Gripping IFRS Capitalisation of borrowing costs Chapter 11 364 Chapter 11 Capitalisation of Borrowing Costs Reference: IAS 23 Contents: Page 1. Introduction and definitions 1.1 Overview 1.2 Borrowing costs 1.3 Qualifying assets 1.4 Qualifying borrowing costs 365 365 365 365 366 2. Expensing borrowing costs 2.1 Recognition 2.2 Measurement Example 1: expensing borrowing costs 366 366 366 366 3. Capitalising borrowing costs 3.1 Recognition 3.1.1 Commencement of capitalisation Example 2: capitalisation of borrowing costs: all criteria met at same time Example 3: commencement of capitalisation: criteria met at different times Example 4: commencement of capitalisation: criteria met at different times 3.1.2 Suspension of capitalisation Example 5: delays in construction 3.1.3 Cessation of capitalisation Example 6: end of construction 3.2 Measurement 3.2.1 Measurement: specific loans Example 7: specific loans Example 8: specific loans: costs paid on specific days Example 9: specific loans: costs paid evenly over a period Example 10: specific loans: loan raised before construction begins 3.2.2 Measurement: general loans Example 11: general loan: costs incurred evenly Example 12: general loan: costs incurred at the end of each month Example 13: general loan: costs incurred at the start of each month 367 367 367 367 368 368 369 369 369 370 370 372 372 373 374 375 375 376 377 379 4. A comparison of the methods 380 5. Disclosure 380 6. Summary 382
Transcript
1. Gripping IFRS Capitalisation of borrowing costs Chapter 11
Capitalisation of Borrowing CostsReference: IAS 23Contents: Page 1.
Introduction and definitions 365 1.1 Overview 365 1.2 Borrowing
costs 365 1.3 Qualifying assets 365 1.4 Qualifying borrowing costs
366 2. Expensing borrowing costs 366 2.1 Recognition 366 2.2
Measurement 366 Example 1: expensing borrowing costs 366 3.
Capitalising borrowing costs 367 3.1 Recognition 367 3.1.1
Commencement of capitalisation 367 Example 2: capitalisation of
borrowing costs: all criteria met at same time 367 Example 3:
commencement of capitalisation: criteria met at different times 368
Example 4: commencement of capitalisation: criteria met at
different times 368 3.1.2 Suspension of capitalisation 369 Example
5: delays in construction 369 3.1.3 Cessation of capitalisation 369
Example 6: end of construction 370 3.2 Measurement 370 3.2.1
Measurement: specific loans 372 Example 7: specific loans 372
Example 8: specific loans: costs paid on specific days 373 Example
9: specific loans: costs paid evenly over a period 374 Example 10:
specific loans: loan raised before construction begins 375 3.2.2
Measurement: general loans 375 Example 11: general loan: costs
incurred evenly 376 Example 12: general loan: costs incurred at the
end of each month 377 Example 13: general loan: costs incurred at
the start of each month 379 4. A comparison of the methods 380 5.
Disclosure 380 6. Summary 382 364 Chapter 11
2. Gripping IFRS Capitalisation of borrowing costs1
Introduction and definitions1.1 OverviewIAS 23 was revised in March
2007. Those of you who have studied this standard previouslywill
notice that in the previous version of IAS 23, accountants were
able to choose between: the benchmark treatment (expensing
borrowing costs); and the allowed alternative treatment
(capitalising borrowing costs).In the revised version of IAS 23,
however, you will notice that there is no reference at all tothe
benchmark or allowed alternative treatments. The revised IAS 23 has
it that accountantsmust capitalise borrowing costs (the previous
allowed alternative treatment) that are incurredon qualifying
assets. Thus borrowing costs on non-qualifying assets are always
expensed.Therefore, IAS 23 now requires that an entity: capitalise
borrowing costs that were incurred on a qualifying asset; and
expense borrowing costs that were not incurred on a qualifying
asset.Up until now you will have indirectly been exposed to
borrowing costs where borrowingcosts are generally expensed (i.e.
