Borrowed headache!

The tangled intersection of IAS 23 and IFRS 15…

Here’s the background to an issue recently discussed by CPA Canada’s IFRS Discussion Group:

  • Entity A constructs and sells an apartment unit to a customer. The customer pays the full consideration up front. Entity A concludes that revenue from apartment sales is recognized at a point in time upon delivery of the apartment, which is expected to be three years after the payment.
  • The apartment unit is considered a qualifying asset under construction in accordance with paragraph 5 of IAS 23 Borrowing Costs.

The group notes: “Paragraph 60 of IFRS 15 requires entities to adjust the promised amount of consideration to reflect the time value of money for contracts with a significant financing component. This requirement applies to payments received both in advance and in arrears. When the payment is recognized in advance, the financing component is recognized as interest expense.” With that in mind, the group considered whether this interest expense should be regarded as part of borrowing costs, and therefore capitalized as part of the apartment unit’s cost, to the extent required by IAS 23.

This is one of those issues that exposes potential mismatches between existing standards (these often seem to be triggered by questions of whether or not to recognize an asset in a particular situation). Observations made by the group include:

  • IFRIC 1 addresses changes in decommissioning and similar liabilities, requiring that the periodic unwinding of the discount on those liabilities is recognized in profit or loss as it occurs. It specifically observes that “capitalization under IAS 23 is not permitted.” If interest accrued on contract liabilities is regarded as being similar in nature, then the same conclusion may apply.
  • On the other hand, IFRIC 1 relates to provisions that are recognized in accordance with IAS 37. Contract liabilities arising from advance payments are different, because they represent actual cash received from customers (and in effect borrowed from them, rather than from a financial institution). Looked at this way, the interest expense more clearly resembles a conventional borrowing cost.
  • IAS 23 includes among its examples of borrowing costs “interest expense calculated using the effective interest method as described in IFRS 9,” perhaps suggesting that interest expense calculated using any other method (as IFRS 15 allows) isn’t eligible. On the other hand, on a closer reading, IAS 23 only cites this as an example of what borrowing costs “may include,” perhaps allowing that it may also include interest expense calculated on a different basis.
  • For purposes of applying IAS 23, the advance payments from the customers may appear to be progress payments. If so, IAS 23.18 says these are treated simply as reductions of the expenditures spent on the qualifying asset.
  • IFRS 15.65 says an entity presents the effects of financing separately from revenue in the income statement. If the IASB envisaged that such finance costs might sometimes be capitalized, you might conclude they would have said so, and amended IAS 23 accordingly.

Overall, most of the group members supported the view that borrowing costs include interest accrued on contract liabilities, although a few of them “did not discount” the other view, as the meeting report puts it. However, going back to the opening fact pattern, this doesn’t in itself mean the interest would automatically be included in the qualifying asset’s cost. You may remember that IAS 23 sets out a methodology involving specific borrowings and general borrowings and capitalization rates and much else, the application of which can become as tangled and arbitrary as any other aspect of IFRS.

For example, in December 2017 the IASB issued an “improvement” to IAS 23 to clarify that when a qualifying asset is ready for its intended use or sale, an entity treats any outstanding borrowing made to obtain that qualifying asset as part of its general borrowings. Suppose we amend the opening fact pattern to indicate that control of the apartment is transferred to the customer over time, and that the issuer therefore recognizes revenue over time (as discussed here). The issuer may keep incurring interest on the contract liability, even though it has no qualifying asset on its balance sheet (because the cost incurred to date has been derecognized, in connection with recognizing revenue over time). In this case, it seems then that the interest would indeed be part of general borrowings. It may seem odd that the cost of a completely unrelated asset under construction would ever end up including a portion of such a financing charge, but there you go.

It’s perhaps funny that for all the complexity that may underlie the application of IAS 23, it only sets out two specific disclosure requirements: the amount of borrowing costs capitalized during the period, and the capitalization rate used to determine the amount of eligible borrowing costs. Of course, IAS 1 may also require highlighting significant judgments and sources of estimation uncertainty arising in applying the standard. Where the issues discussed above are material, it may be no small challenge to describe them coherently…

The opinions expressed are solely those of the author

2 thoughts on “Borrowed headache!

  1. Hi John. My reading of the Standard is to only capitalize actual interest incurred which would have been avoided; had the expenditure on related qualifying assets have not incurred. Having said that capitalization of imputed interest on contract liability arising on IFRS 15 is apparently allowed by all accounting Firms since in their view such cost represent financing obtained for construction of the related asset. I some time wonder is the receipt of advance from customers is always viewed as obtaining finance from them. At time the economics would be way different i.e. it may as you stated viewed as progress payment or may be affecting the pricing strategy as the seller may demand lesser of the margin in such cases since they are not blocking their own capital; hence the transaction price reflect such advance payment from customer. Eventually it get to profit or loss upon de-recognition though timing may be different. But again thought provoking topic you included.

  2. Hi John. There was similar issue raised with the IFRIC. Based on their deliberation of the matter, they concluded that the borrowing cost for cases where the transfer is based on time is not eligible for capitalization as the constructor, in both sold and unsold unit, is recognizing either contract assets or intends to sell the part-constructed units as soon as it finds suitable customers and, on signing a contract with a customer, will transfer control of any work-in-progress relating to that unit to the customer. Hence in both cases entity is not allowed to capitalize borrowing cost. If the customer pays for the property in a manner that is consistent with the transfer of control, the entity would not need to finance the construction of the part-constructed property and would not incur borrowing costs on that part constructed property. They, however, agree that for cases where the transfer would occur at a point in time, the constructor may qualify any borrowing cost it incurred and not specifically discussed the fact pattern where the buyer pays in advance of receipt of the constructed unit.

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