Chapter 4: Borrowing costs

Borrowing costs are “interest and other costs that an entity incurs in connection with the borrowing of funds”.

Examples of borrowing costs include:

• Interest expense calculated using the effective interest rate method (described in IAS 39).
• Finance charges in respect of leases under IFRS 16.
• Exchange differences arising from foreign currency borrowings to the extent that they are regarded as an adjustment to interest costs.

Capitalized interest in hyper-inflation An entity that is applying IAS 29 and accounting for hyper-inflation needs to distinguish borrowing costs that are compensation for inflation and expense those costs. Interest rates normally include an element that compensates for inflation. It is not appropriate both to restate the capital expenditure financed by borrowing and to capitalize that part of the borrowing costs that compensates for the inflation during the same period. The element of borrowing costs that compensates for inflation is recognized as an expense in the period in which the costs are incurred. In economies where the inflation rate is above the interest rate, no borrowing cost should be capitalized.

Gains and losses on derivative instruments not designated in a hedging relationship Is it appropriate to capitalize gains and losses on derivative instruments (for example, interest rate swaps and foreign currency swaps) that have not been designated in a hedging relationship under IFRS 9 (IAS 39)? No. Such instruments fall into the category of ‘fair value through profit or losses. The gains and losses on such derivatives are not considered a borrowing cost as defined under IAS 23, as they are not linked to the borrowing activities of the entity through an IFRS 9 (IAS 39) hedging relationship.

Impact of cash flow or fair value hedging relationship on borrowing costs Should the effects of a cash flow or fair value hedging relationship on interest for a specific project borrowing be capitalized? Yes, the purpose of a qualifying hedging relationship is to modify the borrowing costs of the entity related to a specific debt. An entity should capitalize interest on borrowings in a qualifying hedging relationship, after taking into account the effects of hedge accounting. Ineffectiveness on such hedging relationships should continue to be recognized in the income statement.

Capitalization of debt modification gain or loss An entity has a specific borrowing to finance its qualifying asset. The borrowing cost is capitalized in accordance with IAS 23. The specific borrowing is modified in such a way that this does not result in DE recognition. The entity recalculates the loan’s carrying amount by discounting the new modified cash flows at the original effective interest rate. Does management have to capitalize the modification gain or loss under IAS 23? Solution: It depends. There are two valid views that can be supported to account for the modification gain or loss on a specific borrowing relating to a qualifying asset under IAS 23: 1) No capitalization: IAS 23 specifically refers to ‘borrowing costs’ as including ‘interest expense calculated using the effective interest method as described in IFRS 9’. We can interpret this strictly, and any modification gain or loss does not fit into this definition, so it should be recognized in profit or loss. This is also consistent with IFRS 9, which explicitly states that a modification gain or loss should be recognized in profit or loss and, whilst this paragraph refers to a modification of a financial asset, IFRS 9 states that the requirements also apply to the modification of a financial liability. 2) Capitalization: An alternative view sees the modification gain or loss as the result of cash flows discounted using the original effective interest rate, and it is therefore part of applying the effective interest rate method. The list of possible borrowing costs in IAS 23 is also not exhaustive, and so the modification gain/loss can be included under borrowing costs as an ‘other cost an entity incurs in connection with the borrowing of funds’ in accordance with IAS 23. Both views are acceptable and so an accounting policy choice should be made. The policy choice should be applied consistently to all modification gains or losses on specific borrowings to finance qualifying assets. If the second view is applied, only the portion that relates to the acquisition, construction or production period is capitalized, with the remainder recognized in profit or loss.

Borrowing costs include finance costs on preferred shares that are classified as liabilities under IAS 32, but exclude the actual or imputed costs (including issue costs) of equity and preferred shares that are not classified as liabilities.

Capitalization of borrowing costs includes capitalizing foreign exchange differences relating to borrowings to the extent that they are regarded as an adjustment to interest costs.

