amendments. [IAS 23.28A].
Developing a qualifying asset may take a long time. Moreover, the development of some
assets currently in use may have been completed many years ago. The costs of gathering
the information required to capitalise borrowing costs retrospectively may therefore be
significant. In addition, the nature of each development generally varies and therefore
retrospective application might not provide useful trend information to users of
financial statements. Accordingly, the IASB concluded that the costs of applying the
amendments retrospectively might exceed the potential benefits of doing so.
[IAS 23.BC18A].
5.3.2
Calculation of capitalisation rate
As the standard acknowledges that determining general borrowings will not always be
straightforward, it will be necessary to exercise judgement to meet the main objective
– a reasonable measure of the directly attributable finance costs.
The following example illustrates the practical application of the method of calculating
the amount of finance costs to be capitalised:
Example 21.1: Calculation of capitalisation rate (no investment income)
On 1 April 2019 a company engages in the development of a property, which is expected to take five years
to complete, at a cost of £6,000,000. The statements of financial position at 31 December 2018 and
31 December 2019, prior to capitalisation of interest, are as follows:
31 December
31 December
2018
2019
£
£
Development property
–
1,200,000
Other assets
6,000,000
6,000,000
6,000,000
7,200,000
Loans
5.5% debenture stock
2,500,000
2,500,000
Bank loan at 6% p.a.
–
1,200,000
Bank loan at 7% p.a.
1,000,000
1,000,000
3,500,000
4,700,000
Shareholders’ equity
2,500,000
2,500,000
The bank loan with an effective interest rate of 6% was drawn down to match the development expenditure
on 1 April 2019, 1 July 2019 and 1 October 2019.
Expenditure was incurred on the development as follows:
£
1 April 2019
600,000
1 July 2019
400,000
1 October 2019
200,000
1,200,000
Capitalisation of borrowing costs 1559
If the bank loan at 6% p.a. is a new borrowing specifically to finance the development then the amount of
interest to be capitalised for the year ended 31 December 2019 would be the amount of interest charged by
the bank of £42,000 ((£600,000 × 6% × 9/12) + (£400,000 × 6% × 6/12) + (£200,000 × 6% × 3/12)).
However, if all the borrowings were general (i.e. the bank loan at 6% was not specific to the development) and
would have been avoided but for the development, then the amount of interest to be capitalised would be:
Total interest expense for period
× Development
expenditure
Weighted average total borrowings
Total interest expense for the period
£
£2,500,000 × 5.5%
137,500
£1,200,000 (as above)
42,000
£1,000,000 × 7%
70,000
249,500
Therefore the capitalisation rate would be calculated as:
249,500
= 5.94%
3,500,000 + 700,000*
* Weighted average total borrowings is computed as the sum of £3,500,000 (or £3,500,000 × 12/12) and
£700,000 (or (£600,000 × 9/12) + (£400,000 × 6/12) + (£200,000 × 3/12)).
The capitalisation rate would then be applied to the expenditure on the qualifying asset, resulting in an amount
to be capitalised of £41,580 as follows:
£
£600,000 × 5.94% × 9/12
26,730
£400,000 × 5.94% × 6/12
11,880
£200,000 × 5.94% × 3/12
2,970
41,580
In this example, all borrowings are at fixed rates of interest and the period of
construction extends at least until the end of the period, simplifying the calculation. The
same principle is applied if borrowings are at floating rates i.e. only the interest costs
incurred during that period, and the weighted average borrowings for that period, will
be taken into account.
Note that the company’s shareholders’ equity (i.e. equity instruments – see further
discussion in 5.5.4 below) cannot be taken into account. Also, at least part of the
outstanding general borrowings is presumed to finance the acquisition or construction
of qualifying assets. Regardless of whether they are financing qualifying or non-
qualifying assets, all of the outstanding borrowings are presumed to be general
borrowings – unless they are specific borrowings used to obtain the same or another
qualifying asset not yet ready for its intended use or sale (see discussions in 5.3.1.A
and 5.3.1.B above).
The above example also assumes that loans are drawn down to match expenditure on
the qualifying asset. If, however, a loan is drawn down immediately and investment
income is received on the unapplied funds, then the calculation differs from that in
Example 21.1 above. This is illustrated in Example 21.2 below.
