1. Gripping IFRS Capitalisation of borrowing costs Chapter 11 Capitalisation of Borrowing CostsReference: IAS 23Contents: Page 1. Introduction and definitions 365 1.1 Overview 365 1.2 Borrowing costs 365 1.3 Qualifying assets 365 1.4 Qualifying borrowing costs 366 2. Expensing borrowing costs 366 2.1 Recognition 366 2.2 Measurement 366 Example 1: expensing borrowing costs 366 3. Capitalising borrowing costs 367 3.1 Recognition 367 3.1.1 Commencement of capitalisation 367 Example 2: capitalisation of borrowing costs: all criteria met at same time 367 Example 3: commencement of capitalisation: criteria met at different times 368 Example 4: commencement of capitalisation: criteria met at different times 368 3.1.2 Suspension of capitalisation 369 Example 5: delays in construction 369 3.1.3 Cessation of capitalisation 369 Example 6: end of construction 370 3.2 Measurement 370 3.2.1 Measurement: specific loans 372 Example 7: specific loans 372 Example 8: specific loans: costs paid on specific days 373 Example 9: specific loans: costs paid evenly over a period 374 Example 10: specific loans: loan raised before construction begins 375 3.2.2 Measurement: general loans 375 Example 11: general loan: costs incurred evenly 376 Example 12: general loan: costs incurred at the end of each month 377 Example 13: general loan: costs incurred at the start of each month 379 4. A comparison of the methods 380 5. Disclosure 380 6. Summary 382 364 Chapter 11

2. Gripping IFRS Capitalisation of borrowing costs1 Introduction and definitions1.1 OverviewIAS 23 was revised in March 2007. Those of you who have studied this standard previouslywill notice that in the previous version of IAS 23, accountants were able to choose between: the benchmark treatment (expensing borrowing costs); and the allowed alternative treatment (capitalising borrowing costs).In the revised version of IAS 23, however, you will notice that there is no reference at all tothe benchmark or allowed alternative treatments. The revised IAS 23 has it that accountantsmust capitalise borrowing costs (the previous allowed alternative treatment) that are incurredon qualifying assets. Thus borrowing costs on non-qualifying assets are always expensed.Therefore, IAS 23 now requires that an entity: capitalise borrowing costs that were incurred on a qualifying asset; and expense borrowing costs that were not incurred on a qualifying asset.Up until now you will have indirectly been exposed to borrowing costs where borrowingcosts are generally expensed (i.e. the presupposition in such examples would have been thatthe borrowing costs were not incurred on a qualifying asset). We will now learn how andwhen to capitalise borrowing costs. In a nutshell, borrowing costs that relate to qualifyingassets must be capitalised assuming that criteria for recognition of an asset are also met.One of the more significant reasons behind capitalising borrowing costs instead of expensingthem is that the cost of financing is generally a significant cost, and is generally a necessaryevil in order to bring an asset to a location and condition that makes it useable or saleable.Costs that are significant and necessary should surely form part of the assets cost. There arearguments against capitalizing borrowing costs as well, of course. These are discussed at theend of this chapter, but are largely academic now, given that there is no longer a choice.1.2 Borrowing costsBorrowing costs are those costs that are incurred by the entity in connection with theborrowing of funds.Other names often used for borrowing costs include: interest expense; and finance charges.Borrowings costs may include: interest incurred on loans (including bank overdraft); amortisation of discounts (or premiums); finance charges on finance leases; exchange difference on foreign loan accounts; and costs of raising debt.1.3 Qualifying assetsQualifying assets are those that take a substantial period of time to get ready for theirintended use or sale.Qualifying assets may include: manufacturing plants; power generation facilities; intangible assets; investment properties; and inventories. 365 Chapter 11

3. Gripping IFRS Capitalisation of borrowing costs1.4 Qualifying borrowing costs (IAS 23.8 - .10)Borrowing costs that must be capitalised to the cost of an asset are those that: are directly attributable to the acquisition, manufacture or production of a qualifying asset; and those that would have been avoided had the expenditure on the qualifying asset not been made.It is sometimes quite difficult to identify a direct link between borrowing costs incurred and aspecific asset since: the borrowings may not have been specifically raised for that asset, but may be general borrowings (i.e. the entity may have a range of debt instruments at a range of varying interest rates); the borrowings may not even be denominated in your local currency (i.e. the borrowings may be foreign borrowings); and the borrowings may be subject to hyper-inflation (borrowing costs that compensate for inflation are always expensed).The lists of complications are seemingly endless thus frequently requiring your professionaljudgement. These complications in calculation of the borrowing costs to be capitalised areexpanded upon in the section entitled measuement.2 Expensing borrowing costs2.1 Recognition (IAS 23.8 - .9)Whenever borrowing costs do not meet the conditions for capitalisation, they are expensed.Expensing borrowing costs simply means to include the borrowing costs as an expense inprofit or loss in the period in which they were incurred (i.e. as and when interest is charged inaccordance with the terms of the borrowing agreement).2.2 MeasurementThe amount of borrowing costs expensed is simply the amount charged by the lender inaccordance with the borrowing agreement.Example 1: expensing borrowing costsYay Limited incurred C100 000 interest (during the year ended 31 December 20X5) on a loanthat was used to finance the construction of a factory plant.The factory plant was not considered to be a qualifying asset.Required:Provided the necessary journal entries for expensing the interest in Yay Limiteds books forthe year ended 31 December 20X5.Solution to example 1: expensing borrowing costsComment:When to recognise an expense: when the interest is incurred.How much to expense: the amount of interest charged by the lender in terms of the agreement. Debit CreditFinance costs (expense) 100 000 Bank/ liability 100 000Interest incurred during the period is expensed 366 Chapter 11

