IAS 23 Borrowing Costs — Summary, Worked Example & Practice Questions

The rule at the heart of the standard is short. Where funding costs are directly tied to buying, building or producing a qualifying asset, they are treated as one of the costs of that asset; all other funding costs are charged against profit as they arise (IAS 23.8). Capitalisation is not optional where the criteria are met — the word used is a requirement, not a permission, and an entity cannot choose to expense the interest simply because that is administratively easier.

A borrowing cost means the interest and the other charges an entity carries because it has borrowed money (IAS 23.5). The population is wider than a bank loan coupon, and exam questions routinely include one of the less obvious items to see whether students spot it.

• Interest worked out under the effective interest method, so the figure reflects any discount, premium or issue costs spread across the life of the debt rather than just the cash coupon.
• The finance charge element of a lease liability recognised under IFRS 16, which is a borrowing cost in the same way an interest payment is.
• Differences arising on foreign currency borrowings, but only to the extent they can be regarded as standing in for an interest saving — that is, the part representing the gap between borrowing in the foreign currency and borrowing the same amount domestically.

Two items commonly offered as distractors are not borrowing costs at all. Dividends paid on ordinary shares are a distribution of profit rather than a charge for the use of borrowed money, and the unwinding of a discount on a provision under IAS 37 arises from the passage of time on a liability the entity did not borrow. Neither is capitalised under this standard.

A qualifying asset is one that inevitably needs a considerable stretch of time before it is fit to be used for its intended purpose or offered for sale (IAS 23.5). The standard sets no number of months; judgement is applied to the nature of the asset and the entity discloses its approach where the point is significant. In practice, anything running beyond a reporting period is comfortably inside, and a build of a few months usually is not.

• A manufacturing plant, power station or similar facility built over more than one accounting period.
• Property, plant and equipment the entity constructs for itself rather than buying ready-made.
• Inventories that need an extended maturing or ageing process — spirits, cheeses, timber — as opposed to ordinary trading stock.
• Investment property while it is still being built or redeveloped, provided it is not carried at fair value.
• Intangible assets in a development phase where capitalisation under IAS 38 has begun.
• Bearer plants during the period before they reach the condition in which they can produce.

Three categories sit permanently outside the requirement. An asset that is fit for its purpose the moment it is acquired attracts no interest at all, however it was financed — buying a delivery van on credit does not turn the loan interest into part of the van. Inventory turned out routinely in bulk, over short and repeating production runs, is excluded even where the total quantity is large, because it is the individual item's preparation time that matters and not the aggregate scale of the operation (IAS 23.4(b)).

The third exclusion is more of a relief than a prohibition. Where a qualifying asset is carried at fair value — a biological asset, or investment property measured under the fair value model — the entity is not obliged to capitalise, because any interest added would simply be washed out again at the next remeasurement and the exercise would change nothing except the split between the cost added and the fair value gain reported (IAS 23.4(a)).

Where an entity has borrowed money expressly to fund a particular project, the arithmetic is direct. The amount added to the asset is the interest actually incurred on that facility for the period, reduced by any return the entity made on parking the portion of the loan it had not yet spent (IAS 23.12).

The deduction of investment income surprises students, but it follows from the logic of the rest of the standard. Drawing down a construction loan in full at the outset and leaving part of it on deposit until the contractor invoices is a normal cash-management step; the net cost of financing the build over that stretch is the interest suffered less the interest earned, and it is that net figure that represents what the asset genuinely cost to fund. Note how narrow the offset is: only income from investing the surplus out of that same borrowing is netted off. Returns on the entity's own spare cash, or on funds from an unrelated loan, stay in investment income and never touch the asset's carrying amount.

One further point of order matters when both types of funding are present. Expenditure is treated as absorbed by the specific loan first, and only the excess is regarded as having come from the general pool. Failing to make that deduction is the single most common way of overstating the general-borrowings figure.

Most construction is funded from the entity's overall stock of debt rather than a dedicated facility, and no particular loan can be traced to the asset. IAS 23 solves this by asking what a typical dollar of the entity's general debt costs, then charging the project for the dollars it used and the length of time it used them (IAS 23.14).

• Work out the capitalisation rate: total borrowing costs on the general debt outstanding during the period, divided by the weighted average balance of that debt. Any loan raised specifically for a qualifying asset is stripped out of both halves of that fraction before you start.
• Work out the weighted-average expenditure on the asset that the general pool had to fund — that is, cash spent on the project net of anything covered by a specific loan, with each amount weighted for the fraction of the period it was outstanding.
• Multiply the two. That product is the amount capitalised from general borrowings.
• Apply the ceiling: the figure capitalised in a period can never exceed the borrowing costs the entity actually incurred on its general debt in that period (IAS 23.14).

The weighting step is where marks are usually lost. Money spent on the first day of the year has been funded for twelve months and enters at its full amount; money spent halfway through has been funded for six and enters at half. Cumulative expenditure, not the period's spend alone, is what the pool is financing, so a project running across several years carries forward the earlier outlay into the following year's weighted average at its full value.

The cap exists to stop an entity capitalising interest it never suffered. If the weighted expenditure on several concurrent projects exceeds the general debt outstanding, the raw calculation would manufacture a charge larger than the real one, so the total is pulled back to the actual cost incurred and allocated across the projects.

Capitalisation is switched on only when three things are true at the same time, and it begins on the latest of the dates on which they become true (IAS 23.17). The entity must have started spending money on the asset, it must have started incurring the funding cost, and the work needed to make the asset ready must actually be under way. Sitting on a plot of land with a loan against it and no activity fails the third test, so the interest goes to profit or loss.

That third condition is broader than it sounds. Physical construction is the obvious case, but the technical and administrative effort that necessarily precedes it — securing the permits, finalising the design — counts as well (IAS 23.19). What does not count is simply holding an asset while nothing is being done to change its condition.

Capitalisation is paused where work is interrupted for a prolonged spell and the asset is left standing (IAS 23.20). The exclusions from that pause matter more in exams than the rule itself. A short-lived hold-up does not trigger a suspension, and neither does a break during which substantial technical or administrative work is still being carried out behind the scenes. Nor does a delay that forms an unavoidable part of the process itself: inventory that must sit and mature, or high water levels that predictably stop bridge work every year in the same season, are stages of the build rather than interruptions to it, and interest keeps accruing to the asset.

Capitalisation is switched off for good once essentially everything needed to bring the asset to its intended condition has been done (IAS 23.22). The test is completion in substance rather than to the last detail: minor snagging, decorating or a final round of tidying up left outstanding does not keep the window open. Where a project is built in parts and each part can be used while the rest continues — a business park of separate buildings — capitalisation stops for each part as it is finished. Where the asset only works as a whole, such as a plant with sequential processing stages that are useless individually, the entity keeps capitalising until the entire facility is ready (IAS 23.24–25).

The disclosure burden under this standard is unusually light — two figures (IAS 23.26). The entity states how much it added to asset carrying amounts as borrowing costs during the period, and it states the rate it used to arrive at the amount taken from general borrowings.

Those two numbers are more revealing than they look. Read alongside the finance cost in profit or loss, the capitalised figure shows a reader how much of the year's interest bill has been diverted onto the balance sheet and will surface in later years through depreciation or cost of sales rather than now. Since the choice of qualifying assets and the boundaries of the capitalisation window both involve judgement, the accounting policy note usually explains those judgements as well, even though this standard does not itself demand it.