1560 Chapter 21
Example 21.2: Calculation of amount to be capitalised – specific borrowings
with investment income
On 1 April 2019 a company engages in the development of a property, which is expected to take five years
to complete, at a cost of £6,000,000. In this example, a bank loan of £6,000,000 with an effective interest rate
of 6% was taken out on 31 March 2019 and fully drawn. The total interest charge for the year ended
31 December 2019 was consequently £270,000.
However, investment income was also earned at 3% on the unapplied funds during the period as follows:
£
£5,400,000 × 3% × 3/12
40,500
£5,000,000 × 3% × 3/12
37,500
£4,800,000 × 3% × 3/12
36,000
114,000
Consequently, the amount of interest to be capitalised for the year ended 31 December 2019 is:
£
Total interest charge
270,000
Less: investment income
(114,000)
156,000
5.3.3
Accrued costs and trade payables
As noted in 5.3 above, IAS 23 states that expenditure on qualifying assets includes only
that expenditure resulting in the payment of cash, the transfer of other assets or the
assumption of interest-bearing liabilities. [IAS 23.18]. Therefore, in principle, costs of a
qualifying asset that have only been accrued but have not yet been paid in cash should
be excluded from the amount on which interest is capitalised, as by definition no
interest can have been incurred on an accrued payment. The same principle can be
applied to non-interest bearing liabilities e.g. non-interest-bearing trade payables or
retention money that is not payable until the asset is completed.
The e
ffect of applying this principle is often merely to delay the commencement of the
capitalisation of interest since the capital expenditure will be included in the calculation
once it has been paid in cash. If the time between incurring the cost and cash payment
is not that great, the impact of this may not be material.
5.3.4
Assets carried below cost in the statement of financial position
An asset may be recognised in the financial statements during the period of
production on a basis other than cost, i.e. it may have been written down below cost
as a result of being impaired. An asset may be impaired when its carrying amount or
expected ultimate cost, including costs to complete and the estimated capitalised
interest thereon, exceeds its estimated recoverable amount or net realisable value
(see 6.2.1 below).
The question then arises as to whether the calculation of interest to be capitalised
should be based on the cost or carrying amount of the impaired asset. In this case,
cost should be used, as this is the amount that the entity or group has had to finance.
In the case of an impaired asset, the continued capitalisation based on the cost of
the asset may well necessitate a further impairment. Accordingly, although the
Capitalisation of borrowing costs 1561
amount capitalised will be different, this should not affect net profit or loss as this is
simply an allocation of costs between finance costs and impairment expense.
5.4
Exchange differences as a borrowing cost
An entity may borrow funds in a currency that is not its functional currency e.g. a US
dollar loan financing a development in a company which has the Russian rouble as its
functional currency. This may have been done on the basis that, over the period of the
development, the borrowing costs, even after allowing for exchange differences, were
expected to be less than the interest cost of an equivalent rouble loan.
IAS 23 defines borrowing costs as including exchange differences arising from foreign
currency borrowings to the extent that they are regarded as an adjustment to interest
costs. [IAS 23.6(e)]. The standard does not expand on this point. In January 2008, the
Interpretations Committee considered a request for guidance on the treatment of
foreign exchange gains and losses and on the treatment of any derivatives used to hedge
such foreign exchange exposures. The Interpretations Committee decided not to add
the issue to its agenda because:
• the standard acknowledges that judgement will be required in its application and
appropriate disclosure of accounting policies and judgements would provide users
with the information they need to understand the financial statements; and
• the IASB had considered this issue when developing the new IAS 23 and had
decided not to provide any guidance.8
In our view, as exchange rate movements are partly a function of differential interest
rates, in many circumstances the foreign exchange differences on directly attributable
borrowings will be an adjustment to interest costs that can meet the definition of
borrowing costs. However, care is needed if there are fluctuations in exchange rates
that cannot be attributed to interest rate differentials. In such cases, we believe that a
practical approach is to limit exchange losses taken as borrowing costs such that the
total borrowing costs capitalised do not exceed the amount of borrowing costs that
would be incurred on functional currency equivalent borrowings, taking into
consideration the corresponding market interest rates and other conditions that existed
at inception of the borrowings.
