CA. Amit Kothari, FCA

Paper 5: Advanced Accounting Chapter 2 AS -16 Borrowing Costs

Learning Objectives

1 • Applicability, Scope & Objective

2 • Borrowing Costs

3 • Qualifying Asset

4 • Treatment of Borrowing Cost

5 • Borrowings (Specific and General)

6 • Timings for Capitalization

7 • Exchange Differences on Foreign Borrowings

8 • Disclosure

9 • Sums

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APPLICABILITY, SCOPE AND OBJECTIVE

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Applicability & Scope

AS-16 is mandatory for accounting periods commencing on or after 1.4.2000

This AS should be applied in accounting for borrowing cost.

It does not deal with actual or imputed cost of owner’s equity including preference share capital

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Objective

The objective of this Standard is to prescribe the

accounting treatment for borrowing costs.

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BORROWING COSTS An Intro

Definitions – Borrowing Cost

Interest and other cost* incurred by an enterprise in connection with the borrowing of funds.

*Items of other costs are covered under para 4(b) to 4(e)

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Definitions – Borrowing Cost

The Borrowing Costs as defined in Para 4 include:

a • Interest & commitment charges,

b • Amortization of discount & premium on borrowings,

c • Amortization of ancillary cost in connection with the arrangement of

borrowings,

d • Finance charges in respect of finance lease,

e • Exchange differences from foreign borrowings to the extent they are an

adjustment to the interest cost (explained in detail later).

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QUALIFYING ASSET - QA

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Definition- Qualifying Asset (QA)

Asset that necessarily takes a substantial period of time to get ready for its intended use or sale.

• Egs: Manufacturing plant, • Power generation facilities, • Inventory that require substantial time to bring them to saleable condition, • Investment Properties

Other investments and inventories that are routinely manufactured in large quantities on a repetitive basis over a short period of time are NOT QA’s.

Assets that are ready for their intended use or sale when acquired also are not QA’s. Egs: Vehicles

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Substantial Period of Time- (Erstwhile ASI 1)

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Ordinarily, a period of twelve months is considered as substantial period of time. The following assets

ordinarily take substantial period of time

Assets constructed or otherwise produced for an enterprise’s

own use

Eg: assets constructed under major capital expansions.

Assets intended for sale or lease, constructed or otherwise produced as discrete projects.

Egs: ships or real estate developments.

Are inventories QA?

• Egs: Wine is often required to be kept in store for more than twelve months for maturing. So for a wine manufacturing unit, wine could be a QA.

• Similarly for plantation company’s selling teak wood, inventories could be QA.

In case of inventories, substantial period of time is considered to be involved where time is the major factor in bringing about a change in the condition of inventories.

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TREATMENT OF BORROWING COST

Treatment of Borrowing Cost – Para 6

To be Capitalized Not to be Capitalized Borrowing cost directly attributable to acquisition, production or construction of a QA should be capitalized as a part of the cost of that asset.

Other borrowing cost should be expensed off in the period in which they are incurred.

These are those that would have been avoided if the expenditure on the QA had not been made. Capitalized only when it is probable that they will result in future economic benefits to the enterprise. Cost can be measured reliably.

Any income earned on the temporary investment of those borrowings is deducted from the borrowing costs incurred.

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BORROWINGS (SPECIFIC AND GENERAL)

Borrowings of an Enterprise

Borrowings

Specific General

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Specific Borrowings

Say a company has taken a loan from a bank for express purpose of construction of an office building. This becomes a case of specific borrowing.

Actual borrowing cost incurred on the borrowing during the period is Capitalized.

Any income earned on temporary investment of these borrowings is deducted from the borrowing cost incurred

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GB: Example

Say a company has availed 4 different types of loans totaling Rs. 100 crores. Out of which amount expended for a QA is Rs. 25 crores. Which loan is utilized for the QA is not known. Then how does one capitalize the Borrowing Cost?

This is a case of General Borrowings.

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General Borrowings

• applying a capitalization rate to

• the expenditure on that asset.

The amount of borrowing cost

eligible for capitalization should

be determined by

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GB: Capitalization Rate

It is the weighted average borrowing cost applicable to the general borrowings outstanding during the period.

Borrowing Cost capitalized should not exceed the actual borrowing cost incurred during the year.

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GB – Expenditure on the QA

EXPENDITURE ON THE QUALIFYING ASSET

Payment of cash XX

(+) Transfer of assets XX

(+) Assumption of Interest bearing liabilities XX

(-) Progress payments received (XX)

(-) Grants received in connection with the asset (XX)

The average carrying amount of the asset during a period, including borrowing costs previously capitalized, is normally a reasonable approximation of the expenditure to which the capitalization rate is applied in that period.

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Impairment of QA

When the carrying amount or the expected ultimate cost of the QA exceeds its recoverable amount or net realisable value, the carrying amount is written down or written off in accordance with the requirements of other Accounting Standards.

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TIMINGS FOR CAPITALIZATION

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Commencement of Capitalisation

Three conditions to be satisfied

Activities necessary to prepare the asset for its intended use or sale are in progress*

Borrowing cost is being incurred

Expenditure for acquisition, construction or production of a QA is being incurred.