the presupposition in such examples would have been thatthe
borrowing costs were not incurred on a qualifying asset). We will
now learn how andwhen to capitalise borrowing costs. In a nutshell,
borrowing costs that relate to qualifyingassets must be capitalised
assuming that criteria for recognition of an asset are also met.One
of the more significant reasons behind capitalising borrowing costs
instead of expensingthem is that the cost of financing is generally
a significant cost, and is generally a necessaryevil in order to
bring an asset to a location and condition that makes it useable or
saleable.Costs that are significant and necessary should surely
form part of the assets cost. There arearguments against
capitalizing borrowing costs as well, of course. These are
discussed at theend of this chapter, but are largely academic now,
given that there is no longer a choice.1.2 Borrowing costsBorrowing
costs are those costs that are incurred by the entity in connection
with theborrowing of funds.Other names often used for borrowing
costs include: interest expense; and finance charges.Borrowings
costs may include: interest incurred on loans (including bank
overdraft); amortisation of discounts (or premiums); finance
charges on finance leases; exchange difference on foreign loan
accounts; and costs of raising debt.1.3 Qualifying assetsQualifying
assets are those that take a substantial period of time to get
ready for theirintended use or sale.Qualifying assets may include:
manufacturing plants; power generation facilities; intangible
assets; investment properties; and inventories. 365 Chapter 11
3. Gripping IFRS Capitalisation of borrowing costs1.4
Qualifying borrowing costs (IAS 23.8 - .10)Borrowing costs that
must be capitalised to the cost of an asset are those that: are
directly attributable to the acquisition, manufacture or production
of a qualifying asset; and those that would have been avoided had
the expenditure on the qualifying asset not been made.It is
sometimes quite difficult to identify a direct link between
borrowing costs incurred and aspecific asset since: the borrowings
may not have been specifically raised for that asset, but may be
general borrowings (i.e. the entity may have a range of debt
instruments at a range of varying interest rates); the borrowings
may not even be denominated in your local currency (i.e. the
borrowings may be foreign borrowings); and the borrowings may be
subject to hyper-inflation (borrowing costs that compensate for
inflation are always expensed).The lists of complications are
seemingly endless thus frequently requiring your
professionaljudgement. These complications in calculation of the
borrowing costs to be capitalised areexpanded upon in the section
entitled measuement.2 Expensing borrowing costs2.1 Recognition (IAS
23.8 - .9)Whenever borrowing costs do not meet the conditions for
capitalisation, they are expensed.Expensing borrowing costs simply
means to include the borrowing costs as an expense inprofit or loss
in the period in which they were incurred (i.e. as and when
interest is charged inaccordance with the terms of the borrowing
agreement).2.2 MeasurementThe amount of borrowing costs expensed is
simply the amount charged by the lender inaccordance with the
borrowing agreement.Example 1: expensing borrowing costsYay Limited
incurred C100 000 interest (during the year ended 31 December 20X5)
on a loanthat was used to finance the construction of a factory
plant.The factory plant was not considered to be a qualifying
asset.Required:Provided the necessary journal entries for expensing
the interest in Yay Limiteds books forthe year ended 31 December
20X5.Solution to example 1: expensing borrowing costsComment:When
to recognise an expense: when the interest is incurred.How much to
expense: the amount of interest charged by the lender in terms of
the agreement. Debit CreditFinance costs (expense) 100 000 Bank/
liability 100 000Interest incurred during the period is expensed
366 Chapter 11
4. Gripping IFRS Capitalisation of borrowing costs3
Capitalising borrowing costs3.1 Recognition (IAS 23.8 - .9)To
capitalise borrowing costs simply means to include them in the cost
of the relatedqualifying assets. In other words, the borrowing
costs are recognised as an asset.Before the borrowing costs may be
recognised as an asset, they must meet the basicrecognition
criteria for an asset: future economic benefits must be probable;
and the costs must be reliably measurable.Borrowing costs that must
be capitalised are those: that are directly attributable to the
acquisition, construction or production of a qualifying
asset.Directly attributable means: if the assets had not been
constructed, acquired or produced thenthese costs could have been
avoided.An example of an acquisition is the purchase of a building.
An example of the constructionof an asset is the building of a
manufacturing plant. An example of the production of an assetis the
manufacture of inventory.When to recognise borrowing costs as part
of the asset (capitalisation) is affected by: Commencement date:
capitalisation starts from the date on which certain criteria are
met; Suspension period: capitalisation must stop temporarily when
certain criteria are met; Cessation date: capitalisation must stop
permanently when certain criteria are met.When borrowing costs are
capitalised, the carrying amount of the asset will obviously
beincreased by the borrowing costs incurred. The cost of these
borrowings will eventuallyreduce profits, but only when the
qualifying asset affects profit or loss (e.g. through
thedepreciation expense when the qualifying asset is an item of
property, plant and equipment).3.1.1 Commencement of capitalisation
(IAS 23.17 - .19)Assuming the basic recognition criteria are met,
an entity must start to capitalise borrowingcosts from the date
that all the following criteria are met: the entity is preparing
the asset for its intended use or sale (activity is happening);
expenditure is being incurred by the entity in preparing the asset;
and borrowing costs are being incurred.The date that all three
criteria are met is known as the commencement date.Example 2:
capitalisation of borrowing costs - all criteria met at same
timeYippee Limited incurred C100 000 interest on a loan used to
finance the construction of abuilding during the year ended 31
December 20X5: The building was considered to be a qualifying
asset. Construction of the building began on 1 January 20X5, when
the loan was raised. It is probable that the building would result
in future economic benefits and the borrowing costs are reliably
measurable. The construction of the building began as soon as the
loan was raised.Required:Provide the necessary journal entries to
capitalise the borrowing costs in Yippee Limitedsbooks for the year
ended 31 December 20X5. 367 Chapter 11
5. Gripping IFRS Capitalisation of borrowing costsSolution to
example 2: capitalisation of borrowing costs - all criteria met at
same timeComment: Interest must be recognised as part of the cost
of the qualifying asset. Interest is recognisedas part of the asset
(capitalisation) from the time that all criteria for capitalisation
are met. All criteriaare met on the same date (1 January 20X5): a
loan is raised on 1 January 20X5 on which interest is being
incurred; activities start on 1 January 20X5; and expenditure
related to the activities start on 1 January 20X5 is being
incurred.The basic recognition criteria are also met and therefore
the amount to be capitalised is calculated from1 January 20X5.
Debit CreditFinance costs (expense) 100 000 x 12 / 12 100 000 Bank/
liability 100 000Interest on the loan incurred first
expensedBuilding: cost (asset) 100 000 x 12 / 12 100 000 Finance
costs (expense) 100 000Interest on the loan capitalised to the cost
of the buildingExample 3: commencement of capitalisation - criteria
met at different timesDawdle Limited borrowed C100 000 on the 30
June 20X5 to build a factory to store its goods.The necessary
building materials were only available on 31 August 20X5 and it was
then thatDawdle Limited began construction. The building is
considered to be a qualifying asset.Required:Discuss when Dawdle
Limited may begin capitalising the interest incurred.Solution to
example 3: commencement of capitalisation - criteria met at
different timesAll three criteria must be met before the entity may
begin capitalisation. From the 30 June 20X5,Dawdle Limited borrowed
funds and began incurring borrowing costs, but had not yet met the
othertwo criteria (activities were not underway and costs on the
asset were not being incurred). On the31 August 20X5, however,
Dawdle both acquired the construction materials and began
constructionthereby fulfilling all three criteria. Dawdle Limited
may therefore only begin capitalising theborrowing costs on the 31
August 20X5 (assuming that it was probable that the building would
renderfuture economic benefits and that the costs were considered
reliably measurable).Example 4: commencement of capitalisation -
criteria met at different timesHoorah Limited incurred C100 000
interest for the year ended 31 December 20X5 on a loanof C1 000
000, raised on 1 January 20X5. The loan was raised to finance the
construction ofa building during the year ended 31 December 20X5.
