Expert Advisory Committee

Query No. 27

Subject:

Capitalisation of borrowing costs.1

A. Facts of the Case

1. A public sector company, under the Ministry of Steel, Government of India, is engaged in the manufacture and sale of iron and steel products. During the year 2000-01, the company has repaid interest bearing loans to the tune of Rs. 76.89 crore. According to the querist, the amount incurred on capital account has been financed by internal accruals. The summarised Funds Flow Statement of the company for the year ended 31.03.2001 is given below:

Sources and Utilisation of Funds (Rs. in crore)

A. Sources of Funds

(a) Funds from operations 159.18

(b) Sale of Fixed Assets 3.27

Total funds inflow during the year 162.45

B. Utilisation of Funds

(d) Increase in miscellaneous expenditure(to the extent not written off) 80.05

(e) Decrease in borrowings 76.89

(f) Increase in fixed assets 2.29

Total funds outflow during the year 162.45

2. The querist has contended that it can be observed from the above Funds Flow Statement that there were no borrowings during the year and, in fact, loans to the tune of Rs. 76.89 crore were repaid. Hence, the company did not capitalise any interest or any financing charges incurred on the outstanding loans. However, as per the querist, the government auditors observed that the non-capitalisation of borrowing costs is contrary to Accounting Standard (AS) 16, ‘Borrowing Costs’, issued by the Institute of Chartered Accountants of India.

3. Accounting policy of the company on capitalisation of borrowing costs, comments of government auditors, the company’s reply and reply of the statutory auditors of the company under section 619(4) of the Companies Act, 1956, to the comments of the government auditors are given below:

A. Accounting policy of the company on treatment of borrowing costs:

“Borrowing Costs:

(i) Borrowing costs incurred for obtaining assets which take more than 12 months to get ready for its intended use are capitalised to the respective assets:

(a) wherever the costs are directly attributable to such assets;

and

(b) in other cases by applying weighted average cost of borrowings to the expenditure on such assets.

(ii) Other borrowing costs are treated as expense for the year.”

B. Comments of the government auditors:

As per the accounting policy of the company, borrowing costs incurred for obtaining assets which take more than 12 months to get ready for their intended use are capitalised to the respective assets by applying weighted average cost of borrowings to the expenditure on such assets. However, it is seen that the borrowing costs incurred on obtaining ash pond (Rs. 412.59 lakh) which is under construction, capital advances (Rs. 116.70 lakh) given to 12 parties, and some of the other assets (Rs. 260.54 lakh), have not been capitalised by applying weighted average cost of borrowings (i.e., 11.41%), though the assets took more than 12 months to get ready for their intended use. Non-capitalisation of the borrowing costs in respect of the above is contrary not only to the accounting policy but also to AS 16. This has resulted in understatement of Fixed Assets (Gross Block) by Rs. 29.73 lakh, Capital work-in-progress by Rs. 60.39 lakh, Depreciation by Rs. 1.18 lakh and overstatement of Interest and Finance Charges by Rs. 90.12 lakh and Net Loss for the year by Rs. 88.94 lakh.

C. The company’s reply:

The accounting policy of the company on borrowing costs as well as AS 16 clearly deal with the borrowing costs incurred in relation to a qualifying asset. As can be seen from the Funds Flows Statement submitted to Audit, during the year the company internally generated funds to the tune of Rs. 159.18 crore. During the year the company had not borrowed any funds and in fact, loans to the tune of Rs. 76.89 crore were repaid during the year. From the aforementioned, it is obvious that the fixed assets/capital work-in-progress were financed out of the internally generated funds and not out of borrowings. Hence, no borrowing costs were incurred in relation to the fixed assets/capital work-in-progress during the year. In view of the above, there are no borrowing costs which are eligible for capitalisation. Hence, theaccounting treatment is not contrary to the accounting policy or the Accounting Standard.

D. Statutory auditors’ reply under section 619(4) to the comments of the government auditors:

As the company establishes with its Fund Flow Statement that there is no borrowing source used for capital expenditure incurred, no borrowing cost could be capitalised as per the accounting policy (borrowing costs) and hence both the accounting policy and AS 1 6 have not been contradicted.

