IAS 23 – Borrowing Costs
Why do borrowing costs form part of the cost of an asset?
Most non-financial assets are measured according to the cost model. The need to capitalise borrowing costs arises from the principle that the cost of an asset includes all costs necessary to bring it to use, and from the recognition that such costs also include borrowing costs incurred during the construction or preparation of an asset for its intended use, such as the construction of a plant.
From a purely economic perspective, borrowing costs form part of the cost of the asset. A contractor who sells a completed asset to a market participant, for which a significant period of time was required for construction, will generally include in the selling price of the asset the borrowing costs incurred during construction. Moreover, it is reasonable to assume that a contractor selling a completed asset to a market participant would include notional borrowing costs even if the construction had been financed with equity, since that is how the asset would be priced by competitors.
What comparability issues arise from capitalising borrowing costs?
The disadvantage of including borrowing costs incurred during the construction or preparation period in the measurement of the cost of an asset is the lack of comparability between different reporting entities. This arises because the debt-to-equity ratio of an entity may affect how its assets are measured in the financial statements. For example, a qualifying asset of a reporting entity financed solely with equity will not include notional borrowing costs, unlike an identical asset presented in the financial statements of a reporting entity financed partly with debt.
This comparative distortion arises because borrowing costs represent interest and other costs incurred by the reporting entity as a result of borrowing funds, and do not include an imputed component that results from equity financing. Under IFRS Accounting Standards, unlike debt instruments, equity is measured at historical cost and no expenses reflecting fundraising costs are recognised in profit or loss. It is important to emphasise that the distortion is not limited only to the different measurements of the same asset in the statement of financial position, but may also be reflected in different depreciation expenses included in future profit or loss, as well as in other impacts on performance, e.g., impairment and income on disposal.
How does capitalisation of borrowing costs relate to the definition of an asset?
In any case, according to the definition of an asset in the Conceptual Framework for Financial Reporting, an asset must not be measured above the economic benefits expected from it, and therefore, after capitalising borrowing costs, the relevant principles for impairment testing must be applied as necessary.
What is the guiding principle of IAS 23?
IAS 23 deals with borrowing costs. The guiding principle of the Standard is that borrowing costs directly attributable to the acquisition, construction or production of a qualifying asset form part of the cost of that asset, while other borrowing costs are recognised as an expense when incurred. A qualifying asset is an asset that necessarily takes a substantial period of time to get ready for its intended use or sale. The Standard specifies which borrowing costs are eligible to be capitalised and what is the capitalisation period.
How are specific and general borrowings treated under IAS 23?
The Standard distinguishes between cases in which the reporting entity borrows funds specifically for the purpose of acquiring a qualifying asset (specific borrowing) and cases in which the reporting entity borrows funds generally and uses them for acquiring a qualifying asset (general borrowing). For specific borrowings, the amount of borrowing costs eligible for capitalisation is determined based on the actual borrowing costs incurred. For general borrowings, the borrowing costs eligible for capitalisation are determined by applying the entity’s capitalisation rate to the expenditures incurred for the asset.
When does the existence of general borrowings trigger capitalisation?
As a result, even when a reporting entity has sufficient equity to finance the construction of a qualifying asset, the mere existence of general borrowings within that reporting entity creates a requirement to consider capitalisation of borrowing costs as part of the cost of the qualifying asset.