AS 16 - Borrowing Costs

Accounting Standard on borrowing costs (AS 16) has been made mandatory in
respect of accounting period com-menacing from 1st April 2000. Certain practical
aspects of treatment of borrowing costs are dealt with in the following paragraphs.
Definition: Borrowing costs:
This includes commitment charges, discounts or premium relating to borrowings,
ancillary costs incurred, finance charges under finance lease and exchange
differences arising from foreign currency loans to the extent they are regarded as
adjustment to interest costs. Practically all costs connected with borrowings have
been included under the definition of interest. Thus one has to be careful in
collecting all expenses relating to borrowings which otherwise would have been
grouped under various heads such as bank charges, legal fees, lease charges, etc.
Many banks and financial institutions charges upfront fee or processing charge for
work-ing capital. When debentures are raised, the firm may incur rating fees,
registration charges, stamp duty, etc. For the limited purpose of this AS 16, these
expenses have to be treated as interest on borrowings.
Many firms take forward cover on foreign loans and this involves certain additional
costs. When different alternative avenues are available, firms do take into account
such additional costs for arriving at total interest costs before a particular source of
borrowing is decided. Based on such treatment, the firm has to decide whether
forward cover costs will come under interest costs. In order to have a consistent
policy, firms should draw a policy statement showing the component of interest so
that it can be consistently followed.
Qualifying asset:
Two characteristics are important to make an asset as 'qualifying asset' viz. :
a.
it necessarily takes substantial period of time to get the asset ready for
intended use.
b.

the time taken is substantial.

The qualifying word 'necessarily' should be interpreted in full commercial strength.

Assets that are ready for their intended use or sale when acquired, are not
qualifying assets. A lathe may be purchased after due testing at the manufacturer's
place. But when received at the site one may have to do certain procedural things
or power connection may not be ready. Such type of situations will not make it a

qualifying asset. Items like plant and machinery in an engineering industry where
most of the assets will be working independently will not become qualifying assets.
However in a process industry, the plants may not be able to act independently and
immediately and hence will 'necessarily' take substantial time to get ready for
intended use e.g. refinery. Land may be developed for the purpose of dividing into
plots and sold, or for the purpose of construction of building. In the former case
interest may be added to cost of land and in the latter case it should be added to
cost of building.
The second and most important requirement is that the asset should take
substantial period of time to get ready for intended use. In fact, this is the most
important requirement of this Standard.
What is 'substantial period of time' is likely to enter into controversy. Normally in
commercial parlance one can say that any time over a period of one year may be
termed as 'substantial period'. Hence all normal capital expenditure that is incurred
by any firm may not come under the definition of substantial period and hence on
these assets interest should not be capitalized.
Normally as per AS 2, interest on inventories is not added to the cost of inventories.
However, if inventory requires a substantial period of time to bring it to a saleable
condition, then such cost should be added to inventory cost e.g. maturity of liquor
for 10 years.
A few examples given below may come under the definition of 'substantial period'.
Normally buildings such as tidal park constructed by Tamil Nadu Government take 2
to 3 years for construction. Similarly MRTS project constructed by Railways takes
about 3 to 5 years to complete. Thus this standard is applicable to such projects
without any doubt.
A company which is already in business can expand the capacity at the existing
place or it may commence a new factory in a different place. When expansion is
being done or balancing equipment is added in the same place, assets are generally
ready for intended use within a year. Such assets will not qualify for capitalization of
interest even though there may be specific borrowings for those assets. A company
may also put up an entirely new plant in a new location. Such new plant may come
under qualifying asset only if it takes 'substantial period' of time to get ready for its
intended use. Nowadays firms are demanding 'just in time' supplies from their
suppliers and hence small units put up their plants/assembly units near consuming
centers. These plants are erected in just 3 to 12 months. Such new plants/assembly
units will not come under the definition of 'substantial period' of time. Hence firms
are advised to prepare a policy note on the definition of 'substantial period of time'
and follow the same consistently over period of time.
Quantum of capitalization:

To the extent funds are borrowed specifically for the purpose of obtaining a qualifying asset, actual borrowing costs less any income on temporary investment of the
borrowings should be capitalized.
The following situations may arise after borrowing:
Situation
Borrowings fully used for acquiring capital asset. Partly used for investment in
capital asset and partly used to reduce other borrowings. Partly used Partly
invested.

Partly money remains idle.