4. As per the querist, the government auditors have contended that had the company not utilised the internally generated funds to acquire fixed assets, it would have repaid the existing loans. The amount of interest and finance charges that would have been saved as a result of repayment of loans is attributable to the investment in fixed assets on an opportunity cost basis. Therefore, the company should have capitalised the borrowing costs on the existing loans by applying weighted average cost of borrowings to the expenditure on such assets.

5. As per the querist, the treatment of interest and finance charges adopted by the company is based on due consideration of the following:

(i) Existing loans were taken in the earlier years for various purposes and they do not relate to the qualifying assets of the current period.

(ii) As per paragraph 6 of AS 16, “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.” Also, paragraph 12 of AS 16 states that “To the extent that funds are borrowed generally and used for the purpose of obtaining a qualifying asset, the am ount of borrowing costs eligible for capitalisation should be determined by applying a 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 th e enterprise that are outstanding during the period, other than borrowings made specifically for the purpose of obtaining a qualifying asset.” The qualifying asset has been acquired by the company out of the internal accruals and there were no borrowings during the year 2000-01. Therefore, interest and financing charges incurred on the existing loans are not to be construed as borrowing costs that are directly attributable to the acquisition, construction or production of the qualifying assets.

(iii) As the company has not incurred any borrowing cost in relation to the acquisition of a qualifying asset, non-capitalisation of borrowing costs and thereby the question of contravening the accounting policy on borrowing costs and AS 16 does not arise.

(iv) Opportunity cost is not accounted for in the financial accounts. Further, AS 16 explicitly deals only with the borrowing costs incurred (i.e., actual costs). In view of the above, accounting for opportunity costs is not proper.

6. As per the querist, the company, therefore, is of the view that the treatment of interest and finance charges in the accounts for the year 2000-01 is in line with the accounting policy of the company on borrowing costs and AS 16.

B . Query

7. The querist has sought the opinion of the Expert Advisory Committee as to whether capitalisation based on borrowing costs on the existing loans, though not related to the acquisition of the qualifying asset in the current period, but based on the opportunity cost principle, requires to be accounted for as per the accounting policy of the company stated above and AS 16.

C. Points considered by the Committee

8. The Committee notes paragraphs 12 and 14 of AS 16 as reproduced below:

“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 applying a 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.”

“14. The capitalisation of borrowing costs as part of the cost of a qualifying asset should commence when all the following conditions are satisfied:

(a) expenditure for the acquisition, construction or production of a qualifying asset is being incurred;

(b) borrowing costs are being incurred; and

(c) activities that are necessary to prepare the asset for its intended use or sale are in progress.”

9. On the basis of the above, the Committee is of the view that to capitalise the borrowing costs, it is not sufficient that the funds borrowed generally are outstanding during the period as argued by the government auditors; it is also essential that the funds from those borrowings should be used for the purpose of obtaining a qualifying asset. The Committee notes from the facts of the case that there were certain general borrowings which were outstanding at the beginning of the period, part of which were repaid during the period. The Committee is of the view that it is possible that funds from such borrowings are used for the purpose of acquiring an asset even though part of the borrowings are repaid subsequently. Such a situation arises where the funds from such outstanding borrowings were not completely used in earlier year(s). The borrowing costs in such a case, should be capitalised as required in paragraph 12 of AS 16, provided the conditions specified in paragraph 14 of AS 16 reproduced above, are satisfied. The Committee is of the view that information contained in Funds Flow Statement does not provide conclusive evidence of use of funds from the borrowings. Thus, in the view of the Committee, the company should determine whether the funds from the outstanding borrowings were completely used in earlier years and, if not, borrowing costs should be capitalised as required in paragraph 12 of AS 16, subject to the satisfaction of the conditions specified in paragraph 14 of AS 16.

D. Opinion

10. On the basis of the above, the Committee is of the opinion that the company should ascertain whether funds in respect of outstanding borrowings were completely used in earlier year(s) and, if not, whether these were used for the purpose of acquiring a qualifying asset during the current year. If it is so, borrowing costs should be capitalised as per the requirements of paragraph 12 of AS 16, subject to the satisfaction of the conditions specified in paragraph 14 of AS 16, and vice versa.

1 Opinion finalised by the Committee on 20.1.2003.