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A practical guide to capitalisation

o borrowing costsNovember 2008


2/234 | PricewaterhouseCoopers A practical guide to segment reporting

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A practical guide to capitalisation of borrowing costsGuidance in question and answer format addressing thechallenges of applyiing IAS 23R, including how to treatspecific versus general borrowings, when to startcapitalisation and whether the scope exemptions aremandatory or optional.

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3/23PricewaterhouseCoopers A practical guide to capitalisation o borrowing costs 1

Page

Introduction 2

Questions and answers

1. General scope and denitions 3

2. Borrowing costs eligible or capitalisation 6

3. Foreign exchange dierences 12

4. Cessation o capitalisation 13

5. Interaction between IAS 23 and IAS 11 14

6. Transition, rst-time adoption and US GAAP dierences 15

Contents


4/232 PricewaterhouseCoopers A practical guide to capitalisation o borrowing costs

The IASB amended IAS 23, Borrowing costs, in March 2007 to converge with US GAAP. Thebroad principles o IAS 23 (Revised) are the same as those in FAS 34, Capitalisation o interest

cost, although the details dier. The revised standard requires borrowing costs incurred to

nance construction o qualiying assets to be capitalised. Convergence at this high level was

relatively simple to achieve, with the elimination o the existing option to expense all interest.

Questions about the practical implementation o the new requirements emerged soon ater

the standards release, despite the expectation that the change would be straightorward.

Relatively ew IFRS preparers had been capitalising interest, and perhaps the standard had

not been the subject o much scrutiny or debate. Some o the questions seem related to the

rules-based nature o IAS 23R. It requires borrowing costs to be capitalised but prohibits

consideration o the cost o equity. The cost o equity is not considered when arriving at

net prot or loss, and so there is a distinction rom borrowing costs. The standard may give

a more complete picture o the costs incurred by an entity or qualiying assets but many

would observe that this is a more accurate, but less relevant, number driven by a rule-based

requirement.

Convergence through eliminating the option to expense borrowing costs meant that the IASB

did not reconsider, in any depth, the requirements o IAS 23. Challenges remain about how to

treat specic versus general borrowings, when to start capitalisation in some situations, and

whether the scope exemptions are mandatory or optional.

This publication looks at some o the practical questions that have been raised about how

to apply IAS 23R. It is intended to be guidance on how to apply the standard, not to create a

subset o additional rules. Entities should consider the ull text o the standards, consult with

their auditors and apply proessional judgement to their specic accounting questions.

Introduction



General scope and denitions

1.1 A qualiying asset is an asset that necessarily takes a substantial periodo time to get ready or its intended use or sale. Is there any bright line or

determining the substantial period o time?

No. IAS 23R does not dene substantial period o time. Management exercises

judgement when determining which assets are qualiying assets, taking into account,

among other actors, the nature o the asset. An asset that normally takes more than a

year to be ready or use will usually be a qualiying asset. Once management chooses

the criteria and type o assets, it applies this consistently to those types o asset.

Management discloses in the notes to the nancial statements, when relevant, how the

assessment was perormed, which criteria were considered and which types o assets

are subject to capitalisation o borrowing costs.

1.2 The IASB has amended the list o costs that can be included in borrowing

costs, as part o its 2008 minor improvement project. Will this change

anything in practice?

The amendment eliminates inconsistencies between interest expense as calculated

under IAS 23R and IAS 39. IAS 23R reers to the eective interest rate method as

described in IAS 39. The calculation includes ees, transaction costs and amortisation o

discounts or premiums relating to borrowings. These components were already included

in IAS 23. However, IAS 23 also reerred to ancillary costs and did not dene this term.

This could have resulted in a dierent calculation o interest expense than under IAS 39.

No signicant impact is expected rom this change. Alignment o the denitions meansthat management only uses one method to calculate interest expense.

1.3 Can borrowing costs incurred to nance the production o inventories that has

a long production period, like wine or cheese, be capitalised?

Yes. IAS 23R does not mandate the capitalisation o borrowing costs or inventories

that are manuactured in large quantities on a repetitive basis. Interest capitalisation

is allowed as long as the production cycle takes a substantial period o time, as with

wine or cheese. The choice to capitalise borrowing costs on those inventories is an

accounting policy choice; management discloses it when material.

