Chapter Chapter 1010
Appendix 10AAppendix 10ACapitalization of Borrowing CostsCapitalization of Borrowing Costs
Prepared by:Dragan Stojanovic, CA
Rotman School of Management, University of Toronto
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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.
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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?
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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
made2. Activities for readying the asset are in
progress3. 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:
Lot Sales Developed land
Specific Purpose Land
Structure Site Structure
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 expenditures2. Determine avoidable borrowing costs relating
to asset-specific debt3. Determine avoidable borrowing costs relating
to non-asset-specific debt4. 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 $ 210,000– March 1 $ 300,000– May 1 $ 540,000– December 31 $ 450,000– Total $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 notedated December 31, 2010 $750,000
– Other Debt:10%, five year notedated December 31, 2007 $550,00012%, ten year bondsdated December 31, 2004 $600,000
• Interest on debt is payable each December 31
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Shalla Corporation – ExampleSTEP 1: Determine qualifying asset expendituresWeighted-Average Accumulated Expenditures:Jan. 1 $ 210,000 x 12/12 = $210,000Mar. 1 300,000 x 10/12 = 250,000May. 1 540,000 x 8/12 = 360,000Dec. 31 450,000 x 0/12 = 0WAAE $820,000
Note: Land payment is included in WAAE
Next step: Avoidable interest and appropriateinterest 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
PrincipalBorrowing cost5-year note $550,000 $ 55,00010-year note $600,000 72,000Total $127,000Weighted-Average Interest Rate =Total Interest Total Principal(Do not include Construction Specific Debt)$127,000 (550,000 + 600,000) = 11.04%
STEP 3: Determine avoidable borrowing costs relating to non-asset-specific debt
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Shalla Corporation – Example
Total WAAE $820,000Less: financed by specific loan $750,000WAAE financed by general borrowings $70,000X avoidable borrowing cost on general 11.04%Avoidable costs on general debt $7,728
Shalla Corporation – Example• STEP 4: Determine total borrowing costs
to capitalize
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Avoidable borrowing costsOn asset-specific debt $112,500On general debt $7,728TOTAL $120,228
Actual Interest:$750,000 x 15% = $112,500 550,000 x 10% = 55,000 600,000 x 12% = 72,000Total actual interest paid $239,500
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Shalla Corporation – Example
Avoidable interest = $120,228Actual interest = $239,500
The lesser of these two amounts is capitalized
Journal Entry:Dr. Building 120,228 Cr. Interest Expense 120,228
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Interest Capitalization – Significance
• Capitalized interest increases net income for the period
• Impact on EPS can be significant
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Disclosures
• Two disclosures required: – Amount capitalized– Capitalization rate
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