4. Gripping IFRS Capitalisation of borrowing costs3 Capitalising borrowing costs3.1 Recognition (IAS 23.8 - .9)To capitalise borrowing costs simply means to include them in the cost of the relatedqualifying assets. In other words, the borrowing costs are recognised as an asset.Before the borrowing costs may be recognised as an asset, they must meet the basicrecognition criteria for an asset: future economic benefits must be probable; and the costs must be reliably measurable.Borrowing costs that must be capitalised are those: that are directly attributable to the acquisition, construction or production of a qualifying asset.Directly attributable means: if the assets had not been constructed, acquired or produced thenthese costs could have been avoided.An example of an acquisition is the purchase of a building. An example of the constructionof an asset is the building of a manufacturing plant. An example of the production of an assetis the manufacture of inventory.When to recognise borrowing costs as part of the asset (capitalisation) is affected by: Commencement date: capitalisation starts from the date on which certain criteria are met; Suspension period: capitalisation must stop temporarily when certain criteria are met; Cessation date: capitalisation must stop permanently when certain criteria are met.When borrowing costs are capitalised, the carrying amount of the asset will obviously beincreased by the borrowing costs incurred. The cost of these borrowings will eventuallyreduce profits, but only when the qualifying asset affects profit or loss (e.g. through thedepreciation expense when the qualifying asset is an item of property, plant and equipment).3.1.1 Commencement of capitalisation (IAS 23.17 - .19)Assuming the basic recognition criteria are met, an entity must start to capitalise borrowingcosts from the date that all the following criteria are met: the entity is preparing the asset for its intended use or sale (activity is happening); expenditure is being incurred by the entity in preparing the asset; and borrowing costs are being incurred.The date that all three criteria are met is known as the commencement date.Example 2: capitalisation of borrowing costs - all criteria met at same timeYippee Limited incurred C100 000 interest on a loan used to finance the construction of abuilding during the year ended 31 December 20X5: The building was considered to be a qualifying asset. Construction of the building began on 1 January 20X5, when the loan was raised. It is probable that the building would result in future economic benefits and the borrowing costs are reliably measurable. The construction of the building began as soon as the loan was raised.Required:Provide the necessary journal entries to capitalise the borrowing costs in Yippee Limitedsbooks for the year ended 31 December 20X5. 367 Chapter 11

5. Gripping IFRS Capitalisation of borrowing costsSolution to example 2: capitalisation of borrowing costs - all criteria met at same timeComment: Interest must be recognised as part of the cost of the qualifying asset. Interest is recognisedas part of the asset (capitalisation) from the time that all criteria for capitalisation are met. All criteriaare met on the same date (1 January 20X5): a loan is raised on 1 January 20X5 on which interest is being incurred; activities start on 1 January 20X5; and expenditure related to the activities start on 1 January 20X5 is being incurred.The basic recognition criteria are also met and therefore the amount to be capitalised is calculated from1 January 20X5. Debit CreditFinance costs (expense) 100 000 x 12 / 12 100 000 Bank/ liability 100 000Interest on the loan incurred first expensedBuilding: cost (asset) 100 000 x 12 / 12 100 000 Finance costs (expense) 100 000Interest on the loan capitalised to the cost of the buildingExample 3: commencement of capitalisation - criteria met at different timesDawdle Limited borrowed C100 000 on the 30 June 20X5 to build a factory to store its goods.The necessary building materials were only available on 31 August 20X5 and it was then thatDawdle Limited began construction. The building is considered to be a qualifying asset.Required:Discuss when Dawdle Limited may begin capitalising the interest incurred.Solution to example 3: commencement of capitalisation - criteria met at different timesAll three criteria must be met before the entity may begin capitalisation. From the 30 June 20X5,Dawdle Limited borrowed funds and began incurring borrowing costs, but had not yet met the othertwo criteria (activities were not underway and costs on the asset were not being incurred). On the31 August 20X5, however, Dawdle both acquired the construction materials and began constructionthereby fulfilling all three criteria. Dawdle Limited may therefore only begin capitalising theborrowing costs on the 31 August 20X5 (assuming that it was probable that the building would renderfuture economic benefits and that the costs were considered reliably measurable).Example 4: commencement of capitalisation - criteria met at different timesHoorah Limited incurred C100 000 interest for the year ended 31 December 20X5 on a loanof C1 000 000, raised on 1 January 20X5. The loan was raised to finance the construction ofa building during the year ended 31 December 20X5. The building is a qualifying asset.Construction began on 1 February 20X5.Required:Provide the necessary journal entries to capitalise the borrowing costs in Hoorah Limitedsbooks for the year ended 31 December 20X5.Solution to example 4: commencement of capitalisation - criteria met at different timesComment: Borrowing costs are being incurred from 1 January 20X5, but activities and relatedexpenditure are only incurred from 1 February 20X5: all three criteria for capitalisation are thereforeonly met from 1 February 20X5 and therefore capitalisation may only occur from this date: 368 Chapter 11

