Borrowing cost - IAS 23

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Borrowing Cost – IAS 23:

Borrowing Cost – IAS 23 Concept/Basic explanation of borrowing cost It is the capitalisation (addition to the cost of the asset) of borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset. Borrowing cost = Interest and other costs incurred in connection with the borrowing of funds In my own words – You borrow money to acquire, construct or produce a qualifying asset. You then pay interest or other cost on the money borrowed. A part or all of this interest or other cost will be CAPITALISED (added to the cost price of the asset) towards the cost price of the asset. (depending on certain rules and timeframes, for example when is the asset ready to use) PS! – This is a short, simple description. Unfortunately there is certain rules that you should first study, for example what is borrowing cost, what is a qualifying asset etc. Refer to study unit 3 in the study guide as well as IAS 23 .

Borrowing Cost – IAS 23:

Borrowing Cost – IAS 23 You should now understand the basic principle of IAS 23. As with all accounting standards, there are different rules/principles that should be applied, depending on the scenario: Other rules, principles and scenarios that should be considered: (These are only a few students normally struggle with. For completeness, refer to study unit 3 in the study guide as well as IAS 23 Borrowing cost Specific loans General loans General pool of funds Interest received (investment income) Capitalisation By the bank or other financial institution Capitalisation of borrowing cost towards the asset by the entity Cessation of capitalisation (stop to add borrowing cost towards the asset) READY FOR USE Tax implications PRE-PRODUCTION INTEREST AS A DEDUCTION – BROUGHT INTO USE Expenses incurred: Beginning of period Evenly over period At the end of the period Combination of funding sources (example loan and overdraft) Disclosure (refer to study unit 3 in the study guide as well as IAS 23)

Borrowing Cost – IAS 23:

Borrowing Cost – IAS 23 Simple example to explain the concept: A constructs a vehicle. Construction starts on 1/1/2012 and the vehicle was ready for use on 30/4/2012. A incurs expenditure as follow: 1/1/2012 - Buys vehicle body for R 100 1/2/2012 - Buys tyres for R 10 1/3/2012 – Buys other parts for R 5 A has an overdraft facility of R 115 at X Bank to construct the vehicle. X Bank charges A interest of R 8 (R 2 a month for the 4 months starting at 1/1/2012 ending at 30/4/2012. A will pay the interest to X at the end of month 4 from cash available in Z Bank account.

Borrowing Cost – IAS 23:

Borrowing Cost – IAS 23 T accounts if there was no IAS 23: T accounts taking IAS 23 into account: Motor Vehicles – Cost (SFP) X Bank(Body) 100 X Bank( Tyres) 10 X Bank(Other Parts ) 5 X Bank (overdraft) (SFP) MV –Cost(Body)100 MV –Cost(Tyres) 10 MV –Cost(Other parts) 5 Motor Vehicles – Cost (SFP) X Bank(Body) 100 X Bank( Tyres) 10 X Bank(Other Parts ) 5 Z Bank(Borrowing cost capitalised) 8 X Bank (overdraft) (SFP) MV –Cost(Body) 100 MV –Cost(Tyres) 10 MV –Cost(Other parts) 5

Borrowing Cost – IAS 23:

Borrowing Cost – IAS 23 T accounts if there was no IAS 23: Other notes: Depreciation will be calculated on the total cost of the asset of R115 T accounts taking IAS 23 into account: Other notes: Depreciation will be calculated on the total cost of the asset of R123 (115 + 8) You will still pay interest of R 8 to X bank, the only difference is the interest is not expensed to SPL, but capitalised to the cost price of the asset (SFP). Interest expense (SPL) Z Bank 8 Z Bank (SFP) Interest expense 8 Interest expense (SPL) Z Bank (SFP) MV – Cost 8 (borrowing cost capitalised)

Borrowing Cost – IAS 23:

Borrowing Cost – IAS 23 Explanation of other rules, principles and scenarios that should be considered: Borrowing cost = Interest and other costs incurred in connection with the borrowing of funds (page 29 of study guide) To remember and to do in a question Calculate the total interest and other cost Portion of total to SFP (Capitalised towards asset)= From commencement (p31 study guide) until – READY FOR USE OR SALE (p31 of study guide) Portion of total to SPL= Total less portion to SFP Determine

