Posted inFinances

Finance Costs Capitalised

Finance Costs Capitalised

Finance Costs Capitalised

Finance Costs Capitalised

Capitalisation of finance costs, also known as borrowing costs, refers to the accounting treatment where interest and other expenses related to borrowing are included in the cost of an asset rather than being expensed immediately in the income statement. This practice is permitted under specific accounting standards like IAS 23 (Borrowing Costs) and ASC 835-20 (Interest – Capitalization of Interest). The core principle is that if borrowing costs are directly attributable to the acquisition, construction, or production of a qualifying asset, they should be capitalised.

A qualifying asset is one that necessarily takes a substantial period of time to get ready for its intended use or sale. Examples include property, plant, and equipment (PP&E) under construction, such as a building or a large piece of machinery; intangible assets under development, like software; and certain inventory items like aged wine or whiskey.

The rationale behind capitalising finance costs is to better reflect the true cost of the asset and provide a more accurate matching of revenues and expenses. By adding the borrowing costs to the asset’s carrying value, these costs are depreciated or amortized over the asset’s useful life, aligning the expense recognition with the period when the asset generates revenue. This prevents a potentially significant expense hit in the initial period of acquisition or construction, which might distort the company’s financial performance.

The amount of finance costs that can be capitalised is generally limited. It’s calculated based on the weighted average cost of borrowing applied to the expenditures on the qualifying asset. Specifically, the capitalisation rate is applied to the asset’s average accumulated expenditures. Capitalisation typically begins when the following conditions are met: expenditures for the asset have been made, borrowing costs have been incurred, and activities necessary to prepare the asset for its intended use or sale are in progress. Capitalisation ceases when substantially all the activities necessary to prepare the asset are complete. During temporary suspensions of active development, capitalisation of borrowing costs is usually suspended as well.

Capitalising finance costs can have a significant impact on a company’s financial statements. It increases the carrying value of the asset on the balance sheet. In the income statement, it reduces the interest expense in the period of capitalisation but increases depreciation expense in subsequent periods. For example, higher earnings are typically reported in the short term compared to expensing all borrowing costs immediately. However, over the asset’s life, the total expense recognised will be the same, only shifted in timing. Companies must disclose their policy regarding capitalisation of borrowing costs, including the capitalisation rate used and the amount of borrowing costs capitalised during the period.

While capitalisation aims for improved financial reporting, it also introduces complexities. Determining whether an asset qualifies, calculating the capitalisation rate, and tracking expenditures require careful consideration and documentation. Additionally, capitalisation can be subject to manipulation, highlighting the importance of transparency and adherence to accounting standards.

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