Question

Codification Research Case

What guidance do you find on capitalization of interest in IFRS? How is it different or similar to U.S. GAAP?

When capitalizing interest, there is a limit that the lower of actual interest and avoidable interest should only be capitalized. How do you compute avoidable interest and actual interest? Illustrate with examples.

When a company acquires a long-term asset, how does it determine the cost that should be reported for this asset on the balance sheet?

What is subsequent expenditure? Do you capitalize it or expense it? Discuss.

Answer 1

IAS 23 : CAPITALISATION OF BORROWING COSTS

The broad principles of IAS 23 (Revised) are the same as those in FAS 34, ‘Capitalisation of interest cost’.The core principle of IAS 23 is that the borrowing costs that are directly attributable to the acquisition or construction of a qualifying asset must be capitalised. All other borrowing costs should be expensed. To understand the two terms, :

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

Qualifying asset is defined as ‘an asset that necessarily takes a substantial period of time to get ready for its intended use or sale’. The standard does not define ‘substantial’ and a benchmark of 12 months is often used. Examples of qualifying assets are manufacturing plants, real estate, and infrastructure assets such as bridges and railways.

EXAMPLE :

A telecom company has acquired a 3G licence. The licence 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 licence is acquired.Should borrowing costs on the acquisition of the 3G licence be capitalised until the network is ready for its intended use?

Yes. The licence has been exclusively acquired to operate the wireless network. The fact that the licence can be used or licensed to a third party is irrelevant. The acquisition of the licence is the first step in a wider investment project (developing the network). It is part of the network investment, which meets the definition of a qualifying asset under IAS 23.

The standard has specific requirements for determining borrowing costs eligible for capitalisation for specific borrowings and general borrowings. Specific borrowings are funds borrowed specifically for the purpose of obtaining a qualifying asset. For specific borrowings, the actual costs incurred are capitalised.

All borrowings that are not specific represent general borrowings. Costs eligible for capitalisation are calculated by applying a capitalisation rate to the expenditures on qualifying assets. The capitalisation rate is the weighted average of the borrowing costs applicable to the borrowings of the entity that are outstanding during the period. The amount of borrowing costs eligible for capitalisation is always limited to the amount of actual borrowing costs incurred during the period.

The amount of borrowing costs eligible for capitalisation is calculated as follows:

• The amount of borrowing costs eligible for capitalisation is the actual borrowing costs incurred on a specific borrowing during the period, less any investment income on the temporary investment of those borrowings. [IAS 23 para 12].
• The amount of borrowing costs eligible for capitalisation on general borrowings is determined by applying a capitalisation rate to the expenditures on qualifying assets. The capitalisation rate is the weighted average of the borrowing costs applicable to the borrowings of the entity that are outstanding during the period, other than borrowings made specifically for the purpose of obtaining a qualifying asset. [IAS 23 para 14].
• The following example illustrates how to calculate the amount of borrowing costs to be capitalised.