1.4 Can an intangible asset be a qualiying asset under IAS 23R?

Yes. An intangible asset that takes a substantial period o time to get ready or its

intended use or sale is a qualiying asset. This would be the case or an internally

generated intangible asset in the development phase when it takes a substantial period

o time to complete, such as sotware. The interest capitalisation rate is applied only to

costs that themselves have been capitalised.



1.5 Should managements intention be taken into account to assess thesubstantial period o time to get ready or its intended use or sale?

Yes. When an asset is acquired, management should assess whether, at the date o

acquisition, it is ready or its intended use or sale. Depending on how management

intends to use the asset, it may be a qualiying asset under IAS 23R.

For example, when an acquired asset can only be used in combination with a larger

group o xed assets or was acquired specically or the construction o one specic

qualiying asset, the assessment o whether the acquired asset is a qualiying asset is

made on a combined basis.

Example

A real estate company has incurred expenses or the acquisition o a permit

allowing the construction o a building. It has also acquired equipment that will

be used or the construction o various buildings.

Can borrowing costs on the acquisition o the permit and the equipment be

capitalised until the construction o the building is complete?

Solution

Yes or the permit, which is specic to one building. It is the rst step in a wider

investment project. It is part o the construction cost o the building, which meets

the denition o a qualiying asset.

No or the equipment, which will be used or other construction projects. It is

ready or its intended use at the acquisition date. It does not meet the denition

o a qualiying asset.

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 o the network starts when the licence is

acquired.

Should borrowing costs on the acquisition o the 3G licence be capitalised until

the network is ready or its intended use?

Solution

Yes. The licence has been exclusively acquired to operate the wireless network.

The act that the licence can be used or licensed to a third party is irrelevant.The acquisition o the licence is the rst step in a wider investment project

(developing the network). It is part o the network investment, which meets the

denition o a qualiying asset under IAS 23R.



1.6 In a service concession arrangement, should an operator capitalise borrowingcosts incurred when constructing or upgrading an inrastructure asset?

Service concession arrangements are accounted or under IFRIC 12. The consideration

received in exchange or the construction or upgrade services is recognised at its air

value either as a nancial asset or an intangible asset depending on the terms o the

agreement.

An operator that recognises an intangible asset in exchange or the construction

capitalises the associated borrowing costs incurred during the construction phase.

However, an operator that recognises a nancial asset expenses the associated

borrowing costs as incurred.

1.7 Property under construction or development or uture use as an investment

property is in the scope o amended IAS 40 (May 2008) and should be

measured at air value also during the construction period, i air value is the

accounting policy o the entity or investment property. Can borrowing costs

attributable to investment property measured at air value be capitalised?

Yes. IAS 23R does not mandate the capitalisation o borrowing costs or assets

measured at air value as, on a net basis, the measurement o the asset would not

be aected. But management can still elect to capitalise those borrowing costs. An

entity that elects to do so reduces its interest expense incurred during the period by

the amount o borrowing costs capitalised and adjusts the carrying amount o the

investment property accordingly. Re-measurement o the investment property to airvalue has a direct eect on the gain or loss arising rom a change in the air value o

investment property recorded in prot or loss or the period.


8/23



(b) Capitalisation o borrowing costs is required. However, the amount o theborrowing costs incurred by the subsidiary in the case o inter-company loans

might be adjusted to refect how the qualiying asset was nanced rom the

perspective o the group as a whole:

n I the group uses external general borrowings, the borrowing costs capitalised

by the subsidiary are adjusted i the capitalisation rate at the group level is

dierent rom the rate used by the subsidiary.

n I the group uses specic external borrowings, the borrowing costs are adjusted

i the borrowing costs on the external borrowings vary rom the amount o

borrowings costs capitalised by a subsidiary.

Borrowing costs calculated and capitalised in accordance with IAS 23R cannot

exceed the amount o borrowing costs incurred at the group level.

I the parent company does not have any external borrowings, the borrowing costs

capitalised by the subsidiary are eliminated, as there are no borrowing costs

incurred rom the perspective o the group.

(c) When the proportionate consolidation method is applied to account or jointly

controlled entities, the qualiying asset o the jointly controlled entity will meet

the denition o IAS 23R in the nancial statements o the venturer. The borrowing

costs eligible or capitalisation are thereore determined taking into account the

interests incurred or the bank loan i specic or, i not, the capitalisation rate o the

general borrowings including the bank loan.