The gains and losses that are an adjustment to interest costs include the interest rate differential between borrowing costs that would be incurred if the entity borrowed funds in its functional currency, and borrowing costs actually incurred on foreign currency borrowings.

Other differences that are not adjustments to interest cost might include changes in foreign currency rates as a result of changes in other economic indicators, such as employment or productivity, or a change in government.

Measurement of foreign exchange differences for capitalization as borrowing costs There are two methods that are used to estimate the amount of foreign exchange differences that can be included in borrowing costs, as follows: ·        the portion of the foreign exchange movement can be estimated based on forward currency rates at the inception of the loan; or ·        The portion of the foreign exchange movement can be estimated based on interest rates on similar borrowings in the entity’s functional currency. An entity cannot capitalize costs that are identified as a portion of the foreign exchange movements as borrowing costs that are in excess of actual total costs incurred, using any method. Other methods might be possible. Management uses judgement to assess which foreign exchange differences can be capitalized. The method used to determine the amount that is an adjustment to borrowing costs is an accounting policy choice. The method should be applied consistently to foreign exchange differences, whether they are gains or losses.

Exchange differences on foreign currency borrowings A UK entity has a US$1m foreign currency loan at the beginning of the year. The interest rate on the loan is 4% and is paid at the end of the period. An equivalent borrowing in sterling would carry an interest rate of 6%. The spot rate at the beginning of the year is £1 = US$1.55 and at the end of the year it is £1 = US$1.50. The expected interest cost on a sterling borrowing would be £645,161 at 6% = £38,710. The actual cost of the $ loan is: £ Loan at the beginning of the year: $1,000,000 at 1.55 = 645,161 Loan at the end of the year: $1,000,000 at 1.50 666,667 Exchange loss 21,506 Interest paid: $1,000,000 at 4% = $40,000 at 1.50 = 26,667 Total 48,173 Interest on sterling equivalent: £645,161 at 6% = 38,710 Difference 9,463 The total actual cost of the loan exceeds the interest cost on a sterling equivalent loan by £9,463. Therefore, only £12,043 (£21,506 − £9,463) of the exchange difference of £21,506 can be treated as interest.

All directly attributable borrowing costs should be capitalized. ‘Directly attributable’ means those borrowing costs that would have been avoided (for example, by avoiding additional borrowings or by using the funds paid out for the asset to repay existing borrowings) if there had been no expenditure on the asset. A specific borrowing becomes a general borrowing once the related asset is completed and until the specific borrowing is repaid.

The standard distinguishes between general borrowings and specific borrowings. All borrowings that are not specific represent general borrowings. The distinction between specific and general relates to how the capitalization rate is determined. The capitalization rate for specific borrowings is the effective interest rate of the specific borrowings.

The capitalization rate for general borrowings is the weighted average of the borrowing costs applicable to the borrowings of the entity that are outstanding during the period.

However, an entity should exclude from this calculation those borrowing costs that were made specifically for obtaining a qualifying asset, except where substantially all activities to prepare the qualifying asset for its intended use are complete.

Costs eligible for capitalization are calculated by applying a capitalization rate to the expenditures on qualifying assets. The amount of borrowing costs eligible for capitalization is always limited to the amount of actual borrowing costs incurred during the period.