Borrowing Cost – IAS 23:

Borrowing Cost – IAS 23 Explanation of other rules, principles and scenarios that should be considered: Loans and interest received (investment income) To remember and to do in a question 3 Types of loans (funding sources) Example: Mortgage bond Receive funds: A – All funds when project commence Borrowing cost= Actual cost on full loan less investment income (interest received) B – In parts (progress payments) Borrowing cost = Cost on progress payments Specific Loans General Loans General pool of funds Example: Bank overdraft Borrowing cost = Capitalisation rate x expenditure on asset Capitalisation rate = weighted average rate of borrowings (excluding specific borrowings) Borrowing cost capitalised must < borrowing cost incurred Example: > than 1 General loan Borrowing cost = Capitalisation rate x expenditure on asset Capitalisation rate = weighted average rate of borrowings (excluding specific borrowings) Borrowing cost capitalised must < borrowing cost incurred

Borrowing Cost – IAS 23:

Borrowing Cost – IAS 23 Explanation of other rules, principles and scenarios that should be considered: Example: Mortgage bond Receive funds: A – All funds when project commence Borrowing cost= Actual cost on full loan less investment income (interest received ) Specific Loans

Borrowing Cost – IAS 23:

Borrowing Cost – IAS 23 Explanation of other rules, principles and scenarios that should be considered: Example: Mortgage bond Receive funds: B – In parts (progress payments) Borrowing cost = Cost on progress payments Specific Loans

Borrowing Cost – IAS 23:

Borrowing Cost – IAS 23 Explanation of other rules, principles and scenarios that should be considered: Example: Mortgage bond Receive funds: A – All funds when project commence Borrowing cost= Actual cost on full loan less investment income (interest received) B – In parts (progress payments) Borrowing cost = Cost on progress payments Specific Loans

Borrowing Cost – IAS 23:

Borrowing Cost – IAS 23 Explanation of other rules, principles and scenarios that should be considered: Capitalisation By the bank or other financial institution Capitalisation of borrowing cost towards the asset by the entity To remember and to do in a question Capitalisation (Compounding) by the bank = When the bank calculates the interest on a loan, overdraft etc they calculate it on the loan plus interest Example: A borrows R 10 000 from X Bank to construct an asset. X Bank charges interest at 12% per annum. Assume the loan is for two full years. The total interest for the period (Remember interest towards that bank is not necessarily = to borrowing cost capitalised) is as follow for the different scenarios: A - BANK does not capitalise interest Year 1: 10 000 X 12% = 1 200 Year 2: 10 000 X 12% = 1 200 Total interest: 2 400 B - BANK capitalises interest annually Year 1: 10 000 X 12% = 1 200 Year 2: 11 200 X 12% = (10 000 + 1 200(Interest of year 1 capitalised by bank) ) 1 344 Total interest: 2 544

Borrowing Cost – IAS 23:

Borrowing Cost – IAS 23 Explanation of other rules, principles and scenarios that should be considered: Capitalisation (Compounding) by the bank (continue) Please note the differences in the total interest (borrowing cost) for the three different scenarios. You need to further note that this is the total interest that A will have to pay X Bank. This is not necessarily the total borrowing cost that will be capitalised towards the cost price of the asset. C - BANK capitalise interest monthly Year 1 - m onth 1: 10 000 X 12% x 1/12 = 100 Year 1 - month 2 : 10 100 X 12% x 1/12 = (capital of10 000 + 1 00(Interest of previous month capitalised by bank) ) 101 Year 1 - month 3 : 10 201 X 12% x 1/12 = (capital of10 100 + 1 01(Interest of previous month capitalised by bank) ) 102 Year 1 - month 4 : 10 303 X 12% x 1/12 = (capital of 10 201 + 1 02(Interest of previous month capitalised by bank) ) 103 Etc etc – you will continue with this calculation until the end of two years (24 months) Total interest: (Calculate it yourself and test the answer) The Total interest after 12 months (1 year) = 1 268 2 697

Borrowing Cost – IAS 23:

