Accounting for Borrowing Costs - Ppt. presentation

Accounting for borrowing costs

1. Chapter 8 Accounting for Borrowing Costs ACC 1340 Financial Accounting

2. Learning Outcomes Identify borrowing costs; Identify qualifying assets; Distinguish between the borrowing cost to be capitalized and expensed; Identify and apply criteria relevant to capitalization of borrowing costs; and Provide the disclosures relevant to borrowing costs.

3. Introduction - Borrowing Costs Definition Borrowing costs are interest and other costs incurred by an enterprise in connection with the borrowing of funds (LKAS 23 – Borrowing Costs)

4. Introduction - Borrowing Costs Core Principle Borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset form part of the cost of that asset. Other borrowing costs are recognized as an expense. (LKAS 23 – Borrowing Costs)

5. Examples for Borrowing Costs Interest expense calculated using the effective interest method Finance charges of leases Exchange rate differences arising from foreign currency borrowings to the extent that they are regarded as an adjustment to interest costs

6. LKAS 23 –Borrowing Costs LKAS 23 prescribes the accounting treatments for borrowing costs This standard can be used to determine whether borrowing costs should be capitalized as part of the cost of the asset , or expensed in a particular period LKAS 23, does not deal with actual or imputed cost of equity, including preferred capital not classified as a liability. not required to apply on acquisition, construction or production of; a qualifying asset measured at fair value. (e.g. biological assets) inventories produced on large quantities on a repetitive basis

7. Categorization of Borrowing Costs

8. Qualifying Assets A qualifying asset is an asset that necessarily takes a substantial period of time to get ready for its intended use or sale (LKAS 23- Borrowing Costs) LKAS 23 does not define ‘substantial period of time’ Generally, the ‘substantial period of time’ is determined based on the managerial judgment

9. Qualifying Assets (Cont.) Depending on the circumstances any of the following can be qualifying assets: Inventories Manufacturing plants Power generation facilities Intangible assets Investment property

10. Qualifying Assets (Cont.) Following items cannot be considered as qualifying assets : Financial assets and inventories that are manufactured over a short period of time Assets that are ready for their intended use or sale when acquired.

11. Activity 8.1 State which assets can be considered as qualifying assets. (Adapted from IFRS Workbooks, 2011) Asset Description Yes/ No Wine It will take ten years to mature.   Manufacturing plant It will take two years to complete the constructions.   Power generation facility It will take four years to complete the constructions.   Office building It is expected to upgrade and rent out to a third party.   Orange juice The production process will take five hours   Inventory of a wholesaler These goods will be sold without changing their original condition.   Building It is available for use at the time of acquisition.  

12. Activity 8.1 - Answer (Adapted from IFRS Workbooks, 2011) Asset Description Yes/ No Wine It will take ten years to mature.  Yes Manufacturing plant It will take two years to complete the constructions.  Yes Power generation facility It will take four years to complete the constructions.  Yes Office building It is expected to upgrade and rent out to a third party.  Yes Orange juice The production process will take five hours  No Inventory of a wholesaler These goods will be sold without changing their original condition.  No Building It is available for use at the time of acquisition.  No

13. Recognition of Borrowing Costs As per LKAS 23, borrowing costs can be recognized as follows;

14. Criteria Relevant to Capitalization of Borrowing Costs Commencement of capitalization Suspension of capitalization Cessation of capitalization

15. Criteria Relevant to Capitalization of Borrowing Costs (Cont.) Commencement of capitalization An entity should start to capitalize the borrowing costs as a part of the cost of a qualifying asset on the commencement date The commencement date for capitalization is the date when the entity first meets all of the following conditions : it incurs expenditures for the asset; it incurs borrowing costs; and it undertakes activities that are necessary to prepare the asset for its intended use or sale.

16. Criteria Relevant to Capitalization of Borrowing Costs (Cont.) Commencement of capitalization The activities necessary to prepare the asset for its intended use or sale encompass more than the physical construction of the asset. ( e.g. technical and administrative work prior to the commencement of physical construction) However, such activities exclude the holding of an asset when no production or development that changes the asset’s condition is taking place (e.g. Borrowing costs incurred while land acquired for building purposes is held without any associated development activity do not qualify for capitalization)

17. Criteria Relevant to Capitalization of Borrowing Costs (Cont.) b) Suspension of capitalization An entity should suspend capitalization of borrowing costs during periods in which active development of a qualifying asset is not occurred .

