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June 10th 2020

Accounting for borrowing costs

When your company borrows money to buy, make or produce assets, you need to decide how to account for any interest on the borrowings. There are two different approaches you can take, and the choice of approach directly affects the amount of profits shown in the profit & loss account, and the value of assets in your balance sheet.

Your company can either:

  • recognise borrowing costs as expenses in the profit & loss account in the period in which they are incurred; or, alternatively,
  • “capitalise” the borrowing costs – in other words, including the borrowing costs on the balance sheet as part of the cost of the asset.

When borrowing costs are capitalised in your company’s balance sheet:

  • the value of the relevant asset(s) in the balance sheet increases; and
  • no expenditure is recognised in the profit & loss account initially, therefore profits are not reduced.

Having the option to capitalise borrowing costs is therefore “good news”.

You may adopt a policy of capitalising borrowing costs that are directly attributable to the acquisition, construction or production of a “qualifying asset”. Qualifying assets for this purpose include:

  • Stock
  • Manufacturing plants
  • Power generation facilities
  • Intangible assets
  • Investment properties

When we talk about borrowing costs we are mostly concerned with interest and other finance charges on conventional forms of finance – bank overdrafts and loans, for example, or finance charges in respect of finance leases. However, borrowing costs can also include “notional” interest expense calculated by your accountant in respect of certain financial liabilities that are initially measured at a discounted, present day value. An example would be the notional interest on below-market or zero interest rate loan from directors.

If your company adopts a policy of capitalising borrowing costs, it must apply the policy consistently to all assets in the same class.

Where your company does not adopt a policy of capitalising such borrowing costs, the costs should be recognised as an expense in the profit & loss account in the period in which they are incurred.

The borrowing costs that are “directly attributable” to the acquisition, construction or production of an asset are those borrowing costs that would have been avoided, if the expenditure on the qualifying asset had not been made.

If a company borrows funds specifically for the purpose of obtaining a qualifying asset, the borrowing costs eligible for capitalisation are the actual borrowing costs incurred, less any investment income on the temporary investment of those borrowings. If funds applied to obtain a qualifying asset form part of a company’s general borrowings, the borrowing costs eligible for capitalisation are determined by applying a capitalisation rate to the expenditure on the asset. For this purpose the expenditure on the asset is the average carrying amount of the asset in the period, including any borrowing costs previously capitalised. The capitalisation rate is the weighted average of rates applicable to the company’s general borrowings in the period. The amount of borrowing costs that a company capitalises in a period should not exceed the total borrowing costs it incurred in that period.

If your company adopts a policy of capitalising borrowing costs, you should:

  • capitalise those costs from the point where it first incurs both expenditure on the asset and borrowing costs, and undertakes activities necessary to prepare the asset for its intended use or sale;
  • suspend capitalisation during extended periods where active development of the asset has paused; and
  • cease capitalisation when substantially all the activities necessary to prepare the asset for its intended use or sale are complete.

Expense vs capitalise: a comparison

To illustrate the impact that the choice of accounting policy can have on your company’s accounts, let us imagine the following example.

XYZ Limited takes out a bank loan to construct a new manufacturing facility. Costs of construction to date amount to £450,000. In addition, the company has incurred £12,000 of borrowing costs directly attributable to the asset.

What would the balance sheet look like, depending on whether the company decided to expense the borrowing cost, or adopt a policy of capitalising borrowing costs? Here is a comparison, starting with the balance sheet:

BALANCE SHEET
Option 1 - expense the costOption 2 - capitalise the cost
££
FIXED ASSETS
Tangible assets450,000462,000

And now the profit & loss account:

PROFIT & LOSS ACCOUNT
Option 1 - expense the costOption 2 - capitalise the cost
££
Interest payable and similar charges(12,000)-

Which of these accounts would you rather present?

Summary

Adopting a policy of capitalising borrowing costs will generally lead to higher asset values in the balance sheet and lower expenditure/ higher profits in the profit & loss account, at least in the short term.

It is important to realise, however, that even when a company capitalises borrowing costs, those costs will eventually reach the profit & loss account or statement of comprehensive income in one form or another. Sooner or later the asset in question will probably be sold or scrapped, and in the meantime it may be depreciated or impaired.

The crucial point is that when borrowing costs are capitalised (rather than expensed), the recognition of the expense in the profit & loss account is effectively delayed, so that profits in the short term will be higher than if the costs had been expensed.

Is this relevant to micro-entity accounts prepared under FRS 105?

Under FRS 105, all borrowing costs must be recognised as an expense in the profit & loss account in the period in which they are incurred; capitalising borrowing costs is not permitted.

Therefore, if you wish to capitalise borrowing costs in your company’s balance sheet, you will need to move over to FRS 102.

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