Borrowing Cost – IAS 23 Explanation of other rules, principles and scenarios that should be considered: Capitalisation of borrowing cost towards the asset by the entity Cessation of capitalisation (stop to add borrowing cost towards the asset) = WHEN ASSET IS READY FOR USE Example: Use the same information as in the previous example (where capitalisation by the bank was explained). Additional to that, the asset that A constructed started on day one when the loan was received from x Bank. The asset was ready for use at the end of year 1. Assume all requirements of par .17 of IAS 23 were met (p31 study guide) on day one of loan. . A - BANK does not capitalise interest Borrowing cost capitalised towards asset (SFP) - from day one until ready for use (end of year 1) 1 200 Borrowing cost expensed in the SPL Total borrowing cost less portion to SFP (2 400 – 1 200) 1 200

Borrowing Cost – IAS 23:

Borrowing Cost – IAS 23 Explanation of other rules, principles and scenarios that should be considered: Capitalisation of borrowing cost towards the asset by the entity (continues) Remember! – This borrowing cost that is capitalised towards the cost price of the asset to the SFP. You will depreciate the asset (depreciation goes to the SPL). Eventually this borrowing cost originally allocated to the SFP will end up in the SPL. B - BANK capitalises interest annually Borrowing cost capitalised towards asset (SFP) - from day one until ready for use (end of year 1) 1 200 Borrowing cost expensed in the SPL Total borrowing cost less portion to SFP (2 544 – 1 200) 1 344 C - BANK capitalises interest monthly Borrowing cost capitalised towards asset (SFP) - from day one until ready for use (end of year 1) 1 268 Borrowing cost expensed in the SPL Total borrowing cost less portion to SFP (2 697 – 1 268) 1 429

Borrowing Cost – IAS 23:

Borrowing Cost – IAS 23 Explanation of other rules, principles and scenarios that should be considered: Tax implications PRE-PRODUCTION INTEREST AS A DEDUCTION – WHEN ASSET IS BROUGHT INTO USE To remember and to do in a question Always ask yourself. What will I do for accounting purposes AND what will I do for tax purposes? If there is a difference = Deferred Tax !

Borrowing Cost – IAS 23:

Borrowing Cost – IAS 23 Explanation of other rules, principles and scenarios that should be considered: Tax implications PRE-PRODUCTION INTEREST AS A DEDUCTION – WHEN ASSET IS BROUGHT INTO USE To remember and to do in a question Always ask yourself. What will I do for accounting purposes AND what will I do for tax purposes? If there is a difference = Deferred Tax ! VS Accounting treatment: Cost of asset(including borrowing cost capitalised) – depreciate over the useful life of asset from the date the asset is ready to use Remaining interest will be deducted as an expense when the expense occurred Therefore: Your accounting profit will be reduced with: Depreciation Interest expense

Borrowing Cost – IAS 23:

Borrowing Cost – IAS 23 Explanation of other rules, principles and scenarios that should be considered: Tax implications PRE-PRODUCTION INTEREST AS A DEDUCTION – WHEN ASSET IS BROUGHT INTO USE To remember and to do in a question Always ask yourself. What will I do for accounting purposes AND what will I do for tax purposes? If there is a difference = Deferred Tax ! VS Tax treatment: Cost of asset (without borrowing cost) The borrowing cost will be deducted from taxable income from the date that the asset is brought into use Therefore: Your taxable income will be reduced with: Tax allowance on asset ( wear&tear ) Pre-production interest deduction Both the above from the date the asset is brought into use.

Borrowing Cost – IAS 23:

Borrowing Cost – IAS 23 Explanation of other rules, principles and scenarios that should be considered: Tax implications PRE-PRODUCTION INTEREST AS A DEDUCTION – WHEN ASSET IS BROUGHT INTO USE To remember and to do in a question Always ask yourself. What will I do for accounting purposes AND what will I do for tax purposes? If there is a difference = Deferred Tax ! VS Accounting treatment: Cost of asset(including borrowing cost capitalised) – depreciate over the useful life of asset from the date the asset is ready to use Remaining interest will be deducted as an expense when the expense occurred Therefore: Your accounting profit will be reduced with: Depreciation Interest expense Tax treatment: Cost of asset (without borrowing cost) The borrowing cost will be deducted from taxable income from the date that the asset is brought into use Therefore: Your taxable income will be reduced with: Tax allowance on asset ( wear&tear ) Pre-production interest deduction Both the above from the date the asset is brought into use.