* Activities encompass more than the physical construction of the asset.

They include technical and administrative work prior to commencement of construction.

These exclude the holding of an asset when no production or development that changes the asset’s condition is taking place.

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Suspension of Capitalisation

During extended period in which active development is interrupted, capitalization is suspended.

However, it is not suspended when a temporary delay is necessary as a part of the process of getting the asset ready for its intended use or sale.

Capitalization of borrowing cost is not suspended when high water levels delay the construction of a bridge, if such high water levels are common in the geographic region involved.

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Cessation of Capitalization

When substantially all the activities necessary to prepare the QA for its intended use or sale are completed.

When construction of a QA is completed in parts, and the completed part is capable of being used, while construction continued for the other parts, capitalization of borrowing cost in relation to that part should cease when substantially all the other activities necessary to prepare that part for its intended use or sale is completed.

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Cessation of Capitalization

Examples

1) A business park comprising several buildings, each of which can be used individually, each part is capable of being used while construction continues for the other parts.

2) Diesel Generator sets to generate electricity- on a stand-alone basis or a part of a huge power generation plant In the first case interest cannot be capitalized whereas in the second case interest would be capitalized

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EXCHANGE DIFFERENCES ON FOREIGN BORROWINGS

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Exchange Differences on Foreign Borrowings [para 4(e)]

Loan taken for on 1st April 2003 10,000$ ROI 5% p.a. payable annually Exchange rate on 1st April 2003 Rs. 45 per $ Exchange rate on 31st March 2004 Rs. 48 per $ Equivalent ROI on a rupee loan 11% p.a.

Example

In the above example Normal interest payable on loan is – 10,000$ * 5% * 48 = Rs. 24000/-. This is covered under para 4(a)

The exchange difference accruing on the principal amount is – 10,000$ * (48 – 45) = Rs. 30,000/-. Some amount out of Rs. 30,000/- is deemed to be interest under para 4(e)

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Exchange differences on Foreign Borrowings [para 4(e)]

Interest that would have resulted if the loan was taken in Indian currency = 10000 $ * 45 * 11 % = Rs. 49,500/- Difference between interest on local currency borrowing and foreign currency borrowing = Rs. 49,500 - Rs. 24,000 = Rs. 25,500/- Thus out of the total difference of Rs. 30,000/- being the exchange difference on the principal amount, Rs. 25,500/- is deemed to be borrowing cost under para 4(e). Balance 30,000 – 25,500 = 4500/- is covered under AS 11 Thus, total borrowing cost would be Rs. 49,500 being total of Rs. 24,000 on foreign currency borrowings covered under para 4(a) & Rs. 25,500 being exchange difference covered under para 4(e).

Exchg Diff on

Principal 30000

Int on INR Loan 49500

Int on $ loan 24000

Difference 25500 is deemed interest 30

Exchange Differences on Foreign Borrowings [para 4(e)]

In the above example, if the ROI on rupee loan is assumed to be 13% instead of 11 %, the entire exchange difference of Rs. 30,000 would be considered as borrowing costs.

Exchg Diff on

Principal 30000

Int on INR Loan 58500

Int on $ loan 24000

Difference 34500, restricted to 30000, being

exchange diff is deemed interest

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Exchange differences on Foreign Borrowings [para 4(e)]

Explanation (erstwhile ASI 10)

Paragraph 4(e) of AS-16 covers exchange differences arising from foreign currency borrowings to the extent that they are regarded as an adjustment to interest cost.

The amount of exchange difference on the principal of the foreign currency loan, not exceeding the difference between interest on local currency loan and interest on foreign currency loan is considered as borrowings cost to be accounted for under this Standard and the remaining exchange difference, if any, is accounted for under AS 11, The Effect of Changes in Foreign Exchange Rates.

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Exchange Differences on Foreign Borrowings [para 4(e)]

For this purpose, the interest rate for the local currency borrowings should be that rate at which the enterprise would have raised the borrowings locally had the enterprise not decided to raise the

foreign currency borrowings.

• Foreign exchange difference on the principal borrowing.

• Interest cost on foreign borrowings. • Interest cost on local borrowings.

Thus 3 factors to be seen:

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Exchange differences on Foreign Borrowings [para 4(e)]

IF THEN Difference between interest on local currency borrowings & interest on foreign borrowings > foreign exchange difference on principal

Entire foreign exchange difference on principal is deemed interest under para 4(e)

Difference between interest on local currency borrowings & interest on foreign borrowings < foreign exchange difference on principal

Foreign exchange difference on principal to the extent of difference between interest cost is deemed interest under para 4(e) and remaining is dealt under AS 11

CONCLUSION

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DISCLOSURE

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Disclosure

• the accounting policy adopted for borrowing costs; and

• the amount of borrowing costs capitalized during the period.

The financial

statements should

disclose -

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Summary

We got to learn about the following:

What is borrowing cost?

What are qualifying assets?

What is substantial period of time?

The types of borrowings and their treatment

Timing of Capitalization

Treatment of exchange differences on foreign borrowings 37

Disclaimer

This presentation is for understanding purposes only.

