Companies use assets for various purposes, primarily including the generation of revenues. These assets include resources owned or controlled by a company. Similarly, these resources result in an inflow of economic benefits in the future. They consist of inventories, cash, accounts receivables, and fixed assets. Of these, the fixed assets constitute a significant portion of a company’s overall resources.
Fixed assets include property, plant, equipment, and other long-term resources. In accounting, they fall under the scope of IAS 16. This standard dictates the recognition, subsequent, and various other treatments of those assets. On top of that, it also provides a base to measure and record the depreciation on assets. Companies usually acquire through existing funds. These funds include both equity and debt finance that they obtain over time.
Sometimes, companies also use borrowed funds to acquire, construct or produce fixed assets. These funds may also come with interest or other borrowing costs. IAS 16 requires companies to include those costs as a part of the asset’s value. However, those borrowing costs fall under IAS 23, which has several conditions for recognition. Before accounting for borrowing costs, it is crucial to understand what they are.
What are Borrowing Costs?
When companies borrow finance from other parties, they also bear some costs. Usually, they include interest paid on the borrowed amount. However, it may also have other related expenses. For companies, these expenses constitute borrowing costs. In accounting, they have a similar definition and usage. The primary definition for borrowing costs comes from IAS Borrowing Costs. This standard also dictates the accounting for those costs.
IAS 23 states, “Borrowing costs are interest and other costs that an entity incurs in connection with the borrowing of funds.” Therefore, this definition meets the explanation for those costs listed above. IAS 23 suggests that borrowing costs are finance charges directly attributable to a qualifying asset. These costs also form a part of the asset’s initial cost. Therefore, it requires companies to capitalize on those costs.
Borrowing costs help companies finance the construction, acquisition or production of assets. However, it only applies to debt finance. Companies cannot use IAS 23 to capitalize the actual or imputed cost of equity. On top of that, any interest expense on preferred capital does not fall under the scope of this standard. Similarly, it does not apply to qualifying assets measured at fair value.
Borrowing costs may include interest expenses calculated using the effective interest rate. Similarly, it may involve finance charges on finance leases. On top of that, borrowing costs may also generate from exchange differences from foreign currency borrowings. These events can trigger the recognition and account for borrowing costs under IAS 23. Companies must be aware of these conditions to record these costs promptly.
Overall, borrowing costs are any financial charges on debt finance. However, these costs apply to the context of the assets that they finance. Companies must capitalize on these costs under IAS 23. However, they must ensure it only relates to qualifying assets. These costs may generate from various events, as mentioned above. Any other borrowing costs become an expense in the income statement.
What is the accounting for Borrowing Costs?
As mentioned, borrowing costs only apply to qualifying assets. IAS 23 states, “An entity shall capitalize borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset as part of the cost of that asset. An entity shall recognize other borrowing costs as an expense in the period in which it incurs them.”
Therefore, any borrowing costs incurred on qualifying assets become a part of its cost. This process occurs through the capitalization of those costs. The standard also lists the assets that may fall under the qualifying category. Under IAS 23, these include the following.
- manufacturing plants
- power generation facilities
- intangible assets
- investment properties
- bearer plants.
Qualifying assets include resources that necessarily take a substantial period to get ready. Usually, companies have an intended use or sale for those assets. The getting ready part applies to that purpose. However, companies cannot capitalize on all borrowing costs when they occur. Instead, they must ensure these costs are directly attributable to three uses for the underlying asset. These include its construction, acquisition, or production.
Similarly, borrowing costs may occur during several periods. IAS 23 states that capitalization must begin when those costs meet the following criteria.
- The company is incurring expenses for the asset.
- The company is also incurring borrowing costs.
- The activities necessary to prepare the asset for its intended use or sale are in progress.
IAS 23 states that companies must cease capitalization when either of the following happens.
- The company completes all the activities necessary to prepare the qualifying asset for its intended use or sale.
- The construction gets suspended.
Lastly, IAS 23 also dictates the interest rate that companies must take on the borrowing costs. The standard requires companies to differentiate between specifically borrowed funds and others. In the former case, they can capitalize on all the costs incurred. However, they must deduct any temporary investment income from those borrowed amounts.
What are the journal entries for Borrowing Costs?
Borrowing costs do not have any separate journal entries when capitalized. Instead, companies make these costs a part of the asset’s cost on recognition. However, the underlying resource must meet the qualifying asset definition set by the standard. Once companies satisfy those criteria, they can use the following journal entries for borrowing costs.
|Asset (Inventory, fixed assets, etc.)||XXXX|
However, the borrowing costs may not apply to the qualifying asset. Sometimes, they may not meet the definitions or criteria set by IAS 23. As IAS 23 states, companies cannot capitalize on those costs. Instead, they must account for them as an expense. In that case, the journal entries for those borrowing costs will be as below.
|Borrowing or Finance expense||XXXX|
The above accounting treatments for borrowing costs differ significantly. In the former case, these costs become a part of the asset’s cost on the balance sheet. Similarly, these costs contribute to the depreciation expense on that asset. In the latter case, the company expenses out these costs in the same period. These borrowing costs do not become a part of the asset’s cost or contribute to its depreciation.
A company, ABC Co., started constructing a new factory for its operations. The company purchased the site for $21 million. On top of that, it also incurred a construction cost of $9 million on that site. The company paid these expenses through a bank account. ABC Co. also acquired a loan of $20 million to fund the project with a 10% interest rate. However, it was only available for half the time the construction was in progress.
ABC Co. must determine the costs to capitalize for that borrowing cost. The cost of the factory will include the value of the site and construction. Therefore, it will amount to $30 million ($21 million factory site + $9 million construction). On top of that, the borrowing costs will amount to $2 million ($20 million x 10% interest rate). However, ABC Co. must only capitalize half of this cost since it was only available for that time.
Therefore, the overall cost of the factory will be $31 million ($30 million + $1 million borrowing costs). ABC Co. will use the following journal entries to record this cost.
|Interest payable||$1 mil|
ABC Co. cannot capitalize on the remaining borrowing costs of $1 million. However, it must account for that as an expense. ABC Co. will use the following journal entries to record it.
|Finance expense||$1 mil|
|Interest payable||$1 mil|
Borrowing costs include any finance costs incurred on a qualifying asset. However, these costs must relate to the asset’s acquisition, construction or production. IAS 23 also defines the requirements for when to commence and cease capitalizing those costs. Overall, accounting for borrowing costs involves using the guidelines set by the standard.