Borrowing Cost – IAS 23:

Borrowing Cost – IAS 23 Explanation of other rules, principles and scenarios that should be considered: Tax implications PRE-PRODUCTION INTEREST AS A DEDUCTION – WHEN ASSET IS BROUGHT INTO USE Use the same information as in the previous example (example A). Assume the year end is December 2011 (also the end of year 1 of the 2 years). Assume the expenditure incurred to construct the asset were R 38 800 (cost of the asset before borrowing cost was capitalised). A depreciate the asset over 10 years. SARS allows a tax deduction on the asset of 20% a year (For this example: SARS does allow apportionment of the tax allowance). Scenario 1 – The asset is ready for use and brought into use on 30 November 2011. Deferred tax on 31 December 2011 Calculations and notes: [(38 800 + 1 200*11/12) – ((38 800 + (1 200*11/12))/10 x 1/12)] = 39 568 [38 800 – (38 800 x 20% x 1/12)] = 38 153 As the asset was brought into use on/before year end, SARS allows the interest (1 200) as a deduction for the year ending December 2011 CA TB TD Def tax @ 28% A or L Asset 39 568(1) 38 153 (2) 1 415 396 L Pre-production interest (3) - - - -

Borrowing Cost – IAS 23:

Borrowing Cost – IAS 23 Explanation of other rules, principles and scenarios that should be considered: Tax implications (continue) Scenario 2 – The asset is ready for use on 30 November 2011 and brought into use on 1 January 2012. Deferred tax on 31 December 2011 Calculations and notes: [(38 800 + 1 200*11/12) – ((38 800 + (1 200*11/12))/10 x 1/12)] = 39 568 The asset was brought into use after year end, therefore SARS did not allow any wear and tear deduction up to year-end. As the asset was brought into use after year end, SARS will only allow the interest (1 200) as a deduction in the year it was brought into use , therefore the year ending December 2012 CA TB TD Def tax @ 28% A or L Asset 39 568(1) 38 800 (2) 768 215 L Pre-production interest - 1 200 (3) 1 200 336 A

Borrowing Cost – IAS 23:

Borrowing Cost – IAS 23 Explanation of other rules, principles and scenarios that should be considered: Expenses incurred: Beginning of period Evenly over period At the end of the period To remember This only has an effect on the calculation of interest. Example: A incurred the following expenses to construct an asset: Note! This total expenses of R 19 500 = Cost price of asset(before borrowing cost is capitalised). You now need to calculate the Total interest, and then determine what part of the Total interest will be capitalised towards the cost price of the asset(SFP) and the part that will go to the SPL as an expense. (This part will not be done in this example, only the Total interest to explain the 3 different scenarios) A make use of an overdraft facility to cover the expenses above. The bank charges interest at 10% per annum. The bank does not capitalise interest. Date/period Expense January (period 1) 5 000 February (period 2) 8 000 March (period 3) 6 500 Total 19 500

Borrowing Cost – IAS 23:

Borrowing Cost – IAS 23 Explanation of other rules, principles and scenarios that should be considered: Expenses incurred (continue): Beginning of period Notes: Interest is calculated from day 1. The reason is A incurred the expenses on day 1 (beginning of the period), so A made use of the overdraft from day 1. The bank will charge A interest from the day they make use of there money. The same explanation as in note 1 applies to the 8 000. A adds the 5 000 of the previous period as the expenses was already incurred, so A still owes the bank the money, so they will still charge A interest. A do not add the interest calculated in period 1 to the (5 000 + 8 000) when calculating interest for period 2. The reason = The bank does not capitalise interest. Notes 1 and 2 applies here. Remember this is total interest towards the bank. A now needs to determine what part should be capitalised (towards the asset) SFP and what part should be expensed (SPL). Date/period Expense Calculation Interest Notes January (period 1) 5 000 (5 000 x 10% x 1/12) 41.67 1 February (period 2) 8 000 (5 000 + 8 000) x 10% x 1/12 108.33 2 March (period 3) 6 500 (5 000 + 8 000 + 6 500) x 10% x1/12 162.50 3 Total 19 500 Total Interest 312.50 4

