In this article, you will learn:
Accounting Standard 16 prescribes the accounting treatment for borrowing costs. This accounting standard must be applied in accounting for the borrowing cots.
Furthermore, AS 16 does not deal with the actual or imputed costs of owner’s equity including preference share capital that is not categorized as a liability.
Thus, in this article, you will learn what are borrowing costs, how to account for borrowing costs, borrowing costs eligible for capitalization, commencement, and cessation of capitalization.
What are Borrowing Costs?
Borrowing Costs are the interest and other costs incurred by an enterprise in relation to the borrowing of funds. These costs may include:
- Interest and commitment charges on bank borrowings and other short term and long term borrowings
- Amortization of discounts or premiums pertaining to borrowings
- Amortization of ancillary costs incurred in relation to the arrangement of borrowings
- Finance charges relating to the assets acquired under finance leases or under any other similar arrangement
- Exchange differences resulting from foreign currency borrowings. Such exchange differences must pertain to adjustment to interest costs and not exchange rates
What are Qualifying Assets?
A qualifying asset is an asset that mandatorily takes a longer period of time to get ready for its intended use or sale. The time period depends on the circumstances of each case.
Typically, a period of 12 months is considered a substantial or longer period of time unless a shorter or longer period can be justified based on facts or circumstances of the case. Examples of qualifying assets include:
- Manufacturing plants
- Power generation facilities
- Inventories requiring a substantial period of time to get ready for sale
- Investment properties etc.
However, investments and inventories manufactured routinely in large quantities repetitively over a short period of time are not considered as qualifying assets.
Furthermore, assets ready for sale or intended use when acquired are not considered as qualifying assets.
Recognition of Borrowing Costs for Capitalization
The borrowing costs that directly relate with the acquisition, construction or production of a qualifying asset need to be capitalized as a part of the cost of the asset.
Thus, as per AS 16, you need to determine the amount of the borrowing costs that are eligible for capitalization. The borrowing costs other than the one pertaining to the qualifying asset must be recognized as an expense during the period in which they are incurred.
It is important to note that the borrowing costs are capitalized as a part of the cost of the asset only when it is reasonable to assume that such costs will result in any future economic benefit to the enterprise and such costs can be measured reliably.
Borrowing Costs Eligible for Capitalization
As mentioned above, the borrowings costs that directly relate to the construction, acquisition or production of qualifying assets need to be capitalized as a part of the cost of that asset.
Such borrowing costs eligible for capitalization should be determined as follows:
Actual borrowing costs incurred on borrowings obtained for qualifying assets – income on the temporary investment of those borrowings
Furthermore, in case the funds are borrowed generally and then used for the purpose of acquiring a qualified asset, then the number of borrowing costs to be capitalized should be determined by applying a capitalization rate to the expenditure made on obtaining a qualifying asset.
This capitalization rate is the weighted average of the borrowing costs related to the borrowings of the enterprise outstanding during the period. These borrowing costs do not include the costs incurred on the borrowings made specifically for the purpose of obtaining a qualifying asset.
Also, the number of borrowing costs capitalized during a particular period should not exceed the number of borrowing costs actually incurred in that period.
Commencement of Capitalization
An enterprise should start capitalization of the borrowing costs as a part of the cost of the qualifying asset when all the following conditions are satisfied:
- An enterprise incurs expenditure to acquire, construct or produce a qualifying asset
- The enterprise incurs the borrowing costs
- All activities necessary to prepare the asset for its intended use or sale are in progress
Suspension of Capitalization
An enterprise continues to incur borrowing costs during an extended period during which the activities mandatory for preparing an asset for its intended use or sale are discontinued.
Therefore, these borrowing costs are the costs incurred on holding partially completed assets and hence are not eligible for capitalization.
However, when substantial technical and administrative work is carried out to bring a qualified asset to its intended use, the borrowing costs capitalized during that period need not be suspended.
Likewise, capitalization of borrowing costs is also not suspended when there is a temporary delay in the process of getting an asset ready for its intended use or sale.
Cessation of Capitalization
An enterprise should stop capitalization of borrowing costs when a major part of all the activities necessary to prepare a qualifying asset for its intended use or sale complete.
An asset is considered ready for its intended use or sale when the physical construction or production of such an asset is complete. Though the routine administrative work on such an asset might continue.
Furthermore, if there are any minor modifications outstanding on an asset as per the demand of the user, then also it is considered that substantially all activities are complete.
Then, there also cases where the construction of a qualifying asset is completed in parts. And each completed part is capable of being used while construction continues on rest of the parts.
In this case, the capitalization of the borrowing costs related to the completed part should stop when substantially all the activities necessary to prepare such a part for its intended use or sale are complete.
Example includes a business park comprising of several buildings where each building can be used individually while the construction of the rest of the buildings continue.
Following items must be disclosed by an enterprise pertaining to the borrowing costs:
- Accounting policy adopted for borrowing cost
- Amount of borrowing costs capitalized during the period