The building is a qualifying asset.Construction began on 1 February
20X5.Required:Provide the necessary journal entries to capitalise
the borrowing costs in Hoorah Limitedsbooks for the year ended 31
December 20X5.Solution to example 4: commencement of capitalisation
- criteria met at different timesComment: Borrowing costs are being
incurred from 1 January 20X5, but activities and relatedexpenditure
are only incurred from 1 February 20X5: all three criteria for
capitalisation are thereforeonly met from 1 February 20X5 and
therefore capitalisation may only occur from this date: 368 Chapter
11
6. Gripping IFRS Capitalisation of borrowing costs20X5 Debit
CreditFinance costs (expense) 100 000 x 12 / 12 100 000 Bank/
liability 100 000Interest on the loan incurred first expensed:
total interest incurred forthe year (given: 100 000)Building: cost
(asset) 100 000 x 11 / 12 91 667 Finance costs (expense) 91
667Interest on the loan capitalised to the cost of the building;
fromcommencement date (1 February 20X5)3.1.2 Suspension of
capitalisation (IAS 23.20 - .21)If the active development of the
qualifying asset is interrupted or delayed for a long period
oftime, the capitalisation of the borrowing costs must be
suspended.Capitalisation of borrowing costs must not be suspended,
however, if: the delay is only temporary; if the delay is due to
substantial technical or administrative work; or if the delay is a
necessary part of getting the asset ready for its intended use.A
typical example of when borrowing costs should continue to be
capitalised despite a delayis a wine farm that has to wait for its
inventory of wine to mature in order to ensure a saleablecondition.
In this case, borrowing costs that are incurred during this period
of maturationwould continue to be capitalised to the cost of the
inventory of wine.Example 5: delays in constructionA hotel is under
construction in 20X5. Borrowing costs of C300 000 are incurred on a
loanduring 20X5. The loan was specifically raised on 1 January 20X5
for the sole purpose of theconstruction of the
hotel.Required:Discuss how much of the interest may be capitalised
assuming that:A. The builders go on strike for a period of two
months, during which no progress is made.B. The builders of the
hotel had to wait for five days for the cement in the foundations
to dry.Solution to example 5: delays in constructionA. During these
two months, the interest incurred may not be capitalised to the
asset as it is a substantial and unnecessary interruption to the
construction process.B. The borrowing costs must still be
capitalised as it is merely a temporary delay and is a normal part
of the construction process.3.1.3 Cessation of capitalisationThe
entity must stop capitalising borrowing costs when the asset: is
ready for its intended use or sale; or is substantially complete
and capable of being used or sold.By way of example, capitalisation
would cease if routine administration work or minormodifications
are all that remains to be done (e.g. decoration of a new building
to the clientsspecifications) in order to bring the asset to a
useable or saleable condition.If an asset is completed in parts
where each part is capable of being used separately from theother
parts, then capitalisation of borrowing costs ceases on each part
as and when each part iscompleted. An example of such an asset
would be an office park: as office blocks are 369 Chapter 11
7. Gripping IFRS Capitalisation of borrowing costscompleted,
these office blocks may begin to be used by tenants. An example of
an asset thatwould not be capable of being used or sold in parts is
a factory plant that requires parts to bemade in sequence and where
the plant becomes operational only when all parts are
completed.Example 6: end of constructionFlabby Limited began
construction of a block of flats on 1 January 20X5. The block of
flatsis to be leased out to tenants in the future.On 1 January
20X5, Flabby Limited correctly began capitalising borrowing costs
(on aC2 000 000 loan raised for the construction) to the cost of
the property.On 30 September 20X5, the building of the block was
complete but no tenants could befound. On 15 November 20X5,
however, after lowering the rentals, the entire building wasrented
out to tenants.Interest of C200 000 (at 10% on the loan) was
incurred during the 12-month period ended31 December
20X5.Required:Discuss when Flabby Limited should stop capitalising
the interest expense to the asset(building) and show the journal
entries relating to interest.Solution to example 6: end of
constructionCapitalisation should cease when: the asset is ready
for its intended use or sale.On the 30 September 20X5 the
construction was completed. Although the asset was not being leased
itwas ready to be leased to tenants on 30 September 20X5, and
therefore capitalisation must cease on30 September 20X5 (because
one of the three criteria for capitalisation is no longer met:
activity hasceased). All subsequent interest incurred must be
expensed.Journals in 20X5: Debit CreditFinance costs (expense) 200
000 Bank/ liability 200 000Interest incurred: 200 000
(given)Building (asset) 150 000 Finance costs (expense) 150
000Interest capitalised: 200 000 x 9 / 12 (to completion date:
30/9/20X5)3.2 Measurement (IAS 23.10 - .15)Not all borrowing costs
may be capitalised. The list of borrowing costs that may
becapitalised are given in IAS 23 and are included under paragraph
1.2 above.Notice that this list excludes certain costs associated
with raising funds or otherwise financinga qualifying asset. This
suggests that costs that do not appear on this list may not
becapitalised. Borrowing costs therefore exclude: cost of raising
share capital that is recognised as equity, for example: -
dividends on ordinary share capital; - dividends on non-redeemable
preference share capital (dividends on redeemable preference share
