The definition of borrowing costs under AS-16 is an inclusive definition and not an exclusive definition. However, they must meet the basic criterion in the standard, i.e., that they are costs that are directly attributable to the acquisition, construction or production of a qualifying asset. As per AS-16 borrowing costs may include:
(a) interest and commitment charges on bank borrowings and other short-term and long-term borrowings;
(b) amortisation of discounts or premiums relating to borrowings;
(c) amortisation of ancillary costs incurred in connection with the arrangement of borrowings;
(d) finance charges in respect of assets acquired under finance leases or under other similar arrangements; and because the definition of borrowing costs is an inclusive one, numerous interpretative issues arise. For example, would borrowing costs include hedging costs ? Let me explain my point with the help of a simple example using a commonly encountered floating to fixed interest rate swap (IRS).
Example:
Floating to fixed IRS
Company X is constructing a factory and expects it to take 18 months to complete. To finance the construction, on 1st January 2011 the entity takes an eighteen-month, Rs.10,000,000 variable-rated term loan due on 30th June 2012. Interest payment dates and interest rate reset dates occur on 1st January and 1st July until maturity. The principal is due at maturity. Also on 1st January 2011, the entity enters into an eighteen-month IRS with a notional amount of Rs.10,000,000 from which it will receive periodic payments at the floating rate and make periodic payments at a fixed rate of 10% per annum, with settlement and rate reset dates every 30th June and 31st December. The fair value of the swap is zero at inception. During the eighteen-month period, floating interest rates are as follows:
Under the IRS, Company X receives interest at the market floating rate as above and pays at 10% on the nominal amount of Rs.10,000,000 throughout the period.
At 31st December 2011 the swap has a fair value of Rs.40,000, reflecting the fact that it is now in the money as Company X is expected to receive a net cash inflow of this amount in the period until the instrument is terminated. There are no further changes in interest rates prior to the maturity of the swap. The fair value of the swap declines to zero at 30th June 2012. In this example for sake of simplicity we assume hedge is 100% effective, issue costs are nil and exclude the effect of discounting.
The cash flows incurred by the entity on its borrowing and IRS are as follows:
There are a number of different ways in which Company X could theoretically calculate the borrowing costs eligible for capitalisation, including the following:
(i) The IRS meets the conditions for, and Company X applies, hedge accounting. The finance costs eligible for capitalisation as borrowing costs will be Rs.1,000,000 in the year to 31st December 2011 and Rs.500,000 in the period ended 30th June 2012.
(ii) Company X applies hedge accounting, but chooses to ignore it for the purposes of treating them as borrowing costs. Thus it capitalises Rs.925,000 in the year to 31st December 2011 and Rs.540,000 in the period ended 30th June 2012.
(iii) Company X does not apply hedge accounting. Therefore, it will reflect the fair value of the swap in income in the year ended 31st December 2011, reducing the net finance costs by Rs.40,000 to Rs.960,000 and increasing the finance costs by an equivalent amount in 2012 to Rs.540,000.
(iv) Company X does not apply hedge accounting. However, it considers that it is inappropriate to reflect the fair value of the swap in borrowing costs eligible for capitalisation, so it capitalises costs based on the net cash cost on an accruals accounting basis. In this case this will give the same result as in (i) above.
(v) Company X does not apply hedge accounting and considers only the costs incurred on the borrowing, not the IRS, as eligible for capitalisation. The borrowing costs eligible for capitalisation would be Rs.925,000 in 2011 and Rs.540,000 in 2012.
All the above views have their own arguments for and against, although the preparer will need to consider what method is more appropriate in the circumstances. For example, the following points may be considered by the preparer:
1. The decision to hedge interest cost results in the fixation of interest cost at a fixed level and are directly attributable to the construction of the factory. Therefore, method (ii) may not carry much support.
2. To use method (iv) it is necessary to demonstrate that the derivative financial instrument is directly attributable to the construction of a qualifying asset. In making this assessment it is clearly necessary to consider the term of the derivative and this method may not be practicable if the derivative has a different term to the underlying directly attributable borrowing.
3. In this example, method (v) appears to be inconsistent with the underlying principles of AS-16 — which is that the costs eligible for capitalisation are those costs that could have been avoided if the expenditure on the qualifying asset had not been made — and is not therefore appropriate. However, it may not be possible to demonstrate that specific derivative financial instruments are directly attributable to particular qualifying assets, rather than being used by the entity to manage its interest rate exposure on a more general basis. In such a case, method (v) may be an acceptable treatment. Method (iii) may not be appropriate in any case. Whatever policy is chosen by the entity, it needs to be consistently applied in similar situations.
The bigger issue is: in the era of accounting standards — is this diversity warranted and/or desirable?
