All-About AS 16 | Accounting of Borrowing Cost

Topics covered in this article are as follows:

1. Meaning
2. Recognition Criteria
3. Borrowing Costs Eligible for Capitalization
4. Commencement of Capitalization
5. Cessation of Capitalization
6. Disclosures
7. Illustrative Example

1. Meaning

Enterprises often borrow funds to acquire, build and install the fixed assets and other assets. These assets take time to make them useable or saleable, therefore the enterprises incur the interest expense (cost on borrowings) on these borrowings. Thus, borrowing costs are the cost incurred in connection with the borrowing of funds. Other costs may also form part of borrowing costs like commitment charges on borrowings, ancillary costs incurred for an arrangement of borrowings, premiums or discounts related to borrowings, and exchange differences arising from foreign currency borrowings to the extent these are regulated as an adjustment to interest costs.

2. Recognition Criteria

As per the provisions stated in the Accounting Standard 16 Borrowing Costs, the borrowing costs which are directly attributable to acquisition, construction, or production of qualifying asset shall be capitalized as a part of the cost of asset. Borrowing costs are capitalized as a part of the cost of the qualifying asset only when it is probable that such costs will result in future economic benefits to the entity and such costs can be measured reliably. Other costs shall be recognized as an expense in the period in which they are incurred.

Qualifying Asset – An asset that necessarily takes a substantial period to get ready for its intended use or sale. Generally, a period of 12 months is considered to be a substantial period unless a shorter period is justified.

3. Borrowing costs eligible for Capitalization

As per the recognition criteria, those borrowing costs which are directly relatable to acquisition, construction, or production of qualifying asset shall be capitalized as a part of cost of qualifying asset. Sometimes, it may be difficult to identify a direct relation between particular borrowings and qualifying asset and to determine whether those borrowings can be avoided.

To the extent funds are borrowed specifically for obtaining a qualifying asset, the amount of borrowings eligible for capitalization shall be actual borrowing cost incurred on borrowings obtained specifically for qualifying asset less any income earned on the temporary investment of those borrowings. However, if the funds are borrowed generally and then used for obtaining qualifying asset, then the borrowing cost to be capitalized shall be determined by applying a capitalization rate to the expenditure made on obtaining asset.  The capitalization rate shall be the weighted average of borrowing cost applicable to the borrowings that are outstanding during the period, other than borrowing made specifically to obtain qualifying assets.

4. Commencement of Capitalization

The capitalization of borrowing costs should commence when all the conditions specified below are satisfied –

• Expenditure for acquisition, construction or production of qualifying asset is incurred;
• Borrowing costs are being incurred; and
• Activities necessary to prepare the asset for its intended use or sale are in progress.

5. Cessation of Capitalization

The capitalization of borrowing costs shall cease when all the necessary activities to prepare the qualifying asset for its intended use are complete. While considering this, an entity is required to check only essential activities. Where the construction of a qualifying asset is carried out in parts and each such completed part is capable of being utilized individually while construction continues for other parts, the capitalization of borrowing costs related to that part should be ceased when substantially all the activities necessary to prepare such part for its intended use or sale are complete.

6. Disclosures

An entity should disclose in its financial statements (i) the accounting policy adopted for borrowing costs; and (ii) the amount of borrowing costs capitalized during the year.

7. Illustrative Example

Problem:

A Company say, P Ltd. had the following loans at the beginning of the period 20X1:

1. Bank loan @ 6% p.a. amounting to Rs. 2,00,000 for the construction of factory shed.
2. Bank loan @ 8% p.a. amounting to Rs. 1,30,000 for the general purpose.
3. Debenture stock @ 5.5% p.a. amounting to Rs. 50,000 for the general purpose.

P Ltd. spent Rs. 60,000 as on 1 February 20X1 and Rs. 25,000 as on 1 September 20X1 on the construction of production hall. What amount of borrowing costs should be capitalized as per AS 16 for year ended 31 December 20X1?

Solution:

According to the provisions contained in AS 16 Borrowing Costs, in case any amount is generally for meeting expenditure of qualifying assets as well as other purposes, the amount of borrowing costs to be capitalized should be determined by applying an average capitalization rate to the amount incurred on qualifying asset. The capitalization rate shall be the weighted average of borrowing cost applicable to the borrowings that are outstanding during the period, other than borrowing made specifically to obtain qualifying assets, which should be directly capitalized.

Accordingly,

Bank loan amounting to Rs. 2,00,000 is ignored for the purpose of calculation since the amount was borrowed specifically for the construction of the factory shed. Only general borrowings relate to the financing of the construction of production hall and therefore, calculation will be as follows:-

Weighted average rate:

(8% X 1,30,000 /(1,30,000 +50,000)) + (5.5% X 50,000 (1,30,000 +50,000))

= 5.78% + 1.53%

= 7.31%

Calculation of borrowing cost eligible for capitalization:

= (60,000 X 7.31% X 11/12) + (25,000 X 7.31% X 4/12)

= Rs. 4,021 + Rs. 609

= Rs. 4,630