AAAP7 INT
Syllabus D. Audit of Historical Financial Information D3. Evaluation and review

D3a. IAS 23 Borrowing Costs 23 / 41

Syllabus D3a)

Evaluate the matters (e.g. materiality, risk, relevant accounting standards, audit evidence) relating to:
xxv) borrowing costs

Borrowing Costs

Let’s say you need to get a loan to construct the asset of your dreams - well the interest on the loan then is a directly attributable cost.

So instead of taking interest to the I/S as an expense you add it to the cost of the asset. 
(in other words - you capitalise it)

There are 2 scenarios here to worry about:

  1. You use current borrowings to pay for the asset

  2. You get a specific loan for the asset

1) Use current borrowings

This is looking at the scenario where we use funds we have already borrowed from different sources.

So, if the funds are borrowed generally – we need to calculate the weighted average cost of all the loans we have generally. 

(I know you're thinking - how the cowing'eck do I work out the weighted average of borrowings... aaarrgghh!).

Well relax my little monkey armpit - here's how you do it:

  1. Calculate the total amount of borrowings

  2. Calculate the interest payable on these in total

  3. Weighted average  of borrowing costs = Divide the interest by the borrowing - et voila!

  4. We then take this weighted average of borrowing costs and multiply it by any expenditure on the asset. 

    The amount capitalised should not exceed total borrowing costs incurred in the period.

Illustration

5% Overdraft 1,000
8% Loan 3,000
10% Loan 2,000

We buy an asset with a cost of 5,000 and it takes one year to build - how much interest goes to the cost of the asset?

Solution

Calculate the WA cost of the borrowings:

  1. Total Borrowing = (1,000+3,000+2,000) = 6,000

  2. Interest payable = (50+240+200) = 490

  3. 490/6,000 = 8.17%

  4. So the total interest to be added to the asset is 8.17% x 5,000 = 408

2) Get a specific loan

Ok well you would think this is easy - just the interest paid, surely?! But it’s not quite that easy…

It is the actual borrowing costs less investment income on any temporary investment of the funds

So what does this mean exactly?

Well imagine you need 10,000 to build something over 3 years. You borrow 10,000 at the start but dont need it all straight away. 

So the bit you dont need you leave in the bank to gain interest

So, the amount you could capitalise would be the interest paid on the 10,000 less the interest received on the amount not used and left in the bank (or reinvested elsewhere)

Steps:

  1. Calculate the interest paid on the specific loan

  2. Calculate any interest received on loans proceeds not used

  3. Add the net of these 2 to 'cost of the asset'

Illustration

Buy asset for 2,000 - takes 2 years to build. 

Get a 2,000 10% loan. 

We reinvest any money not used in an 8% deposit account. 
In year 1 we spend 1,200. 

How much interest is added to the cost of the asset?

  1. Interest Paid = 2,000 x 10% = 200

  2. Interest received = ((2,000-1,200) x 8%) = 64

  3. Dr  PPE Cost (200-64) = 136
    Cr  Interest Accrual

Basic Idea

Borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset form part of the cost of that asset.

Other borrowing costs are recognised as an expense.

So what is a “Qualifying asset?”

It is one which needs a substantial amount of time to get ready for use or sale.

This means it can’t be anything that is available for use when you buy it. 

It has to take quite a while to build (PPE, Investment Properties, Inventories and Intangibles).

You don’t have to add the interest to the cost of the following assets:

  1. Assets measured at fair value,

  2. Inventories that are manufactured or produced in large quantities on a repetitive basis even if they take a substantial period of time to get ready for use or sale.

When should we start adding the interest to the cost of the asset?

Capitalisation starts when all three of the following conditions are met:

  1. Expenditure begins for the asset

  2. Borrowing costs begin on the loan

  3. Activities begin on building the asset e.g. Plans drawn up, getting planning etc.

    So just having an asset for development without anything happening is not enough to qualify for capitalisation

Are borrowing costs just interest?

It’s actually any costs that an entity incurs in connection with the borrowing of funds.

So it includes:

  • Interest expense calculated using the effective interest method.

  • Finance charges in respect of finance leases

What about if the activities stop temporarily?

Well you should stop capitalising when activities stop for an extended period

During this time borrowing costs go to the profit or loss.

Be careful though - If the temporary delay is a necessary part of the construction process then you can still capitalise, e.g. Bank holidays etc.

When will capitalisation stop?

Well, when virtually all the activities work is complete. This means up to the point when just the finalising touches are left.

NB

  • Stop capitalising when AVAILABLE for use. This tends to be when the construction is finished

  • If the asset is completed in parts then the interest capitalisation is stopped on the completion of each part

  • If the part can only be sold when all the other parts have been completed, then stop capitalising when the last part is completed