In this competition market mostly business work on borrowed funds. Finance has the work to arrange and utilize the funds. But after this Q is raised, when this borrowing cost will be capitalized and when it is charged to revenue. AS-16 deals with this. A quick study of AS-16 is as follows:
Borrowing cost are interest and other costs incurred by an enterprise in connection with the borrowing of funds.
In this other costs comprises:
1. Interest and commitment charges on bank borrowing and other short term and long term borrowings.
2. Amortization of discounts or premiums relating to borrowings.
3. Amortization of ancillary costs incurred in connection with the arrangement of borrowings.
4. Finance charges in respect of assets acquired under finance leases
5. Exchange difference arising from foreign currency borrowings to the extent that they are regarded as an adjustment to interest costs.
Above shows that not only interest part even other charges and finance charges will be capitalized.
We capitalize cost only that part which is related to acquisition, construction or production of a qualifying asset.
Now what is qualifying asset? Qualifying asset is an asset that necessarily takes a substantial period of time to get ready for its intended use or sale.
What is substantial period of time? It is not mentioned anywhere. Normally a period of 12 months is considered as substantial period of time. But it depends on the facts and circumstances of each case.
So AS-16 says it must be asset. Inventory is also asset. AS-2 (Valuation of inventories) says” interest and other borrowing costs are usually considered as not relating to brining the inventories to their present location and conditions and are, therefore, usually not included in the cost of inventories”. So AS-2 uses usually word. It doesn’t prohibit including interest cost in inventory. But AS-16 tells us when it is added in inventory cost. “Substantial period of time” it is the base condition. So that inventories which takes substantial period of time to get ready, on them we can add interest cost as part of cost. For example Liquor is often required to be kept in store for more than 12 months for maturing. So on this we can add interest cost in inventory valuation.
For capitalization Q is raised, when capitalization to start? What amount to capitalized? And till when interest cost is capitalized?
When capitalization to start:
When following conditions are satisfied then capitalization is commenced.
1. Expenditure for the acquisition, construction or production of a qualifying asset is being incurred;
2. Borrowing costs are being incurred; and
3. Activities that are necessary to prepare the asset for its intended use or sale are in progress.
What amount to be capitalized:
1. If funds are borrowed specifically for a qualifying asset then borrowing cost of that loan is to be capitalized.
2. If funds are borrowed for general purpose and then it used in obtaining qualifying asset then this borrowing cost should be capitalized by applying a capitalization rate to the expenditure on that asset. This capitalization rate should be the weighted average of the borrowing costs applicable to the borrowings of the enterprise that are outstanding during the period, other than borrowings made specifically for the purpose to obtain a qualifying asset.
As we all know, all funds can’t be used at once. So enterprises invest this fund in short term investments. If this is the case, then income on that investment will be reduced from that borrowing cost.
The amount of borrowing cost capitalized can’t be exceeded the amount of borrowing costs incurred during the period. (This is used in 2nd point because in this a capitalization rate is used, so borrowing cost applied for capitalization can be different from actual borrowing cost)
Suspension of Capitalization
If we see the 3rd point of When capitalization to start then we will find sometime some incidents occurred which stop the development of the asset. In these cases, because it doesn’t fulfil the 3rd condition so capitalization of borrowing cost is suspended.
Cessation of Capitalization
When all activities to prepare qualifying asset is completed then borrowing cost capitalization will be stopped.
If the asset is like, it can be completed in parts and a part can be used independently then capitalization of borrowing cost on that part will be ceased.
It is immaterial if some minor modification of fabrication work is pending. Capitalization can be completed by ignoring that minor repairs.