capital may be capitalised because redeemable preference shares are
recognised as liabilities and not equity); cost of using internal
funds (e.g. if one uses existing cash resources instead of
borrowing more funds, there is a indirect cost being the lost
income, often measured using the 370 Chapter 11
8. Gripping IFRS Capitalisation of borrowing costs companies
weighted average cost of capital or the market interest rates that
could otherwise have been earned); foreign exchange differences
that are incurred as a result of acquiring the qualifying asset on
credit terms with no interest charged (e.g. if an asset is
purchased for $ 1 000 on 1 January 20X1 when the exchange rate is
C7: $1, then the entity owes C7 000 on the transaction date, but if
the payment is only necessary on 30 June 20X1 and if the payment is
made on this date, and if the exchange rate is C10: $1 on this
date, then the entity will have to pay C10 000: the asset will be
recorded at C7 000 and the C3 000 exchange difference will have to
be expensed since it does not relate to a borrowing cost).The
formula used to measure the borrowing costs that may be capitalised
depends on thesource of the borrowings. There are two sources of
borrowings, which include: specific borrowings and general
borrowings.Unfortunately IAS 23 does not define what is meant by
specific and general borrowings. Thedifference between specific and
general borrowings can, however, be explained as follows: specific
borrowings are taken out for the sole purpose of financing the
construction, acquisition or production of a qualifying asset;
whereas general borrowings are those funds that are entered into
for a general purpose. These funds may be utilised for buying
inventory, paying off creditors and a multitude of other purposes
in addition to the construction, acquisition or production of a
qualifying asset.When determining whether your borrowings are
either general or specific, it is useful toremember that whilst a
bank overdraft facility is often used as general purpose
borrowings, itis also possible for a bank overdraft facility to be
arranged specifically for a qualifying asset.The particular
circumstances should, therefore, always be considered when deciding
whetherthe borrowing is specific or general.Measuring the borrowing
costs to be capitalised is sometimes more complicated that it
firstappears. The basic questions that one needs to answer when
measuring the borrowing coststo be capitalised include: are the
borrowings specific or general or is there a mix of both specific
and general? is the borrowing a precise amount (e.g. a loan) or
does it increase as expenditure is paid for (e.g. a bank
overdraft)? are the expenditures (on which interest is incurred)
incurred evenly or at the beginning or end of a period or at
haphazard times during a period? how long are the periods during
which capitalisation is allowed?In considering whether the
borrowings specific or general or is there a mix of both
specificand general, remember that: where the borrowings are
specific: - you will need the actual rate of interest/s charged on
the borrowing/s; and - you will need to ascertain whether any
surplus borrowings were invested upon which interest income was
earned (if so, remember to reduce the interest expense by the
interest income); where the borrowings are general: - you will need
the weighted average rate of interest charged (assuming there is
more than one general borrowing outstanding during the period);In
considering whether the borrowing is a precise amount (e.g. a loan)
or whether it increaseas expenditure is paid for (e.g. a bank
overdraft), bear in mind that: if the borrowing is a loan ( a
precise amount), you will use the capital sum; and if the borrowing
is an overdraft (a fluctuating amount), you will use the relevant
expenditures and will need to know when they were incurred (or
whether they were incurred relatively evenly). 371 Chapter 11
9. Gripping IFRS Capitalisation of borrowing costsIn assessing
whether the expenditures (on which interest is incurred) are
incurred evenly or atthe beginning or end of a period or at
haphazard times during a period, bear in mind that: interest
expense can be measured using average borrowing balances if the
costs are incurred evenly, whereas actual borrowing balances should
be used (whether specific or general borrowings) if costs are
incurred at the beginning or end of a period; and interest income
should be measured using average investment balances if the costs
are incurred evenly, whereas actual investment balances should be
used (if it is a specific borrowing) if costs are incurred at the
beginning or end of a period,.In determining the periods during
which capitalisation must occur, you will need to know: the
commencement date: borrowings may be outstanding (and incurring
interest) before commencement date in which case interest expense
(and interest income on any surplus funds invested) up to
commencement date must be ignored when calculating the portion to
be capitalised; the cessation date: borrowings may be outstanding
(and incurring interest) after cessation date in which case
interest expense (and interest income on any surplus funds
invested) after cessation date must be ignored when calculating the
portion to be capitalised; and whether there was a suspension
period between these two dates: borrowings may be outstanding (and
incurring interest) during a suspension period in which case
interest expense (and interest income on any surplus funds
invested) during this period must be ignored when calculating the
portion to be capitalised.3.2.1 Measurement: specific loans (IAS
23.12 - .13)All of the borrowing costs incurred on a specific loan
are capitalised to the asset. If thesefunds are invested prior to
the date they were utilised then any interest earned must
