Borrowing cost includes interest, processing fee, or any other costs associated with the borrowing of funds. Generally, borrowing costs are charged as expense in income statement. However, borrowing costs incurred for the acquisition, production, or construction of a qualifying asset are capitalized as part of that qualifying asset. In this chapter, we’ll discuss the capitalization of borrowing costs and conditions and requirements associated with it.
What is a qualifying asset? An asset that requires substantial period of time to get ready for its intended purpose is known as a qualifying asset.
Management’s judgement is needed to make a call about what will be considered as a substantial period of time. However, this judgement should be reasonable and should be applied consistently. For instance, a company is involved in two lines of businesses, manufacturing of furniture and construction of small flats. On average, furniture items are manufactured in two-three weeks, which cannot be considered as substantial period of time, and therefore cannot be classified as qualifying assets. However, small flats are constructed in almost 10 months. So, management can make a judgement call that small flats are qualifying assets, as substantial period of time is required for construction.
Qualifying asset can be an entity’s property, plant and equipment, investment property, intangible asset, inventory etc. depending on its intended purpose.
Borrowing costs incurred only during the capitalization period is capitalized. Capitalization period commences when all of the following conditions are met:
- borrowing costs are being incurred
- expenditure for the asset is being incurred
- activities that are necessary to prepare the asset for its intended purpose are in progress
Capitalization period ends when the qualifying asset is substantially complete. The costs that have already been capitalized remain as a part of the asset’s cost, but no additional borrowing costs are capitalized once the asset is substantially complete.
During this capitalization period, capitalization of borrowing costs can be suspended if the development of the qualifying asset is suspended for an extended period of time.
Borrowing costs can be associated with the following two types of borrowings:
- Specific borrowings (funds borrowed specifically to finance the development of a qualifying asset)
- General borrowings (borrowings other than specific borrowings, for e.g. Funds borrowed to meet the general working capital requirements of the business etc.)
Methods for capitalization of borrowing costs associated with both types of borrowings are different which are summarized below.