Capitalization of specific borrowing costs An entity has borrowed C1m specifically to finance the cost of constructing a new head office. The loan is drawn on 1 February 20X9 and, during the year, the entity pays interest on that loan at a rate of 12% until 1 November 20X9, when the interest rate is increased to 13% due to a rise in LIBOR. Construction of the building does not begin until 1 September 20X9 and continues, without interruption, until after the year end on 31 December 20X9. During the period of construction, the entity incurs directly attributable costs of C100,000 in September 20X9 and C250,000 in each month from October 20X9 to December 20X9 (for simplicity, it is assumed that these costs are incurred on the first day of each month). Each month, the borrowings (less any amount that is to be expended for the building works in that month) are re-invested and earn interest at a rate of 5% per annum. During the year ended 31 December 20X9, the entity, therefore, incurs interest on the C1m loan totaling C111, 667 and earns interest on the reinvested portion of the loan of C37, 917. The interest paid and received during the period of construction is as follows:    C Interest payable for September 20X9 at 12% 10000 Interest payable for October 20X9 at 12% Interest payable for November 20X9 at 13% 10000 10,833 Interest payable for December 20X9 at 13% 10834 Total interest payable during period of construction to end December 41667 Interest receivable on re-invested funds of C900,000 in September 20X9 3750 Interest receivable on re-invested funds of C650,000 in October 20X9 2708 Interest receivable on re-invested funds of C400,000 in November 20X9 1667 Interest receivable on re-invested funds of C150,000 in December 20X9 625 Total interest receivable to end December 20X9 8,750 Net interest cost 32,917 The borrowing is specific to the qualifying asset, and the borrowing costs eligible for capitalization are the actual cost during the period of construction less any investment income on the temporary investment of the borrowings. The amount of borrowing costs that can be capitalized is, therefore, C32, 917, being interest expense incurred of C41, 667 from 1 September to 31 December 20X9 less interest earned of C8, 750 from 1 September to 31 December 20X9. Although the funds were drawn down under the borrowing on 1 February 20X9, the borrowing costs incurred prior to 1 September 20X9 cannot be said to be directly attributable to the asset’s construction, as no expenditure on the asset is being incurred.

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How to treat general borrowings and cash used to finance qualifying assets An entity uses general borrowings and cash from operating activities to finance its qualifying assets. It has a capital structure of 20% equity and 80% current and non-current liabilities, including interest-bearing debt from general borrowings. Can management argue that only 80% of the qualifying assets are financed with borrowings, and apply the capitalization rate to only 80% of the amount of qualifying assets? No. The borrowing rate is applied to the full carrying amount of the qualifying asset, up to the total amount of borrowing costs incurred. IAS 23 does not deal with the actual or imputed cost of capital.

Calculation of borrowing costs when there are specific and general borrowings An entity might have a combination of specific borrowings and general borrowings. The following example shows how to calculate the amount of borrowing costs to be capitalized in this situation. On 1 July 20X9, entity A contracted for the construction of a building for C2.2m. The land under the building is regarded as a separate asset and is not part of the qualifying assets. The building was completed at the end of June 20Y0, and during the period the following payments were made to the contractor: PAYMENT DATE AMOUNT (C ‘000) 1 July 20X9 200 30 September 20X9 600 31 March 20Y0 1200 30 June 20Y0 200 Total 2200 Entity A’s borrowings as at its year end of 30 June 20Y0 were as follows: a. 10% 4-year note with simple interest payable annually, which relates specifically to the project; debt outstanding at 30 June 20Y0 amounted to C700, 000. Interest of C65, 000 was incurred on these borrowings during the year, and interest income of C20, 000 was earned on these funds while they were held in anticipation of payments; b. 12.5% 10-year note with simple interest payable annually; debt outstanding at 1 July 20X9 amounted to C1,000,000 and remained unchanged during the year; and c. 10% 10-year note with simple interest payable annually; debt outstanding at 1 July 20X9 amounted to C1, 500,000 and remained unchanged during the year. What amount of the borrowing costs can be capitalized at year end? IAS 23 requires different treatment for borrowing costs incurred on specific borrowings when compared to general borrowings. Borrowing costs eligible for capitalization on specific borrowings are the actual costs incurred. Any interest income earned on specific borrowings taken out and then put on deposit should be deducted in calculating the net amount eligible for capitalization. Once the specific borrowings have been fully utilized, the general borrowings should be considered. The amount of borrowing costs eligible for capitalization, in cases where the funds are borrowed generally, should be determined based on the expenditures incurred in obtaining a qualifying asset. The costs incurred should first be allocated to the specific borrowings. Analysis of expenditure: DATE EXPENDITURE (C’000) AMOUNT ALLOCATED TO GENERAL BORROWINGS (C’000) WEIGHTED FOR PERIOD OUTSTANDING (C’000) 1 July 20X9 200 00 0 30 September 20X9 600 100* 100 × 9 / 1 31 March 20Y0 1200 1200 1,200 × 3 / 12 30 June 20Y0 200 200 0200 × 0 / 12 Total 2200 375 * Specific borrowings of C700000 fully utilized, hence remainder of expenditure now allocated to general borrowings. The capitalization rate relating to general borrowings should be the weighted average of the borrowing costs applicable to the entity’s borrowings that are outstanding during the period, other than borrowings made specifically for the purpose of obtaining a qualifying asset. Weighted average borrowing cost = 12.5% (1,000 / 2,500) + 10% (1,500 / 2,500) = 11% Borrowing cost to be capitalized: Amount (C) Specific loan 65,000 General borrowings (C375000 × 11%) 41,250 Total 116,250 Less interest income on specific borrowings (20,000) Amount eligible for capitalization 86,250 Therefore, the borrowing costs to be capitalized are C86250.

