Borrowing costs that directly relate to the acquisition, construction or production of a qualifying asset must be capitalized as a part of the cost of that asset.
A qualifying asset is an asset that necessarily takes a substantial period of time to be ready for its intended use or sale.
Borrowing costs eligible for capitalization fall into one the following categories:
- Funds borrowed specifically for a qualifying asset
- In this case, the amount to be capitalized is the actual borrowing costs incurred less investment income on temporary investment of the funds.
- Funds borrowed generally
- Here, we use the weighted average of borrowing costs outstanding during the period (excluding borrowings specifically for a qualifying asset) multiplied by expenditure on qualifying asset.
- The amount capitalized should not exceed total borrowing costs incurred in the period.
Commencement of capitalization begins when:
- Expenditures for the asset are being incurred;
- Borrowing costs are being incurred; and
- Activities that are necessary to prepare the asset for its intended use or sale are in progress.
ABC Ltd has borrowed $5 million to finance the building of a factory. Construction is expected to take three years. The loan was drawn down and incurred on 1 January 2016 and work began on 1 April 2016.
$2 million of the loan was not utilized until 1 July 2016 so ABC Ltd was able to invest it until needed.
ABC Ltd is paying 8% on the loan and can invest surplus funds at 5%.
Borrowing costs = ($5m * 8% × 9/12) – ($2m × 5% × 3/12) = $275.000
ABC Ltd had the following bank loans outstanding during the whole of 2017:
8% loan repayable 2022 – $17m
11% loan repayable 2024 -$14m
ABC Ltd began construction of a qualifying asset on 1 May 2017 and withdrew funds of $7 million on that date to fund construction. On 1 October 2017 an additional $3 million was withdrawn for the same purpose.
Weighted average capitalization rate = (8% * 17/31) + (11% * 14/31) = 9,4%
Borrowing costs = ($7m * 9,4% * 8/12) + ($3m * 9,4% * 3/12) = $509.000
Capitalization is suspended during extended periods when development is interrupted.
Capitalization ceases when substantially all the activities necessary to prepare the qualifying asset for its intended use or sale are complete.