18. Activity 8.2 Assume that the required funds have been borrowed to finance each of the given scenarios. State whether the capitalization of borrowing costs should be suspended or not. You are going to buy some land as an investment. You will hold it for one year then sell it or develop it. Until then, no action is being taken to prepare the asset for use or sale. You are building a shopping complex in Africa. You have to halt the construction for an uncertain period of time due to a civil unrest. You are building a bridge in a tropical country. As expected, the monsoon season delays completion of bridge.

19. Activity 8.2 - Answer You are going to buy some land as an investment. You will hold it for one year then sell it or develop it. Until then, no action is being taken to prepare the asset for use or sale. If no action is taking place, no capitalization is allowed. You are building a shopping complex in Africa. You have to halt the construction for an uncertain period of time due to a civil unrest. Capitalization should also be suspended from the day the work stopped, until the day it restarts. You are building a bridge in a tropical country. As expected, the monsoon season delays completion of bridge. If a temporary delay is part of the process to prepare the asset, such as maturing of a distilled product, capitalization continues.

20. Criteria Relevant to Capitalization of Borrowing Costs (Cont.) c) Cessation of capitalization An entity should stop capitalizing borrowing costs when substantially all the activities necessary to prepare the qualifying asset for its intended use or sale are completed An asset is normally ready for its intended use or sale when the physical construction of the asset is complete even though routine administrative work might still continue If minor modifications, such as the decoration of a property to the purchaser’s or user’s specification, are all that are outstanding, this indicates that substantially all the activities are completed

21. Criteria Relevant to Capitalization of Borrowing Costs (Cont.) c) Cessation of capitalization When an entity completes the construction of a qualifying asset in parts and each part is capable of being used while construction continues on other parts, the entity shall cease capitalizing borrowing costs when it completes substantially all the activities necessary to prepare that part for its intended use or sale ( e.g. A business park comprising several buildings each of which can be used individually ) Some qualifying assets need to be fully completed before using any part of that asset ( e.g. an industrial plant such as a steel mill )

22. Calculation of Borrowing Costs Eligible for Capitalization There are two conditions under which borrowing costs will be entitled for capitalization When funds are borrowed specifically for the purpose of obtaining a qualifying asset When funds are borrowed generally and use them for the purpose of obtaining a qualifying asset.

23. Calculation of Borrowing Costs Eligible for Capitalization When funds are borrowed specifically for the purpose of obtaining a qualifying asset In this case, the borrowing costs eligible for capitalization can be calculated as: The actual borrowing costs incurred on that borrowing during the period - Any investment income on the temporary investment of those borrowings

24. Activity 8.3 Wasana PLC started a construction of a building on 01.04.2017. For this purpose, on 01.04.2017, they obtained a bank loan amounting to Rs . 4 million. The construction was in the progress as at 31.03.2018 and Rs.2.5 million had been incurred for the building by that date. The interest cost of the loan for the year ending 31.03.2018 was Rs . 780,000. Required: Identify the borrowing costs to be capitalized for the year ending 31.03.2018. Show the extracts from income statement for the year ended 31.03. 2018 and Statement of financial position as at 31.03.2018.

25. Activity 8.3 - Answer Finance cost that can be capitalized = Rs. 780,000 2. Extracts of the statement of financial position as at 31 March 2018 Property, plant and equipment (cost incurred +finance cost element) (2,500,000+780,000) 3,280,000

26. Activity 8.4 Chamara PLC borrowed Rs.1,500,000 worth loan from a bank with an interest rate of 10% which was equal to its effective interest rate on 01.04.2017 to construct a manufacturing plant. The company utilized Rs . 500,000 from the borrowed money to build a special machine inside this manufacturing plant and deposited the remaining amount in a bank yielding interest at 6% per annum on the same date. The entire amount deposited was withdrawn and paid to the contractor on 31.12.2017 when the construction was completed and ready for use. The company repaid the loan to bank on 31.03. 2018. Manufacturing plant was available for use in the business from 01.04.2018. Required: Calculate the net borrowing cost that should be capitalized as part of the cost of the special machine and the finance cost that should be reported in the income statement for the year ended 31.03.2018. Show the extracts from income statement for the year ended 31.03. 2018 and Statement of financial position as at 31.03.2018.