6. Gripping IFRS Capitalisation of borrowing costs20X5 Debit CreditFinance costs (expense) 100 000 x 12 / 12 100 000 Bank/ liability 100 000Interest on the loan incurred first expensed: total interest incurred forthe year (given: 100 000)Building: cost (asset) 100 000 x 11 / 12 91 667 Finance costs (expense) 91 667Interest on the loan capitalised to the cost of the building; fromcommencement date (1 February 20X5)3.1.2 Suspension of capitalisation (IAS 23.20 - .21)If the active development of the qualifying asset is interrupted or delayed for a long period oftime, the capitalisation of the borrowing costs must be suspended.Capitalisation of borrowing costs must not be suspended, however, if: the delay is only temporary; if the delay is due to substantial technical or administrative work; or if the delay is a necessary part of getting the asset ready for its intended use.A typical example of when borrowing costs should continue to be capitalised despite a delayis a wine farm that has to wait for its inventory of wine to mature in order to ensure a saleablecondition. In this case, borrowing costs that are incurred during this period of maturationwould continue to be capitalised to the cost of the inventory of wine.Example 5: delays in constructionA hotel is under construction in 20X5. Borrowing costs of C300 000 are incurred on a loanduring 20X5. The loan was specifically raised on 1 January 20X5 for the sole purpose of theconstruction of the hotel.Required:Discuss how much of the interest may be capitalised assuming that:A. The builders go on strike for a period of two months, during which no progress is made.B. The builders of the hotel had to wait for five days for the cement in the foundations to dry.Solution to example 5: delays in constructionA. During these two months, the interest incurred may not be capitalised to the asset as it is a substantial and unnecessary interruption to the construction process.B. The borrowing costs must still be capitalised as it is merely a temporary delay and is a normal part of the construction process.3.1.3 Cessation of capitalisationThe entity must stop capitalising borrowing costs when the asset: is ready for its intended use or sale; or is substantially complete and capable of being used or sold.By way of example, capitalisation would cease if routine administration work or minormodifications are all that remains to be done (e.g. decoration of a new building to the clientsspecifications) in order to bring the asset to a useable or saleable condition.If an asset is completed in parts where each part is capable of being used separately from theother parts, then capitalisation of borrowing costs ceases on each part as and when each part iscompleted. An example of such an asset would be an office park: as office blocks are 369 Chapter 11

7. Gripping IFRS Capitalisation of borrowing costscompleted, these office blocks may begin to be used by tenants. An example of an asset thatwould not be capable of being used or sold in parts is a factory plant that requires parts to bemade in sequence and where the plant becomes operational only when all parts are completed.Example 6: end of constructionFlabby Limited began construction of a block of flats on 1 January 20X5. The block of flatsis to be leased out to tenants in the future.On 1 January 20X5, Flabby Limited correctly began capitalising borrowing costs (on aC2 000 000 loan raised for the construction) to the cost of the property.On 30 September 20X5, the building of the block was complete but no tenants could befound. On 15 November 20X5, however, after lowering the rentals, the entire building wasrented out to tenants.Interest of C200 000 (at 10% on the loan) was incurred during the 12-month period ended31 December 20X5.Required:Discuss when Flabby Limited should stop capitalising the interest expense to the asset(building) and show the journal entries relating to interest.Solution to example 6: end of constructionCapitalisation should cease when: the asset is ready for its intended use or sale.On the 30 September 20X5 the construction was completed. Although the asset was not being leased itwas ready to be leased to tenants on 30 September 20X5, and therefore capitalisation must cease on30 September 20X5 (because one of the three criteria for capitalisation is no longer met: activity hasceased). All subsequent interest incurred must be expensed.Journals in 20X5: Debit CreditFinance costs (expense) 200 000 Bank/ liability 200 000Interest incurred: 200 000 (given)Building (asset) 150 000 Finance costs (expense) 150 000Interest capitalised: 200 000 x 9 / 12 (to completion date: 30/9/20X5)3.2 Measurement (IAS 23.10 - .15)Not all borrowing costs may be capitalised. The list of borrowing costs that may becapitalised are given in IAS 23 and are included under paragraph 1.2 above.Notice that this list excludes certain costs associated with raising funds or otherwise financinga qualifying asset. This suggests that costs that do not appear on this list may not becapitalised. Borrowing costs therefore exclude: cost of raising share capital that is recognised as equity, for example: - dividends on ordinary share capital; - dividends on non-redeemable preference share capital (dividends on redeemable preference share capital may be capitalised because redeemable preference shares are recognised as liabilities and not equity); cost of using internal funds (e.g. if one uses existing cash resources instead of borrowing more funds, there is a indirect cost being the lost income, often measured using the 370 Chapter 11

