Introduction:
In August 2007, the revised international standard IAS 23 Borrowing Costs become a reality for South African GAAP (the international standard was issued in March 2007). We’ve known the previous statement as one to which not many people paid much attention other than to review it briefly to cover the risk of being asked a five point question, back in their university days (please note that there are some exceptions where a few larger companies have elected to apply the capitalisation option under the old statement).
Now, suddenly, it has become very important to all preparers of financial statements, as entities no longer have a choice regarding the capitalisation of borrowing costs. If an entity is acquiring, constructing or producing a qualifying asset, it has to capitalise the borrowing cost relating to the asset against the cost price of that asset. All other borrowing cost must be expensed in the income statement.
In other words, the choice not to capitalise borrowing costs has been done away with!
As a result, it is important that entities take a closer look at IAS 23 and develop a policy with regard to grey areas that may arise from practical application of a standard that was previously mostly ignored.
This article highlights some of the difficulties that may arise from implementation of the standard.
Basic theory:
According to IAS 23.1, borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset form part of the cost of that asset. Other borrowing costs are recognised as an expense.
The statement goes on to describe exceptions, provide definitions and to prescribe when to start, suspend and cease capitalisation on a qualifying asset, as well as to list disclosure requirements. These are the matters that now, with the wider application of this specific standard, become more relevant.
Problem areas (i.e. the murky waters):
First, most people in practice today have become unfamiliar with the statement itself and its application, and now have a responsibility, as part of their Continual Development Programme, to touch up their knowledge on the statement.
Second, entities also have to develop a policy regarding capitalisation (for example, on periods or terms used to capitalise borrowing costs, being monthly, quarterly or yearly, for example).
Third, (the focus of this article) in the past most entities just ignored the option to capitalise borrowing costs because of the complex calculations required (IAS 23.DO1). As a result, the theory of the standard remained greatly untested in practice (with no generally accepted practices being established for the grey or murky areas arising from practical application).
Shortly after the new standard was released in South Africa, my colleagues and I had to lecture the subject to a class of students, and the issues discussed below are the gray areas that arose from discussions between lecturers and students.
Exclusions:
Par 04 sets out which assets are excluded from the scope of the standard. These are:
- a qualifying asset measured at fair value, for example a biological asset (which is rather straight forward), or
- inventories that are manufactured, or otherwise produced in large quantities on a repetitive basis (causing more difficult questions to be asked).
A classic example always used, is wine. It seems to be a qualifying asset, as it necessarily takes a substantial period of time to get ready for its intended use or sale (the definition for a qualifying asset, in terms of the standard).
But then again, isn’t it wine inventory that is produced, in large quantities on a repetitive basis, and thus is excluded from the scope?
I initially argued that every year’s vintage differs and therefore wine doesn’t qualify to be excluded. Then, whilst writing this article, I looked to the “basis for conclusion” (BC) in the standard for guidance on the matter. In BC 5 and 6, the IASB explains that the exclusion of inventories referred to above (even if such repetitively manufactured or produced inventories take a substantial period to get ready for their intended use) is based on the fact that costs to allocate, may exceed benefits in doing so.
This is the case, for example, with production or manufacturing plants where there are large quantities of items being produced and a daily repetitive output is created, even though it takes a substantial period for each item to go through the manufacturing process from start to finish. Based on this (because wine is mostly produced once or so during the year, even if in large quantities) I am still of the opinion that inventories, such as wine, do not qualify to be treated under the exclusion, as borrowing costs can reasonably be allocated to each year’s vintage.
Suspension of capitalisation:
Suspension of capitalisation because of stoppages in manufacturing/production of a qualifying asset is treated in IAS 23.20 and 21.
Par. 20 states: “An entity shall suspend capitalisation of borrowing costs during extended periods in which it suspends active development of a qualifying asset”.
“Extended periods” is not defined by IAS 23 and professional judgement is needed in this case (similarly “a substantial period of time” in the definition of a qualifying asset isn’t defined). Again general practices need to be established over time.
Par. 21 expresses that an entity may incur borrowing costs during extended periods in which it suspends the activities necessary to prepare the asset for its intended use or sale, and that such costs are costs of holding partially completed assets and do not qualify for capitalisation.
In addressing different scenarios with regard to whether or not suspension of capitalisation should take place in these circumstances, the standard states that things that naturally form part of the process (aging of wine for example), do not create a need to suspend capitalisation.
Let’s look at different scenarios to understand the difficulty in deciding whether or not suspension is required by the statement:
Scenario 1: An entity has to suspend activities of getting a qualifying asset ready for use, as it has to wait for a component that has been ordered from overseas. The waiting period could have been avoided, if the planning for the specific project had been done properly.
As the above suspension clearly does not form part of the normal process needed to get the asset ready for its intended use (as it could have been avoided), capitalisation of borrowing costs should be suspended until activities can be resumed.
Scenario 2: High water levels delay the construction of a bridge.
- a) Let’s assume first that such high water levels are common for this time of year in the specific geographical region involved (IAS 23.21). According to IAS 23, capitalisation can continue, as rain is part of the normal construction process for this part of the year, even though the delay could have been avoided if construction were to take place at a different time of year.
- b) Let’s now assume that the high water levels are uncommon for this time of year in the specific geographical region involved. As the statement states that capitalisation should not be suspended if it were common, must we assume that the opposite applies to uncommon weather, meaning that capitalisation should be suspended?
Vorster et al (2005:394) formulated an opinion (this may already be an established generally accepted practice?) stating that one could look at whether the circumstances leading to the suspension of activities were under the control of management and that, if under control of management, capitalisation should be suspended in accordance with scenario one (the component ordered too late). This would, however, result in the consequence that capitalisation of borrowing costs should not be suspended in the “uncommon” scenario. There doesn’t seem to be a clear-cut answer in this scenario and we’ll have to see how generally accepted practices develop if no further guidance is given by the standard setting authority.
Effect on ED dealing with Small and Medium-sized Entities:
The Exposure Draft for IFRS for Small and Medium-sized Entities, was released in February 2007. Although it is a standalone standard, the process that the IASB took was to look at current IFRS and IAS and simplify them for smaller entities in various ways. One of which was, where a standard permits a choice on accounting policy, only to incorporate the easier option.
In line with this, the ED included only the simpler option available with regard to borrowing costs (in February 2007 when the ED was issued entities still had a choice on whether or not to capitalise borrowing cost in the old IAS 23), i.e. expensing borrowing costs in the income statement. Now that the main standard has changed, it remains to be seen if the ED will be amended for this when it is issued as a standard (expected to happen in the second half of 2008).
Conclusion:
IAS 23 Borrowing Costs (August 2007) shall be applied by an entity for annual periods beginning on or after 1 January 2009. As this date draws near, clearer generally accepted practices with regard to the problems mentioned above may materialise.
It is also important that preparers and auditors of financial statements get themselves up to date on the requirements of the standard, as it will have a definite effect on their financial statements.
One of those effects, as highlighted in DO1 at the back of the standard, is the fact that accounting and auditing costs may (will) be negatively influenced by the requirement to capitalise.
This is one of many changes that has taken place in the accounting scene in South Africa in the recent past, and surely the related issues will change into more lucid waters over time, in the same way as most of the other changes have.
References:
- Vorster, Q., Koorhof, C., Oberholster, JGI. & Koppeschaar, Z.R. 2005. Descriptive Accounting 16th edition. LexisNexis Butterworths.
Durban.
Zacharias Enslin CA(SA), BCom (Hons) Acc Sc., is a lecturer in the Department of Accounting at the Stellenbosch University.
