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Home / ... / IAS 23 Revision – Borrowing costs get ‘interesting’

IAS 23 on Borrowing Costs is one of the shorter and less complex of the currently circulating standards. For many companies, its provisions have had little significance while interest rates were low. However, with rates on the rise and an important amendment to the standard being sought for mid 2007, IAS 23 is likely to receive considerably more attention in the coming months.

The basic aim of IAS 23 is to prescribe the treatment of borrowing costs incurred in financing the acquisition, construction or production of certain assets. Mainly, these assets (qualifying assets) will be of the capital variety and will take a 'substantial' period of time to bring to its intended use. Assets envisaged to be included under such a definition would be plant, property and equipment, investment property and some inventories - 'off the shelf' purchases would not satisfy the 'substantial' requirement. The borrowing costs that qualify include interest and other costs related to the borrowing. Essentially, the standard is dealing with incremental borrowing costs that relate to the asset and that would otherwise be saved if debt finance was not used to fund the relevant asset. Actual or imputed cost of equity does not qualify for capitalisation.

As with a number of IFRS’, IAS 23 permits two treatments. The 'benchmark' (or preferred) treatment is to expense all borrowing costs in the period and it is believed that this is the approach adopted by most businesses. The 'alternative' treatment permits companies to capitalise relevant borrowing costs incurred in financing the acquisition, construction or production of the qualifying asset. However, there are restrictions in terms of how much may be capitalised and for how long this may continue. For borrowings taken out specifically to finance the asset in question, the borrowing costs are those that arise directly i.e. interest, arrangement fees, premiums on borrowings, net of any income earned on the temporary investment of the borrowings. Where the funds used are taken from a general pool of borrowings, a 'capitalisation rate' must be calculated in order to determine the interest element that may be capitalised. This rate is the weighted average of the borrowing costs that arise on the general pool of funds.

In terms of how long capitalisation may continue, the standard outlines when commencement, suspension and cessation arise. Commencement of capitalisation begins when capital spending has started, borrowing costs are being incurred and the relevant activities concerning the asset have begun - for example, in terms of construction, one might expect this to be once site preparation has commenced. Once the asset is substantially complete, capitalisation should cease. From this point on, any further borrowing costs are simply expensed. The standard also requires that if work is suspended at any stage, capitalisation of borrowing costs should also be suspended until work recommences.

The availability of two accepted treatments means that comparability across companies, even in the same industry, is somewhat compromised. However, by limiting treatments and setting strict rules regarding what can be capitalised and for how long, the IASB have tried to mitigate this somewhat. There are strong arguments for both treatments - on one hand, capital assets should be recorded at their real cost to the business while, on the other hand, it can be contended that the mere incurrence of borrowing costs does not add any value to the building.

This will be a moot point, however, if the IASB succeed in their plans for amending IAS 23. In May 2006, the board issued an Exposure Draft as part of its ongoing convergence project with FASB. The main crux of this draft is to prescribe that all borrowing costs that relate to qualifying assets must be capitalised - in effect, for specified assets the 'alternative' treatment becomes the 'benchmark' treatment. The treatment of other borrowing costs is not being changed and there will be no material change to the definitions of borrowing costs or qualifying assets. This change will, in most respects, bring IAS 23 in line with its US equivalent, SFAS 34 'Capitalization of Interest Cost', though some differences will remain in definitions and how calculations are made. The board does not expect that the standard will be formally amended before June 2007 and retrospective application will not be required, though early adoption will be permitted.

The proposed change is likely to have an impact on Irish and UK businesses adopting IFRS - according to Ken Wild, Deloitte Touche Tomatsu's Global IFRS Leader, "Our recent experience of transition to IFRS’ in Europe in 2005 is that entities were more likely to stick to their existing practice of expensing all interest when incurred. Therefore, a new requirement to switch to capitalisation will be quite a change". Furthermore, because of the residual differences that will remain between the IAS and SFAS, capitalisation of borrowing costs will still not be the same for some companies under the different jurisdictions. In effect, the IASB’s desired outcome is only being partially achieved, even outside of the question of whether the amendment is appropriate or not. It will be interesting to see if the board are successful in their proposed change and whether companies are satisfied to amend their practices - which they have, no doubt, chosen for their own compelling business reasons - for the sake of convergence.

Chris O’Riordan is a Lecturer at Waterford Institute of Technology.

what are the challenges and opportunities brought about in disregarding alternative treatment

What would you say the advantages and disadvantages of the change implemented in this IAS on March 2007?

Good work, Thanks