Borrowing Costs - IAS 23
Borrowing costs related to the funding of revenue earning fixed assets are a recurring cost of operation and should be charged against the revenue earned.
But what about funding the construction of future revenue earning fixed assets?
A legitimate argument is that borrowing costs should be capitalised during the construction phase of a fixed asset. Unless clear rules exist borrowing costs could disappear from the P&L account, instead appearing as a constituent of a fixed assets “worth”! Capitalising revenue related costs was one of the techniques used by Worldcom to lower costs and thus enhance earnings.
Ideas – concepts
Borrowing costs are an inevitable cost of funding business activities. They should most prudently be considered a cost to be charged as incurred against revenue.
However, fixed assets often require considerable funds to finance their construction or purchase. Borrowing costs incurred during the construction phase could legitimately be considered a necessary cost to bring the asset into a revenue earning condition, that is, they are a cost of the fixed asset as much as materials or labour are. A good way of justifying this view is to consider that if a business purchased a completed property say, the construction company that built the property would have factored into its selling price the borrowing costs of funding their work in progress during the property’s construction.
Borrowing costs should be recognised as an expense in the period in which they are incurred except to the extent that they are directly attributable to acquisition, construction or production of a qualifying asset.
The accounting policy adopted for borrowing costs should be disclosed. Also the amount of borrowing costs capitalised during the period and the interest rate used to determine the amount of capitalised borrowing costs.
Problems areas and questions to ask about the accounts
What borrowing costs qualify to be capitalised?
Those that specifically relate to the construction of a fixed asset. An appropriate weighted average cost of relevant general borrowings may be capitalised.
Consistency of approach
If a policy of capitalising interest is adopted then it must be applied to all qualifying assets - the policy cannot be used selectively. Businesses can either capitalise interest on all qualifying assets or not apply it to any.
When should capitalisation commence and cease?
When expenditure and borrowing costs are being incurred on activities necessary to prepare the asset for its intended use. When all the preparatory activities are substantially complete then capitalisation should cease.
What happens if a capital project is suspended?
Capitalisation should be suspended during extended periods during which active development is interrupted.
What happens if a project is completed in stages?
If each stage or part is capable of being used while construction continues on other parts then capitalisation of borrowing costs should cease for the part that is in revenue earning service.
What happens if capitalisation of borrowing costs leads to over valuation of an asset?
Where the cost of assets contain an element of capitalised borrowing costs check that the asset is not over valued.
There is no significant difference between the requirements of UK FRS 15 - Tangible Fixed Assets and this IAS.
Objective and definitions from the standard
The objective of this standard is to prescribe the accounting treatment for borrowing costs. This standard generally requires the immediate expensing of borrowing costs. However, the standard permits, as an allowed alternative treatment, the capitalisation of borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset.
Borrowing costs are interest and other costs incurred by an enterprise in connection with the borrowing of funds
A qualifying asset is an asset that necessarily takes a substantial period of time to get ready for its intended use or sale.
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