Borrowing costs include all costs related to borrowing funds, primarily interest costs. The borrowing costs related to the construction or production of certain qualifying assets are recognized as part of the asset’s cost rather than as expenses.

Example: A company takes out a $1 million loan to build a new manufacturing plant. The interest on this loan is a borrowing cost and should be capitalized. 

Qualifying Assets?

A qualifying asset is one that takes a substantial amount of time to be ready for its intended use or sale. Typical examples include:

• Manufacturing plants.

• Large-scale construction projects.

• Some types of inventories (e.g., wine aging in barrels for years)

Example: If a company is building a high-rise office building, which will take three years to complete, the office building qualifies as a qualifying asset.

Capitalization of Borrowing Costs

When borrowing costs are directly linked to the acquisition, construction, or production of a qualifying asset, they should be capitalized as part of the cost of that asset, provided two conditions are met:

1. Future Economic Benefits: It must be probable that the asset will bring future economic benefits.
2. Reliability of Measurement: The borrowing costs can be measured reliably.

If these criteria are not met, the borrowing costs are expensed.

Example: The company building the office tower has a loan and incurs borrowing costs (interest). These costs are capitalized as part of the cost of constructing the tower, increasing the building’s value on the balance sheet instead of expensing the interest.

Specific vs. General Borrowing

• Specific Borrowing: When a loan is specifically taken for a qualifying asset. The interest costs, net of any income earned from unused funds, are capitalized.

• General Borrowing: When borrowing is not directly tied to a specific asset but used for general purposes. In this case, the borrowing cost is capitalized using a capitalization rate, which is a weighted average of the borrowing costs.

Example 1 (Specific Borrowing): A company takes out a $500,000 loan to build a warehouse. Any interest paid on this loan during the construction is capitalized as part of the cost of the warehouse.

Example 2 (General Borrowing): A company uses a pool of general borrowings, like a credit line, to fund multiple projects. The interest cost related to the portion used for building a new factory is calculated using the weighted average of the interest rates for the company’s general borrowings and then capitalized.

When Does Capitalization Start?

Borrowing costs capitalization starts when all the following conditions are met:

• The entity incurs expenditure on the asset.
• The entity incurs borrowing costs.
• The entity undertakes activities to prepare the asset for its intended use or sale.

Example: A company starts building a power plant. Once it begins spending money on the plant, takes out a loan for the project, and actively works on construction, it can capitalize the interest costs.

Suspension of Capitalization

If the construction is temporarily stopped for an extended period due to unforeseen interruptions, the capitalization of borrowing costs is suspended during that time.

Example: If the company constructing a building halts work for six months due to a labor strike, it will stop capitalizing borrowing costs during this period.

When Does Capitalization Stop?

Capitalization stops when the asset is ready for its intended use or sale. Any borrowing costs incurred after this point are expensed.

Example: Once the office building is completed and ready for tenants, the company stops capitalizing interest costs. Any borrowing costs incurred after that will be recognized as an expense in the profit and loss statement.

Key Takeaways:

• Borrowing costs include interest expenses incurred from loans.
• Qualifying assets are those that take a long time to construct or produce.
• Borrowing costs related to such assets are capitalized as part of the asset’s cost.
• Capitalization starts when expenditures are incurred, borrowing costs are being paid, and construction is ongoing, and it stops when the asset is ready for use.
• If construction is interrupted, capitalization is paused.