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.
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
### Can the interest on a loan used to purchase a short-term investment be capitalized?
- [ ] Yes, all borrowing costs can be capitalized.
- [x] No, short-term investments do not qualify for capitalization.
- [ ] Only if the interest is below market rate.
- [ ] Only if the investment is hedged.
> **Explanation:** Short-term investments are generally not qualifying assets as they do not take a substantial period of time to be ready for their intended use or sale.
### What type of assets are typically classified as qualifying?
- [ ] Office supplies
- [x] Construction projects
- [ ] Marketable securities
- [ ] Intangible assets with indefinite lives
> **Explanation:** Qualifying assets are typically those that take a substantial period of time to get ready for their intended use or sale, such as construction projects.
### When does capitalization of borrowing costs typically cease?
- [ ] At the end of the financial year
- [ ] When the loan is repaid
- [ ] When the borrowing costs exceed a specified limit
- [x] When the asset is ready for its intended use or sale
> **Explanation:** Capitalization of borrowing costs ceases when substantially all the activities necessary to prepare the qualifying asset for its intended use or sale are complete.
### Which of the following borrowing costs can be capitalized?
- [ ] Interest expense from any loan
- [x] Interest expense directly attributable to acquiring a qualifying asset
- [ ] Financial advisory fees
- [ ] Debt insurance premiums
> **Explanation:** Only interest expense directly attributable to the acquisition, construction, or production of a qualifying asset can be capitalized.
### What is the effect of capitalizing borrowing costs on the income statement?
- [ ] It has no effect.
- [x] It reduces interest expense.
- [ ] It increases revenue.
- [ ] It decreases net assets.
> **Explanation:** Capitalizing borrowing costs reduces the interest expense on the income statement because these costs are added to the asset's cost rather than expensed immediately.
### How are borrowing costs that are not attributable to qualifying assets treated?
- [ ] Capitalized by default
- [x] Expensed immediately
- [ ] Accrued and deferred
- [ ] Off balance sheet
> **Explanation:** Borrowing costs that are not directly attributable to the acquisition, construction, or production of qualifying assets are expensed immediately.
### When calculating the amount to capitalize, which rate is applied?
- [ ] The corporate bond yield rate
- [x] The weighted average borrowing rate
- [ ] The prime loan rate
- [ ] The discount rate of central bank lending
> **Explanation:** The amount of borrowing costs eligible for capitalization is typically computed using the weighted average borrowing rate applied to the expenditures on the qualifying assets.
### Does the capitalization of borrowing costs apply under both IFRS and GAAP?
- [x] Yes
- [ ] No
- [ ] Only under IFRS
- [ ] Only under GAAP
> **Explanation:** Both International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP) allow the capitalization of borrowing costs.
### Can borrowing costs attributable to the production of inventory be capitalized?
- [x] Yes, if the inventory takes a substantial period of time to prepare for sale.
- [ ] No, inventory borrowing costs are never capitalized.
- [ ] Only for perishable goods.
- [ ] Only if specifically allowed by local GAAP.
> **Explanation:** Borrowing costs attributable to the production of inventory can be capitalized if the inventory takes a substantial period of time to prepare for its intended sale.
### Which accounting standard covers the capitalization of borrowing costs under IFRS?
- [ ] IAS 24
- [ ] IFRS 15
- [x] IAS 23
- [ ] IFRS 9
> **Explanation:** International Accounting Standard (IAS) 23 under IFRS specifically provides guidance on the capitalization of borrowing costs.
Thank you for diving deep into the subject of capitalization of borrowing costs and tackling our advanced quiz questions. Keep pushing forward to deepen your understanding of accounting principles!