In situation one, entire borrowing cost is capitalized. In the second situation to the
extent funds are used for capitalization, interest is capitalized. In the third situation,
actual cost less income is capitalized. The fact that part of the funds remained idle
will still make interest paid eligible to be capitalized. Only actual income earned
should be deducted from actual cost. This means if no income is earned, entire cost
should still be capitalized.
A firm may borrow generally and use it for acquiring a qualifying asset. In such
cases average cost of borrowing should be applied based on actual expenditure.
The firm should find out weighted average cost of borrowing taking both time and
quantum of borrowing for the period to arrive at the rate of borrowing. Suitable
credit should be given for any subsidy or grant received. Here the firm should work
out the actual cost based on such weighted average cost and actual usage of funds.
Commencement of capitalization:
The following three important criteria should be satisfied for interest to be
capitalized:
a.

Capital expenditure should be incurred.

b.

Borrowing costs are incurred.

There are many activities that are necessarily required to be done including
technical and administrative work prior to commencement of work. If a land is
acquired and kept without any development activity, such activity does not qualify
for capitalization. Hence one should be extra careful in ascertaining the period for
which interest should be capitalized. capitalization of borrowing costs should be
suspended during extended period in which active development is interrupted. Facts
alone can prove this, based on circumstances.
Cessation of capitalization:

Capitalization of borrowing costs should be stopped when substantially all activities

necessary to prepare the qualifying asset for its intended use are complete. Many
companies capitalize interest up to the date of commercial production.
Capitalization of interest should stop when substantially all activities are complete
and need not wait till commercial production is commenced.
Further the qualifying asset may be completed in parts. Capitalization of interest
should stop when that part can be put to use even though construction of other part
may continue. In factory expansion, building may be completed and ready for use.
The installation of machineries may be in progress. The capitalization of interest on
building will stop as soon as building is complete, even though construction of
machinery may be under progress.
Disclosure : The financial statements should disclose :
a.

the accounting policy adopted for borrowing costs and

b.

the amount of borrowing costs capitalised during the period

What companies must do :

Companies were earlier following the guidance note issued by the Institute of
Chartered Accountants of India on expenditure during the construction period. Now
it is given statutory recognition in the form of AS-16. A company should frame
internal standard operating procedure to cover the following important points :
a.
Definition of 'Substantial period of time' to get the asset ready for its
intended use or sale.
b.

Definition of borrowing costs.

c.

Determination of commencement of capitalization.

d.

Determination of when substantial activity is completed.

Such an operating procedure will help to have a uniform policy on this Accounting
Standard.
Example 1 The company has replaced high cost debt from a bank with low cost debts from
another bank by
making a 2% prepayment fee. As per AS 16, borrowing costs include amortization of
ancillary
costs incurred in connection with the arrangement of borrowings. Whether 2%
prepayment fee could be treated as being in the nature of a borrowing cost for
purposes of capitalization under AS-16?

Ans:- The question will be solved with reference to AS 16 Borrowing Costs issued
by ICAI and notified under the Companies (Accounting Standards) Rules, 2006.
According to AS 16 Borrowing costs means interest and other cost incurred by an
enterprise in connection with the borrowing of funds. In a given case, the
prepayment fee is incurred by the company for the extinguishment of borrowings .
It is not incurred for the arrangement of borrowings. Further there is no nexus
between borrowings from the earlier lending bank and the new lending bank, it
cannot be regarded as borrowing cost under AS 16.

Example 2
X Ltd borrowed the following as on 1st April 2012:12% SBI LoanRs.100 lacs
13% DebenturesRs.200 lacs
The amount is utilised on the following assets
Power Plant-Rs.150 lacs (Work started from 1st March 2013)May 2012 and
completed on 31
Working Capital -Rs.150 Lacs
Compute the Borrowing Costs and give the treatment thereof for FY 2012-2013.
Solution
Computation of Borrowing Costs
12% SBI Loan100 lacs x 12% = 12 lacs
13% Debetures 200 lacs x 13% = 26 lacs
Total Borrowing Cost= 38 lacs
Since the borrowings are General Borrowings we need to calculate capitalization
rate.
Capitalisation Rate = (26 lacs + 12 lacs)/ 300 lacs
= 12.67%
Power Plant 150 lacs x 12.67% x 11/12 = 17.42 lacs
Revised Cost of Plant = 150 + 17.42 = 167.42 lacs
Working Capital= 150 lacs x 12.67% = 19 lacs
Since Working capital is not qualifying asset,

borrowing cost cannot be capitalised.

Total Borrowing Cost in 2012-2013= 38 lacs

1.

Capitalised as per AS 16 = Rs.17.42 Lacs

2.

Recognised as an Expense in P&L Statement = Rs.20.58 Lacs