A parent entity might have little or no borrowing but have subsidiaries with qualifying assets. In such circumstances, a subsidiary can capitalize interest in its separate financial statements, based on borrowings provided by another group entity. The intra-group interest is eliminated in the consolidated financial statements, however, because the group as a whole has not incurred interest on those borrowings.

But, if another group company borrows externally and lends to an entity with qualifying assets, any interest capitalized will remain in consolidation, subject to the overall limit that capitalized borrowing costs cannot exceed the consolidated borrowing costs incurred.

Period of capitalization

Three criteria must be met before borrowing costs can be capitalized:

The commencement date for capitalization is the date when the entity first meets all of the following conditions:

• it incurs expenditures for the asset;
• it incurs borrowing costs; and
• it undertakes activities that are necessary to prepare the asset for its intended use or sale.

Qualifying asset constructed by a third party A third party might construct a qualifying asset on behalf of the entity. Borrowing costs incurred are capitalized on the same basis as the borrowing costs incurred on the asset constructed by the entity. Capitalization starts when the following three conditions are met: expenditures are incurred; borrowing costs are incurred; and activities necessary to prepare the asset for its intended use or sale are in progress. In March 20X9, entity A ordered four aircraft from a manufacturer for delivery in the period 20Y2 to 20Y6. There is a down-payment for each aircraft upon signing the contract. The remaining payment schedule for each aircraft varies based on the expected delivery date for the individual aircraft. Entity A funds all payments with bank borrowings. Entity A received information from the manufacturer that the production of the parts for the first planes started in February 20Y0. No action has yet been undertaken by the manufacturer for the production of the other three aircraft. The aircraft is a qualifying asset, as its construction takes a substantial period of time to complete. The borrowing costs incurred by entity A are, therefore, capitalized. Entity A incurs expenditure on the aircraft by making a pre-payment. It also incurs the borrowing cost as the bank borrowing was obtained. Capitalization of borrowing costs starts when the manufacturer starts the construction activity. The construction activity (production of parts) started in February 20Y0, but only in relation to one aircraft. The borrowing costs incurred in relation to this one aircraft can, therefore, be capitalized from February 20Y0. The borrowing costs incurred on the pre-payments made in relation to the remaining three aircraft are expensed until the construction process begins.

Borrowing costs, both general and specific, are not capitalized in the period before the commencement of the activities necessary to prepare the asset for use. Activities might include technical and administrative work prior to the commencement of physical construction (for example, drawing up site plans and obtaining planning permission).

Activities exclude holding the asset where no production or development that changes the asset’s condition is being undertaken.

An asset’s construction might span more than one financial period. Borrowing costs capitalized in respect of the asset’s construction in earlier periods are included in the total expenditure on the asset.

The capitalization rate in the current period is then applied to the total expenditure. Previously capitalized interest is included when calculating the expenditures to which a capitalization rate is applied in the next period.

