Chapter Chapter 1010

Appendix 10AAppendix 10ACapitalization of Borrowing CostsCapitalization of Borrowing Costs

Prepared by:Dragan Stojanovic, CA

Rotman School of Management, University of Toronto

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Borrowing Costs• Under IFRS, borrowing costs that can be

directly attributed to acquisition, construction, or development of “qualifying assets” should be capitalized.

• Under PE GAAP, management has a choice of capitalizing or expensing such costs.

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Capitalization of Borrowing Costs

• Four questions must be answered:• What are the qualifying assets?• What is the capitalization period?• What is the amount of interest to be

capitalized?• What disclosures are needed?

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Qualifying Assets• Assets that take a substantial period of time to get

ready for intended use or sale• Examples of assets that do not qualify:

– Assets ready for use or sale when acquired– Assets produced over a short period of time– Assets not undergoing development to get them

ready for use

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Capitalization Period• Capitalization period begins when all three

conditions are present:1. Expenditures for the asset have been

made2. Activities for readying the asset are in

progress3. Borrowing costs are being incurred

• Capitalization continues for as long as these three conditions exist

• Capitalization ends when asset is substantially complete and ready for use

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Amount to Capitalize• Borrowing costs must be directly related to

asset• Lower of actual borrowing costs or avoidable

borrowing costs– cost of capital for shareholders’ equity is

not included in borrowing costs• Weighted-average accumulated expenditures

(WAAE) method is used to find borrowing costs to be capitalized

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Borrowing Costs Capitalization – Issues

Amount of capitalized interest is based on the intended use of the land purchased

Intended Use: Capitalized Interest Cost Attached to:

Lot Sales Developed land

Specific Purpose Land

Structure Site Structure

Investment Interest costs should not be capitalized

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Calculating Avoidable Borrowing Costs

• To calculate avoidable borrowing costs, follow four steps:

1. Determine qualifying asset expenditures2. Determine avoidable borrowing costs relating

to asset-specific debt3. Determine avoidable borrowing costs relating

to non-asset-specific debt4. Determine final avoidable borrowing costs

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Shalla Corporation – Example

Given:• November 1, 2010 contracts with Pfeifer Construction

Co. Ltd. to construct a $1.4 million building (on land costing $100,000)

• First payment made by Shalla to Pfeifer includes the payment for the land

• Payments made in 2011:– January 1 $ 210,000– March 1 $ 300,000– May 1 $ 540,000– December 31 $ 450,000– Total $1,500,000

• Building completed December 31, 2011

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Shalla Corporation – Example

• Debt outstanding at December 31, 2011– Specific Construction Debt:

15%, three year notedated December 31, 2010 $750,000

– Other Debt:10%, five year notedated December 31, 2007 $550,00012%, ten year bondsdated December 31, 2004 $600,000

• Interest on debt is payable each December 31

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Shalla Corporation – ExampleSTEP 1: Determine qualifying asset expendituresWeighted-Average Accumulated Expenditures:Jan. 1 $ 210,000 x 12/12 = $210,000Mar. 1 300,000 x 10/12 = 250,000May. 1 540,000 x 8/12 = 360,000Dec. 31 450,000 x 0/12 = 0WAAE $820,000

Note: Land payment is included in WAAE

Next step: Avoidable interest and appropriateinterest rate calculation

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Shalla Corporation – Example• STEP 2: Determine avoidable borrowing

costs relating to asset-specific debt• $750,000 x 15% = $112,500

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Shalla Corporation – Example

PrincipalBorrowing cost5-year note $550,000 $ 55,00010-year note $600,000 72,000Total $127,000Weighted-Average Interest Rate =Total Interest Total Principal(Do not include Construction Specific Debt)$127,000 (550,000 + 600,000) = 11.04%

STEP 3: Determine avoidable borrowing costs relating to non-asset-specific debt

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Shalla Corporation – Example

Total WAAE $820,000Less: financed by specific loan $750,000WAAE financed by general borrowings $70,000X avoidable borrowing cost on general 11.04%Avoidable costs on general debt $7,728

Shalla Corporation – Example• STEP 4: Determine total borrowing costs

to capitalize

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Avoidable borrowing costsOn asset-specific debt $112,500On general debt $7,728TOTAL $120,228

Actual Interest:$750,000 x 15% = $112,500 550,000 x 10% = 55,000 600,000 x 12% = 72,000Total actual interest paid $239,500

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Shalla Corporation – Example

Avoidable interest = $120,228Actual interest = $239,500

The lesser of these two amounts is capitalized

Journal Entry:Dr. Building 120,228 Cr. Interest Expense 120,228

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Interest Capitalization – Significance

• Capitalized interest increases net income for the period

• Impact on EPS can be significant

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Disclosures

• Two disclosures required: – Amount capitalized– Capitalization rate

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