Illustrative example On 1 July 2013, entity A entered into a C2.2 million contract for the construction of a building. The building was completed at the end of June 2007. During the period, the following payments were made to the contractor: Payment date Amount (C’000) 1 July 2013 200 30 September 2013 600 31 March 2014 1,200 30 June 2014 200 Total 2,200 Entity A’s borrowings as at its year end of 30 June 2014 were as follows: 10% four-year note with simple interest payable annually, which relates specifically to the project; debt outstanding at 30 June 2014 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. 12.5% 10-year note with simple interest payable annually; debt outstanding at 1 July 2013 amounted to C1 million and remained unchanged during the year. 10% 10-year note with simple interest payable annually; debt outstanding at 1 July 2013 amounted to C1.5 million and remained unchanged during the year. Assume for the purposes of this example that interest expense equals borrowing costs. Solution Expenditures incurred in obtaining a qualifying asset are first allocated to any specific borrowings. The remaining expenditures are allocated to any general borrowings. Analysis of expenditure: Amount (C’000) Amount allocated to specific borrowing (C’000) Amount allocated to general borrowings (C’000) Weighted for period outstanding (C’000) 1 July 2013 200 200 - - 30 September 2013 600 500 100* 100 x 9/12 = 75 31 March 2014 1,200 - 1,200 1,200 x 3/12 = 300 30 June 2014 200 - 200 200 x 0/12 = 0 Total 2,200 700 1,500 375 * Specific borrowings of C700,000 are fully utilised; remainder of expenditure is therefore allocated to general borrowings. The capitalisation rate relating to general borrowings is 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 costs to be capitalised Amount (C) Specific loan 65,000 General borrowings (C375,000 × 11%) 41,250 Total 106,250 Less interest income on specific borrowings (20,000) Amount eligible for capitalisation 86,250 Therefore, the borrowing costs to be capitalised is 86,250. KEY DIFFERENCES OF IAS AND US GAAP Borrowing costs related to assets that take a substantial time to complete IFRS: Capitalisation is an available accounting policy choice. US GAAP: Capitalisation is mandatory. Types of borrowing costs eligible for capitalisation IFRS: Includes interest, certain ancillary costs, and exchange differences that are regarded as an adjustment of interest. US GAAP: Generally includes only interest. Income on temporary investment of funds borrowed for construction of an asset IFRS: Reduces borrowing cost eligible for capitalisation. US GAAP: Generally does not reduce borrowing cost eligible for capitalisation. Calculation of avoidable interest Capitalized interest = weighted-average accumulated expenditures up to the principal balance of specific borrowing * interest rate on that specific borrowing + weighted-average accumulated expenditures in excess of specific borrowing * weighted-average interest rate. Journal entries Capitalized interest is included in the cost of the qualifying assets using the following journal entry: Qualifying Asset XXXXX Interest Expense XXXXX Example KPK Infrastructures, Inc. (KPKI) is a company set up to build, own and operate all key public infrastructure projects in KPK. On 1 January 2013, it contracted Gandahara Inc. (GI) to build a bridge over Indus at a total cost of $8,000,000. Following is the schedule of payments made by KPKI to GI over the year: Payment Date Expenditure 01-Jan-13 3,000,000 01-May-13 1,000,000 01-Sep-13 2,000,000 01-Dec-13 2,000,000 Half of the project cost is financed by a specific loan carrying annual interest rate of 8% and the rest is financed out of two general loans: a loan from MCB of $10,000,000 carrying 10% annual interest rate and another loan from UBL of $5,000,000 carrying 11% annual interest rate. GI ceases work on the project in the monsoon season i.e. July and August. Calculate the interest expense that KPKI can capitalize. Solution Following schedule calculates the weighted-average accumulated expenditures: Payment Date Expenditures (A) Capitalization Period (B) Weight (C=B/12) Weighted Expenditures (A×C) 01-Jan-13 3,000,000 12 months 1.00 3,000,000 01-May-13 1,000,000 8 months 0.67 666,667 01-Sep-13 2,000,000 4 months 0.33 666,667 01-Dec-13 2,000,000 1 month 0.08 166,667 4,500,000 Out of this $4.5 million, $4 million is financed by specific loan. The rest i.e. $500,000 is financed out of the general loans. The interest rate on specific loan is 8% while the weighted interest rate on the general loans is calculated below. Loan Principal Rate Annual Interest MCB 10,000,000 10% 1,000,000 UBL 5,000,000 11% 550,000 15,000,000 1,550,000 Weighted-average Interest Rate = 1550,000/15,000,0000 = 10.33% The above calculations furnish us with all the data needed to arrive at an estimate of avoidable interest. Funding Amount Rate Avoidable Interest Specific Loan 4,000,000 8% 320,000 General pool 500,000 10.33% 51,667 371,667 This $371,667 is the amount of interest that could have been avoided. This much interest can be capitalized provided it doesn’t exceed the actual interest expense for the period. KPKI should pass the following journal entry while recording the capitalized interest. Bridges-Indus $371,667 Interest expense $371,667 This would form part of the total cost of the bridge and will be amortized over the useful life of the bridge. LONG TERM ASSETS Long-term assets are the value of a company's property, equipment and other capital assets, minus depreciation. This is reported on the balance sheet. Be aware that long-term assets are usually recorded at the price at which they were purchased and do not always reflect the current value of the asset. Depreciation is an accounting convention that allows companies to expense an estimate for the portion of long -term operating assets used in the current year. It is a non-cash expense that inflates net income and thus is deducted from the purchase price of asset on a %age basis or any other methods of depreciation , and then shown in balance sheet. Subsequent expenditures refers to such costs which are incurred after the asset is recognized in the financial statement and brought to the location and condition intended. Examples of such expenditures include repair and maintenance, overhauling, upgradation, replacement costs etc. However, not all the subsequent costs can be capitalized in the carrying amount (carrying value or book value) of the asset in the statement of financial position.