Borrowing costs might be incurred during an extended period in which activities necessary to prepare an asset for its intended use are interrupted. These borrowing costs do not qualify for capitalization.

However, capitalization continues during periods when substantial technical and administrative work is being carried out. Capitalization also continues when a temporary delay is a necessary part of the process of preparing an asset for its intended use.

Example – Period of capitalization Entity A has purchased a piece of land, formerly used for agricultural purposes, in order to construct a new factory. Entity A has applied to the local authorities for permission to change the use of the land from agricultural to industrial. The process is expected to last six months, but entity A’s management is confident that approval will be given, as the new factory will bring 1,000 new jobs to the area. Entity A has financed the purchase of the land with a bank loan, which will be repaid over seven years. The application to the local authorities for the change in use of the land is an activity necessary to prepare the asset for its intended use. Entity A can, therefore, capitalize borrowing costs in respect of the loan used to finance the land’s purchase while local authority approval is awaited. This conclusion relies on the expectation that the local authorities will approve the change in use of the land. If entity A was to become aware, during the approval process, that approval is unlikely to be given, it should cease capitalizing borrowing costs and test the asset for impairment.

Capitalization during interruption in construction activities Normally, interest capitalization ceases when construction activities cease. However, capitalization can continue when construction activities are interrupted and the interruption is a necessary and foreseeable part of the process of bringing the asset to working condition for its intended use. Interest can continue to be capitalized during interruptions in construction activities that are normally interrupted during winter months or for periodic and predictable flooding. A long-term strike by construction workers would generally not be regarded as necessary and foreseeable. Capitalizing borrowing costs would cease during an extended strike. Similarly, capitalizing borrowing costs should be suspended in situations of political unrest that disrupts the construction work for an extended period.

Capitalization of borrowing costs ceases when the qualifying asset is ready for use. ‘Ready for use’ is when the asset’s physical construction is complete, even though routine administrative work or minor modification might still continue.

When is an asset ‘ready for use’? Management should assess whether an asset, at the date of acquisition, is “ready for its intended use or sale”. The asset might be a qualifying asset, depending on how management intends to use it. For example, where an acquired asset can only be used in combination with a larger group of fixed assets (or was acquired specifically for the construction of one specific qualifying asset), the assessment of whether the acquired asset is a qualifying asset is made on a combined basis. Example 1 – Qualifying asset based on management intention A telecom entity 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 on acquisition of the license. The license has been exclusively acquired to operate the wireless network. Whilst the spectrum covered by the license is ‘ready for use’, it has been acquired with the intention of combining it with a network of fixed assets. The acquisition of the license is the first step in the wider investment project of developing the network. The network investment meets the definition of a qualifying asset under IAS 23. Interest should be capitalized on the cost of the license during the development period. Example 2 – Permits as qualifying assets An entity has incurred expenses for the acquisition of a permit allowing the construction of an office building to use as its local headquarters. The permit is specific to the building being constructed. It is the first step in a wider investment project and is part of the construction cost of the office building, which meets the definition of a qualifying asset. Interest should be capitalized on the cost of the permit during the construction phase.

A major qualifying asset or group of assets might be completed in several phases. If a phase or part is capable of being used while construction continues on other parts, capitalization of borrowing costs ceases on the completed parts.

Interest capitalization for an asset constructed in phases A retail store might be constructed in three phases: the first phase is the construction of the car park; the second phase is the construction of the core building; and the final phase is the construction and installation of internal fixtures and fittings. On completion of the first phase, the car park is made available to a nearby theatre to use as overflow parking. Capitalization of borrowing costs in respect of phase one should cease when the car park is brought into use, despite the fact that phases two and three are incomplete. Phase one is being used for its intended use, which is the provision of parking facilities. Capitalizing borrowing costs associated with each part should cease when each part is capable of being used, even if it has not yet been put into use. However, this does not apply to a part of an asset that is not capable of being put into use without the completion of another part – for example, if the retail store is constructed as follows: ·        the first phase is the construction of the core building and the main car park closest to the store; ·        the second phase is the construction of the internal fixtures and fittings; and the final phase is the completion of the overflow car park. The first phase (that is, the basic building and initial car park) is not capable of being used as a store until the internal store fixtures and fittings are complete and, therefore, capitalizing borrowing costs in respect of phases one and two should cease when both phases are complete, but before phase three is complete.