besubtracted from the interest incurred (borrowing costs), in which
case only the net amountmay be capitalised.Example 7: specific
loansYahoo Limited borrowed C500 000 from the bank on 1 January
20X5 to begin theconstruction of a building. The interest payable
on the loan during 20X5 was C50 000(calculated at 10%). The company
invested all surplus funds raised in a fixed deposit andearned C24
000 interest during 20X5. No capital portion of the loan was repaid
during theyear ended 31 December 20X5. All criteria for
capitalisation of borrowing costs were meton 1 January 20X5. The
building is a qualifying asset.Required:Calculate the amount of
borrowing costs that must be capitalised in terms of IAS 23 and
showthe necessary journal entries.Solution to example 7: specific
loansComment: this example shows that interest income is used to
reduce the amount of borrowings thatmay be capitalised when the
borrowing is a specific borrowing. Calculations: CInterest incurred
500 000 x 10% 50 000Interest earned given (24 000)Total to be
capitalised 26 000 Debit CreditFinance costs (expense) 50 000 Bank/
liability 50 000Interest incurred on the loan first expensed 372
Chapter 11
10. Gripping IFRS Capitalisation of borrowing costs Debit
CreditBank/ liability 24 000 Interest income 24 000Interest income
earned on investment of surplus loan fundsBuilding: cost (asset) 50
000 24 000 26 000 Finance costs (expense) 26 000Portion of interest
on the loan capitalised to the cost of the buildingWhen calculating
the interest income you may find that actual amounts invested can
be used.This happens when, for example, the expenditures are
infrequent and/ or happen at the start orend of a period. This will
mean that the investment balance will remain unchanged for aperiod
of time. The calculation of the amount of borrowing costs on
specific borrowings thatmust be capitalised is therefore: total
interest incurred on specific borrowings: capital borrowed x
interest rate x period borrowed less interest income earned from
investment of surplus borrowings: amount invested x interest rate x
period invested.Very often, however, average amounts invested need
to be used instead of actual amountsinvested. This happens more
frequently when the borrowing is a general borrowing, but canapply
to a specific borrowing where, for example, the expenditure is paid
relatively evenlyover a period of time, with the result that the
balance on the investment account (being thesurplus borrowings that
are invested) is constantly changing. In this case, it is
normallyacceptable to calculate the interest earned on the average
investment balance over a period oftime (rather than on the actual
balance on a specific day). The calculation of the amount
ofborrowing costs on specific borrowings that must be capitalised
could therefore be: total interest incurred on specific borrowings:
capital borrowed x interest rate x period borrowed less interest
income earned from investment of surplus borrowings: (investment o/
balance + investment c/ balance) / 2 x interest rate x period
investedExample 8: specific loans costs paid on specific daysHaha
Limited borrowed C500 000 from the bank on 1 January 20X5 to begin
theconstruction of a building (a qualifying asset). Construction
began on 1 January 20X5 (i.e.all criteria for capitalisation of
borrowing costs were met). The interest rate payable on theloan was
10%. The company paid construction costs of C400 000 on 1 March
20X5.Surplus funds were invested in a fixed deposit and earned
interest at 6% per annum. Nocapital portion of the loan was repaid
during the year ended 31 December 20X5.Required:Calculate the
amount of borrowing costs that must be capitalised.Solution to
example 8: specific loans costs paid on specific daysComment: The
borrowings are raised two months before they were required. These
surplus funds areinvested for January and February and the balance
on this account for these two months remains stableat C500 000. On
March, however, payments totaling C400 000 are made, thus reducing
the investmentbalance to C100 000. This balance remains stable for
the remaining ten months of the year. Since theexpenditure is not
incurred evenly over a period but is incurred on a specific day,
the interest incomefor the purposes of the calculation of the
borrowing costs to be capitalised should be calculated usingthe
actual investment balances (C500 000 for 2 months and C100 000 for
10 months). Calculations: CBorrowing costs incurred 500 000 x 10% x
12 / 12 50 000Interest earned 500 000 x 6% x 2 / 12 + (500 000 400
000) x 6% x 10/ 12 (10 000)Capitalised borrowing costs 40 000 373
Chapter 11
11. Gripping IFRS Capitalisation of borrowing costs Debit
CreditFinance costs (expense) 50 000 Bank/ liability 50 000Interest
incurred on the loan is first expensedBank/ liability 10 000
Interest income 10 000Interest income earned on investment of
surplus loan fundsBuilding: cost (asset) 40 000 Finance costs
(expense) 40 000Portion of interest on the loan capitalised to the
cost of the buildingExample 9: specific loans costs paid evenly
over a periodHooray Limited borrowed C500 000 from the bank on 1
January 20X5 to begin theconstruction of a building (a qualifying
asset).Construction begins on 1 January 20X5 (all criteria for
capitalisation of borrowing costswere met on this date).The
interest rate payable on the loan was 10%.The company paid
construction costs of C400 000 evenly between 1 March 20X5 and31
December 20X5.Surplus funds are invested in a fixed deposit and
earned interest at 6% per annum. Nocapital portion of the loan was
repaid during the year ended 31 December 20X5.Required:Calculate
the amount of borrowing costs that must be capitalised.Solution to
example 9: specific loans costs paid evenly over a periodComment:
The borrowings are raised two months before they were required.
