Chapter 10 Appendix 10A Chapter 10 Appendix 10A Capitalization of Borrowing Costs Prepared by: Dragan Stojanovic, CA Rotman School of Management, University of Toronto

2 Borrowing Costs Under IFRS, borrowing costs that can be directly attributed to acquisition, construction, or development of “qualifying assets” should be capitalized. Under PE GAAP, management has a choice of capitalizing or expensing such costs.

3 Capitalization of Borrowing Costs Four questions must be answered: What are the qualifying assets? What is the capitalization period? What is the amount of interest to be capitalized? What disclosures are needed?

4 Qualifying Assets Assets that take a substantial period of time to get ready for intended use or sale Examples of assets that do not qualify: –Assets ready for use or sale when acquired –Assets produced over a short period of time –Assets not undergoing development to get them ready for use

5 Capitalization Period Capitalization period begins when all three conditions are present: 1.Expenditures for the asset have been made 2.Activities for readying the asset are in progress 3.Borrowing costs are being incurred Capitalization continues for as long as these three conditions exist Capitalization ends when asset is substantially complete and ready for use

6 Amount to Capitalize Borrowing costs must be directly related to asset Lower of actual borrowing costs or avoidable borrowing costs –cost of capital for shareholders’ equity is not included in borrowing costs Weighted-average accumulated expenditures (WAAE) method is used to find borrowing costs to be capitalized

7 Borrowing Costs Capitalization – Issues Amount of capitalized interest is based on the intended use of the land purchased Intended Use:Capitalized Interest Cost Attached to: Lot SalesDeveloped land Specific PurposeLand Structure SiteStructure InvestmentInterest costs should not be capitalized

8 Calculating Avoidable Borrowing Costs To calculate avoidable borrowing costs, follow four steps: 1.Determine qualifying asset expenditures 2.Determine avoidable borrowing costs relating to asset-specific debt 3.Determine avoidable borrowing costs relating to non-asset-specific debt 4.Determine final avoidable borrowing costs

9 Shalla Corporation – Example Given: November 1, 2010 contracts with Pfeifer Construction Co. Ltd. to construct a $1.4 million building (on land costing $100,000) First payment made by Shalla to Pfeifer includes the payment for the land Payments made in 2011: –January 1 $ 210,000 –March 1 $ 300,000 –May 1 $ 540,000 –December 31 $ 450,000 –Total $1,500,000 Building completed December 31, 2011

10 Shalla Corporation – Example Debt outstanding at December 31, 2011 –Specific Construction Debt: 15%, three year note dated December 31, 2010$750,000 –Other Debt: 10%, five year note dated December 31, 2007$550,000 12%, ten year bonds dated December 31, 2004$600,000 Interest on debt is payable each December 31

11 Shalla Corporation – Example STEP 1: Determine qualifying asset expenditures Weighted-Average Accumulated Expenditures: Jan. 1$ 210,000 x 12/12=$210,000 Mar ,000 x 10/12= 250,000 May ,000x 8/12= 360,000 Dec ,000x 0/12= 0 WAAE$820,000 Note: Land payment is included in WAAE Next step: Avoidable interest and appropriate interest rate calculation

12 Shalla Corporation – Example STEP 2: Determine avoidable borrowing costs relating to asset-specific debt $750,000 x 15% = $112,500

13 Shalla Corporation – Example PrincipalBorrowing cost 5-year note$550,000$ 55, year note$600,000 72,000 Total $127,000 Weighted-Average Interest Rate = Total Interest  Total Principal (Do not include Construction Specific Debt) $127,000  (550, ,000) = 11.04% STEP 3: Determine avoidable borrowing costs relating to non-asset-specific debt

14 Shalla Corporation – Example Total WAAE$820,000 Less: financed by specific loan$750,000 WAAE financed by general borrowings$70,000 X avoidable borrowing cost on general11.04% Avoidable costs on general debt$7,728

Shalla Corporation – Example STEP 4: Determine total borrowing costs to capitalize 15 Avoidable borrowing costs On asset-specific debt$112,500 On general debt$7,728 TOTAL$120,228 Actual Interest: $750,000x15%=$112, ,000x10%= 55, ,000x12%= 72,000 Total actual interest paid $239,500

16 Shalla Corporation – Example Avoidable interest = $120,228 Actual interest = $239,500 The lesser of these two amounts is capitalized Journal Entry: Dr.Building120,228 Cr. Interest Expense120,228

17 Interest Capitalization – Significance Capitalized interest increases net income for the period Impact on EPS can be significant

18 Disclosures Two disclosures required: –Amount capitalized –Capitalization rate

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