Query No. 15

 

Subject:           

Capitalisation of borrowing costs. 1

 

A.  Facts  of  the  Case

 

1.  A company has undertaken an expansion plan comprising five projects. The work on projects commenced in November 2000.  The company has incurred about Rs. 800 million thereon upto 31st March, 2001.

 

2.  The finance charges aggregating to Rs. 200 million have been accounted for in the financial statements for the period ending on 31st  March, 2001. Though the company also has borrowings for working capital requirements, it had surplus funds during the year (but not at the year-end) that it kept on parking in inter-corporate deposits, investments in debt instruments and other short-term securities.  Further, there has been an equity inflow of Rs. 900 million during the year.  The equity inflow was in two stages in November 2000 and March 2001.

 

3.  According to the querist, the company has borrowed funds for working capital requirements and not specifically for acquisition or construction of fixed assets. These funds were obtained by the company in a phased manner during November 2000 to January 2001. The company has transferred equity inflows into its current accounts which resulted in a pool of funds reducing the overdraft balances and losing its distinct identity as equity inflow. Capital payouts and other payments have also been made from these accounts.

 

4.   As per the querist, the timing of capital expenditure, equity inflows and borrowings match to a fair degree.  Further, the capital expenditure is well within the amount of equity inflows.

 

5. The querist has stated that it is difficult to determine whether expenditure on acquiring qualifying assets is out of borrowed funds or from own funds. As per the company’s contention, the expenditure on qualifying assets has been met out of equity although no written documentation is available which indicates  that the  equity inflow  was for  the purpose  of incurring capital expenditure  on  projects.   However,  a  letter  of  representation  from  the management confirming the same is available.

 

6. The querist has referred to paragraphs 6 to 9, 12 and 15 of Accounting Standard (AS) 16, ‘Borrowing Costs’, issued by the Institute of Chartered Accountants of India, which is mandatory w.e.f. 1st April, 2000. The aforesaid paragraphs provide as below:

 

“6.   Borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset should be capitalised as part of the cost of that asset. ...

 

7.  Borrowing costs are capitalised as part of the cost of a qualifying asset when it is probable that they will result in future economic benefits to the enterprise and the costs can be measured reliably. ...

 

8.  The borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset are those borrowing costs that would have been avoided if the expenditure on the qualifying asset had not been made. When an enterprise borrows funds specifically for the purpose of obtaining a particular qualifying asset, the borrowing costs that directly relate to that qualifying asset can be readily identified.

 

9.  It may be difficult to identify a direct relationship between particular borrowings and a qualifying asset and to determine the borrowings that could otherwise have been avoided. Such a difficulty occurs, for example, when the financing activity of an enterprise is co-ordinated centrally or when a range of debt instruments are used to borrow funds at varying rates of interest and such borrowings are not readily identifiable with a specific qualifying asset.  As a result, the determination of the amount of borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset is often difficult and the exercise of judgement is required.”

 

“12. To the extent that funds are borrowed generally and used for the purpose of obtaining a qualifying asset, the amount of borrowing costs eligible for capitalisation should be determined by applyinga capitalisation rate to the expenditure on that asset. The capitalisation rate should be the weighted average of the borrowing costs applicable to the borrowings of the enterprise that are outstanding during the period, other than borrowings made specifically for the purpose of obtaining a qualifying asset.  The amount of borrowing costs capitalised during a period should not exceed the amount of borrowing costs  incurred  during  that  period.”  

“15.  Expenditure on a qualifying asset includes only such expenditure that has resulted in payments of cash, transfers of other assets or the assumption of interest-bearing liabilities.  Expenditure is reduced by any progress payments received and grants received in connection with the asset (see Accounting Standard 12, Accounting for Government Grants).  The average carrying amount of the asset during a period, including borrowing costs previously capitalised, is normally a reasonable approximation of the expenditure to which the capitalisation rate is applied in that period.”

