BORROWING COSTS MFRS 123

Learning Objectives Define borrowing costs. Explain the accounting issues for borrowing costs. Apply the accounting treatment for borrowing costs. Prepare financial statement extracts for borrowing costs.

Definition of borrowing costs Interest and other costs that are incurred when funds are borrowed. MFRS 123 SCOPE: Borrowing costs incurred on funds borrowed to construct or develop an asset. (Qualifying assets) Include: Interest on bank overdrafts, short-term & long-term borrowings Amortisation of discounts/premiums relating to borrowings Amortisation of ancillary costs incurred in the arrangement of borrowings Finance charges in respect of finance leases (MFRS 117) Exchange differences arising from foreign currency borrowings, to the extent they are regarded as an adjustment to interest costs.

Issue Capitalise? the borrowing cost as part of the cost of assets (qualifying assets), because: They are part of construction costs just like material, labour & overheads – without borrowed funds, construction costs cannot proceed Cost of the ready-made asset includes the borrowing costs & will be taken into account when pricing the asset. Write off? the borrowing cost in income statement when incurred because: Borrowing costs are period costs Borrowing costs may not be specifically for the construction but for the overall operation of the enterprise

Qualifying assets An asset that necessarily takes a substantial period of time to get ready for its intended use or sale. This include: the construction of building, long term construction contract R&D; and the production of inventories that take a considerable period of time to bring to saleable condition and others. Not qualifying assets are: inventories routinely produced on a repetitive manner over a short period of time Assets ready for intended use If entity borrows for other reasons – these costs will be expensed off as period costs.

Capitalisation of borrowing costs Conditions: It is probable that they will result in future economic benefit to the enterprise; and The cost can be measured reliably Funds borrowed are specifically for the purpose of obtaining a qualifying asset

Borrowing costs eligible for capitalisation = Borrowing costs on the funds borrowed less any income from temporary investment of the borrowing E.g. An entity borrowed RM39m for the construction of a building that is estimated to cost RM45m. However, only RM10m was used and the balance of RM29m was invested temporarily. Investment income of RM400,000 was earned on the temporary investments. Interest accrued on the borrowing of RM39m was RM2m. Borrowing costs could be capitalised if borrowing was to construct a qualifying asset. Borrowing costs to be capitalised = RM2m – RM400,000 = RM1.6m. To be capitalised as part of construction cost of building.

Central borrowings Borrowing is sometimes done centrally Or entity might take up different loan packages with varying interest rates If the fund was borrowed generally, without specification of amount for the project: Measure borrowing cost by applying a WEIGHTED AVERAGE INTEREST RATE

Central borrowings On 1 Jan x5, Jay Bhd raised finance amounting to RM400,000. The borrowing was to finance both a construction of a plant and for operations. On 31 Dec x5, the outstanding borrowings were RM400,000 with no capital repayment in x5. The borrowings were mainly used for the construction of the plant at the cost of RM300,000. Jay Bhd wants to capitalise borrowing costs on qualifying assets. Borrowings details: 31.12.x5 (RM) 12% loan stock 100,000 10% term loan 220,000 8% redeemable preference shares 80,000

Central borrowings Compute the capitalisation rate & the amount of interest that qualifies for capitalisation for the year ended 31.12.x5. Of the borrowings of RM400,000, only the borrowing costs pertaining to RM300,000 is eligible for capitalisation. The borrowings are from different sources & differ in interest rates. The weighted average rate will be used to determine the amount of interest that can be capitalised.

Central borrowings Capitalisation rate: Principal at 31.12.x5 Weighted average (a) Interest rate (b) (a) X (b) (%) 12% loan stock 100,000 25% 12% 3.0 10% term loan 220,000 55% 10% 5.5 8% redeemable preference shares 80,000 20% 8% 1.6 400,000 100% 10.1%

Central borrowings Principal at 31.12.x5 Interest rate RM Total interest: Interest that can be capitalised: RM300,000 x 10.1% = RM30,300 Interest that can be charged as expense = RM40,400 – RM30,300 = RM10,100 Principal at 31.12.x5 Interest rate RM 12% loan stock 100,000 12% 12,000 10% term loan 220,000 10% 22,000 8% redeemable preference shares 80,000 8% 6,400 400,000 40,400

Limitation to Capitalisation If the carrying amount of an asset on the total cost of the asset (including borrowing cost) > its recoverable amount or net realisable value (NRV) Asset has to be written down/written off accordingly. Inventory  written down to NRV PPE  written down to recoverable amount

Commencement of Capitalisation When: Expenditure for the asset is being incurred Borrowing costs are being incurred; and Activities that are necessary to prepare the assets for its intended use or sale are in progress If the fund is raised before the construction starts, borrowings cost to be capitalised is from the date when the construction starts.

Suspension of Capitalisation Capitalisation stops when active development is interrupted. Borrowing costs incurred during the interruption period will not be capitalised. Not considered interruption of construction: If the physical activities were not carried out, but technical works still carried on Necessary temporary delays Extended period for inventory to mature Delays in construction

Cessation of Capitalisation When all the construction activity is completed When substantially all activities necessary to prepare the assets for its intended use or sale are complete Usually when physical construction is complete, eventhough some admin work/decoration of asset is not done When the construction of a qualifying asset is completed in parts and each part is ready for use while construction continues on the other parts, capitalisation should cease when substantially all the activities necessary to prepare that pat for its intended use/sale are complete.

Worked Example Everywhere Bhd started constructing a building on 1.1.x1. The building was completed on 31.12.x3. The useful life of the building was estimated to be 50 years. Construction costs (excluding interest) incurred on the building was RM1.5m. Everywhere Bhd secured a loan of RM1m from Rich Finance Bhd in x1 to finance the construction costs. Interest on the loan was charged at 10% p.a. Repayment period of the loan was 5 years. Since Everywhere Bhd did not need the full amount of the loan in the first year of the construction, it deposited RM600,000 in a fixed deposit which yielded an interest of 8% p.a. The deposit matured on 31.12.x1.

Worked Example Calculate the cost of the building. Construction cost of building RM1,500,000 Interest capitalised: RM1m x 10% x 3 years = RM300,000 Less: Interest income from fixed deposit 600,000 x 8% = (48,000) RM1,752,000

Interest costs have been capitalised during construction Worked Example Show the statements of comprehensive income (extract) for the years ended 31.12.X1 to 31.12.X4. Interest costs are charged as expenses after year 3: RM1m x 10% X1 RM X2 X3 X4 Expenses: Interest expense - 100,000 Depreciation 35,040 Cost of building RM1,752,000/50 years Interest costs have been capitalised during construction

Disclosures in Financial Statements Should include: Amount of borrowing capitalised for the period Capitalisation rate used to determine amount of borrowing costs eligible for capitalisation.

Class exercise