Question
Can the borrowing costs incurred on funds used to purchase and develop land for the construction of a building for its use or sale be capitalized as part of the cost of the land?
Solution
As per Ind AS 23: Borrowing cost
Paragraph 3.2: A qualifying asset is an asset that necessarily takes a substantial period to get ready for its intended use or sale.
Paragraph 6: Borrowing costs may include:
- Interest expense calculated using the effective interest method as described in Ind AS 109, Financial Instruments
- Interest in respect of lease liabilities recognised in accordance with Ind AS 116 Leases and
- Exchange differences arising from foreign currency borrowings to the extent that they are regarded as adjustment to interest costs
(Recognition) Paragraph 8: An entity shall capitalise borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset as part of the cost of that asset. An entity shall recognise other borrowing costs as an expense in the period in which it incurs them.
(Borrowing costs eligible for capitalisation) Paragraph 10: The borrowing costs that are directly attributable to the acquisition, construction or production of qualifying asset are those borrowing costs that would have been avoided if the expenditure on the qualifying asset had not been made. When an entity borrows funds specifically for the purpose of obtaining a particular qualifying asset, the borrowing costs that directly relate to that qualifying asset can be readily identified.
(Specific borrowings) Paragraph 12: To the extent an entity borrows funds specifically for the purpose of obtaining the qualifying asset, the entity shall determine the amount of borrowings costs eligible for capitalisation as actual borrowing costs incurred on that borrowing during the period less any investment income on the temporary investment of those borrowings.
Interpretation
The intended use of the land is to construct a Building and run operations. However, this objective can only be achieved after the land has been properly developed and building construction has been completed, a process that will require substantial time and effort. All the cumulative conditions are fulfilled in this case. Also, the land will not be available for any alternative use during construction of the building, so we need to see the land and building together to evaluate the definition of a qualifying asset and capitalisation of the borrowing cost.
As a result, interest and processing fees (i.e., actual borrowings cost as per paragraph 12) on project finance can be capitalised as per Ind AS 23.
And as paragraph 8 specifies that borrowing costs should be capitalised to the cost of that respective asset, thus capitalise the total interest cost to CWIP and after completion of building construction, should be apportioned to respective assets (Land and building).
When to Cess Capitalization of borrowing costs on land?
An Example from ICAI Educational Material
X Ltd. acquires and develops a piece of land. After the development of the land, X Ltd. commences construction of a building on the piece of land. To finance both activities, X Ltd. relies on its general borrowings. Both the land and the building meet the definition of a qualifying asset. Developing the piece of land and the construction of the building on the land, both the activities take a substantial period of time for its completion. Can X Ltd. continue to capitalise the borrowing costs incurred is respect of the expenditure incurred for developing the land while it constructs a building on the same land?
Response: The guidance on cessation of capitalisation of borrowing costs has been provided in paragraph 22 of Ind AS 23 which states that:
"22 An entity shall cease capitalising borrowing costs when substantially all the activities necessary to prepare the qualifying asset for its intended use or sale are complete.” Therefore, to determine when to cease capitalising borrowing costs incurred on land expenditure an entity considers the intended use of the land. The intended use of land cannot be said to be solely for the purpose of construction of a building.
The land and building together may be used for:
a) conducting the business activities of the entity from that premises, in which case such land and building will be recognised as Property, Plant and Equipment under Ind AS 16;
b) earning rent revenue or capital appreciation in which case the land and the building will be recognised as Investment Property under Ind AS 40;
c) for sale in which case the land and building will be recognised as inventory under Ind AS 2.
Further, paragraph 19 and 24 of Ind AS 23 states as follows:
"19 The activities necessary to prepare the asset for its intended use or sale encompass more than the physical construction of the asset. They include technical and administrative work prior to the commencement of physical construction, such as the activities associated with obtaining permits prior to the commencement of the physical construction. However, such activities exclude the holding of an asset when no production or development that changes the asset’s condition is taking place.
For example, borrowing costs incurred while land is under development are capitalised during the period in which activities related to the development are being undertaken. However, borrowing costs incurred while land acquired for building purposes is held without any associated development activity do not qualify for capitalisation.
24 Where an entity completes the construction of a qualifying asset in parts and each part is capable of being used while construction continues on other parts, the entity shall cease capitalising borrowing costs when it completes substantially all the activities necessary to prepare that part for its intended use or sale.” It should be assessed whether the land (part of qualifying asset) is capable of being used for its intended purpose while construction of the building continues. If the land is not capable of being used for its intended purpose while construction of the building continues, then the land and building should be considered together to assess when to cease capitalising borrowing costs on the land expenditures.
In the given case, X Ltd. shall cease capitalising borrowing costs when it completes substantially all activities necessary to prepare land for its intended use and for this purpose the land can be said to be ready for its intended use or sale when it substantially completes all the activities necessary to prepare both the land and building for that intended use or sale. Thus, X Ltd. should continue to capitalise borrowing costs incurred on the expenditure for developing land while it constructs the building on it.
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