8. Gripping IFRS Capitalisation of borrowing costs companies weighted average cost of capital or the market interest rates that could otherwise have been earned); foreign exchange differences that are incurred as a result of acquiring the qualifying asset on credit terms with no interest charged (e.g. if an asset is purchased for $ 1 000 on 1 January 20X1 when the exchange rate is C7: $1, then the entity owes C7 000 on the transaction date, but if the payment is only necessary on 30 June 20X1 and if the payment is made on this date, and if the exchange rate is C10: $1 on this date, then the entity will have to pay C10 000: the asset will be recorded at C7 000 and the C3 000 exchange difference will have to be expensed since it does not relate to a borrowing cost).The formula used to measure the borrowing costs that may be capitalised depends on thesource of the borrowings. There are two sources of borrowings, which include: specific borrowings and general borrowings.Unfortunately IAS 23 does not define what is meant by specific and general borrowings. Thedifference between specific and general borrowings can, however, be explained as follows: specific borrowings are taken out for the sole purpose of financing the construction, acquisition or production of a qualifying asset; whereas general borrowings are those funds that are entered into for a general purpose. These funds may be utilised for buying inventory, paying off creditors and a multitude of other purposes in addition to the construction, acquisition or production of a qualifying asset.When determining whether your borrowings are either general or specific, it is useful toremember that whilst a bank overdraft facility is often used as general purpose borrowings, itis also possible for a bank overdraft facility to be arranged specifically for a qualifying asset.The particular circumstances should, therefore, always be considered when deciding whetherthe borrowing is specific or general.Measuring the borrowing costs to be capitalised is sometimes more complicated that it firstappears. The basic questions that one needs to answer when measuring the borrowing coststo be capitalised include: are the borrowings specific or general or is there a mix of both specific and general? is the borrowing a precise amount (e.g. a loan) or does it increase as expenditure is paid for (e.g. a bank overdraft)? are the expenditures (on which interest is incurred) incurred evenly or at the beginning or end of a period or at haphazard times during a period? how long are the periods during which capitalisation is allowed?In considering whether the borrowings specific or general or is there a mix of both specificand general, remember that: where the borrowings are specific: - you will need the actual rate of interest/s charged on the borrowing/s; and - you will need to ascertain whether any surplus borrowings were invested upon which interest income was earned (if so, remember to reduce the interest expense by the interest income); where the borrowings are general: - you will need the weighted average rate of interest charged (assuming there is more than one general borrowing outstanding during the period);In considering whether the borrowing is a precise amount (e.g. a loan) or whether it increaseas expenditure is paid for (e.g. a bank overdraft), bear in mind that: if the borrowing is a loan ( a precise amount), you will use the capital sum; and if the borrowing is an overdraft (a fluctuating amount), you will use the relevant expenditures and will need to know when they were incurred (or whether they were incurred relatively evenly). 371 Chapter 11

9. Gripping IFRS Capitalisation of borrowing costsIn assessing whether the expenditures (on which interest is incurred) are incurred evenly or atthe beginning or end of a period or at haphazard times during a period, bear in mind that: interest expense can be measured using average borrowing balances if the costs are incurred evenly, whereas actual borrowing balances should be used (whether specific or general borrowings) if costs are incurred at the beginning or end of a period; and interest income should be measured using average investment balances if the costs are incurred evenly, whereas actual investment balances should be used (if it is a specific borrowing) if costs are incurred at the beginning or end of a period,.In determining the periods during which capitalisation must occur, you will need to know: the commencement date: borrowings may be outstanding (and incurring interest) before commencement date in which case interest expense (and interest income on any surplus funds invested) up to commencement date must be ignored when calculating the portion to be capitalised; the cessation date: borrowings may be outstanding (and incurring interest) after cessation date in which case interest expense (and interest income on any surplus funds invested) after cessation date must be ignored when calculating the portion to be capitalised; and whether there was a suspension period between these two dates: borrowings may be outstanding (and incurring interest) during a suspension period in which case interest expense (and interest income on any surplus funds invested) during this period must be ignored when calculating the portion to be capitalised.3.2.1 Measurement: specific loans (IAS 23.12 - .13)All of the borrowing costs incurred on a specific loan are capitalised to the asset. If thesefunds are invested prior to the date they were utilised then any interest earned must besubtracted from the interest incurred (borrowing costs), in which case only the net amountmay be capitalised.Example 7: specific loansYahoo Limited borrowed C500 000 from the bank on 1 January 20X5 to begin theconstruction of a building. The interest payable on the loan during 20X5 was C50 000(calculated at 10%). The company invested all surplus funds raised in a fixed deposit andearned C24 000 interest during 20X5. No capital portion of the loan was repaid during theyear ended 31 December 20X5. All criteria for capitalisation of borrowing costs were meton 1 January 20X5. The building is a qualifying asset.Required:Calculate the amount of borrowing costs that must be capitalised in terms of IAS 23 and showthe necessary journal entries.Solution to example 7: specific loansComment: this example shows that interest income is used to reduce the amount of borrowings thatmay be capitalised when the borrowing is a specific borrowing. Calculations: CInterest incurred 500 000 x 10% 50 000Interest earned given (24 000)Total to be capitalised 26 000 Debit CreditFinance costs (expense) 50 000 Bank/ liability 50 000Interest incurred on the loan first expensed 372 Chapter 11

