Study of IAS 23 Standard: Borrowing Costs

IAS 23 Standard “Borrowing Costs” outlines how to account for costs incurred by an entity when borrowing funds. IAS 23 Standard specifies when borrowing costs should be capitalized as part of the cost of an asset, and when they should be recognized as an expense in the income statement. In this article, we will provide a comprehensive study of IAS 23 Standard, discuss its objectives, scope, and key requirements, focusing on the definition of borrowing costs, the conditions for their capitalization, and how to calculate them, in addition to highlighting the importance of this standard and its impact on financial statements.

What are Borrowing Costs?

Borrowing costs are interest and other costs that an entity incurs in connection with the borrowing of funds.

Borrowing costs include:

• Interest expense calculated using the effective interest method as described in International Financial Reporting Standard 9 (IFRS 9).  
• Finance charges relating to finance leases recognized in accordance with International Financial Reporting Standard 16 (IFRS 16).
• Exchange differences arising from foreign currency borrowings to the extent that they are regarded as an adjustment to interest costs.  

Examples of borrowing costs:

• Interest on bank loans.
• Interest on overdrafts.
• Interest on bonds.
• Loan arrangement costs, such as commitment fees and issuance fees.
• Interest expense on lease liabilities.
• Exchange differences arising from foreign currency borrowings (under specific conditions).

What is IAS 23 Standard: Borrowing Costs?

IAS 23 Standard is one of the International Financial Reporting Standards that specifies the accounting treatment for borrowing costs. The standard specifies when borrowing costs should be capitalized as part of the cost of an asset, and when they should be recognized as an expense in the income statement.

Objectives of International Accounting Standard 23 Standard (IAS 23 Standard):

• Specify the accounting treatment for borrowing costs: IAS 23 Standard provides clear guidance on how to account for borrowing costs, whether by capitalizing them or charging them to expenses.
• Improve the quality of financial information: IAS 23 Standard aims to improve the quality, relevance, and reliability of financial information relating to borrowing costs.
• Enhance comparability: IAS 23 Standard contributes to improving the comparability of companies’ financial statements by standardizing how borrowing costs are treated.
• Provide useful information for decision-making: IAS 23 Standard helps users of financial statements understand the impact of borrowing costs on an entity’s financial position and financial performance.

Scope of International Accounting Standard 23 Standard (IAS 23 Standard):

IAS 23 Standard applies to all entities that prepare financial statements in accordance with International Financial Reporting Standards, except for:  

• Qualifying assets measured at fair value, such as biological assets that fall within the scope of International Accounting Standard 41 “Agriculture.”
• Inventory that is produced or manufactured in large quantities on a repetitive basis.

Qualifying Asset:

A qualifying asset is an asset that necessarily takes a substantial period of time (usually more than one year) to get ready for its intended use or sale.

Examples of qualifying assets:

• Factories.
• Power generation plants.
• Self-constructed property, plant, and equipment.
• Intangible assets under development, such as computer software.
• Investment properties under construction.
• Ships and aircraft.
• Pipelines.

The following assets are not considered qualifying assets:

• Financial assets.
• Inventory that is manufactured or produced over a short period of time.
• Assets that are ready for their intended use or sale upon acquisition.

Key Requirements of IAS 23 Standard:

1. Capitalization of Borrowing Costs:
   • Basic Rule: 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.  
   • Expense Recognition: Other borrowing costs shall be recognized as an expense in the period in which they are incurred.
2. Commencement of Capitalization:
   • Capitalization of borrowing costs as part of the cost of a qualifying asset commences when:
     • Expenditures on the asset are being incurred: That is, when the entity begins to spend money on the acquisition, construction or production of the asset.
     • Borrowing costs are being incurred: That is, when the entity incurs interest or other costs related to borrowing.
     • Activities that are necessary to prepare the asset for its intended use or sale are in progress: That is, when the actual development activities of the asset begin, and are not limited to preliminary activities.
3. Suspension of Capitalization:
   • Capitalization of borrowing costs shall be suspended during extended periods in which active development of the asset is interrupted. Capitalization is not usually suspended when substantial technical or administrative work is being carried out, or when a temporary delay is a necessary part of the process of getting an asset ready.  
4. Cessation of Capitalization:
   • Capitalization of borrowing costs ceases when:
     • Substantially all the activities necessary to prepare the qualifying asset for its intended use or sale are complete. This is usually when the physical construction of the asset is complete, even if routine administrative work is still ongoing.  
     • Or when the asset is sold.

