financial instrument affect the amount available for capitalisation? If hedge accounting
is not adopted, does this affect the amount available for capitalisation?
The following examples illustrate the potential differences.
Example 21.5: Cash flow hedge of variable-rate debt using an interest rate swap
Entity A is constructing a building and expects it to take 18 months to complete. To finance the construction, on
1 January 2018 the entity issues an eighteen month, €20,000,000 variable-rate note payable, due on 30 June 2019 at
a floating rate of interest plus a margin of 1%. At that date the market rate of interest is 8%. Interest payment dates
and interest rate reset dates occur on 1 January and 1 July until maturity. The principal is due at maturity. On 1 January 2018, the entity also enters into an eighteen month interest rate swap with a notional amount of €10,000,000 from
which it will receive periodic payments at the floating rate and make periodic payments at a fixed rate of 9%, with
settlement and rate reset dates every 30 June and 31 December. The fair value of the swap is zero at inception.
On 1 January 2018, the debt is recorded at €20,000,000. No entry is required for the swap on that date because
its fair value was zero at inception.
During the eighteen month period, floating interest rates change as follows:
Rate paid by
Entity A on
Floating rate
note payable
Period to 30 June 2018
8%
9%
Period to 31 Dec 2018
8.5%
9.5%
Period to 30 June 2019
9.75%
10.75%
Under the interest rate swap, Entity A receives interest at the market floating rate as above and pays at 9% on
the nominal amount of €10,000,000 throughout the period.
At 31 December 2018, the swap has a fair value of €37,500, reflecting the fact that it is now in the
money as Entity A is expected to receive a net cash inflow of this amount in the period until the
instrument is terminated. There are no further changes in interest rates prior to the maturity of the swap
and the fair value of the swap declines to zero at 30 June 2019. Note that this example excludes the
effect of issue costs and discounting. In addition, it is assumed that, if Entity A is entitled to, and applies,
hedge accounting, there will be no ineffectiveness.
The cash flows incurred by the entity on its borrowing and interest rate swap are as follows:
Cash
payments
Interest
on
Interest rate swap
Total
principal
(net)
€
€
€
30 June 2018
900,000
50,000
950,000
31 Dec 2018
950,000
25,000
975,000
30 June 2019
1,075,000
(37,500)
1,037,500
Total 2,925,000
37,500
2,962,500
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There are a number of different ways in which Entity A could calculate the borrowing costs eligible for
capitalisation, including the following:
(i) The interest rate swap meets the conditions for, and entity A applies, hedge accounting. The finance
costs eligible for capitalisation as borrowing costs will be €1,925,000 in the year to 31 December 2018
and €1,037,500 in the period ended 30 June 2019.
(ii) Entity A does not apply hedge accounting. Therefore, it will reflect the fair value of the swap in income
in the year ended 31 December 2018, reducing the net finance costs by €37,500 to €1,887,500 and
increasing the finance costs by an equivalent amount in 2019 to €1,075,000. However, if it considers
that it is inappropriate to reflect the fair value of the swap in borrowing costs eligible for capitalisation,
it capitalises costs based on the net cash cost on an accruals accounting basis. In this case this will give
the same result as in (i) above.
(iii) Entity A does not apply hedge accounting and considers only the costs incurred on the borrowing, not
the interest rate swap, as eligible for capitalisation. The borrowing costs eligible for capitalisation would
be €1,850,000 in 2018 and €1,075,000 in 2019.
In our view, all these methods are valid interpretations of IAS 23; however, the preparer
will need to consider the most appropriate method in the particular circumstances after
taking into consideration the discussion below.
In particular, if using method (ii), it is necessary to demonstrate that the gains or losses
on the derivative financial instrument are directly attributable to the construction of a
qualifying asset. In making this assessment it is necessary to consider the term of the
derivative and this method may not be appropriate if the derivative has a different term
to the underlying directly attributable borrowing.
Based on the facts in this example, and assuming that entering into the derivative
financial instrument is considered to be related to the borrowing activities of the entity,
method (iii) may not be an appropriate method to use because it appears to be
inconsistent with the underlying principle of IAS 23 – that the costs eligible for
capitalisation are those costs that would have been avoided if the expenditure on the
qualifying asset had not been made. [IAS 23.10]. However, method (iii) may be an
appropriate method to use in certain circumstances where it is not possible to
demonstrate that the gains or losses on a specific derivative financial instrument are
directly attributable to a particular qualifying asset, rather than being used by the entity
to manage its interest rate exposure on a more general basis.
