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September 2011

GAPs in GAAP — What is substantial period of time?

By Dolphy D’Souza
Chartered Accountant
Reading Time 5 mins
What is substantial period of time?

Borrowing costs are capitalised during the construction of a qualifying asset, which is an asset that necessarily takes a substantial period of time to get ready for its intended use or sale. The explanation to the definition of the term ‘qualifying asset’ in AS-16 ‘Borrowing Cost’, notified by the Central Government under the Companies (Accounting Standards) Rules, 2006, provides as follows:


“What constitutes a substantial period of time primarily depends on the facts and circumstances of each case. However, ordinarily a period of twelve months is considered as substantial period of time unless a shorter or longer period can be justified on the basis of facts and circumstances of the case. In estimating the period, time which an asset takes, technologically and commercially, to get it ready for its intended use or sale is considered.”

Let us see how this explanation was interpreted in the context of the example below.


Salon Ltd. provides health and beauty solutions through its various salons across the country. From the time of acquiring the premises to the development of the salon, a period of three to five months is required and a substantial cost including capital cost on leasehold improvement is incurred on creating the right aesthetic and ambience. The period of three to five months is representative of the time required for similar construction of assets. The amount to be capitalised (if permitted) is material.

Position prior to EAC opinion (which was finalised on 30-5-2008)

In light of the explanation in AS-16, a period of three to five months was considered far below the 12-month threshold level, and hence in many similar situations companies may not have capitalised the bor-rowing expenses to comply with the explanation.

Position after EAC opinion (which was finalised on 30-5-2008)

The above position has changed completely vide an EAC opinion that was finalised on 30-5-2008 but was only published and available recently in Compendium Volume XXVIII. Paragraph 14 of the opinion states: “The committee is of the view that ordinarily, three to five months cannot be considered as a substantial period of time. The company should itself evaluate what constitutes a substantial period of time considering the peculiarities of facts and circumstances of its case, such as nature of the asset being constructed, etc. In this regard, time which an asset takes, technologically and commercially to get it ready for its intended use should be considered. Accordingly, the assets concerned may be considered as qualifying asset as per the provisions of AS-16.”

EAC opined that the borrowing costs could be capitalised by Salon Ltd.

Author’s comments

It may be noted that IAS 23 Borrowing Costs contains similar principles of capitalisation on qualifying asset. Like AS-16, substantial period of time has not been defined but unlike AS-16, there is no 12-month threshold level in IAS 23. Under IAS 23 there is no consensus globally on what constitutes a substantial period of time, though literature suggests a period of six months or more, to be substantial. Under FAS 34 interest cost is capitalised for all assets that require a period of time (not necessarily substantial) to get them ready for their intended use. However, in many cases, the benefit in terms of information about enterprise resources and earnings may not justify the additional accounting and administrative cost involved in providing the information. The benefit may be less than the cost, because the effect of interest capitalisation and its subsequent amortisation or other disposition, compared with the effect of charging it to expense when incurred, would not be material. In that circumstance, FAS 34 does not require interest capitalisation.

The substantial period criteria ensures that enterprises do not spend a lot of time and effort capturing immaterial interest cost for purposes of capitalisation. This aspect is very clear under FAS 34. Therefore if the interest cost is very material the same may be capitalised even if the asset has taken less than 12 months to complete, provided other factors indicate capitalisation is appropriate.

The explanation to AS-16 requires assessing the time which an asset should take technologically and commercially to be ready for its intended use. In fact, under present circumstances where construction period has reduced drastically due to technical innovation, the 12-month period should at best be looked at as a general benchmark and not a conclusive yardstick. It may so happen that an asset under normal circumstances may take more than 12 months to complete. However an enterprise that constructs the asset in 10 months should not be penalised for its efficiency by denying it interest capitalisation and vice versa.

Seen from this perspective, and the mixed practice under IAS 23, the EAC opinion is a step in the right direction as it clarifies that the 12-month period should not be seen as a strict benchmark, and other facts and circumstances should be kept in mind. In that sense, it is more aligned to global practice.

However additional guidance is required with regards to the following issues:

1. The EAC opinion changes the existing thought and practice in this area. In similar situations, if a company had not capitalised borrowing cost in earlier years, would they have to apply the correct treatment retrospectively (from the date AS-16 came into force)?

2. Would retrospective adjustment constitute a change in accounting policy or a rectification of prior period error?

3. Can such change be applied prospectively, given that the EAC opinion establishes a new principle?

4. If it is applied on a prospective basis, should it from the date the EAC finalised the opinion or the date when such an opinion was made public?

More importantly, given that it is intended that India will converge to IFRS, it may be worthwhile for the Institute of Chartered Accountants of India to raise this issue with the International Accounting Standards Board.

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