10. Gripping IFRS Capitalisation of borrowing costs Debit CreditBank/ liability 24 000 Interest income 24 000Interest income earned on investment of surplus loan fundsBuilding: cost (asset) 50 000 24 000 26 000 Finance costs (expense) 26 000Portion of interest on the loan capitalised to the cost of the buildingWhen calculating the interest income you may find that actual amounts invested can be used.This happens when, for example, the expenditures are infrequent and/ or happen at the start orend of a period. This will mean that the investment balance will remain unchanged for aperiod of time. The calculation of the amount of borrowing costs on specific borrowings thatmust be capitalised is therefore: total interest incurred on specific borrowings: capital borrowed x interest rate x period borrowed less interest income earned from investment of surplus borrowings: amount invested x interest rate x period invested.Very often, however, average amounts invested need to be used instead of actual amountsinvested. This happens more frequently when the borrowing is a general borrowing, but canapply to a specific borrowing where, for example, the expenditure is paid relatively evenlyover a period of time, with the result that the balance on the investment account (being thesurplus borrowings that are invested) is constantly changing. In this case, it is normallyacceptable to calculate the interest earned on the average investment balance over a period oftime (rather than on the actual balance on a specific day). The calculation of the amount ofborrowing costs on specific borrowings that must be capitalised could therefore be: total interest incurred on specific borrowings: capital borrowed x interest rate x period borrowed less interest income earned from investment of surplus borrowings: (investment o/ balance + investment c/ balance) / 2 x interest rate x period investedExample 8: specific loans costs paid on specific daysHaha Limited borrowed C500 000 from the bank on 1 January 20X5 to begin theconstruction of a building (a qualifying asset). Construction began on 1 January 20X5 (i.e.all criteria for capitalisation of borrowing costs were met). The interest rate payable on theloan was 10%. The company paid construction costs of C400 000 on 1 March 20X5.Surplus funds were invested in a fixed deposit and earned interest at 6% per annum. Nocapital portion of the loan was repaid during the year ended 31 December 20X5.Required:Calculate the amount of borrowing costs that must be capitalised.Solution to example 8: specific loans costs paid on specific daysComment: The borrowings are raised two months before they were required. These surplus funds areinvested for January and February and the balance on this account for these two months remains stableat C500 000. On March, however, payments totaling C400 000 are made, thus reducing the investmentbalance to C100 000. This balance remains stable for the remaining ten months of the year. Since theexpenditure is not incurred evenly over a period but is incurred on a specific day, the interest incomefor the purposes of the calculation of the borrowing costs to be capitalised should be calculated usingthe actual investment balances (C500 000 for 2 months and C100 000 for 10 months). Calculations: CBorrowing costs incurred 500 000 x 10% x 12 / 12 50 000Interest earned 500 000 x 6% x 2 / 12 + (500 000 400 000) x 6% x 10/ 12 (10 000)Capitalised borrowing costs 40 000 373 Chapter 11

11. Gripping IFRS Capitalisation of borrowing costs Debit CreditFinance costs (expense) 50 000 Bank/ liability 50 000Interest incurred on the loan is first expensedBank/ liability 10 000 Interest income 10 000Interest income earned on investment of surplus loan fundsBuilding: cost (asset) 40 000 Finance costs (expense) 40 000Portion of interest on the loan capitalised to the cost of the buildingExample 9: specific loans costs paid evenly over a periodHooray Limited borrowed C500 000 from the bank on 1 January 20X5 to begin theconstruction of a building (a qualifying asset).Construction begins on 1 January 20X5 (all criteria for capitalisation of borrowing costswere met on this date).The interest rate payable on the loan was 10%.The company paid construction costs of C400 000 evenly between 1 March 20X5 and31 December 20X5.Surplus funds are invested in a fixed deposit and earned interest at 6% per annum. Nocapital portion of the loan was repaid during the year ended 31 December 20X5.Required:Calculate the amount of borrowing costs that must be capitalised.Solution to example 9: specific loans costs paid evenly over a periodComment: The borrowings are raised two months before they were required. These surplus funds areinvested for January and February and the balance on this account for these two months remains stableat C500 000. From March, however, the amount invested gradually reduces as payments are made (thebalance of C500 000 on 1 March gradually decreases to a balance of C100 000 (C500 000 C400 000)on 31 December. Since the payments are incurred evenly over this ten-month period, the interestincome for the purposes of the calculation of the borrowing costs to be capitalised may be calculatedusing the average of these two balances (C500 000 and C100 000). Calculations: CInterest incurred 500 000 x 10% x 12 / 12 50 000Interest earned (500 000 x 6% x 2 / 12) + (500 000 + 100 000) / 2 x 6% x 10/ 12 (20 000)Capitalised borrowing costs 30 000 Debit CreditFinance costs (expense) 50 000 Bank/ liability 50 000Interest incurred on the loan is first expensedBank/ liability 20 000 Interest income 20 000Interest income earned on investment of surplus loan fundsBuilding: cost (asset) 30 000 Finance costs (expense) 30 000Portion of interest on the loan capitalised to the cost of the building 374 Chapter 11