(d) The only asset recognised in the nancial statements o an investor that uses

the equity method is the investment in associate or jointly controlled entity. Neitheris a qualiying asset as dened in IAS 23R. The borrowing costs cannot thereore

be capitalised.

2.5 An entity has investment income on general borrowings. Does management

deduct investment income rom the borrowing costs available or

capitalisation?

No. No specic guidance is given about general borrowings, unlike specic borrowings

(borrowing costs less investment income). The unds invested temporarily cannot be

considered to be those rom the general borrowings rather than rom other sources

(equity or cash generated rom operating activities). It cannot thereore be demonstrated

that the income is earned rom the general borrowings.

2.6 How is the amount o borrowing costs eligible or capitalisation determined

when a qualiying asset is nanced by a combination o borrowings that are

specic to the asset and by general borrowings?

The amount o borrowing costs eligible or capitalisation is calculated asollows:

n To the extent that an entity borrows unds specically or the purpose o

obtaining a qualiying asset, management determines the amount o borrowing

costs eligible or capitalisation as the actual borrowing costs incurred on that

borrowing during the period, less any investment income on the temporary

investment o those borrowings (IAS 23R paragraph 12).



n To the extent that an entity borrows unds generally and uses them or the purpose oobtaining a qualiying asset, management determines the amount o borrowing costs

eligible or capitalisation by applying a capitalisation rate to the expenditures on that

asset. The capitalisation rate is the weighted average o the borrowing costs

applicable to the borrowings o the entity that are outstanding during the period,

other than borrowings made specically or the purpose o obtaining a qualiying

asset (IAS 23R paragraph14).

The ollowing example illustrates how to calculate the amount o borrowing costs to be

capitalised.

Example

On 1 July 2006, entity A entered into a C2.2 million contract or the construction

o a building . The building was completed at the end o June 2007. During the

period, the ollowing payments were made to the contractor:

Payment date Amount (C000)

1 July 2006 200

30 September 2006 600

31 March 2007 1,200

30 June 2007 200

Total 2,200

Entity As borrowings as at its year end o 30 June 2007 were as ollows:

1. 10% our-year note with simple interest payable annually, which relates

specically to the project; debt outstanding at 30 June 2007 amounted to

C700,000. Interest o C65,000 was incurred on these borrowings during the

year, and interest income o C20,000 was earned on these unds while they

were held in anticipation o payments.

2. 12.5% 10-year note with simple interest payable annually; debt outstanding

at 1 July 2006 amounted to C1,000,000 and remained unchanged during

the year.

3. 10% 10-year note with simple interest payable annually; debt outstanding

at 1 July 2006 amounted to C1,500,000 and remained unchanged during

the year.

Assume or purposes o this example that interest expenses equals borrowingcosts.

Solution

Expenditures incurred in obtaining a qualiying asset are rst allocated to any

specic borrowings. The remaining expenditures are allocated to any general

borrowings.


11/23



2.8 Is it appropriate to capitalise gains and losses on derivative instruments (orexample, interest rate swaps and oreign currency swaps) that have not been

designated in a hedging relationship under IAS 39?

No. Such instruments all under the category air value through prot or loss. As they

have not been linked to borrowing activities o the entity through an IAS 39 hedging

relationship, the gains and losses on such derivatives are not considered a borrowing

cost as dened under IAS 23R.

2.9 Are the eects o a cash fow or air value hedging relationship on interest or

a specic project borrowing capitalised?

Yes. IAS 23R BC 21 indicates that the standard does not address whether the eects ohedging should be capitalised. However, the purpose o an IAS 39 hedging relationship

is to modiy the borrowing costs o the entity related to a specic debt. We thereore

believe that entities should capitalise interest on borrowings in an IAS 39 designated

hedging relationship ater taking into account the eects o hedge accounting.

Ineectiveness on such hedging relationships should continue to be recognised in prot

or loss.

2.10 In computing the capitalisation rate or an entity, is the eect o cash fow or

air value hedging relationships on borrowings taken into account?

Yes. IAS 39 designated hedging relationships modiy the borrowing costs o the entity.Where an entity borrows unds not related to specic projects, the capitalisation rate

computed in accordance with IAS 23R paragraph 14 is calculated ater taking into

account eective hedging relationships designated under IAS 39 or all outstanding

borrowings other than those borrowings made specically or the purposes o obtaining

a qualiying asset.

