Definition
Capitalization of borrowing costs refers to the accounting practice of adding interest and other borrowing costs incurred to finance the construction or acquisition of qualifying assets to the cost of those assets. This contrasts with expensing these costs immediately on the income statement. By capitalizing borrowing costs, businesses can more accurately match costs with the periods in which the benefits from the assets are realized.
Qualifying Assets
These assets generally include:
- Assets that take a substantial period of time to get ready for their intended use or sale, such as buildings, machinery, and certain inventory.
- Investment properties being constructed or developed.
Examples
Example 1: Construction of a Manufacturing Plant
A company is constructing a new manufacturing plant which will take two years to complete. The company takes out a loan to finance this construction, incurring $500,000 in interest over the construction period. Instead of expensing this interest cost on the income statement, the company capitalizes it and adds it to the cost of the plant in the balance sheet. This results in a higher asset value for the plant.
Example 2: Developing Proprietary Software
A tech company is developing new proprietary software that will take 18 months to complete. The company incurs $100,000 in interest on borrowed funds during this period. By capitalizing these borrowing costs, the $100,000 is added to the cost of the software as an asset.
Frequently Asked Questions (FAQs)
What are borrowing costs?
Borrowing costs are interest and other costs incurred by a company in connection with the borrowing of funds. They include interest expense, finance charges on finance leases, and certain exchange differences arising from foreign currency borrowings.
Can all borrowing costs be capitalized?
No, only borrowing costs directly attributable to the acquisition, construction, or production of qualifying assets are eligible for capitalization.
How do companies determine the amount of borrowing costs to capitalize?
The amount capitalized is typically computed based on the weighted average cost of borrowing rates applied to expenditures on qualifying assets.
When should the capitalization of borrowing costs cease?
Capitalization should cease when substantially all the activities necessary to prepare the qualifying asset for its intended use or sale are complete.
How does capitalization of borrowing costs affect financial statements?
Capitalizing borrowing costs increases the cost of assets on the balance sheet and reduces interest expense on the income statement in the periods the costs are being capitalized.
Related Terms
Borrowing Costs
Costs incurred by an organization in the borrowing of funds, which include interest expense and other associated financial costs.
Qualifying Asset
Assets that require a substantial period of time to get ready for their intended use or sale, such as construction projects or large-scale developments.
Interest Expense
The cost incurred by an entity for borrowed funds, it often appears as a line item on the income statement.
Finance Lease
A type of lease classified as a purchase by the lessee, with finance charges included as borrowing costs.
Online Resources
Suggested Books for Further Studies
- Intermediate Accounting by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield
- Financial Accounting Theory by William R. Scott
- IFRS – A Quick Reference Guide by Robert Kirk
Accounting Basics: Capitalization of Borrowing Costs Fundamentals Quiz
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