These surplus funds areinvested for January and February and the
balance on this account for these two months remains stableat C500
000. From March, however, the amount invested gradually reduces as
payments are made (thebalance of C500 000 on 1 March gradually
decreases to a balance of C100 000 (C500 000 C400 000)on 31
December. Since the payments are incurred evenly over this
ten-month period, the interestincome for the purposes of the
calculation of the borrowing costs to be capitalised may be
calculatedusing the average of these two balances (C500 000 and
C100 000). Calculations: CInterest incurred 500 000 x 10% x 12 / 12
50 000Interest earned (500 000 x 6% x 2 / 12) + (500 000 + 100 000)
/ 2 x 6% x 10/ 12 (20 000)Capitalised borrowing costs 30 000 Debit
CreditFinance costs (expense) 50 000 Bank/ liability 50 000Interest
incurred on the loan is first expensedBank/ liability 20 000
Interest income 20 000Interest income earned on investment of
surplus loan fundsBuilding: cost (asset) 30 000 Finance costs
(expense) 30 000Portion of interest on the loan capitalised to the
cost of the building 374 Chapter 11
12. Gripping IFRS Capitalisation of borrowing costsExample 10:
specific loans loan raised before construction beginsYeeha Limited
borrowed C500 000 from the bank on 1 January 20X5 to begin
theconstruction of a building (a qualifying asset).Construction
began on 1 February 20X5 (i.e. all criteria for capitalisation of
borrowingcosts were met on this date).The interest rate payable on
the loan is 10%.The company paid construction costs of C400 000 on
1 March 20X5.Surplus funds are invested in a fixed deposit and
earned interest at 6% per annum.No capital portion of the loan was
repaid during the year ended 31 December 20X5.Required: Calculate
the amount of borrowing costs that may be capitalised.Solution to
example 10: specific loans loan raised before construction
beginsCompare this to example 8, in which the construction began on
1 January 20X5. In this example, theloan is taken out before
construction begins. All criteria for capitalisation are therefore
only met on1 February 20X1 (commencement date) and therefore the
interest that is incurred/ earned before thisdate must be ignored
for the purpose of calculating the portion of interest to be
capitalised. Calculations: CInterest incurred after 500 000 x 10% x
11 / 12 45 833commencement date (i.e. excludes January interest
expense)Interest earned after (500 000 x 6% x 1 / 12) + (500 000 -
400 000) x 6% x 10 / 12 (7 500)commencement date (i.e. excludes
January interest income)Capitalised borrowing costs 38 333 Debit
CreditFinance costs (expense) 50 000 Bank/ liability 50 000Interest
incurred on the loan first expensed: 500 000 x 10% x 12/ 12Bank/
liability 10 000 Interest income 10 000Interest income earned on
investment of surplus loan funds:(500 000 x 6% x 2 / 12) + (500 000
400 000) x 6% x 10 / 12Building: cost (asset) 38 333 Finance costs
(expense) 38 333Portion of interest on the loan capitalised to the
cost of the building3.2.2 Measurement: general loans (IAS 17.14 -
.15)General loans are used for many purposes and therefore it
cannot be said that all the interestincurred thereon was directly
attributable to the qualifying asset. Therefore, not all
theinterest incurred on a general loan may be capitalised to the
asset.If the entity has used a general loan for a qualifying asset,
the costs eligible for capitalisationare the weighted average cost
of borrowings, calculated as follows: capitalisation rate x the
average expenditure relating to the qualifying asset. The
capitalisation rate is: the weighted average interest rate on the
loans borrowed by the entity. The average expenditure is:
expenditure for the period / 2The total amount of interest
capitalised may not exceed the total interest paid or incurred. 375
Chapter 11
13. Gripping IFRS Capitalisation of borrowing costsExample 11:
general loans costs incurred evenlyBizarre Limited had a C500 000
7% existing general loan outstanding on 1 January 20X5. Itraised an
additional general loan of C600 000 on 1 January 20X5 at an
interest rate of 12.5%.Bizarre Limited did not make any repayments
on either loan during the year.Construction began on 1 January
20X5.The company spent the following amounts per month on the
construction of a building, aqualifying asset: C per month 1
January 31 July (7 months) 50 000 1 August 30 November (4 months)
30 000 1 31 December (1 month) 100 000Required:Calculate the amount
of borrowing costs that must be capitalised and provide the
necessaryjournal entries for the year ended 31 December 20X5,
assuming that the amounts were spentevenly during each
month.Solution to example 11: general loans costs incurred
evenlyComment: There are two borrowings, both of which are general
borrowings and therefore theborrowing costs to be capitalised is
based on the expenditures incurred and the weighted averageinterest
rate. Since the expenditures are incurred evenly, average
expenditures are used. Since theborrowings are general, one does
not consider interest income in the calculation of the amount to
becapitalised.W1: Borrowing costs to be capitalisedThe loans are
general loans and therefore the formula is: Capitalisation rate x
Average expenditure. Capitalisation rate (weighted average interest
rate): = interest incurred on general borrowings/ borrowings
outstanding during the period = [(C500 000 x 7% x 12 / 12) + (C600
000 x 12.5% x 12 / 12)] / 1 100 000 total borrowings = 10%
Cumulative expenditure C 1 January 20X5 Opening balance 0 January
July 50 000 x 7 months 350 000 31 July 20X5 Closing balance 350 000
August - November 30 000 x 4 months 120 000 30 November 20X5
Closing balance 470 000 December 100 000 x 1 month 100 000 31
December 20X5 Closing balance 570 000 Capitalisation rate x average
expenditure: C Jan July (0 + 350 000) / 2 x 10% x 7 / 12 months; 10
208 OR: (50 000 x 7 months) / 2 x 10 % x 7 / 12 months Aug Nov (350
000 + 470 000) / 2 x10% x 4 / 12 months; 13 667 OR: {(30 000 x 4
months) / 2 + 50 000 x 7} x 10 % x 4 / 12 months Dec (470 000 + 570
000) / 2 x 10% x 1 / 12 months; 4 333 OR {(100 000 x 1) / 2 + 50
000 x 7 + 30 000 x 4 }x 10% x 1/ 12 Total to be capitalised: 28 208
376 Chapter 11
14. Gripping IFRS Capitalisation of borrowing costsThe above
calculation can be done the long way around, if preferred:Expense
incurred evenly during each month Balance (A) Expense (B) Balance
(C ) Balance (D ) Interest % Months CapitaliseJanuary 0 50 000 50
000 25 000 10% 1 208February 50 000 50 000 100 000 75 000 10% 1
625March 100 000 50 000 150 000 125 000 10% 1 1 042April 150 000 50
000 200 000 175 000 10% 1 1 458May 200 000 50 000 250 000 225 000
10% 1 1 875June 250 000 50 000 300 000 275 000 10% 1 2 292July 300
000 50 000 350 000 325 000 10% 1 2 708August 350 000 30 000 380 000
365 000 10% 1 3 042September 380 000 30 000 410 000 395 000 10% 1 3
292October 410 000 30 000 440 000 425 000 10% 1 3 542November 440
000 30 000 470 000 455 000 10% 1 3 792December 470 000 100 000 570
000 520 000 10% 1 4 333 570 000 28 209Balance (A): first day of the
monthExpense (B): incurred on the last day of the monthBalance (C):
last day of the monthBalance (D): average balance = (A + C) /
2Capitalise: interest expense that may be capitalised: Balance (A)
x interest rate x 1 / 12Capitalisation rate (weighted average
interest rate): see calculation aboveJournals in 20X5: Debit
CreditBuilding (asset) 570 000 Bank/ liability 570 000Construction
costs incurred: 50 000 x 7 + 30 000 x 4 + 100 000 x 1This journal
would actually be processed separately for each andevery payment
but is shown here as a cumulative journal for easeFinance costs
(expense) 110 000 Bank/ liability 110 000Finance costs incurred:
500 000 x 7% + 600 000 x 12.5%Building (asset) 28 209 Finance costs
(expense) 28 209Finance costs capitalised: (W1)Example 12: general
loans costs incurred at the end of each monthBizarre Limited had a
C500 000 7% existing general loan outstanding on 1 January 20X5.
