Differences on the capitalization of borrowing costs under IAS 23 and interest costs under US GAAP.
From the IFRS Institute – August 30, 2019
IAS 231 and US GAAP2 are broadly converged when it comes to the capitalization of borrowing costs as part of the cost of certain assets. However, a closer look reveals multiple differences with the potential for different applications to similar arrangements. In this article, we summarize the Top 10 differences to be aware of.
How are borrowing costs treated under IFRS Standards?
IAS 23 requires the capitalization of interest and certain other costs that are directly attributable to the acquisition or construction of ‘qualifying assets’. Companies apply the following step-by-step analysis to determine the borrowing costs to be capitalized.
Step 1: Identify qualifying assets
Qualifying assets are those that necessarily take a substantial period of time to get ready for their intended use or sale. While IAS 23 does not define ‘substantial period of time’, in our view it is a period well in excess of six months. Qualifying assets might be, for example, manufacturing plants, intangible assets and infrastructure assets such as bridges and railways. Inventories that are manufactured or otherwise produced in a short period of time, and assets that are ready for their intended use or sale when acquired, are not qualifying assets. Borrowing costs related to these types of assets do not qualify for capitalization.
The IFRS Interpretations Committee recently clarified in an Agenda Decision how IAS 23 applies to the construction of a residential multi-unit real estate development if the developer is selling units to customers before and during construction and recognizes the related revenue over time as it transfers control to customers. The Agenda Decision concludes that the receivable, contract asset and inventory recognized for the development are not qualifying assets.
A receivable could never be a qualifying asset because it is ‘ready for use’ at the time of its initial recognition. Likewise, the contract asset, as defined in IFRS 153, represents the real estate developer’s right to financial consideration as it transfers control of each unit over time. Inventory for the unsold units could be sold at any time during development; therefore, the units are ready for their intended sale and are not qualifying assets, even though their completion may take a substantial period of time.
This clarification may bring change to certain long-standing practices of capitalizing borrowing costs in residential multi-unit and other real estate development contracts. See KPMG’s article on revenue recognition post-implementation observations.
Step 2: Identify eligible costs
Not all amounts classified as interest costs qualify for capitalization. Only those that are ‘directly attributable’ to the acquisition or development of the qualifying asset are eligible. Such costs would have been avoided if the expenditure on the qualifying asset had not been made. This includes interest on borrowings made specifically for the purpose of obtaining the qualifying asset (specific borrowings) and the cost of other borrowings that could have been repaid if the expenditure for the asset had not been incurred (general borrowings).
Eligible costs are pre-tax and include interest costs calculated under the effective interest method, finance charges on lease liabilities, and foreign exchange differences to the extent that they are regarded as an adjustment to interest costs.
Step 3: Determine the capitalization rate for general borrowings and calculate the costs to be capitalized
The capitalization rate considers the weighted-average interest cost applicable to general borrowings outstanding during the period. It is applied to the weighted-average accumulated expenditure on the asset during the period minus any progress payments or grants received on the asset. The amount capitalized cannot exceed the actual interest costs incurred during the period. If qualifying assets are financed through specific borrowings, the company capitalizes the actual borrowing costs on those specific borrowings less any income from temporary investment.
Step 4: Determine the period of capitalization
Capitalization begins when expenditure and borrowing costs for the asset are being incurred and activities that are necessary to prepare the asset for its intended use are in progress. Capitalization ceases when activities necessary to prepare the asset for its intended use are substantially complete.
Example 1 – Financing through general borrowings
XYZ Corp. finances the construction of its new headquarters through funds it borrows generally. The average outstanding balances of these general borrowings for the year are:
XYZ incurs $350 of interest expense ($5,000 × 4% + $3,000 × 5%) for the year. The capitalization rate is the weighted average of borrowing costs divided by the total general borrowings: 4.375% ($350 / $8,000).
Expenditure on the building starts January 1 and is not complete at year-end, and the average carrying amount of the building during the year is $4,000. XYZ therefore capitalizes $175 ($4,000 × 4.375%) of borrowing costs for the year.
Under US GAAP, the amount capitalized is the same as calculated above.
How is IAS 23 different from US GAAP?
The guidance for capitalizing borrowing costs under IAS 23 and interest under US GAAP are converged at a high level. However, differences in the detailed requirements exist. We summarize 10 key differences.
1. US GAAP has specialized industry guidance; IFRS Standards do not
US GAAP includes specialized guidance for several industries, including real estate and oil and gas producing activities, which may lead to different qualifying assets. IAS 23 applies similarly to all companies, although there is specific guidance on exploration and evaluation of mineral resources.
2. Certain inventory may be a qualifying asset under IAS 23, but not under US GAAP
Inventory that takes a long time to produce but is otherwise produced in large quantities on a repetitive basis (e.g. wine or cheese) can be a qualifying asset under IFRS Standards as an accounting policy choice.