Calculation of Capitalizable Borrowing Costs:

• If an entity borrows funds specifically for the purpose of obtaining a particular qualifying asset, the capitalizable borrowing costs are the actual costs incurred on that borrowing during the period less any investment income from the temporary investment of those borrowings.
• If an entity borrows funds generally and uses them for the purpose of obtaining a qualifying asset, the amount of capitalizable borrowing costs shall be determined by applying a capitalization rate to the expenditures on that asset. The capitalization rate shall be the weighted average of the borrowing costs applicable to the entity’s outstanding borrowings during the period, other than borrowings made specifically.  
• Note: The amount of borrowing costs that an entity capitalizes during a period shall not exceed the amount of borrowing costs it incurs during that period.  

Disclosures Required under IAS 23 Standard:

IAS 23 Standard requires entities to disclose the following information:

• The accounting policy adopted for borrowing costs.
• The amount of borrowing costs capitalized during the period.
• The capitalization rate used to determine the amount of capitalizable borrowing costs.
• The amount of interest expense recognized during the period.
• The basis for considering what an asset is a qualifying asset.

Importance of IAS 23 Standard for Companies:

IAS 23 Standard is an important International Financial Reporting Standard that helps companies:

• Comply with International Financial Reporting Standards: IAS 23 Standard ensures that companies treat borrowing costs consistently with International Financial Reporting Standards.
• Improve the quality of financial reporting: The application of IAS 23 Standard improves the quality, relevance, and reliability of financial information relating to borrowing costs and their treatment.
• Enhance investor confidence: IAS 23 Standard helps build investor confidence by providing more accurate and transparent information about how borrowing costs are treated and their impact on an entity’s financial position and financial performance.
• Determine the cost of assets more accurately: Capitalizing borrowing costs helps to determine the cost of qualifying assets more accurately, leading to better pricing and investment decisions.
• Better manage financing costs: IAS 23 Standard provides a clear accounting framework for borrowing costs, helping companies manage financing costs more effectively.

Challenges in Applying IAS 23 Standard:

• Determining whether an asset qualifies for capitalization: It can be difficult in some cases to determine whether an asset is considered a “qualifying asset” as defined by IAS 23 Standard, especially when the construction of the asset takes a long time or involves multiple stages.
• Determining the borrowing costs that are directly attributable to the qualifying asset: It may be difficult to determine the borrowing costs that can be directly attributed to the acquisition, construction or production of the qualifying asset, especially in the case of general borrowing.
• Calculating the capitalization rate: Calculating the capitalization rate in the case of general borrowing requires the use of the weighted average of borrowing costs, which can be a complex process and requires accurate data on all outstanding loans.
• Determining when capitalization should commence, be suspended and cease: Determining the timing of commencement, suspension and cessation of capitalization may require a degree of professional judgment, especially in cases of temporary or partial suspension of asset development.

The Role of Technology in Applying IAS 23 Standard:

Accounting software and Enterprise Resource Planning (ERP) systems help in applying IAS 23 Standard more efficiently and accurately by:

• Automating the process of calculating capitalizable borrowing costs.
• Tracking borrowing costs related to each qualifying asset.
• Determining the timing of commencement, suspension and cessation of capitalization.
• Issuing the necessary reports to comply with disclosure requirements.
• Improving the accuracy and comprehensiveness of financial information relating to borrowing costs.

Detailed Examples of Applying IAS 23 Standard:

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Conclusion:

International Accounting Standard 23 Standard (IAS 23 Standard) “Borrowing Costs” provides clear guidance on how to treat borrowing costs related to qualifying assets. The application of this standard ensures that financial statements reflect the