Itraised an additional general loan of C600 000 on 1 January 20X5
at an interest rate of 12.5%.Bizarre Limited did not make any
repayments on either loan during the year.Construction began on 1
January 20X5.The company spent the following amounts per month on
the construction of a building, aqualifying asset: C per month 1
January 31 July 50 000 1 August 30 November 30 000 1 31 December
100 000Required:Calculate the amount of borrowing costs that must
be capitalised and provide the necessaryjournal entries for the
year ended 31 December 20X5, assuming that the amounts were paid
atthe end of each month. 377 Chapter 11
15. Gripping IFRS Capitalisation of borrowing costsSolution to
example 12: general loans costs incurred at the end of each
monthComment: There are two borrowings, both of which are general
borrowings and therefore the interest tobe capitalised is based on
the expenditures incurred and the weighted average interest rate.
Since theexpenditures are incurred at the end of the month, actual
expenditures should be used instead(assuming the difference between
using actual and average expenses is considered by the entity to
bematerial). The interest is calculated as follows: the opening
balance at the beginning of each monthmultiplied by the weighted
average interest rate multiplied by 1/ 12.W1: Borrowing costs to be
capitalisedThe loans are general loans and therefore the formula
is: Capitalisation rate x Average expenditure.Expense incurred at
end of each month Balance (A) Expense (B) Balance (C ) Interest
Months Capitalise (D)January 0 50 000 50 000 10% 1 0February 50 000
50 000 100 000 10% 1 417March 100 000 50 000 150 000 10% 1 833April
150 000 50 000 200 000 10% 1 1 250May 200 000 50 000 250 000 10% 1
1 667June 250 000 50 000 300 000 10% 1 2 083July 300 000 50 000 350
000 10% 1 2 500August 350 000 30 000 380 000 10% 1 2 917September
380 000 30 000 410 000 10% 1 3 167October 410 000 30 000 440 000
10% 1 3 417November 440 000 30 000 470 000 10% 1 3 667December 470
000 100 000 570 000 10% 1 3 917 570 000 25 835Balance (A): balance
on the first day of the monthExpense (B): incurred on the last day
of the monthBalance (C): balance on the last day of the
monthCapitalise (D): interest expense that may be capitalised: A x
interest rate x 1 / 12Capitalisation rate (weighted average
interest rate): = interest incurred on general borrowings/
borrowings outstanding during the period = [(C500 000 x 7% x 12 /
12) + (C600 000 x 12.5% x 12 / 12)] / 1 100 000 total borrowings =
10%Journals in 20X5: Debit CreditBuilding (asset) 570 000 Bank/
liability 570 000Construction costs incurred: 50 000 x 7 + 30 000 x
4 + 100 000 x 1This journal would actually be processed separately
for each andevery payment but is shown here as a cumulative journal
for easeFinance costs (expense) 110 000 Bank/ liability 110
000Finance costs incurred: 500 000 x 7% + 600 000 x 12.5%Building
(asset) 25 835 Finance costs (expense) 25 835Finance costs
capitalised: (W1) 378 Chapter 11
16. Gripping IFRS Capitalisation of borrowing costsExample 13:
general loans costs incurred at the start of each monthBizarre
Limited had a C500 000 7% existing general loan outstanding on 1
January 20X5. Itraised an additional general loan of C600 000 on 1
January 20X5 at an interest rate of 12.5%.Bizarre Limited did not
make any repayments on either loan during the year.Construction
began on 1 January 20X5.The company spent the following amounts per
month on the construction of a building, aqualifying asset: C per
month 1 January 31 July 50 000 1 August 30 November 30 000 1 31
December 100 000Required:Calculate the amount of borrowing costs
that must be capitalised and provide the necessaryjournal entries
for the year ended 31 December 20X5, assuming that the amounts were
paid atthe beginning of each month.Solution to example 13: general
loans costs incurred at the start of each monthComment: There are
two borrowings, both of which are general borrowings and therefore
the interest tobe capitalised is based on the expenditures incurred
and the weighted average interest rate. Since theexpenditures are
incurred at the beginning of each month, actual expenditures should
be used instead(assuming that the difference between using actual
and average expenses is considered by the entity tobe material).