12. Gripping IFRS Capitalisation of borrowing costsExample 10: specific loans loan raised before construction beginsYeeha Limited borrowed C500 000 from the bank on 1 January 20X5 to begin theconstruction of a building (a qualifying asset).Construction began on 1 February 20X5 (i.e. all criteria for capitalisation of borrowingcosts were met on this date).The interest rate payable on the loan is 10%.The company paid construction costs of C400 000 on 1 March 20X5.Surplus funds are invested in a fixed deposit and earned interest at 6% per annum.No capital portion of the loan was repaid during the year ended 31 December 20X5.Required: Calculate the amount of borrowing costs that may be capitalised.Solution to example 10: specific loans loan raised before construction beginsCompare this to example 8, in which the construction began on 1 January 20X5. In this example, theloan is taken out before construction begins. All criteria for capitalisation are therefore only met on1 February 20X1 (commencement date) and therefore the interest that is incurred/ earned before thisdate must be ignored for the purpose of calculating the portion of interest to be capitalised. Calculations: CInterest incurred after 500 000 x 10% x 11 / 12 45 833commencement date (i.e. excludes January interest expense)Interest earned after (500 000 x 6% x 1 / 12) + (500 000 - 400 000) x 6% x 10 / 12 (7 500)commencement date (i.e. excludes January interest income)Capitalised borrowing costs 38 333 Debit CreditFinance costs (expense) 50 000 Bank/ liability 50 000Interest incurred on the loan first expensed: 500 000 x 10% x 12/ 12Bank/ liability 10 000 Interest income 10 000Interest income earned on investment of surplus loan funds:(500 000 x 6% x 2 / 12) + (500 000 400 000) x 6% x 10 / 12Building: cost (asset) 38 333 Finance costs (expense) 38 333Portion of interest on the loan capitalised to the cost of the building3.2.2 Measurement: general loans (IAS 17.14 - .15)General loans are used for many purposes and therefore it cannot be said that all the interestincurred thereon was directly attributable to the qualifying asset. Therefore, not all theinterest incurred on a general loan may be capitalised to the asset.If the entity has used a general loan for a qualifying asset, the costs eligible for capitalisationare the weighted average cost of borrowings, calculated as follows: capitalisation rate x the average expenditure relating to the qualifying asset. The capitalisation rate is: the weighted average interest rate on the loans borrowed by the entity. The average expenditure is: expenditure for the period / 2The total amount of interest capitalised may not exceed the total interest paid or incurred. 375 Chapter 11

13. Gripping IFRS Capitalisation of borrowing costsExample 11: general loans costs incurred evenlyBizarre Limited had a C500 000 7% existing general loan outstanding on 1 January 20X5. Itraised an additional general loan of C600 000 on 1 January 20X5 at an interest rate of 12.5%.Bizarre Limited did not make any repayments on either loan during the year.Construction began on 1 January 20X5.The company spent the following amounts per month on the construction of a building, aqualifying asset: C per month 1 January 31 July (7 months) 50 000 1 August 30 November (4 months) 30 000 1 31 December (1 month) 100 000Required:Calculate the amount of borrowing costs that must be capitalised and provide the necessaryjournal entries for the year ended 31 December 20X5, assuming that the amounts were spentevenly during each month.Solution to example 11: general loans costs incurred evenlyComment: There are two borrowings, both of which are general borrowings and therefore theborrowing costs to be capitalised is based on the expenditures incurred and the weighted averageinterest rate. Since the expenditures are incurred evenly, average expenditures are used. Since theborrowings are general, one does not consider interest income in the calculation of the amount to becapitalised.W1: Borrowing costs to be capitalisedThe loans are general loans and therefore the formula is: Capitalisation rate x Average expenditure. Capitalisation rate (weighted average interest rate): = interest incurred on general borrowings/ borrowings outstanding during the period = [(C500 000 x 7% x 12 / 12) + (C600 000 x 12.5% x 12 / 12)] / 1 100 000 total borrowings = 10% Cumulative expenditure C 1 January 20X5 Opening balance 0 January July 50 000 x 7 months 350 000 31 July 20X5 Closing balance 350 000 August - November 30 000 x 4 months 120 000 30 November 20X5 Closing balance 470 000 December 100 000 x 1 month 100 000 31 December 20X5 Closing balance 570 000 Capitalisation rate x average expenditure: C Jan July (0 + 350 000) / 2 x 10% x 7 / 12 months; 10 208 OR: (50 000 x 7 months) / 2 x 10 % x 7 / 12 months Aug Nov (350 000 + 470 000) / 2 x10% x 4 / 12 months; 13 667 OR: {(30 000 x 4 months) / 2 + 50 000 x 7} x 10 % x 4 / 12 months Dec (470 000 + 570 000) / 2 x 10% x 1 / 12 months; 4 333 OR {(100 000 x 1) / 2 + 50 000 x 7 + 30 000 x 4 }x 10% x 1/ 12 Total to be capitalised: 28 208 376 Chapter 11

