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Financial Reporting Standards

FRS 123: Borrowing Costs


Objective
The objective of this Standard is to prescribe the accounting treatment of borrowing cost. This Standard
generally requires the immediate expensing of borrowing costs. However, the Standard permits as an
allowed alternative treatment, the capitalization of borrowing costs that is directly attributable to the
acquisition, construction or production of a qualifying asset.

What are the factors that favor capitalization of borrowing costs?


1. Borrowing costs form part of the total costs incurred in bringing an asset into use for its intended
purpose; if an asset takes a substantial time to complete, borrowing costs may be incurred and if
they are they should be capitalized.
2. Capitalization of borrowing costs achieves a better matching of the use of the asset with the
revenue generated from the asset concerned as the costs are expensed over the useful life to that
asset and not to income whilst the asset was unproductive.
3. Failure to capitalize borrowing costs where incurred will that an entitys performance will appear to
be different depending upon whether it has constructed an asset during the period or has acquired
similar ones; profits are biased downwards during periods of substantial asset construction unless
borrowing costs are capitalized.
4. Capitalization leads to similar assets being accounted for in a like way in the balance sheet which
results in a greater comparability between the costs of the self-constructed assets and those of
acquired ones because when one asset is acquired the purchase price will normally reflect the
borrowing costs incurred by the entity that has constructed it

What are the factors against capitalization of borrowing costs?


1. It is illogical to treat borrowing costs as a period expense in normal circumstances then to treat
them as a direct cost of an asset during its period of construction and to revert to treating them as a
period expense once the asset is complete even though borrowing costs are probably continuing to
be incurred in respect of that asset.
2. Borrowing costs are generally incurred to support the whole of the activities of the entity; any
attempt to associate borrowing costs with a particular asset will often be arbitrary.
3. Capitalization of borrowing costs results in similar assets having different carrying amounts
depending on the method of financing adopted by the entity. An entity with a large proportion of
equity capital will generally carry its assets at a lower carrying amount than a highly leveraged
entity.

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Borrowing costs are interest and other costs incurred by an entity in connection with the borrowing of
funds. They may include:
Interest on bank overdraft; short-term and long-term borrowings;
Amortization of discounts or premiums relating to borrowings;
Amortization of ancillary costs incurred in connection with the arrangement of borrowings;
Finance charges in respect of finance leases: FRS 117 Leases
Exchange differences arising from foreign currency borrowings to the extent they are regarded
as an adjustment to interest costs: FRS 121 The Effects of Changes in FOREX rates

Definition

Prepared by Norsurianna Teh Binti Abdullah

Financial Reporting Standards


FRS 123: Borrowing Costs
Criteria for Capitalization of borrowing costs:
FRS 123 prescribes that borrowing costs can be capitalized on qualifying assets. Borrowing
costs definition are interest and other costs incurred in relation to borrowing of funds. This
includes interest amortization of discounts, premiums and ancillary costs relating to
borrowings. For qualifying asset, it is an asset that takes a substantial period of time to be
ready for intended use or sale.
Accounting treatment of borrowing costs
Expensed when incurred
Capitalized
Limitations to the amount of borrowing costs to be capitalized

Borrowing is specific to the construction of the asset or the borrowing could be avoided
if not for the construction of the asset

Where the borrowing for the construction is part of a general pool of borrowing, the
interest capitalized is based on the weighted average rate of the borrowing costs
applicable to the general pool

Where funds specifically borrowed are utilized progressively as the construction


progresses, the borrowing costs capitalized are reduced by any income earned on the
idle funds invested

Capitalization should commence when expenditure and borrowing costs are being
incurred and activities necessary to prepare the asset for its intended use or sale are in
progress

Capitalization should be suspended during periods in which active development is


interrupted

Capitalization should cease when substantially all of the activities necessary to prepare
the asset for its intended use or sale are complete

The policy should be applied consistently to all borrowing costs incurred for the

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acquisition, construction and production of qualifying assets.