However students are requested to go through the actual text of AS as well.

This presentation should not be construed as a replacement of the actual text of the AS.

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PRACTICE QUESTIONS

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Question No. 1

On 1 April 2005 ABC Ltd. undertook construction of a factory building for expansion purpose. Total cost of project was 3 crores. The building was completed by end of 31st March 2006 and during the period following payments were made:

Payment made Amount 1 April 2005 20,00,000 30 June 2005 60,00,000 31 December 2005 1,80,00,000 31 March 2006 40,00,000 Total 3,00,00,000

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Question No. 1

ABC Ltd. borrowings as at 31st March, 2006 were as follows: 1) 9% term loan amounting to Rs.80,00,000 taken on December 31, 2004. Simple interest is payable annually. Amount outstanding as at March 31, 2005 and during 05-06 is Rs 80,00,000. The loan was taken specifically for the project. 2) 11% p.a. debentures issued on March 31,2004. Amount outstanding for the year 05-06 is Rs 1,50,00,000. 3) 10% p.a. bonds issued on December 31,2003 amounting to Rs 1,70,00,000. Amount outstanding for the year 05-06 is Rs 1,60,00,000 How much borrowing cost should be capitalized for construction of the building as per AS-16 ?

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Question No. 1

Calculate the weighted average interest rate of the general borrowings & apply the general borrowings to the extent required to finance the balance expenditure incurred on the project.

First we allocate specific borrowings to the project i.e. Rs.80 lacs.

Solution

Wt Avg General borrowing rate is arrived as under: Interest = (1,50,00,000*11%) + (1,60,00,000*10%) = 32.5 lacs Principal = 1,50,00,000 + 1,60,00,000 = 310 lacs ROI = (Interest / Principal)*100 = 10.48%

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Question No. 1

Borrowing date Amt of expenditure

Calculation Capitalized interest

1/4/2005 20,00,000 @9% for 12 months 1,80,000

30/6/2005 60,00,000 @9% for 9 months 4,05,000

31/12/2005 1,80,00,000 @10.48% for 3 months 4,71,600

31/3/2006 40,00,000 NIL NIL

3,00,00,000 10,56,600

Borrowing cost to be capitalized as under:

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Question 2

On 20.4.2010 JLC Ltd. obtained a loan from the bank for Rs 50 lakhs to be utilised as under -

Particulars Amt Construction of a shed 20 lakhs Purchase of machinery 15 lakhs Working capital 10 lakhs Advance for purchase of truck 5 lakhs

In March,2011 construction of shed was completed and machinery installed. Delivery of truck was not received. Total interest charged by the bank for the year ending 31.3.2011 was Rs. 9 lakh. Show the treatment of interest under AS-16

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Question 2

Particulars Nature Interest to be capitalised (lacs)

Interest to be charged to P/L A/c (lacs)

Construction of a shed

Qualifying asset (9 * 20/50) = Rs 3.60

Purchase of machinery

Not a qualifying asset (assumed ready to use)

(9 * 15/50) = Rs 2.70

Working capital Not a qualifying asset

(9 * 10/50) = Rs 1.80

Advance for purchase of truck

Not a qualifying asset (vehicles are not QA)

(9 * 5/50) = Rs 0.90

TOTAL Rs. 3.60 lacs Rs. 5.40 lacs 45

Question 3

AXE Ltd. began construction of a new plant on April 1, 2008 and obtained a special loan of Rs 4,00,000 to finance the construction of the plant. The rate of interest was 10%. The expenditure that were made on project of plant were as follows:

Date Amt

April 1, 2008 5,00,000 August 1, 2008 12,00,000 January 1,2009 2,00,000

The company’s other outstanding non-specific loan was Rs 23,00,000 at an interest rate of 12%. The construction of the plant completed on 31st March, 2009. 1. Calculate the interest to be capitalized as per AS-16 2. Pass a journal entry for capitalizing the cost and the

borrowing cost 46

Question 3

Solution 1. Computation of BC to be capitalized

Date Calculation(in Rs) Amt (in Rs)

1st April, 2008 4,00,000*10%*12/12 40,000 1st April, 2008 1,00,000*12%*12/12 12,000 1st August, 2008 12,00,000*12%*8/12 96,000 1st January, 2009 2,00,000*12%*3/12 6,000

TOTAL 1,54,000

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Question 3

1. Total expenses to be capitalised for borrowings as per AS-16

Particulars Amt

Cost of plant (5,00,000+12,00,000+2,00,000) Add: Amount of interest to be capitalized

19,00,000 1,54,000 20,54,000

2. Journal entry

Date Entry Debit (Rs) Credit (Rs)

31st March, 2009

Plant a/c Dr. To bank a/c (Being amount of cost of plant and borrowing cost thereon capitalized)

20,54,000 20,54,000

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Question 4

A company capitalizes interest cost of holding investments and adds to cost of investment every year, thereby understating interest cost in P/L A/c. Comment.

As per the opinion of ASB, investments other then investment properties are not QA and so interest cost on holding such investments cannot be capitalized.

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Email: abkothari@gmail.com

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