14. Gripping IFRS Capitalisation of borrowing costsThe above calculation can be done the long way around, if preferred:Expense incurred evenly during each month Balance (A) Expense (B) Balance (C ) Balance (D ) Interest % Months CapitaliseJanuary 0 50 000 50 000 25 000 10% 1 208February 50 000 50 000 100 000 75 000 10% 1 625March 100 000 50 000 150 000 125 000 10% 1 1 042April 150 000 50 000 200 000 175 000 10% 1 1 458May 200 000 50 000 250 000 225 000 10% 1 1 875June 250 000 50 000 300 000 275 000 10% 1 2 292July 300 000 50 000 350 000 325 000 10% 1 2 708August 350 000 30 000 380 000 365 000 10% 1 3 042September 380 000 30 000 410 000 395 000 10% 1 3 292October 410 000 30 000 440 000 425 000 10% 1 3 542November 440 000 30 000 470 000 455 000 10% 1 3 792December 470 000 100 000 570 000 520 000 10% 1 4 333 570 000 28 209Balance (A): first day of the monthExpense (B): incurred on the last day of the monthBalance (C): last day of the monthBalance (D): average balance = (A + C) / 2Capitalise: interest expense that may be capitalised: Balance (A) x interest rate x 1 / 12Capitalisation rate (weighted average interest rate): see calculation aboveJournals in 20X5: Debit CreditBuilding (asset) 570 000 Bank/ liability 570 000Construction costs incurred: 50 000 x 7 + 30 000 x 4 + 100 000 x 1This journal would actually be processed separately for each andevery payment but is shown here as a cumulative journal for easeFinance costs (expense) 110 000 Bank/ liability 110 000Finance costs incurred: 500 000 x 7% + 600 000 x 12.5%Building (asset) 28 209 Finance costs (expense) 28 209Finance costs capitalised: (W1)Example 12: general loans costs incurred at the end of each monthBizarre Limited had a C500 000 7% existing general loan outstanding on 1 January 20X5. Itraised an additional general loan of C600 000 on 1 January 20X5 at an interest rate of 12.5%.Bizarre Limited did not make any repayments on either loan during the year.Construction began on 1 January 20X5.The company spent the following amounts per month on the construction of a building, aqualifying asset: C per month 1 January 31 July 50 000 1 August 30 November 30 000 1 31 December 100 000Required:Calculate the amount of borrowing costs that must be capitalised and provide the necessaryjournal entries for the year ended 31 December 20X5, assuming that the amounts were paid atthe end of each month. 377 Chapter 11

15. Gripping IFRS Capitalisation of borrowing costsSolution to example 12: general loans costs incurred at the end of each monthComment: There are two borrowings, both of which are general borrowings and therefore the interest tobe capitalised is based on the expenditures incurred and the weighted average interest rate. Since theexpenditures are incurred at the end of the month, actual expenditures should be used instead(assuming the difference between using actual and average expenses is considered by the entity to bematerial). The interest is calculated as follows: the opening balance at the beginning of each monthmultiplied by the weighted average interest rate multiplied by 1/ 12.W1: Borrowing costs to be capitalisedThe loans are general loans and therefore the formula is: Capitalisation rate x Average expenditure.Expense incurred at end of each month Balance (A) Expense (B) Balance (C ) Interest Months Capitalise (D)January 0 50 000 50 000 10% 1 0February 50 000 50 000 100 000 10% 1 417March 100 000 50 000 150 000 10% 1 833April 150 000 50 000 200 000 10% 1 1 250May 200 000 50 000 250 000 10% 1 1 667June 250 000 50 000 300 000 10% 1 2 083July 300 000 50 000 350 000 10% 1 2 500August 350 000 30 000 380 000 10% 1 2 917September 380 000 30 000 410 000 10% 1 3 167October 410 000 30 000 440 000 10% 1 3 417November 440 000 30 000 470 000 10% 1 3 667December 470 000 100 000 570 000 10% 1 3 917 570 000 25 835Balance (A): balance on the first day of the monthExpense (B): incurred on the last day of the monthBalance (C): balance on the last day of the monthCapitalise (D): interest expense that may be capitalised: A x interest rate x 1 / 12Capitalisation rate (weighted average interest rate): = interest incurred on general borrowings/ borrowings outstanding during the period = [(C500 000 x 7% x 12 / 12) + (C600 000 x 12.5% x 12 / 12)] / 1 100 000 total borrowings = 10%Journals in 20X5: Debit CreditBuilding (asset) 570 000 Bank/ liability 570 000Construction costs incurred: 50 000 x 7 + 30 000 x 4 + 100 000 x 1This journal would actually be processed separately for each andevery payment but is shown here as a cumulative journal for easeFinance costs (expense) 110 000 Bank/ liability 110 000Finance costs incurred: 500 000 x 7% + 600 000 x 12.5%Building (asset) 25 835 Finance costs (expense) 25 835Finance costs capitalised: (W1) 378 Chapter 11

16. Gripping IFRS Capitalisation of borrowing costsExample 13: general loans costs incurred at the start of each monthBizarre Limited had a C500 000 7% existing general loan outstanding on 1 January 20X5. Itraised an additional general loan of C600 000 on 1 January 20X5 at an interest rate of 12.5%.Bizarre Limited did not make any repayments on either loan during the year.Construction began on 1 January 20X5.The company spent the following amounts per month on the construction of a building, aqualifying asset: C per month 1 January 31 July 50 000 1 August 30 November 30 000 1 31 December 100 000Required:Calculate the amount of borrowing costs that must be capitalised and provide the necessaryjournal entries for the year ended 31 December 20X5, assuming that the amounts were paid atthe beginning of each month.Solution to example 13: general loans costs incurred at the start of each monthComment: There are two borrowings, both of which are general borrowings and therefore the interest tobe capitalised is based on the expenditures incurred and the weighted average interest rate. Since theexpenditures are incurred at the beginning of each month, actual expenditures should be used instead(assuming that the difference between using actual and average expenses is considered by the entity tobe material). The interest is calculated as: the opening balance at the beginning of each monthmultiplied by the weighted average interest rate multiplied by 1/ 12.W1: Borrowing costs to be capitalisedThe loans are general loans and therefore the formula is: Capitalisation rate x Average expenditure.Expense incurred at beginning of each month Balance (A) Expense (B) Balance (C ) Interest % Months CapitaliseJanuary 0 50 000 50 000 10% 1 417February 50 000 50 000 100 000 10% 1 833March 100 000 50 000 150 000 10% 1 1 250April 150 000 50 000 200 000 10% 1 1 667May 200 000 50 000 250 000 10% 1 2 083June 250 000 50 000 300 000 10% 1 2 500July 300 000 50 000 350 000 10% 1 2 917August 350 000 30 000 380 000 10% 1 3 167September 380 000 30 000 410 000 10% 1 3 417October 410 000 30 000 440 000 10% 1 3 667November 440 000 30 000 470 000 10% 1 3 917December 470 000 100 000 570 000 10% 1 4 750 570 000 30 585Balance (A): balance on the first day of the month before payment of expenseExpense (B): incurred on the first day of the monthBalance (C): adjusted balance on the first day of the month after payment of expenseCapitalise: interest expense that may be capitalised: C x interest rate x 1 / 12Capitalisation rate (weighted average interest rate): = interest incurred on general borrowings/ borrowings outstanding during the period = [(C500 000 x 7% x 12 / 12) + (C600 000 x 12.5% x 12 / 12)] / 1 100 000 total borrowings = 10% 379 Chapter 11

