Normally, an entity would look for funding their operations. In the initial period, it is difficult to raise money through issue of shares. Hence, the usual option available to the entity is to raise money through debt. Bank loans, issue of debentures, etc are common means to raise money. When assets are procured through borrowed funds, it is an important question to ask whether the interest on this money is capitalized or is charged to income statement. IAS 23 seeks to provide a solution to this question.
Borrowing costs: are interest and other costs incurred by an entity as a result of borrowing money.
The standard provides that borrowing costs must be capitalized when these are incurred for a qualifying asset. These borrowing costs do not include internal accrual or the cost of equity. The prime reason for exclusion of these costs is that there is no objective basis to calculate the cost of equity.
Qualifying asset: Is an asset that necessarily takes a substantial period of time to get ready for its intended use or sale.
The standard does not define what substantial period of time is. An entity may need to justify its basis of identifying the substantial period of time.
A qualifying asset includes a variety of assets, including:
Inventories that require a long time to bring them to a saleable condition;
Example: You are distilling whisky, and it must be allowed 10 years to mature. The inventory is considered as a qualifying asset. Any money borrowed for procurement of these inventory items is added to the cost of inventory.
Manufacturing plants, power-generation facilities, Investment property etc. since these would take a considerable time for getting ready for intended use or sale.
Intangible assets if these take substantial period of time for preparation for intended use or sale.
Example: A telecom company has acquired a 3G license. The license could be sold or licensed to a third party. However, management intends to use it to operate a wireless network. Development of the network starts when the license is acquired.
Since the intention of the company is to use the license for operating a wireless network, the intended use would take a substantial period of time. If the company has borrowed funds for getting the license, the cost of such borrowings will be added to the cost of license.
Qualifying assets do not include:
Assets acquired and are ready for intended use or sale immediately or within a short span of time.
Example: A real estate company has incurred expenses for the acquisition of a permit allowing the construction of a building. It has also acquired equipment that will be used for the construction of various buildings.
In the above example, the borrowing costs for acquiring the permit will be added to the cost of the permit. However, the equipment acquired for construction of buildings is ready to be used for the intended purpose the moment it is bought. Hence, any borrowing costs incurred for buying these equipment are not added to the cost, but charged to the Income statement.
Capitalization of borrowing costs
The standard requires that borrowing costs are added to the cost of asset when all of the following conditions are satisfied:
Costs for the assets are incurred
Borrowing costs are being incurred
Activities needed to prepare the asset for its intended use / sale are being done
Usually, funds would be available much before the acquisition of the qualifying asset. The borrowing costs would start from the day funds are borrowed. However, it may not be necessary that the qualifying asset is bought on that day itself. Also, the intention of the management has to be seen with regard to what is the prime objective of having the qualifying asset.
Example: AV Ltd borrows $1 million @ 12% per annum for construction of a building. The money is available on 1st January. The company had acquired the land just before the borrowing. However, no construction is happening because the inaugration of land is due to happen on 10th January. From 11th January, construction material is bought and construction for the building has started.
In the above example, the borrowing costs from 1st January until 10th January is charged to Income statement. After 10th January, to the extent of funds applied for construction of the building, borrowing costs thereon is capitalized.
Example: AV Ltd wishes to build a factory. It pays for an option to buy the land, and applies for state planning permission. Costs are being incurred for the asset while awaiting planning permission.
In the above example, the borrowing costs would be capitalized, since all the conditions with regard to IAS 23 are duly met.
Example: You are building an extension to your office. It is financed from your share capital and reserves.
In the above example, the sources of funds are equity and internal accruals. IAS 23 specifically prohibits capitalization of such costs.
Example: You buy some land as an investment. You will hold it for one year, then sell it, or develop it. Until then, no action is being taken to prepare the asset for use, or sale.
In the above example, no capitalization is allowed for borrowing costs.
Suspension of capitalization of borrowing costs
There are events when an asset is a qualifying asset. However, it may not be possible to continue with preparation of the asset for a temporary period. For example, a company which is manufacturing aircrafts may face a strike from workers demanding wage rate hike. For this period, the preparation of the asset would not happen. However, borrowing costs would continue to incur. In this case, the borrowing costs are not capitalized, but are charged to the income statement.
Cessation of capitalization of borrowing costs
The borrowing costs are not capitalized any further when substantially all the activities necessary to prepare the asset for its intended use or sale are complete.
Example: AV Ltd is preparing a machinery for the manufacture of goods it intends to sell. The machine is ready to use. However, the painting of machinery is yet to be completed, since the colour symbolizes the branding of the plant where the machine is installed.
In the above example, it can be assumed that substantially all the activities necessary for intended use are completed. Therefore, the borrowing costs would not be capitalized any further.
Example: DMRC builds a metro station during phase 4. The trial runs are complete, platforms are constructed. However, the finishing of stairs for the use of passengers is still incomplete. There is a space which can be used by passengers to reach the platform. There have been continuous complaints by the passengers of lack of cleanliness of the area around the stairs. No lifts work at this particular station.
In the above example, since the construction of the station is substantially complete for intended use. Any borrowing costs incurred further would be charged to income statement, and not capitalized to the cost of the construction.
Income earned by use of funds specifically borrowed
Usually, the funds are available to an entity before these could be used for construction of qualifying asset. The time gap may arise as the entity may await some clearances, or acquiring licenses etc. It is not wise to keep the funds idle until these are used. Hence, the entity may deposit these funds in bank and earn interest thereon.
IAS 23 provides that in this case, the interest to be capitalized should be net of this temporary income.
It is easy to capitalize specific borrowings relating to the qualifying asset. However, it may be a case that there are general borrowings already available with an entity. IAS 23 suggests that cost of these general borrowings may be capitalized on a weighted average basis, since these borrowings would contribute to bring the asset for its intended use or sale.