Prepared by Norsurianna Teh Binti Abdullah

Financial Reporting Standards


FRS 123: Borrowing Costs
Borrowing costs eligible for capitalization
a) Specific Borrowing (for purpose of obtaining a QA)
The amount of borrowing costs eligible for capitalization on the asset should be the total borrowing
costs incurred during the period less any investment income on the temporary investment of those
funds.
Borrowing costs capitalized
Actual Borrowing Costs Incurred
Less: Any income on temporary investment of those borrowings

xx
xx

b) General Borrowing (borrowings are not wholly & exclusively for financing a QA)
The amount of borrowing costs eligible for capitalization should be determined by applying a
capitalization rate to the expenditure on the asset. The capitalization rate should be weighted
average of borrowing costs applicable to the borrowings of the entity that are outstanding during the
period other than borrowings made specifically for the purpose of obtaining a qualifying asset.
However the amount of borrowing costs capitalized should not exceed the amount of borrowing
costs incurred during the period. Where funds are borrowed generally the amount of borrowing
costs is not reduced by interest income earned. The base ie the amount to which the capitalization
rate is applied should be the average amount of accumulated net capital expenditure incurred on
the qualifying asset within the relevant time frame.
Borrowing costs capitalized
Capitalization Rate (CR) (see below) x Expenditure Incurred To-Date of each QA

Question 5(a) March 2005 MIA Inquest Berhad


Computation of Capitalization Rate
Type of Borrowings
10% Redeemable Preference Shares

12% Fixed Interest Bank Loan


7% Convertible Coupon Bond
Total

Balance at
year-end
RM
20,000
120,000
60,000
200,000

(a)
Weighted
Average
10.00%
60.00%
30.00%
100.00%

(b)
Interest
Rate
10.00%
12.00%
7.00%

(a) x (b)
Cap
Rate
1.00%
7.20%
2.10%
10.30%

Total
Annual
Interest
2,000
14,400
4,200
20,600

Interest to be capitalized
Method 1
Total Interest paid in the year
Expenditure on the qualifying asset
Interest charged to Income Statement

20,600
16,480
4,120

RM160,000 x 10.30%

Method 2
20,600
---------------------------------20,000 + 120,000 + 60,000

Interest to be capitalized

RM160,000 x 10.30%

Prepared by Norsurianna Teh Binti Abdullah

x 100

= 10.30%

= RM16,480

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Total interest expense for the period


------------------------------------------------Weighted average total borrowings

Financial Reporting Standards


FRS 123: Borrowing Costs
What are the treatments under FRS 123: Borrowing Costs?
Borrowing costs should be recognized as an expense in the period in which they are incurred
regardless of how the borrowings are applied. However, FRS 123 provides an allowed alternative
treatment.
Allowed Alternative Treatment

Qualifying Assets

FRS 123 permits as an allowed alternative


treatment the capitalization of borrowing costs
that is directly attributable to the acquisition,
construction or production of a qualifying
asset.

Qualifying asset (QA) is an asset that necessarily


takes a substantial period of time to get ready for its
intended use or sale. The asset is usually under
construction and will take a long period of time to
complete the construction work.

However, it should only be capitalized as part of the


cost of that asset provided if it is probable that they
will result in future economic benefits and costs
can be measured reliably

Examples of Qualifying Assets


Inventories requiring a long time to reach a saleable
condition (FRS 102); Construction Contracts (FRS
111); Plant & Equipment (FRS 116); Development
Expenditure (FRS 138); Property including
investment (FRS 140); Internal Tangibles

Capitalization
Commencement of Capitalization
The capitalization of borrowing costs should
commence when:
Expenditure for the assets are being incurred;
Borrowing costs are being incurred and
Activities to prepare the asset for its intended
use or sale in progress

Borrowing Costs eligible for Capitalization


Specific Borrowing
(for purpose of obtaining a QA)
Borrowing costs capitalized
Actual Borrowing Costs Incurred
Less: Any income on temporary investment of
those borrowings

Suspension of Capitalization
The capitalization of borrowing costs should be
suspended during the period in which active
development is interrupted ie charged to Income
Statement as an expense during the period work is
suspended (see Whitewater).
However, capitalization is not suspended when a
temporary delay is a necessary part of the process
of getting an asset ready for its intended use or sale
(where temporary delay is unavoidable).

General Borrowing
(borrowings are not wholly & exclusively for
financing a QA)
Borrowing costs capitalized
Capitalization Rate (CR) (see below) x Expenditure
Incurred To-Date of each QA

Cessation of Capitalization
The capitalization of borrowing costs should cease when 'substantially all the activities' necessary to prepare the
QA for its intended use or sale are completed.

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Substantially all the activities can be interpreted as physical construction of the asset is completed even though
routine administration work may still continue or minor modification still outstanding.

Prepared by Norsurianna Teh Binti Abdullah

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