IAS 23 Borrowing cost F7 PDF

Preview

Summary

IAS 23 Borrowing cost notes...

Description

Financial Reporting (F7/FR)

BORROWING COSTS (IAS 23) IAS 23, Borrowing Costs, prescribes the criteria for determining whether borrowing costs can be capitalized as part of the cost of acquiring, constructing, or producing a “qualifying asset.” The Standard prescribes the capitalization of borrowing costs into the cost of a qualifying asset. Borrowing costs in relation to a qualifying asset such as a building or major construction contract should therefore be capitalised and included in the cost of the asset, provided that the borrowing costs can be directly related to it. • •

The cost of the asset will be more accurately stated by the inclusion of these costs. The borrowing costs will be more accurately matched to future revenues when they are depreciated as part of the cost of the asset.

DEFINITIONS OF KEY TERMS

•

Borrowing costs.

Include interest and other costs incurred by an entity in relation to borrowing of funds. •

Qualifying asset.

An asset that necessarily takes a substantial period of time to get ready for its intended use or sale. Assets that are ready for their intended use or sale when acquired are not qualifying assets as envisioned by this Standard. Qualifying assets, for the purposes of this Standard, are assets that take a substantial period of time to get ready for their intended use. Examples of qualifying assets include • A toll bridge that takes a couple of years to construct before it is ready for use and is opened to the public • A power plant that takes a substantial period of time to get ready for its intended use • A hydroelectric dam that services the needs of a village and takes a considerable period of time to construct Inventories that are routinely manufactured or are produced on a repetitive basis over a short period of time are obviously not qualifying assets. However, inventories that require a

Masters’ Academy of professional studies +923215040978

Page 1

Financial Reporting (F7/FR) substantial period of time to bring to a saleable condition can be regarded as qualifying assets for the purposes of this Standard. Example

On December 1, 2009, Compassionate Inc. began construction of homes for those families that were hit by the tsunami disaster and were homeless. The construction is expected to take 3.5 years. It is being financed by issuance of bonds for $7 million at 12% per annum. The bonds were issued at the beginning of the construction. The bonds carry a 1.5% issuance cost. The project is also financed by issuance of share capital with a 14% cost of capital. Compassionate Inc. is required under IAS 23 to capitalize borrowing costs. Required Compute the borrowing costs that need to be capitalized under IAS 23. Solution Since these homes are “qualifying assets,” borrowing costs can be capitalized and are computed thus: Interest on 7m bond = 7m ×12% = $840000 Amortization of issuance cost = 0.015×7m/3.5 = 30000 Total= 870000 COMMENCEMENT OF CAPITALIZATION

Capitalization of borrowing costs shall commence when • Expenditures for the asset are being incurred. • Borrowing costs are being incurred. • Activities necessary to prepare the asset for its intended use or sale are in progress. Specific borrowing

If loan is specifically taken for qualifying asset, capitalization start from start whether amount of loan is utilized or not Amount to be capitalized= total interest- investment income generated from extra funds

Masters’ Academy of professional studies +923215040978

Page 2

Financial Reporting (F7/FR) Example

On 1 January 20X6 Stremans Co borrowed $1.5m to finance the production of two assets, both of which were expected to take a year to build. Work started during 20X6. The loan facility was drawn down and incurred on 1 January 20X6, and was utilised as follows, with the remaining funds invested temporarily. Asset A

Asset B

$'000

$'000

1 January 20X6

250

500

1 July 20X6

250

500

The loan rate was 9% and Stremans Co can invest surplus funds at 7%. Required Ignoring compound interest, calculate the borrowing costs which may be capitalised for each of the assets and consequently the cost of each asset as at 31 December 20X6. Answer Asset A

Asset B

$

$

Borrowing costs To 31 December 20X6 $500,000/$1,000,000 ×9%

45,000

90,000

(8,750)

(17,500)

36,250

72,500

Less investment income To 30 June 20X6 $250,000/$500,000 × 7% × 6/12

Cost of assets Expenditure incurred

500,000

1,000,000

Borrowing costs

36,250

72,500

536,250

1,072,5001

Masters’ Academy of professional studies +923215040978

Page 3

Financial Reporting (F7/FR) General borrowing

• •

Interest is capitalized when payment is made When there are multiple loans available weighted average interest is used

