Chapter 10
Appendix 10A
Capitalization of Borrowing Costs
Prepared by:
Dragan Stojanovic, CA
Rotman School of Management, University of Toronto
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.
2
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?
3
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
made
2. Activities for readying the asset are in
progress
3. 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:
Specific Purpose
Land
Structure Site
Structure
Lot Sales
Developed land
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 expenditures
2. Determine avoidable borrowing costs relating
to asset-specific debt
3. Determine avoidable borrowing costs relating
to non-asset-specific debt
4. 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
– March 1
– May 1
– December 31
– Total
$ 210,000
$ 300,000
$ 540,000
$ 450,000
$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 note
dated December 31, 2010 $750,000
– Other Debt:
10%, five year note
dated December 31, 2007 $550,000
12%, ten year bonds
dated December 31, 2004 $600,000
• Interest on debt is payable each December 31
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Shalla Corporation – Example
STEP 1: Determine qualifying asset expenditures
Weighted-Average Accumulated Expenditures:
Jan. 1
Mar. 1
May. 1
Dec. 31
WAAE
$ 210,000
300,000
540,000
450,000
x
x
x
x
12/12
10/12
8/12
0/12
=
=
=
=
$210,000
250,000
360,000
0
$820,000
Note: Land payment is included in WAAE
Next step: Avoidable interest and appropriate
interest 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
STEP 3: Determine avoidable borrowing costs relating
to non-asset-specific debt
5-year note
10-year note
Total
Principal
Borrowing cost
$550,000
$600,000
$ 55,000
72,000
$127,000
Weighted-Average Interest Rate =
Total Interest  Total Principal
(Do not include Construction Specific Debt)
$127,000  (550,000 + 600,000) = 11.04%
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Shalla Corporation – Example
Total WAAE
Less: financed by specific loan
WAAE financed by general borrowings
X avoidable borrowing cost on general
Avoidable costs on general debt
$820,000
$750,000
$70,000
11.04%
$7,728
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Shalla Corporation – Example
• STEP 4: Determine total borrowing costs
to capitalize
Avoidable borrowing costs
On asset-specific debt
On general debt
TOTAL
Actual Interest:
$750,000
x
15%
550,000
x
10%
600,000
x
12%
Total actual interest paid
$112,500
$7,728
$120,228
=
=
=
$112,500
55,000
72,000
$239,500
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Shalla Corporation – Example
Avoidable interest = $120,228
Actual interest
= $239,500
The lesser of these two amounts is capitalized
Journal Entry:
Dr. Building
120,228
Cr. Interest Expense
120,228
16
Interest Capitalization –
Significance
•
•
Capitalized interest increases net income
for the period
Impact on EPS can be significant
17
Disclosures
• Two disclosures required:
– Amount capitalized
– Capitalization rate
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