Note that method (i) appears to be permitted under US GAAP for fair value hedges.
IAS 23 makes reference in its basis of conclusion that under US GAAP, derivative gains
and losses (arising from the effective portion of a derivative instrument that qualifies as
a fair value hedge) are considered to be part of the capitalised interest cost. IAS 23 does
not address such derivative gains and losses. [IAS 23.BC21].
Whichever policy is chosen by an entity, it needs to be consistently applied in
similar situations.
5.5.2
Gains and losses on derecognition of borrowings
If an entity repays borrowings early, in whole or in part, then it may recognise a gain
or loss on the early settlement. Such gains or losses include amounts attributable to
expected future interest rates; in other words, the settlement includes an estimated
prepayment of the future cash flows under the instrument. The gain or loss is a
function of relative interest rates and how the interest rate of the instrument differs
Capitalisation of borrowing costs 1565
from current and anticipated future interest rates. There may be circumstances in
which a loan is repaid while the qualifying asset is still under construction. IAS 23
does not address this issue.
IFRS 9 requires that gains and losses on extinguishment of debt should be
recognised in profit or loss (see Chapter 48 at 6.3). Accordingly, in our view, gains
and losses on derecognition of borrowings are not eligible for capitalisation. It would
be extremely difficult to determine an appropriate am
ount to capitalise and it would
be inappropriate thereafter to capitalise any interest amounts (on specific or general
borrowings) if doing so would amount to double counting. Decisions to repay
borrowings early are not usually directly attributable to the qualifying asset but to
other circumstances of the entity.
The same approach would be applied to gains and losses arising from a refinancing when
there is a substantial modification of the terms of borrowings as this is accounted for as
an extinguishment of the original financial liability and the recognition of a new financial
liability (see Chapter 48 at 6.2 to 6.3).
5.5.3
Gains or losses on termination of derivative financial instruments
If an entity terminates a derivative financial instrument, for example, an interest rate
swap, before the end of the term of the instrument, it will usually have to either make
or receive a payment, depending on the fair value of the instrument at that time. This
fair value is typically based on expected future interest rates; in other words it is an
estimated prepayment of the future cash flows under the instrument.
The treatment of the gain or loss for the purposes of capitalisation will depend on
the following:
• the basis on which the entity capitalises the gains and losses associated with
derivative financial instruments attributable to qualifying assets (see 5.5.1 above); and
• whether the derivative is associated with a borrowing that has also been terminated.
Entities must adopt a treatment that is consistent with their policy for capitalising the
gains and losses from derivative financial instruments that are attributable to qualifying
investments (see 5.5.1 above).
The accounting under IFRS 9 will differ depending on whether the instrument has
been designated as a hedge or not. Assuming the instrument has been designated as
a cash flow hedge and that the borrowing has not also been repaid, the entity will
usually maintain the cumulative gain or loss on the hedging instrument, subject to
reclassification to profit or loss during the same period that the hedged cash flows
affect profit or loss. In such a case, the amounts that are reclassified from other
comprehensive income will be eligible for capitalisation for the remainder of the
period of construction.
Similarly, assuming the instrument has been designated as a fair value hedge and that
the borrowing has not also been repaid, entities would continue to recognise the
cumulative gain or loss on the hedging instrument in the carrying amount of the
hedged item and would form part of the ongoing determination of amortised cost of
the financial liability using the effective interest rate method. Interest expense
1566 Chapter 21
calculated using the effective interest method is eligible for capitalisation for the
remainder of the period of construction (see 4.1 above).
If the entity is not hedge accounting for the derivative financial instrument, but
considers it to be directly attributable to the construction of the qualifying asset then it
will have to consider whether part of the gain or loss relates to a period after
construction is complete.
If the underlying borrowing is also terminated then the gain or loss will not be capitalised
and the treatment will mirror that applied on derecognition of the borrowing, as
described in 5.5.2 above.
5.5.4
Dividends payable on shares classified as financial liabilities
An entity might finance its operations in whole or in part by the issue of preference
shares and in some circumstances these will be classified as financial liabilities (see
Chapter 43 at 4.5). In some circumstances the dividends payable on these instruments
would meet the definition of borrowing costs. For example, an entity might have funded
the development of a qualifying asset by issuing redeemable preference shares that are
redeemable at the option of the holder and so are classified as financial liabilities under
IAS 32. In this case, the ‘dividends’ would be treated as interest and meet the definition
of borrowing costs and so should be capitalised following the principles on specific
borrowings discussed in 5.2 above.
