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Borrowing cost eligible for capitalization Amendments to IAS 23
The IFRS board has proposed to amend the IAS 23 in order to clarify the borrowing costs that are eligible for capitalization. The board plans to issue an amendment in December 2017 as part of its annual improvement of IFRS cycle. In September 2017, the board discussed what should be done to clarify the borrowing cost that should be capitalized in specific circumstance (IFRS 2017). The board plans to finalize this amendment in December 2017 as part of its annual improvement of IFRS cycle. The board discussed:
- How to account for interest on borrowed capital (IFRS 3 business combination).
- Consequence of income tax as a result of accounting for financial instrument classified as equity IAS 12
- Borrowing cost eligible for capitalization IAS 23
The board decided that the amendment is consistent with the requirement of annual improvement process. Moreover, entities were permitted to apply the amendment from January 2019 with early adoption permitted. This decision was agreed upon by 14 board members out of 15 members. Those who passed the amendment agreed that the process followed due process and there was adequate consultation. There was no member who showed intent to dissent the adoption of IFRS amendment 2015-2017. The board concluded that all borrowing cost should be capitalized only if they are directly related to the acquisition, production, and construction of qualifying assets.
Differences between GAAP and IFRS
Irrespective of measures taken to converge GAAP with IFRS, significant differences still exists. First, GAAP uses capitalized interest which refers to the expense capitalized as part of cost of asset (Veronica & lonel, 2010). The IFRS uses the term borrowing costs which refer to the costs incurred in relation to debt for construction of asset. This can be interpreted to mean that borrowing cost refers to finance cost, interest expense on debt, and finance lease. However, it is important to note that not all costs are capitalized. Only costs that are eligible for qualifying assets can undergo capitalization in a given period. Moreover, this capitalization is limited to a certain maximum costs. GAAP under FAS 34 argues that borrowing costs can only be added back under defined conditions to the cost of lived tangible assets; however, it only occurs under certain circumstances. In some circumstance, it is mandatory under GAAP that the cost of equity be treated as a cost of assets where defined criteria have been met. However, it is not mandatory for capitalize cost of equity under IFRS. Historically, IFRS has taken a different approach on the treatment of borrowing cost from that stipulated by GAAP. In 2007, IAS 23 tried to make amendment in order to converge the two accounting standards. However, there are still some differences between GAAP and IFRS about how to account for borrowing cost. The key differences between GAAP and IFRS are as follows:
- GAAP and IFRS differ on the definition of the term borrowing costs. IFRS uses the term borrowing cost which is a broader term than the term “interest cost” used by GAAP 34. GAAP clearly stipulates how to capitalize derivative gains and losses that are part of capitalized cost. This is different from IFRS which does not stipulate how derivative gains and losses should be treated.
- The term qualifying asset under GAAP and IFRS differs. Some assets that meet the criteria stipulated under qualifying asset in IFRS do not qualify under GAAP. Moreover, some assets that qualify in GAAP do not qualify under IFRS. For instance, GAAP includes qualifying assets in investee account while IFRS does not recognize such investments under the equity method. According to US GAAP, businesses are not permitted to capitalize interest cost of grant or gifts which is not covered under IFRS.
- IFRS and GAAP do not measure borrowing cost the same way. IAS 23 state that businesses must capitalize actual borrowing cost while in SFAS 34 the rate of borrowing can be employed.
According to GAAP, there are three costs that can be capitalized. First, interest expense which qualifies as borrowing cost under the effective interest method in IFRS (Henry, Lin, & Yang, 2009). Secondly, finance charge on lease qualifies as borrowing cost which should be capitalized under IAS 17. Lastly, exchange on borrowing should be capitalized but is limited to adjustment to interest costs. The proposed amendment did not clarify how to treat certain expenses such as interest cost on derivative and dividend payable on preference shares. The board failed to identify how these costs should be treated; this has created doubt whether the cost qualifies as borrowing cost or not. Another cost that has not been explored by the IFRS board is gains and losses resulting from repayment of borrowings. Accountants are left with one option which is to utilize the principles of IFRS standards when dealing with these costs to make their judgment.
Conclusions reached by the IASB committee
The revised standard was aimed at converging the differences between GAAP and IFRS. The board concluded that all borrowing cost should be capitalized only if they are directly related to the acquisition, production, and construction of qualifying assets. Before these amendments, the IFRS recognized all financing costs including interest expenses as period costs. These costs were deducted from the income statement. According to the proposed approach, all borrowing costs should be added back to the carrying value of a business if there is high probability that the asset will generate future economic benefits. However, these benefits must be measureable and consistent with US GAAP. The board concluded that assets that had been measured at fair value can be recognized in the income statement if borrowing cost is subjected to capitalization. Finally, the board noted that borrowing costs that do not qualify for capitalization should be measured at fair value.
The final outcome will not change significantly from GAAP. GAAP and IFRS agree that capitalization of interest on asset should be employed if the effect of capitalization and interest expense is material (Bushong & Cornell, 2015). However, if the effect is not material, then capitalization is not required. This means that both IFRS and GAAP agree that capitalization of borrowing/interest should only be employed if the effect is material. The proposed amendments are based on this principle which means that the effect of the new changes will have little impact on GAAP. In fact, the interest cost eligible for capitalization in both standards is the interest charged on borrowings and other obligations. Both GAAP and IFRS also capitalize interest expense on the bases of interest cost during a given period required to compete the asset. It is against this backdrop that this paper concludes that the proposed amendment by IFRS will have little impact on the accounting treatment of capitalization of interest expense/borrowing.
- Bushong, J. G., & Cornell, D. W. (2015). An Approach to Reducing Accounting Costs for Small Businesses. Journal of Small Business Strategy, 7(2), 45-58.
- Henry, E., Lin, S., & Yang, Y. W. (2009). The European-US “GAAP Gap”: IFRS to US GAAP Form 20-F Reconciliations. Accounting Horizons, 23(2), 121-150.
- IFRS (2017). Borrowing costs eligible for capitalization (Amendments to IAS 23). Retrieved from http://www.ifrs.org/projects/work-plan/borrowing-costs-eligible-for-capitalisation/
- Veronica, G., & lonel, B. (2010). IAS/IFRS Standards for SMEs and the impact on the Romanian accounting system. International Journal of academic research, 2(4), 3-9.