If this approach is used and the construction of the qualifying asset takes more than one
accounting period, there could be situations where in one period only a portion of
foreign exchange differences could be capitalised. However, in subsequent years, if the
borrowings are assessed on a cumulative basis, foreign exchange losses previously
expensed may now meet the recognition criteria. The two methods of dealing with this
are illustrated in Example 21.3 below.
In our view, whether foreign exchange gains and losses are assessed on a discrete
period basis or cumulatively over the construction period is a matter of accounting
policy, which must be consistently applied. As alluded to above, IAS 1 –
Presentation of Financial Statements – requires clear disclosure of significant
accounting policies and judgements that are relevant to an understanding of the
financial statements (see 7.2 below).
1562 Chapter 21
Example 21.3: Foreign exchange differences in more than one period
Method A – The discrete period approach
The amount of foreign exchange differences eligible for capitalisation is determined for each period
separately. Foreign exchange losses that did not meet the criteria for capitalisation in previous years are not
capitalised in subsequent years.
Method B – The cumulative approach
The borrowing costs to be capitalised are assessed on a cumulative basis based on the cumulative
amount of interest expense that would have been incurred had the entity borrowed in its functional
currency. The amount of foreign exchange differences capitalised cannot exceed the amount of foreign
exchange losses incurred on a cumulative basis at the end of the reporting period. The cumulative
approach looks at the construction project as a whole as the unit of account ignoring the occurrence of
reporting dates. Consequently, the amount of the foreign exchange differences eligible for capitalisation
as an adjustment to the borrowing cost in the period is an estimate, which can change as the exchange
rates vary over the construction period.
An illustrative calculation of the amount of foreign exchange differences that may be capitalised under
Method A and Method B is set out below.
Year 1
Year 2
Total
$
$
$
Interest expense in foreign currency (A)
25,000
25,000
50,000
Hypothetical interest expense in functional
currency (B)
30,000
30,000 60,000
Foreign exchange loss (C)
6,000
3,000
9,000
Method A – Discrete Approach
Foreign exchange loss capitalised – lower
of C and (B minus A)
5,000
3,000 8,000
Foreign exchange loss expensed
1,000
– 1,000
Method B – Cumulative Approach
Foreign exchange loss capitalised
5,000 *
4,000 **
9,000
Foreign exchange loss expensed
1,000
(1,000)
–
*
Lower of C and (B minus A) in Year 1.
** Lower of C and (B minus A) in total across the two years. In this example this represents the sum of the foreign exchange loss of $3,000 capitalised using the discrete approach plus the $1,000 not capitalised in year 1.
5.5
Other finance costs as a borrowing cost
5.5.1
Derivative financial instruments
The most straightforward and commonly encountered
derivative financial instrument
used to manage interest rate risk is a floating to fixed interest rate swap, as in the
following example.
Example 21.4: Floating to fixed interest rate swaps
Entity A has borrowed €4 million for five years at a floating interest rate to fund the construction of a building.
In order to hedge the cash flow interest rate risk arising from these borrowings, A has entered into a matching
pay-fixed receive-floating interest rate swap, based on the same underlying nominal sum and duration as the
original borrowing, that effectively converts the interest on the borrowings to fixed rate. The net effect of the
periodic cash settlements resulting from the hedged and hedging instruments is as if A had borrowed
€4 million at a fixed rate of interest.
Capitalisation of borrowing costs 1563
These instruments are not addressed in IAS 23. IFRS 9 sets out the basis on which such
instruments are recognised and measured. See Chapter 49 regarding how to account for
effective hedges and the conditions that these instruments must meet.
An entity may consider that a specific derivative financial instrument, such as an interest
rate swap, is directly attributable to the acquisition, construction or production of a
qualifying asset. If the instrument does not meet the conditions for hedge accounting
then the effects on income will be different from those if it does, and they will also be
dissimilar from year to year. What is the impact of the derivative on borrowing costs
eligible for capitalisation? In particular, does the accounting treatment of the derivative
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 308