Example

Acruni Co had the following loans in place at the beginning and end of 20X6. 1 January 31 December

20X6

20X6

$m

$m

10% Bank loan repayable 20X8

120

120

9.5% Bank loan repayable 20X9

80

80

8.9% debenture repayable 20X7

–

150

The 8.9% debenture was issued to fund the construction of a qualifying asset (a piece of mining equipment), construction of which began on 1 July 20X6 On 1 January 20X6, Acruni Co began construction of a qualifying asset, a piece of machinery for a hydroelectric plant, using existing borrowings. Expenditure drawn down for the construction was: $30m on 1 January 20X6, $20m on 1 October 20X6. Required Calculate the borrowing costs that can be capitalised for the hydro-electric plant machine.

SUSPENSION OF CAPITALIZATION

Capitalization shall be suspended during extended periods in which active development is interrupted unless that period is a necessary part of the process for the production of the asset. For example, capitalization would be suspended during an interruption to the construction of a bridge during very high water levels, which are common in the area where construction is taking place. However, capitalization of borrowing costs should not be suspended when there is only a

Masters’ Academy of professional studies +923215040978

Page 4

Financial Reporting (F7/FR) temporary delay that is caused by certain expected and anticipated reasons, such as while an asset is getting ready for its intended use. CESSATION OF CAPITALIZATION

Capitalization of borrowing costs shall cease when substantially all the activities necessary to prepare the asset for its intended use or sale are complete. If all that is left are minor modifications, such as decoration or routine administrative work, then the asset is considered to be substantially complete. In some instances, such as a business park or extensive development, parts may become ready for use in stages. In such cases, capitalization ceases on those parts that are ready for use. RECOGNITION

Borrowing costs that are directly attributable to the acquisition, construction, or production of a qualifying asset shall be capitalized as part of the cost of that asset. Capitalization of borrowing costs that are directly attributable to the acquisition, construction, or production of a qualifying asset as part of the cost of the asset is possible only if both these conditions are met: • It is probable that they will result in future economic benefits to the entity. • The costs can be measured reliably. (If borrowing costs do not meet these criteria, then they are expensed.) BORROWINGS ELIGIBLE FOR CAPITALIZATION

When borrowings are taken specifically to acquire, construct, or produce an asset, the borrowing costs that relate to that particular qualifying asset are readily identifiable. In such circumstances, it is easy to quantify the borrowing costs that would need to be capitalized by using the process of elimination, that is, capitalizing the borrowing costs that would have been avoided had the expenditure on the qualifying asset not been made. Difficulties arise, however, if borrowings and funding are organized centrally, say, within a group of companies. In such cases, a weighted-average capitalization rate may be applied to the expenditures on the qualifying asset. When funds borrowed specifically to finance a qualifying asset are not utilized immediately, and instead the idle funds are invested temporarily until required, the borrowing costs that are

Masters’ Academy of professional studies +923215040978

Page 5

Financial Reporting (F7/FR) capitalized should be reduced by any investment income resulting from the investment of idle funds. Borrowing costs capitalized in a period cannot exceed the amount of borrowing costs incurred by the entity during that period Example

A socially responsible multinational corporation (MNC) decided to construct a tunnel that will link two sides of the village that were separated by a natural disaster years ago. Realizing its role as a good corporate citizen, the MNC has been in this village for a couple of years exploring oil and gas in the nearby offshore area. The tunnel would take two years to build and the total capital outlay needed for the construction would be not less than $20 million. To allow itself a margin of safety, the MNC borrowed $22 million from three sources and used the extra $2 million for its working capital purposes. Financing was arranged in this way: • Bank term loans: $5 million at 7% per annum • Institutional borrowings: $7 million at 8% per annum • Corporate bonds: $10 million at 9% per annum In the first phase of the construction of the tunnel, there were idle funds of $10 million, which the MNC invested for a period of six months. Income from this investment was $500,000. Required When MNC capitalizes borrowing costs under IAS 23, how would it treat the borrowing costs? How would it capitalize the borrowing costs, and what would it do with the investment income? Solution Under IAS 23, borrowing costs would be capitalized as part of the cost of the asset. 1. In order to capitalize the borrowing costs, a weighted-average cost of funds borrowed is computed: 1. In order to capitalize the borrowing costs, a weighted-average cost of funds borrowed is computed: = ($5 million × 7%) + ($7 million × 8%) + ($10 million × 9%)/($5 million + $7 million + $10 million) = ($1.81 million/$22 million) × 100