Ineectiveness on such hedging relationships should continue to be recognised in prot

or loss.

2.11 The entity uses general borrowings to nance its qualiying assets. However,

cash fows rom the operating activities would be sucient to nance the

capital expenditures incurred during the period. Can management claimthat the general borrowings are used to nance working capital and other

transactions (or example, merger and acquisition activity, nance leases) but

not to nance the qualiying assets, in which case no borrowing costs would

be capitalised?

No. It is presumed that any general borrowings in the rst instance are used to nance

the qualiying assets (ater any unds specic to a qualiying asset). This is the case

even where the cash fows rom operating activities are sucient to nance the capital

expenditures.

It may be appropriate in some limited circumstances to exclude some general

borrowings rom the calculation o the borrowing rate to the extent it does not result in acapitalisation rate o nil.



2.12 The entity uses general borrowings and cash rom operating activities tonance its qualiying assets. It has a capital structure o 20% equity and 80%

current and non-current liabilities including interest-bearing debt rom general

borrowings. Can management argue that only 80% o the qualyng assets are

nanced with borrowings and apply the capitalisation rate to only 80% o the

amount o qualyng assets?

No. The borrowing rate is applied to the ull carrying amount o the qualiying asset. IAS

23R does not deal with the actual or imputed cost o capital.

2.13 A subsidiary obtained an interest-ree loan rom its parent and used it or the

construction o a qualiying asset. Is the accretion o interest capitalised asborrowing costs in the subsidiarys separate nancial statements?

The liability is initially recognised at air value according to IAS 39. The subsidiary has an

accounting policy choice regarding how to account or the dierence between the air

value o the loan and the amount o unds received rom the parent. This dierence may

be treated as either an addition to the subsidiarys equity or as income in the income

statement. This should refect the economic substance o the transaction. When treated

as income, the gain does not represent a reduction o borrowing costs.

The liability is subsequently measured at amortised cost, with interest accrued using

the eective interest rate method. The interest determined using the eective interest

method is an element o the borrowing costs and is considered or determining the costs

eligible or capitalisation.

2.14 When the construction o a qualiying asset is perormed by a third party, are

borrowing costs capitalised on the prepayments made to the third party or

the acquisition o the asset?

Yes. The borrowing costs incurred by an entity to nance prepayments on a qualiying

asset are capitalised on the same basis as the borrowing costs incurred on assets

constructed by the entity.

The capitalisation starts when all three conditions are met: expenditures are incurred,

borrowing costs are incurred, and the activities necessary to prepare the asset or its

intended use or sale are in progress.

Expenditures on the asset are incurred when the prepayments are made (payments o

the instalments). Borrowing costs are incurred when borrowing is obtained. The last

condition the activities necessary to prepare the asset or its intended use or sale are

in progress can vary depending on acts and circumstances. When the construction

process by the third party does not start at the prepayment date, management assesses

whether it is appropriate to start capitalisation rom this date or whether it should be

deerred to a later date.


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Cessation o capitalisation

4.1 When does capitalisation cease i the construction is completed in phasesand each phase can be operated separately?

Capitalisation or one given phase ceases when this phase is ready or its intended use

or sale. Each subsequent phase will give rise to capitalisation o borrowing costs over its

own construction period.



5.1 An entity incurs borrowing costs or the construction o an asset accountedor under IAS 11. Does management treat the borrowing costs as a contract

cost under IAS 11?

Yes. Borrowing costs that are directly attributable to the construction o an asset are

treated as contract costs in accordance with IAS 23 and IAS 11.

5.2 Does management take into account payments received in advance rom

customers when determining the amount o borrowing costs to be included in

contract costs?

Yes. The determination o the amount o borrowing costs to be capitalised in the

nancial statements o the constructor are based on the net position o the contract,ater taking into account any customer payments in respect o the contract.

5.3 A contract accounted or under IAS 11 is nanced with general borrowings

and is in a net credit position (advances in excess o costs incurred). Is the

net interest income treated as a contract cost?

No. I the contract is in a net credit position during the whole construction period, no

costs are capitalised. The constructor has not incurred any borrowing costs, as the

nancing was provided by the client.

The net position in a contract may change over the construction period rom net debit to

net credit (or vice versa). Capitalisation is required or those periods when the contract isin a net debit position.

5.4 Does the amount o borrowing costs capitalised under IAS 11 become part o

the cost that is used as a measure or the stage o completion?