Under US GAAP, a qualifying asset could be either (1) an asset constructed or produced for own use or (2) an asset intended for sale or lease that is constructed or produced as a ‘discrete project’. In either case, costs are separately accumulated, and construction of the asset takes considerable time and entails substantial expenditures (e.g. ships or real estate developments). Inventory that takes a long time to produce but is otherwise produced in large quantities on a repetitive basis is not a qualifying asset under US GAAP because it’s not produced for a company’s own use or as a discrete project.
3. Internally generated intangible assets can be qualifying assets under IAS 23, but generally not under US GAAP
Under US GAAP, both internal research and development expenditures are expensed as incurred and therefore are not qualifying assets. However, under IFRS Standards, development expenditures are capitalized if they meet certain criteria and can be a qualifying asset. Capitalized software developed for internal use may be a qualifying asset under US GAAP and IAS 23. For more information on accounting for R&D costs, read KPMG’s article, IFRS vs. US GAAP: R&D costs.
4. Equity method investments are not qualifying assets under IAS 23, but may be under US GAAP
US GAAP allows an investment accounted for by the equity method to be a qualifying asset, if (1) the investee has activities in progress necessary to commence its planned principal operations and (2) the investee's activities include the use of funds to acquire qualifying assets for its operations.
Borrowing costs eligible for capitalization
5. Interest on leases includes all leases under IAS 23, but only finance leases under US GAAP
Under IFRS 164, lessees generally recognize all leases on-balance sheet and companies now capitalize eligible interest on any lease liability. Under US GAAP, the new definition of interest costs only includes interest related to a finance lease determined under ASC 842.5
6. Foreign exchange gains and losses may be eligible interest under IAS 23, but not under US GAAP
Borrowings are often obtained in foreign currency – e.g. to offset currency exposure related to the qualifying asset. IAS 23 includes in ‘borrowing costs’ foreign exchange differences to the extent they are regarded as an adjustment to interest costs. Judgment is therefore required to determine which foreign exchange differences are eligible interest.
Unlike IAS 23, US GAAP excludes foreign exchange gains or losses from eligible interest.
7. US GAAP has prescriptive guidance on derivative gains and losses; IAS 23 does not
Derivative instruments such as interest rate swaps are commonly used to manage interest rate risk on borrowings. IAS 23 is silent on whether eligible interest includes derivative gains and losses that are used to hedge interest rate risk. In our view, payments and accruals of interest under interest rate swaps that are economic hedges of eligible borrowing costs may be eligible for capitalization. However, changes in fair value of interest rate swaps are not.
US GAAP generally excludes fair value gains or losses on derivatives from eligible interest. However, there are exceptions for fixed-rate debt designated as the hedged item in a fair value hedge. Also, amounts in accumulated other comprehensive income related to cash flow hedges of borrowings whose interest is capitalized are reclassified to earnings over the useful life of the asset – which would be the same period over which the associated capitalized interest is amortized.
8. Income earned on the temporary investment of specific borrowings of funds is deducted under IAS 23, but not under US GAAP
Under US GAAP, interest income on any temporary investment of funds pending expenditure on the asset is not generally offset against interest costs in determining either the capitalization rates or limitations on the amount of interest to be capitalized. An exception exists for circumstances involving tax-exempt borrowings that are restricted externally.
Example 2 – Specific borrowing with temporary investment of funds
ABC Corp. borrows $2,000 on January 1 at 3% per annum to finance the construction of factory equipment, which is determined to be a qualifying asset under IAS 23. ABC incurs $60 of interest expense ($2,000 × 3%) for the year.
ABC invests the excess funds for part of the year, and earns $10 of interest income.
Expenditure on the equipment starts January 1 and is not complete at year-end. The average carrying amount of the equipment during the year is $1,500.
Under IFRS Standards, ABC capitalizes $50 ($60 - $10) of borrowing costs for the year.
Under US GAAP, the amount capitalized is calculated by applying the rate of the specific borrowing to the average expenditure and is not reduced by the interest earned from the temporary investment of funds. ABC capitalizes $45 ($1,500 × 3%) of borrowing costs.
Presentation and disclosure
9. IFRS Standards allow a policy choice for presentation in the statement of cash flows; US GAAP does not
Under IFRS Standards, a company may make a policy choice for classifying cash flows related to capitalized interest as either:
US GAAP requires that capitalized interest paid be classified as investing cash flows.
10. IAS 23 has different disclosure requirements compared to US GAAP
Both GAAPs require disclosure of capitalized borrowing costs. Additionally, IAS 23 requires disclosure of the capitalization rate for borrowing costs, while US GAAP requires disclosure of total interest costs incurred and charged to expense during the period.
While IFRS Standards and US GAAP are converged at a high level on the accounting for borrowing costs, complexities arise when determining qualifying assets, eligible borrowing costs and the amount to be capitalized. Dual reporting companies should closely assess their methodologies to determine what and how much to capitalize under both accounting frameworks. Companies may take the benefit of the accounting policy elections available under both frameworks to achieve consistency to the extent possible.
Understanding the guidance in IFRS 16 on accounting for lease modifications by both lessees and lessors.
Companies continue to address implementation issues for revenue recognition and disclosure under IFRS 15 and ASC 606.
Lessons we’ve learned.