Borrowing Cost – IAS 23:

Borrowing Cost – IAS 23 Explanation of other rules, principles and scenarios that should be considered: Expenses incurred (continue): Evenly over period Notes: Interest in period 1 is calculated on the expenses divided by 2. The reason is A incurred the expenses evenly over the period, therefore you take the average so you divide it by 2. The same explanation as in note 1 applies to the 8 000. A adds the 5 000 of the previous period as the expenses was already incurred, so A owes the bank the full 5 000 on day 1 of period 2, so they will charge A interest on the full 5 000 in period 2. A do not add the interest calculated in period 1 to the (5 000 + (8 000/2)) when calculating interest for period 2. The reason = The bank does not capitalise interest. Notes 1 and 2 applies here. Remember this is total interest towards the bank. A now needs to determine what part should be capitalised (towards the asset) SFP and what part should be expensed (SPL). Date/period Expense Calculation Interest Notes January (period 1) 5 000 (5 000/2 x 10% x 1/12) 20.83 1 February (period 2) 8 000 (5 000 + (8 000/2)) x 10% x 1/12 75.00 2 March (period 3) 6 500 (5 000 + 8 000 + (6 500/2)) x 10% x1/12 135.42 3 Total 19 500 Total Interest 231.25 4

Borrowing Cost – IAS 23:

Borrowing Cost – IAS 23 Explanation of other rules, principles and scenarios that should be considered: Expenses incurred (continue): At the end of the period Notes: No interest in period 1 is calculated. The reason is A incurred the expenses at the end of the period. The bank will charge A interest from the day they make use of there money, the last day of period 1. End of period 1 = beginning of period 2. The bank will therefore charges A interest on the 5 000 from period 2. The same explanation as in note 1 applies to the 8 000. A adds the 5 000 of the previous period as the expenses was already incurred, so A owes the bank the full 5 000 on day 1 of period 2, so they will charge A interest on the full 5 000 in period 2. Notes 1 and 2 applies here. . A do not add the interest calculated in period 2 to the (5 000 + (0) when calculating interest for period 3. The reason = The bank does not capitalise interest. Remember this is total interest towards the bank. A now needs to determine what part should be capitalised (towards the asset) SFP and what part should be expensed (SPL). Date/period Expense Calculation Interest Notes January (period 1) 5 000 0 1 February (period 2) 8 000 (5 000 + 0) x 10% x 1/12 41.67 2 March (period 3) 6 500 (5 000 + 8 000 + 0) x 10% x1/12 108.33 3 Total 19 500 Total Interest 150.00 4

Borrowing Cost – IAS 23:

Borrowing Cost – IAS 23 Explanation of other rules, principles and scenarios that should be considered: Expenses incurred (continue): Remember: This period can be one month, 3 months (a quarter), 10 days etc. For one month you use 1/12 if a annual rate was given, 3/12 for 3 months (a quarter) and 10/365 for 10 days. Beginning of period: Period 1: Calculate interest on expenses of period 1 from day 1 Period 2: Calculate interest on expenses of period 2 plus all expenses of previous period from day 1 of period 2. Period 3 onwards: Calculate interest on expenses of this period plus all expenses of previous periods from day 1 of this period. Evenly over period: Period 1: Calculate interest on expenses of period /2 for the period. Period 2: Calculate interest on expenses of period /2 plus all expenses of previous period from day 1 of period 2. Period 3 onwards: Calculate interest on expenses of this period /2 plus all expenses of previous periods from day 1 of this period. End of period: Period 1: Calculate no interest. Period 2: Calculate interest on expenses of period 1 from day 1 of period 2. Period 3 onwards: Calculate interest on expenses of all previous periods from day 1 of this period.

Borrowing Cost – IAS 23:

Borrowing Cost – IAS 23 Explanation of other rules, principles and scenarios that should be considered: Combination of funding sources (example loan and overdraft) To remember You will always use the funding source with the lowest interest rate first to incur expenditure, except if the question stipulates otherwise. Disclosure (refer to study unit 3 in the study guide as well as IAS 23)

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