IAS 23 describes the treatment of borrowing costs. Most of the entities borrow, to fund their activities and incur interest (finance charge) on the same.
Finance charge can be either:-
- Charged to Profit & Loss or;
- Capitalized with the asset.( in this case the cost will be charged off by way of depreciation after the asset is put to use)
Borrowing cost (finance charge) is added to the cost of qualifying asset (capitalized) if they are directly attributable to it’s:
- Construction or
Qualifying asset is an asset that takes substantial period of time to get ready for its intended use or sale. Any asset which is ready for its intended use or sale is excluded.
- Manufacturing plant
- Power generation facilities
- Investment property (assets held for letting out or capital appreciation)
- Intangible assets (Eg: development cost)
- Inventories that require substantial period of time to bring them into saleable condition (eg. Whisky, made to order goods). Inventories produced on a large scale repetitively is excluded.
All other borrowing cost should be recognized as an expense in the period in which it is incurred.
Borrowing costs includes:
- Interest cost
- Other costs incurred in connection with borrowing of funds(Eg : processing charges)
- Exchange differences to the extent they are adjustment to interest costs
- Preference dividend if preference capital is classified as debt.
Any income earned on temporary investment of the loan during the period when finance charge is capitalized should be reduced from the finance charge capitalized. In case the income is earned when the capitalization is suspended then it should be reduced from interest charged off to profit and loss.
A project may be financed through specifically arranged borrowings or a general pool of borrowings. When borrowing is specifically allocated to a project, it is very easy to identify finance costs for capitalization. However when funds are borrowed generally at different rates and utilized across various projects then, a weighted average borrowing cost of borrowings outstanding during the period other than specific borrowings (if any) should be ascertained for arriving at finance charge.
Outstanding Liability Interest Charge
5-Year Term Loan 500 100
Cash Credit 700 140
Weighted average borrowing cost will be (100+140) *100 = 20%
Capitalization shall commence when
- Activities necessary to prepare the asset for its intended use or sale are in progress,(Eg: technical and administrative work including obtaining permits)
- expenditure for asset being constructed are being incurred (Eg: Labour, material etc) ,
- Borrowing costs are incurred.
Expenditure are reduced by any progress payments or grants received in connection with the asset.
Capitalization shall be suspended when active development of the construction of asset is interrupted. It will not be suspended if the delay is a necessary part of the process of getting an asset ready for its intended use or sale.
Capitalization is ceased when all activities necessary for preparing the qualifying asset for its intended use or sale are complete. When construction of qualifying asset is completed in parts then, capitalization of borrowing cost shall cease when substantially all the activities necessary to prepare that part for its intended use or sale are completed.
Disclosure: The financial statements should disclose:
- Accounting policy adopted for borrowing costs
- Amount of borrowing costs capitalized during the period
- Capitalization rate used to determine borrowing costs eligible for capitalization
Note: Notional borrowing costs cannot be capitalized.