Interest capitalization for an asset completed in phases Telecom entity A is in the process of rolling out its 3G network. Entity A plans to commence the offering of 3G services once it has achieved 60% population coverage. Throughout the roll-out period, which lasts for 18 months, entity A completes the roll-out of cell sites, testing the sites and the leased lines and microwave links between the sites and the core network. Testing the network sites continues up to the point that entity A achieves 60% population coverage. Certain final tests on all sites are completed just in advance of the commercial launch and are vital to confirming the network’s operational readiness. Entity A capitalizes borrowing costs incurred from the inception of the roll-out through to the confirmation of the network’s overall operational readiness. While parts of the network are built over time, and much of the network testing is also completed over the 18-month roll-out period, the final testing and sign-off of the network’s operational readiness is not completed until just before entity A is ready to launch the network. The network assets are not ‘ready for use in the manner intended by management’ until the final network tests covering 60% of the population. Capitalization on the remaining 40% will commence when construction activities for that 40% starts.

Borrowing costs on land Entity A acquires and develops land and thereafter constructs a building on that land. Both the land and the building meet the definition of a qualifying asset, and entity A uses general borrowings to fund the expenditures on the land and construction of the building. Should entity A cease capitalizing borrowing costs incurred in respect of expenditures on the land once it starts constructing the building, or should it continue to capitalize borrowing costs incurred in respect of land expenditures while it constructs the building? In June 2018, this issue was discussed by the IFRS IC. The IC observed that entity A should consider the intended use of the land – for example, whether land and building are intended to be used for owner-occupation, rent/capital appreciation or sale. According to IAS 23, entity A considers if the land is capable of being used for its intended purpose while construction on the building is still continuing. If the land is not capable of being used for its intended purpose, entity A considers the land and building together to assess when to cease capitalizing borrowing costs on the land expenditures. In this situation, the land would not be ready for its intended use or sale until substantially all of the activities necessary to prepare both the land and the building for that intended use or sale are complete. Based on the discussion, entity A would continue to capitalize borrowing costs in respect of the land development expenditures while it constructs the building, until both the land and the building are ready for their intended use or sale. The IC finally concluded not to add this issue to its agenda.

Borrowing costs related to real estate development where revenue is recognized over time Entity A, a real estate developer, is constructing a building and sells individual units in the building to customers. Entity A entered into contracts with customers to sell some of the units prior to beginning construction. For these units, it was determined that control of each unit transfers over time, in applying IFRS 15. For the unsold units, entity A has these units listed for sale and, on entering into a contract with a customer, would transfer control of the partially constructed unit to the customer. Entity A expects that it will enter into contracts for the unsold units in the near term, and that those contracts will also result in the transfer of control over time. Entity A borrowed funds specifically to finance construction of this building. Does this arrangement give rise to a qualifying asset on which interest can be capitalized? Answer: No. Any receivable or IFRS 15 contract asset recognized in connection with the sold units under this arrangement is not a qualifying asset within the scope of IAS 23. Any inventory (work in progress) for unsold units under construction would not be qualifying assets, because these units are ready for sale in their current condition (that is, the entity intends to sell the partially constructed units as soon as it finds a suitable customer and, on signing a contract with a customer, will transfer control of any work in progress to the customer). In a different situation (for example, where an entity enters into a contract with a customer to transfer control on completion of construction), it is likely that the units would meet the definition of a qualifying asset, and so interest would be capitalized. Judgement is required as to whether interest could be capitalized on the cost of the land on which the building is being constructed, based on specific facts and circumstances. Entities should consider when control of the land transfers in determining whether it meets the definition of a qualifying asset.