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 entity’s 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.

Definition
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
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 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
acquisition, construction and production of qualifying assets. 2
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 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 xx
Less: Any income on temporary investment of those borrowings 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
Balance at (a) (b) (a) x (b) Total
year-end Weighted Interest Cap Annual
Type of Borrowings RM Average Rate Rate Interest
10% Redeemable Preference Shares 20,000 10.00% 10.00% 1.00% 2,000
12% Fixed Interest Bank Loan 120,000 60.00% 12.00% 7.20% 14,400
7% Convertible Coupon Bond 60,000 30.00% 7.00% 2.10% 4,200
Total 200,000 100.00% 10.30% 20,600

Interest to be capitalized

Method 1
Total Interest paid in the year 20,600
Expenditure on the qualifying asset RM160,000 x 10.30% 16,480
Interest charged to Income Statement 4,120

Method 2
Total interest expense for the period 20,600
------------------------------------------------- = ---------------------------------- x 100 = 10.30%
Weighted average total borrowings 20,000 + 120,000 + 60,000
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Interest to be capitalized = RM160,000 x 10.30% = RM16,480

Prepared by Norsurianna Teh Binti Abdullah®

 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.
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
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.
Examples of Qualifying Assets

Inventories requiring a long time to reach a saleable

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
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).
condition (FRS 102); Construction Contracts (FRS
111); Plant & Equipment (FRS 116); Development
Expenditure (FRS 138); Property including
investment (FRS 140); Internal Tangibles
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
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.

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.
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