requirements of the definition of a qualifying asset, i.e. an asset that requires a substantial period of time to prepare it for its intended use or sale, then the financing costs must be capitalised.

Capitalization of the acquisition or production costs ends at the time of adapting the asset to the location and conditions necessary for the initiation of its functioning as intended by the management (the asset is ready for use).

According to IAS 23, borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset are included in the cost of the asset purchase or production. It means that the borrowing costs of the asset increase its carrying amount. Other borrowing costs are recognised as expenses of the period in which they were incurred.

Costs that may be activated include:

a)     funds that were borrowed for the purposes of a qualifying asset - financial costs minus financial income from short-term investment are subject to activation from the funds received;

b)    funds received for other purposes - costs determined by applying a capitalization rate to the expenditures on the asset are subject to activation, whereas the value of borrowing costs should not exceed the total value of the financial costs incurred in the period.

 

Weighted average interest rate = Total amount of interest on other loans/Average outstanding amount of debt in a given period

 

The basis for the application of the rate determined in such a way should be the average value of capital expenditures incurred for qualified assets (average carrying value in the period) minus the amount of loans taken out specifically to finance the construction of assets.

These capital expenditures do not include the total amount spent for the construction of assets qualified for capitalization, but only those for which it is possible to justify the fact of taking out loans in a reliable way.

If the carrying value of a fixed asset exceeds its recoverable value or net realisable value (e.g. due to the fact that the financial costs have been capitalised), then it is necessary to correct the value of the asset made in accordance with IAS 36.

Example

The ABC company in 20X8 took the two following loans:

(a) USD 250 million, 8% annual interest rate, maturity date - two years (20Y0);

(b) USD 180 million, 10% annual interest rate, maturity date - four years (20Y2).

On 1 July 20X8, ABC used USD 60 million out of the above-mentioned means to build a factory. This construction began on 1 July 20X8.

Task

Calculate the amount of interest on the cost of construction that the ABC company can capitalise as of 31 December 20X8.

Solution

The weighted average interest rate for capitalization can be calculated as follows:

8% X (250/(250+180)) + 10% X (180/(250+180)) = 8.8%

The costs to be capitalized: 60 million x 8.8% x 6/12 = USD 2.64 million

When interest is not cost?

Currently, it is impossible to directly recognise in the profit and loss account the borrowing costs that are directly attributable to the acquisition, construction or production of the qualifying asset.

The general definition set out in IAS 23 indicates that borrowing costs are interest and other costs incurred in connection with borrowing the funds. The financing costs may include, in accordance with § 6 of IAS 23, the costs of:

  1. interest calculated using the effective interest rate in accordance with IAS 39,
  2. finance burdens due to financial lease agreements,
  3. exchange differences arising due to loans and credits in foreign currency to the extent that they are regarded as the adjustment of the interest expense.

Under certain conditions, all entities preparing financial statements under IFRS are required to capitalise the borrowing costs.

To begin the capitalization of interest, the following conditions should be met:

  1. the construction of assets has already been started,
  2. some expenses have already been made,
  3. interest costs are incurred.

For the construction process to be considered started, necessary activities of the planning phase need to be carried out. They will continue until the assets are ready for use. If the activities are deliberately withheld or suspended, capitalization of interest should also be withheld or suspended. It may be resumed after the activities described are resumed. This does not apply to the situation of a standard short interruption of work.

One is not allowed to capitalise the interest on assets acquired through special donations or grants because as a principle in such cases no additional funding is necessary to make the purchase.

The period of capitalization ends when basically all the activities necessary to prepare the asset for its intended use or sale are completed.

IAS 23 allows the capitalization of exchange differences to the extent to which they represent the interest costs adjustment. The problem is how to interpret this clause... but you will find more information on that issue on our blog soon.

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