 

B .        Query

 

7.  The querist has sought the opinion of the Expert Advisory Committee on the following issues:

 

(a)  What is the significance of the concept of ‘avoidable borrowing costs’?  What are the situations under which borrowing costs can be said to be ‘avoidable’ and, conversely, what are the situations under which borrowing costs can be said to be unavoidable?

(b)   Paragraph 12 of AS 16 requires capitalisation of borrowing costs related to general borrowings to the extent funds borrowed generally are “used for the purpose of obtaining a qualifying asset”. What factors are to be considered to determine whether, and to what extent, general borrowings have been so used?  In the instant case where it is being argued that equity flows more or less match the expenditure on qualifying assets, as do the general borrowings made during the period of the expenditure, whether it can be stated that it is the equity funds that have been used for financing the asset and not the said general borrowings.

(c)   Whether it would make any difference to answer to (b) above, if general borrowings made during the period of the expenditure did not match the pattern of expenditure, or if no general borrowings were made during this period but there were general borrowings made earlier but outstanding during this period also.

(d)  Whether it would make any difference to answer to (b) above, if the documentation showed that equity funds were infused specifically for financing the qualifying assets. (e)  If general borrowing costs are to be capitalised, whether the weighted average borrowing rate should be calculated based on borrowings for the whole year or based on borrowings during the period of the expenditure.

C.  Points  considered  by  the  Committee

 

8. The Committee notes from the facts of the case that the company had, during the year ended March 31, 2001, surplus funds, besides equity inflow and borrowings for working capital requirements.  The surplus funds were parked, from time to time, in inter-corporate deposits, debt instruments and other short-term securities. The Committee also notes that it has transferred equity inflows into its current accounts which resulted in a pool of funds reducing the overdraft balances and losing its distinct identity as equity inflow. Capital payouts for acquisition of qualifying assets have been made out of the current account. The Committee, thus, concludes from the facts that surplus funds were not used for acquisition of qualifying assets since these were invested out of the business.  The querist has not clearly mentioned whether the borrowings for working capital were in the form of the bank overdrafts or whether these were different.   However, from paragraph 5 above, where the querist has stated that it is difficult to determine whether expenditure on qualifying assets is out of borrowed funds or from own funds, it appears that the borrowings for working capital refers to bank overdrafts.

It also appears that reference to ‘own funds’ is to equity funds since surplus funds, as per the facts, had been invested outside the business.   Thus, it appears  from  the  facts  that  the  issue  primarily  relates  to  whether  the qualifying assets were financed out of bank overdrafts or equity inflow.

9.  The Committee further notes from the facts of the case that while the company has contended that the qualifying assets were acquired out of equity funds, no written documentation is available in this regard.  The Committee notes that while raising funds by means of an equity issue, the offer document concerned normally states the purpose for which the funds are raised.  In the present case, in the absence of any evidence regarding the use of the funds, if the offer document clearly states that the equity capital was issued for the purpose of financing projects, including acquisition of qualifying assets, the funds used from the current accounts may be considered to be out of equity funds.  In such a case, the question of ‘avoidable borrowing costs’, as stipulated in AS 16, does not arise since there would be no borrowings for acquisition of qualifying assets.

 

D.   Opinion

 

10.  On the basis of the above, the Expert Advisory Committee is of the following opinion on the issues raised by the querist in paragraph 7:

(a)  The question of avoidable borrowing costs would not arise under the facts of the case.

(b) The factors to be considered for determining whether, and to what extent, general borrowings have been used for obtaining a qualifying asset, include the information related to cash inflows and outflows. Therefore, the utilisation of funds borrowed generally for obtaining a qualifying asset is a question of fact. In the instant case, for the purpose of determining whether it can be stated that equity funds were used for financing qualifying assets, please refer to paragraph 9 above.

(c) The question is not based on the facts of the case as supplied above.

(d) If the evidence clearly indicates that equity funds were infused specifically for financing the qualifying assets and the funds were used for the same, the question of capitalising borrowing costs does not arise.

(e )  In the situation of general borrowings, the weighted average borrowing rate should be calculated based on the borrowings during the period of the expenditure.