Borrowing costs that are attributable to contract activity are considered to be part o the

contract costs. The cost-to-cost method will generally take into account all actual costs

incurred and expected costs to complete when measuring the stage o completion.

Costs that do not refect the stage o completion (or example costs that relate to uture

activity (IAS 11 paragraph 27) are excluded. This might include borrowing costs incurred

on specic borrowings obtained in advance or the whole project.

Interaction between IAS 23 and IAS 11



6.1 What is the eective date o IAS 23R?

IAS 23R is eective or annual periods beginning on or ater 1 January 2009. Earlier

application is permitted.

Entities preparing nancial statements in accordance with IFRSs as adopted by the EU

cannot apply IAS 23R until it is endorsed.

6.2 Does IAS 23R apply to qualiying assets existing at the transition date?

No. IAS 23R applies to qualiying assets or which the commencement date or

capitalisation is on or ater the eective date. IAS 23R does not aect qualiying assets

or which the commencement date or capitalisation is earlier than the transition dateHowever, management can decide to designate any date beore the eective date

and apply IAS 23R to borrowing costs relating to all qualiying assets or which the

commencement date or capitalisation is on or ater that date.

The commencement date or capitalisation is the date when the entity rst meets all o

the ollowing conditions:

n it incurs expenditures or the asset;

n it incurs borrowing costs; and

n it undertakes activities that are necessary to prepare the asset or its intended

use or sale.

Transition, rst-time adoption and

US GAAP dierences

Example

A company decides to designate 1 January 2008 as the date rom which

borrowing costs will be capitalised.

The borrowings were obtained at the same time when the construction o the

qualiying assets A, B and C started; the capitalisation criteria or all assets

(A, B and C) were thereore rst met when the construction started.

Solution

I the designation date is 1 January 2007, borrowing costs will be capitalised or

qualiying asset B but not capitalised or qualiying asset A. The capitalisation

criteria or asset A were met beore 1 January 2008.

I the designation is 1 January 2009, borrowing costs will be capitalised or

qualiying asset C but not capitalised or qualiying assets A and B.

Construction period o a qualiying asset A

Construction period o a qualiying asset B

Date o designation,

say 1 January 2007

Construction period o a qualiying asset C

Reporting date o

31 December 2009

Reporting date o

31 December 2007

Reporting date o

31 December 2008



6.3 Should management restate the comparative period(s) in its nancial

statements i it decides to adopt IAS 23R rom a date that is beore theopening balance sheet date o the current year presented?

IAS 23R is applied prospectively rom the date elected or early application. I this date

is beore the opening balance sheet o the current reporting period, the early application

would result in restating the numbers o the prior-year nancial statements. Thereore,

the comparatives in the nancial statements or the current period will show the eect o

the prospective application o IAS 23R rom the earlier date.

6.4 Are companies that capitalised borrowing costs under IAS 23 aected by

IAS 23R?

No. Most companies will not be aected, as the guidance regarding the determination

o the amount o the borrowing costs eligible or capitalisation, commencement,

suspension and cessation o capitalisation remain substantially unchanged.

A company that capitalised borrowing costs on inventories or assets measured at air

value might be aected, as this is no longer required under IAS 23R.

6.5 Under previous GAAP, a rst-time adopter was capitalising borrowing costs

using a methodology dierent rom IAS 23R. Can the same methodology be

used or the assets under construction at the date o transition to IFRS?

No. A rst-time adopter has the ollowing two options under IFRS 1 or the assets

already under construction at the date o transition to IFRS:

n measure the assets in accordance with other standards (IAS 16, IAS 38, IAS 11)

without capitalising any borrowing costs (alternatively, some assets can be measured

at air value in accordance with IFRS 1 i certain conditions are met); or

n designate a date beore the transition date that coincides with the commencement

date o capitalisation under IAS 23R. Borrowing costs are measured and capitalised

under IAS 23R rom this date orward.

6.6 When reporting under US GAAP, a oreign private issuer was capitalising

interest expense in accordance with FAS 34. Can management use the same

methodology as the one used under US GAAP to report under IFRS?

No. IAS 23R is a converged standard but some aspects o measurement still dier rom

FAS 34. The main theoretical dierences are presented in IAS 23R BC19-26.


23/23

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PricewaterhouseCoopers office or visit www.cch.co.uk/ifrsbooks

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