27. Activity 8.4 - Answer . Total finance cost for the year ended 31.03.2018 = 1,500,000 * 10% = 150,000 Borrowing cost to be capitalized = 150,000 * 9/12 = 112,500 Borrowing cost to be expensed (finance cost) 150,000 * 3/12 = 37,500 Interest earned = 1,000,000*.06*9/12 = 45, 000 Net Borrowing cost to be capitalized = 112,500 - 45, 000 = 67,500 2. Extracts of the income statement for the year ended 31 March 2018 Finance cost 37,500 Extracts of the statement of financial position as at 31 March 2018 Property, plant and equipment (cost incurred +finance cost element) (1,500,000+112,500-45,000) 1,567,5000

28. Calculation of Borrowing Costs Eligible for Capitalization When funds are borrowed generally and use them for the purpose of obtaining a qualifying asset. The eligible amount of borrowing cost for capitalization is determined by applying a capitalization rate to the expenditure incurred on that asset Capitalization rate is the weighted average of the borrowing costs applicable to the general pool of funds that are outstanding during the period .

29. Activity 8.5 Ranga PLC had the following loans as at 31.03.2017 12% Bank loan Rs . 1,200,000 15% Bank loan Rs . 800,000 The company started the construction of a qualifying asset on 01.04.2017 by using existing loans and the construction was completed on 30.09.2018. The expenditure incurred for the construction is given below. 01.04.2017 Rs . 400,000 01.10.2017 Rs . 500,000 Required: Calculate the total borrowing costs to be capitalized for the year ending 31.03.2018.

30. Activity 8.5 - Answer 1200000 x 12% 144,000 800000 x 15% 120,000 264,000 Capitalization Rate 264000/2000000 x 100 13.20% Borrowing cost to be capitalized for the Y/E 31.03.2018 400,000*13.2% 52,800   500,000*13.2%*(6/12) 33,000   85,800

31. Activity 8.6 Ganga PLC had the following loans outstanding as at 01.04.2017 The effective interest rates of loans were equal to the coupon interest rates.   Repayable on Loan amount (Rs.) Loan 01 at 10% 31.12. 2018 700,000 Loan ­ 02 at 8% 31.03. 2019 500,000 Loan ­03 at 6% 31.09. 2020 300,000

32. Activity 8.6 The company spent following amounts on construction of a power generation facility. As at 31st March 2018 construction was in progress. Required: Calculate the capitalization rate Calculate the borrowing cost eligible for capitalization Show the extracts from income statement for the year ended 31st March 2018 and Statement of financial position as at 31st March 2018. Payment date Rs. 01.04.2017 400,000 01.10.2017 300,000 01.01.2018 100,000

33. Activity 8.6 - Answer 1. Capitalization Rate=(Total interest)/(Weighted Average Loan ) Capitalization Rate=128,000/(1,500,000 )=8.53% Loans Outstanding @ 1 April 2017 to 31 March 2018 Weighted Average Loan Rate Finance cost Loan 1 700,000 700,000 10% 70,000 Loan 2 500,000 500,000 8% 40,000 Loan3 300,000 300,000 6% 18,000     1,500,000   128,000

34. Activity 8.6 - Answer 2. Borrowing cost eligible for capitalization (Rs.) 400,000*8.53% 34,120 300,000* 8.53%*6/12 12,795 100,000*8.53% x 3/12 2,133   49,048

35. Activity 8.6 - Answer 3. Income statement for the year ended 31 March 2018 (Rs.) Finance cost (128,000-49,048) (78,952)   Statement of financial position as at 31 March 2018 Property, plant and equipment in progress (cost incurred +finance cost element) (800,000+49,048) 849,048     Non-current liabilities   10% Loan 1 700,000 8% Loan 2 500,000 6% Loan 3 300,000

36. Calculation of Borrowing Costs Eligible for Capitalization –Summary Source: https://www.ifrsbox.com/capitalize-borrowing-costs-ias-23/

37. Disclosures As per LKAS 23, an entity should disclose: the amount of borrowing costs capitalized during the period; and the capitalization rate used to determine the amount of borrowing costs eligible for capitalization.

38. Thank You