Masters’ Academy of professional studies +923215040978

Page 6

Financial Reporting (F7/FR) = 8.22 % per annum 2. Total borrowing cost = $20 million × 8.22 % per annum × 2 years = $1.644 million × 2 years = $3.288 million 3. Borrowing costs to be capitalized = Interest expense – Investment income (resulting from investment of idle funds) = $3,288,000 – $500,000 = $2,788,000 EXCESS OF CARRYING AMOUNT OF THE QUALIFYING ASSET OVER THE RECOVERABLE AMOUNT

When the carrying amount or the expected ultimate cost of the qualifying asset exceeds its recoverable amount or net realizable value, the carrying amount is to be written down or written off in accordance with the requirements of other Standards, such as IAS 36, Impairment of Assets. Disclosure

The following should be disclosed in the financial statements in relation to borrowing costs. (a) Amount of borrowing costs capitalised during the period (b) Capitalisation rate used to determine the amount of borrowing costs eligible for capitalization

Masters’ Academy of professional studies +923215040978

Page 7

Financial Reporting (F7/FR) Chapter end exercise

Q1 Under what conditions can an entity capitalise borrowing costs? A The borrowing costs are incurred for purchases of inventory items B The borrowing costs are directly attributable to the acquisition, construction, or production of a qualifying asset C The borrowing costs are directly attributable to the acquisition, construction, or production of routinely manufactured assets D The borrowing costs are incurred for purchases of property, plant and equipment Q2 Which of the following would qualify as a borrowing cost as defined in IAS 23 Borrowing Costs? (1) Premium on redemption of preference share capital (2) Discount on the issue of convertible debt (3) Interest expense calculated using the effective interest rate (4) Finance charges related to finance leases A 1, 2 and 3 only B 2, 3 and 4 only C 1 and 4 only D 1, 2, 3 and 4 Q3 For which of the following categories of funds used to construct a factory, that is a qualifying asset, can borrowing costs NOT be capitalised? A Funds borrowed specifically to construct the factory B Funds borrowed in advance of expenditure on the factory C General borrowed funds used to finance the building of the factory D Funds borrowed that have been applied to the construction of a new office

Masters’ Academy of professional studies +923215040978

Page 8

Financial Reporting (F7/FR) Q4 Which qualitative characteristic is applied by IAS 23 Borrowing Costs to the capitalisation of borrowing costs? A Consistency B Timeliness C Materiality D Understandability Q5 QI is incurring expenditure on project 275 which meets the definition of a qualifying asset, in accordance with IAS 23 Borrowing Costs. The company has the following debt components: (1) 6% $100,000 debt used specifically to finance project 274 (2) 7% $500,000 preference share capital (3) 10% $80,000 short-term loan (4) 4% $200,000 convertible debt What capitalisation rate would QI apply to expenditure incurred on project 275? A 7% B 6.75% C 6.54% D 4% Q6 Details relating to construction of Apex’s new store: Apex issued a $10 million unsecured loan with a coupon (nominal) interest rate of 6% on 1 April 2016. The loan is redeemable at a premium which means the loan has an effective finance cost of 7·5% per annum. The loan was specifically issued to finance the building of the new store which meets the definition of a qualifying asset in IAS 23. Construction of the store commenced on 1 May 2017 and it was completed and ready for use on 28 February 2017, but did not open for trading until 1 April 2017. During the year trading at Apex’s other stores was below expectations so Apex suspended the construction of the new store for a two month period

Masters’ Academy of professional studies +923215040978

Page 9

Financial Reporting (F7/FR) during July and August 2016. The proceeds of the loan were temporarily invested for the month of April 2016 and earned interest of $40,000. Required: Calculate the net borrowing cost that should be capitalised as part of the cost of the new store and the finance cost that should be reported in the statement of profit or loss for the year ended 31 March 2017. Q7 Which of the following assets would NEVER qualify for capitalisation of borrowing costs under IAS 23 Borrowing Costs? A Intangible assets B Financial assets C Manufacturing plants D Power generation facilities

Masters’ Academy of professional studies +923215040978

Page 10...