17. Gripping IFRS Capitalisation of borrowing costsJournals in 20X5: Debit CreditBuilding (asset) 570 000 Bank/ liability 570 000Construction costs incurred: 50 000 x 7 + 30 000 x 4 + 100 000 x 1This journal would actually be processed separately for each andevery payment but is shown here as a cumulative journal for easeFinance costs (expense) 110 000 Bank/ liability 110 000Finance costs incurred: 500 000 x 7% + 600 000 x 12.5%Building (asset) 30 585 Finance costs (expense) 30 585Finance costs capitalised: 30 585 (W1)4 A comparison of the methodsIt is interesting to note that many accountants expected the revised IAS 23 to make theexpensing of borrowing costs compulsory and to outlaw the capitalisation thereof not theother way around! There are arguments both for and against the capitalisation of borrowingcosts.Some argue that the capitalisation of borrowing costs is more appropriate than the expensingthem because: interest should not be treated any differently to the other directly attributable costs that are capitalised in terms of IAS 16: Property, Plant and Equipment (improves consistency); if the entity had purchased the qualifying asset, the construction company (seller) would have included any borrowing costs that they incurred into the purchase price: it therefore improves comparability between companies that purchase assets and those that construct their own (improves comparability); and if the entity does not capitalise the borrowing costs, it will result in a decrease in their profit, merely because they decided to self-construct the asset. A better approach, it is argued, would be to recognise the borrowing costs as part of the cost of the asset and then recognise these costs as an expense (e.g. depreciation) over the period that the asset is used and earns revenue (improves matching of expense to income).Some of the arguments against capitalizing borrowing costs include: borrowing costs incurred when constructing an asset should be expensed in the period in which they are incurred, just as any other finance costs would be (improves consistency and matching of expenses to the period in which they were incurred); the calculation of the portion of the borrowing costs to be capitalised is, in practice, very subjective and could therefore result in errors and manipulation and therefore expensing the actual borrowing costs incurred is less prone to error (improves reliability); and when interest is treated as an expense, cash flows for the period will approximate the profit for the period, which is more useful to the user (improves relevance) since it helps to predict cash flows.5 Disclosure (IAS 23.26)The entity must disclose the following in the financial statements: the total amount of borrowing costs capitalised; the amount of borrowing costs expensed as finance costs in the statement of comprehensive income (this is an IAS 1 requirement not a requirement of IAS 21); the capitalisation rate used to calculate the borrowing costs for a general loan. 380 Chapter 11

18. Gripping IFRS Capitalisation of borrowing costsCompany nameStatement of comprehensive income (extracts)For the year ended 31 December 20X5 20X4 Note C CProfit before finance costs x xFinance costs 3. X XProfit before tax x xOther comprehensive income x xTotal comprehensive income x xCompany nameNotes to the financial statement (extracts)For the year ended 31 December3. Finance costs 20X5 20X4 C C Interest incurred Z Z Less interest capitalised IAS 23 requirement (Y) (Y) Finance cost expense IAS 1 requirement X X 381 Chapter 11

19. Gripping IFRS Capitalisation of borrowing costs 6. Summary IAS 23 Borrowing costs Expense Capitalise If not related to a qualifying asset If it relates to a qualifying asset and meets all criteria for capitalisation Qualifying borrowing costs Capitalise borrowing costs that relate to costs: directly attributable to the acquisition, construction or production of a qualifying asset and if future economic benefits are probable and costs can be reliably measured Qualifying asset those that take a long time to get ready Measurement General borrowings Specific borrowings Capitalise borrowing costs using Capitalise the total amount of the following formula: borrowing costs actually incurred Capitalisation rate (CR) x the Less any interest income earned expenditure; on the temporary investment of but limit to the actual borrowing any surplus borrowings costs incurred CR = weighted average borrowing costs divided by the general outstanding borrowings Start Pause Stop Interest is being the construction of the the asset is ready for incurred; asset is interrupted or its intended use or Expenditure on the delayed for a long period of sale; production of the time; (or if it is substantially asset is being (do not pause if the delay ready). incurred; and is necessary). Activities are in progressThis is thecommencement date 382 Chapter 11