The interest is calculated as: the opening balance at the beginning
of each monthmultiplied by the weighted average interest rate
multiplied by 1/ 12.W1: Borrowing costs to be capitalisedThe loans
are general loans and therefore the formula is: Capitalisation rate
x Average expenditure.Expense incurred at beginning of each month
Balance (A) Expense (B) Balance (C ) Interest % Months
CapitaliseJanuary 0 50 000 50 000 10% 1 417February 50 000 50 000
100 000 10% 1 833March 100 000 50 000 150 000 10% 1 1 250April 150
000 50 000 200 000 10% 1 1 667May 200 000 50 000 250 000 10% 1 2
083June 250 000 50 000 300 000 10% 1 2 500July 300 000 50 000 350
000 10% 1 2 917August 350 000 30 000 380 000 10% 1 3 167September
380 000 30 000 410 000 10% 1 3 417October 410 000 30 000 440 000
10% 1 3 667November 440 000 30 000 470 000 10% 1 3 917December 470
000 100 000 570 000 10% 1 4 750 570 000 30 585Balance (A): balance
on the first day of the month before payment of expenseExpense (B):
incurred on the first day of the monthBalance (C): adjusted balance
on the first day of the month after payment of expenseCapitalise:
interest expense that may be capitalised: C x interest rate x 1 /
12Capitalisation rate (weighted average interest rate): = interest
incurred on general borrowings/ borrowings outstanding during the
period = [(C500 000 x 7% x 12 / 12) + (C600 000 x 12.5% x 12 / 12)]
/ 1 100 000 total borrowings = 10% 379 Chapter 11
17. Gripping IFRS Capitalisation of borrowing costsJournals in
20X5: Debit CreditBuilding (asset) 570 000 Bank/ liability 570
000Construction costs incurred: 50 000 x 7 + 30 000 x 4 + 100 000 x
1This journal would actually be processed separately for each
andevery payment but is shown here as a cumulative journal for
easeFinance costs (expense) 110 000 Bank/ liability 110 000Finance
costs incurred: 500 000 x 7% + 600 000 x 12.5%Building (asset) 30
585 Finance costs (expense) 30 585Finance costs capitalised: 30 585
(W1)4 A comparison of the methodsIt is interesting to note that
many accountants expected the revised IAS 23 to make theexpensing
of borrowing costs compulsory and to outlaw the capitalisation
thereof not theother way around! There are arguments both for and
against the capitalisation of borrowingcosts.Some argue that the
capitalisation of borrowing costs is more appropriate than the
expensingthem because: interest should not be treated any
differently to the other directly attributable costs that are
capitalised in terms of IAS 16: Property, Plant and Equipment
(improves consistency); if the entity had purchased the qualifying
asset, the construction company (seller) would have included any
borrowing costs that they incurred into the purchase price: it
therefore improves comparability between companies that purchase
assets and those that construct their own (improves comparability);
and if the entity does not capitalise the borrowing costs, it will
result in a decrease in their profit, merely because they decided
to self-construct the asset. A better approach, it is argued, would
be to recognise the borrowing costs as part of the cost of the
asset and then recognise these costs as an expense (e.g.
depreciation) over the period that the asset is used and earns
revenue (improves matching of expense to income).Some of the
arguments against capitalizing borrowing costs include: borrowing
costs incurred when constructing an asset should be expensed in the
period in which they are incurred, just as any other finance costs
would be (improves consistency and matching of expenses to the
period in which they were incurred); the calculation of the portion
of the borrowing costs to be capitalised is, in practice, very
subjective and could therefore result in errors and manipulation
and therefore expensing the actual borrowing costs incurred is less
prone to error (improves reliability); and when interest is treated
as an expense, cash flows for the period will approximate the
profit for the period, which is more useful to the user (improves
relevance) since it helps to predict cash flows.5 Disclosure (IAS
23.26)The entity must disclose the following in the financial
statements: the total amount of borrowing costs capitalised; the
amount of borrowing costs expensed as finance costs in the
statement of comprehensive income (this is an IAS 1 requirement not
a requirement of IAS 21); the capitalisation rate used to calculate
the borrowing costs for a general loan. 380 Chapter 11
18. Gripping IFRS Capitalisation of borrowing costsCompany
nameStatement of comprehensive income (extracts)For the year ended
31 December 20X5 20X4 Note C CProfit before finance costs x
xFinance costs 3. X XProfit before tax x xOther comprehensive
income x xTotal comprehensive income x xCompany nameNotes to the
financial statement (extracts)For the year ended 31 December3.
Finance costs 20X5 20X4 C C Interest incurred Z Z Less interest
capitalised IAS 23 requirement (Y) (Y) Finance cost expense IAS 1
requirement X X 381 Chapter 11
19. Gripping IFRS Capitalisation of borrowing costs 6. Summary
IAS 23 Borrowing costs Expense Capitalise If not related to a
qualifying asset If it relates to a qualifying asset and meets all
criteria for capitalisation Qualifying borrowing costs Capitalise
borrowing costs that relate to costs: directly attributable to the
acquisition, construction or production of a qualifying asset and
if future economic benefits are probable and costs can be reliably
measured Qualifying asset those that take a long time to get ready
Measurement General borrowings Specific borrowings Capitalise
borrowing costs using Capitalise the total amount of the following
formula: borrowing costs actually incurred Capitalisation rate (CR)
x the Less any interest income earned expenditure; on the temporary
investment of but limit to the actual borrowing any surplus
borrowings costs incurred CR = weighted average borrowing costs
divided by the general outstanding borrowings Start Pause Stop
Interest is being the construction of the the asset is ready for
incurred; asset is interrupted or its intended use or Expenditure
on the delayed for a long period of sale; production of the time;
(or if it is substantially asset is being (do not pause if the
delay ready). incurred; and is necessary). Activities are in
progressThis is thecommencement date 382 Chapter 11