When a company builds something big like a factory, a power plant, or even a large office building, it often borrows money to finance the construction. The cost of borrowing this money is what we call "borrowing costs."
IAS 23 provides guidance on how to account for these borrowing costs, specifically whether they should be recorded as an expense or included in the cost of the asset being constructed. Let’s break it down step by step.
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What Are Borrowing Costs?
Borrowing costs are essentially the interest and other costs that a company incurs when it takes out a loan. These costs might include:
- Interest on bank loans.
- Interest on bonds issued by the company.
- Amortization of discounts and premiums related to borrowings
- Amortization of ancillary costs incurred in connection with the arrangement of borrowing
- Finance charges on leases (where applicable).
- Exchange differences on foreign currency borrowings (if these are regarded as an adjustment to interest costs).
Capitalization of Borrowing Costs
The main idea behind IAS 23 is that if borrowing costs are directly attributable to the construction of an asset, they should be capitalized. Capitalizing means adding the borrowing cost to the cost of the asset rather than treating it as an expense. This only applies to “qualifying assets.”
What is a Qualifying Asset?
A qualifying asset is an asset that takes a substantial period of time to get ready for its intended use or sale. Examples include:
- Buildings
- Manufacturing plants
- Ships
- Power generation facilities
- Sometimes, large inventories (like wine aging in barrels)
When to Start Capitalizing Borrowing Costs
You begin to capitalize borrowing costs when three conditions are met:
- Expenditures for the asset are being incurred. This means the company has started spending money on constructing or purchasing the asset.
- Borrowing costs are being incurred (the company is paying interest on the loan).
- Activities necessary to prepare the asset for its intended use or sale are in progress. This includes physical construction, design work, or any activities before actual construction, like site surveys.
When to Stop Capitalizing Borrowing Costs
Capitalization of borrowing costs should stop when the asset is substantially ready for use or sale. This could be when the asset is in the location and condition necessary for it to operate as intended, even if minor work is still ongoing.
Practical Example of Capitalizing Borrowing Costs
Imagine Company XYZ is building a new factory that will take two years to complete. They take out a loan of ₦5 million at an interest rate of 8% per year to finance the construction.
- Year 1:
- The company spends ₦3 million on construction.
- Interest for the first year = ₦5 million * 8% = ₦400,000.
Here, the ₦400,000 interest is a borrowing cost directly attributable to the factory's construction. IAS 23 says to add this to the cost of the factory, not as an expense in the profit and loss account.
- Year 2:
- The company spends another ₦2 million on construction.
- Interest for the second year = ₦5 million * 8% = ₦400,000.
Again, the ₦400,000 interest for the second year will be capitalized.
At the end of the two years, the factory’s total capitalized cost includes the ₦5 million spent directly on construction plus the ₦800,000 in borrowing costs (₦400,000 from Year 1 and ₦400,000 from Year 2). So, the factory's book value will be ₦5.8 million.
Over time, the company will depreciate the total value of the factory, including the interest, spreading it out as an expense over many years.
What if the Asset Construction Pauses?
If for any reason, construction of the asset is temporarily halted, you should stop capitalizing the borrowing costs during that period. However, if the pause is necessary (for instance, waiting for the ground to settle after excavation), you can continue capitalizing.
Disclosure Requirements
IAS 23 also requires companies to disclose:
- The amount of borrowing costs capitalized during the period.
- The capitalization rate used.