Companies with outstanding preference shares which are treated as liabilities under
IAS 32 might subsequently obtain a qualifying asset. In such cases, these preference
share liabilities would be considered to be part of the company’s general borrowings.
The related ‘dividends’ would meet the definition of borrowing costs and could be
capitalised following the principles on general borrowings discussed in 5.3 above – i.e.
that they are directly attributable to a qualifying asset.
If these shares were both irredeemable, but still treated as liabilities under IAS 32 (see
Chapter 43 at 4.5.2), and the only general borrowings, it would generally be difficult to
demonstrate that such borrowings would have been avoided if the expenditure on the
qualifying asset had not been made. In such a case capitalisation of related ‘dividends’
would not be appropriate, unless the qualifying asset is demonstrably funded (at least
partly) by such borrowings. In cases where such instruments were just a part of a general
borrowing ‘pool’, it would be appropriate to include applicable ‘dividends’ in
determining the borrowing costs eligible for capitalisation (see
5.3.2 above),
notwithstanding the fact that these instruments are irredeemable, provided that:
• at least part of any of the general borrowings in the pool was applied to obtain the
qualifying asset; or
• it can be demonstrated that at least part of the fund specifically allocated for repaying
any of the redeemable part of the pool was used to obtain the qualifying asset.
Capitalisation of dividends or other payments made in respect of any instruments that
are classified as equity in accordance with IAS 32 is not appropriate as these instruments
would not meet the definition of financial liabilities. In addition, as discussed in 2.2
above, IAS 23 does not deal with the actual or imputed cost of equity, including
preferred capital not classified as a liability. [IAS 23.3].
Capitalisation of borrowing costs 1567
5.6 Capitalisation
of
borrowing costs in hyperinflationary economies
In situations where IAS 29 – Financial Reporting in Hyperinflationary Economies –
applies, an entity needs to distinguish between borrowing costs that compensate for
inflation and those incurred in order to acquire or construct a qualifying asset.
IAS 29 states that ‘[t]he impact of inflation is usually recognised in borrowing costs. It is
not appropriate both to restate the capital expenditure financed by borrowing and to
capitalise that part of the borrowing costs that compensates for the inflation during the
same period. This part of the borrowing costs is recognised as an expense in the period
in which the costs are incurred.’ [IAS 29.21].
Accordingly, IAS 23 specifies that when an entity applies IAS 29, the borrowing costs
that can be capitalised should be restricted and the entity must expense the part of
borrowing costs that compensates for inflation during the same period in accordance
with paragraph 21 of IAS 29 (as described above). [IAS 23.9].
For detailed discussion and requirements of IAS 29, see Chapter 16.
5.7 Group
considerations
5.7.1
Borrowings in one company and development in another
A question that can arise in practice is whether it is appropriate to capitalise interest in
the group financial statements on borrowings that appear in the financial statements of
a different group entity from that carrying out the development. Based on the underlying
principle of IAS 23, capitalisation in such circumstances would only be appropriate if
the amount capitalised fairly reflected the interest cost of the group on borrowings from
third parties that could have been avoided if the expenditure on the qualifying asset
were not made.
Although it may be appropriate to capitalise interest in the group financial statements, the
entity carrying out the development should not capitalise any interest in its own financial
statements as it has no borrowings. If, however, the entity has intra-group borrowings
then interest on such borrowings may be capitalised in its own financial statements.
5.7.2
Qualifying assets held by joint arrangements
A number of sectors carry out developments through the medium of joint arrangements
(see Chapter 12) – this is particularly common with property developments. In such cases,
the joint arrangement may be financed principally by equity and the joint operators or
joint venturers may have financed their participation in this equity through borrowings.
In situations where the joint arrangement is classified as a joint venture in accordance
with IFRS 11 – Joint Arrangements, it is not appropriate to capitalise interest in the joint
venture on the borrowings of the venturers as the interest charge is not a cost of the
joint venture. Neither would it be appropriate to capitalise interest in the financial
statements of the venturers, whether separate or consolidated financial statements,
because the qualifying asset does not belong to them. The investing entities have an
investment in a financial asset (i.e. an equity accounted investment), which is excluded
by IAS 23 from being a qualifying asset (see 3.3 above).
1568 Chapter 21
In situations where the joint arrangement is classified as a joint operation in accordance
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 309