E-14 Advanced Accounting and Financial Reporting

1. E-14 Advanced Accounting and Financial Reporting Lecture 04 IAS 23 Borrowing Costs IAS 20 Government Grants Sajid Shafiq, ACA

2. IAS 23-Overview • Objectives, Scope and Definitions • Which Cost should be capitalized? • When should capitalisation of BC commence and suspend? • Ceasing capitalising • Class Practice Questions IAS 23 & 20

3. Objectives • Scope • Definitions Objectives, scope and Definitions • BC that are directly attributable to the acquisition, construction or production of a QA form part of the cost of that asset. • Other BC are recognised as an expense. • This IAS is applied in accounting for BC • This IAS does not deal with the actual or imputed cost of equity, including preferred capital not classified as a liability. • An entity is not required to apply the Standard to BC directly attributable to the acquisition, construction or production of: • (a) a QA measured at FV, for example a biological asset; or • (b) inventories that are manufactured, or otherwise produced, in large quantities on a repetitive basis. • Borrowing Costs are interest and other costs that an entity incurs in connection with the borrowing of funds.BC may include: • interest on bank overdrafts and short-term and long-term borrowings; • amortisation of discounts or premiums relating to borrowings; • amortisation of ancillary costs incurred in connection with the arrangement of borrowings; • finance charges in respect of finance leases recognised in accordance with IAS 17 Leases; and • exchange differences arising from foreign currency borrowings to the extent that they are regarded as an adjustment to interest costs. • A Qualifying Assets is an asset that necessarily takes a substantial period of time to get ready for its intended use or sale. Depending on the circumstances, any of the following may be QA: • Inventories • manufacturing plants • power generation facilities • intangible assets • investment properties. • Financial assets, and inventories that are manufactured, or otherwise produced, over a short period of time, are not QA. Assets that are ready for their intended use or sale when acquired are not QA. IAS 23 & 20

4. Capitalisation of BC The Core Principle: BC that are directly attributable to the acquisition, construction, or production of a QA form part of the cost of that asset, and should be capitalised as part of that asset. Other BC are recognised as an expense in profit or loss. Illustration 1 An entity has a bank overdraft of CU500,000 and a loan of CU1 million which was taken out to finance the expansion of the entity several years ago. The entity has just commissioned the construction of a new factory to expand the business. The factory will cost CU2 million to build and this will be financed by a new loan. The finance costs on the new loan only (i.e. loan of CU2 million) should be capitalised as part of the cost of the new factory. Finance cost on earlier loans and bank overdraft are not included. The entity should also capitalise the ancillary costs incurred in connection with setting up the new borrowing facility. Capitalisation and purpose of borrowings: • Where funds are specifically borrowed to finance the construction of an asset, the specific BC incurred can be readily identified. • However, the asset may also be financed from borrowings made for general use within the entity or group. The amount of borrowings that should be capitalised is calculated by applying to the expenditure on the asset a capitalisation rate calculated by reference to a weighted average of the costs of all the 'general use' borrowings. The weighted average calculation will exclude any borrowings used to finance a specific purchase or construction. IAS 23 & 20

5. Capitalisation of BC Illustration 2 (capitalization rate) An entity already has a number of general loan arrangements: • Loan 1 of CU800,000, interest paid at 9%; • Loan 2 of CU2 million, interest paid at 8%; and • Loan 3 of CU400,000, interest paid at 7.5%. The entity has commissioned a new printing press to be constructed on its behalf. The total cost will be CU800,000 and the entity will be able to fund the purchase from its existing borrowings since it has arranged for stage payments to be made. The construction takes six months. The weighted average (capitlalzation rate)is calculated as follows: (800,000 x 0.09) + (2,000,000 x 0.08) + (400,000 x 0.075) = 8% (800,000 + 2,000,000 + 400,000) BC to be capitalised: Cost of asset 800,000 x 8% x 6/12 = CU32,000 IAS 23 & 20

6. Capitalisation of BC Specific borrowings and idle funds Where the funds specifically borrowed to finance the asset are not wholly utilised immediately but are instead invested until they are required, the finance cost to be capitalised should be reduced by any investment income received on the excess funds invested. Illustration 3 An entity borrowed CU5 million to fund the construction of a new building. Interest is payable on the loan at 8%. Stage payments were due throughout the construction period and therefore excess funds were reinvested during that period. By the end of the project investment income of CU150,000 had been earned and the construction took twelve months to complete. Interest capitalised as part of the cost of the asset is the actual interest cost less income earned on the temporary investment of the surplus funds. Interest cost: CU5,000,000 x 8% = CU400,000 Total BCcapitalised: CU400,000 - CU150,000 = CU250,000 The amount of BC that should be capitalised is limited by the requirement that the carrying amount of the asset (including BC) should not exceed the asset’s recoverable amount. IAS 23 & 20

7. When should capitalisation of BC commence and suspend? Commencement: • BC of the asset should be capitalised when ALL the following three conditions have been met: • expenditure on the acquisition, construction, or production of the asset is being incurred; • BC are being incurred; and • activities are taking place that are necessary to prepare the asset for its intended use or sale. • Activities necessary to prepare the asset for use include more than just the actual construction and may include, for example, drawing up plans and obtaining permits for a building where the land has been purchased. However, merely holding assets for use or development without any associated development activity does not qualify for capitalisation. • Suspension: • There may be periods when the development of an asset is temporarily suspended. During such inactive periods the capitalisation of BC should be discontinued and instead finance costs incurred during this period should be immediately recognised in profit or loss. • It is possible that a temporary delay is part of the production or construction process, and during such periods BC should continue to be capitalised. Examples include where the maturity of an asset is an essential part of the production process or where there is expected non-activity due to geological features (such as periods of very high tides and floods). IAS 23 & 20

8. Illustration 4 The following events take place: • An entity buys some land on 1 December. • Planning permission is obtained on 31 January. • Payment for the land is deferred until 1 February. • The entity takes out a loan to cover the cost of the land and the construction of the building on 1 February. • Due to adverse weather conditions there is a delay in starting the building work for six weeks and work does not commence until 15 March. In the above scenario the key dates are: • Expenditure on the acquisition is incurred on 1 February when construction commences. • BC start to be incurred from 1 February. • Although work was being undertaken on planning permission etc. during December and January, no BC were incurred during this period. • During the six-week inactive period BC should not be capitalised. • Capitalisation of BC should commence from 15 March. IAS 23 & 20

9. Ceasing Capitalisation • Capitalisation should cease when substantially all the activities necessary to get the asset ready for its intended use or sale are complete. It is the availability for use which is important, not when the asset is actually brought into use. An asset is normally ready for its intended use or sale when its physical construction is complete. • Some assets are completed in parts. Where each part is capable of being used separately while other parts continue to be constructed, for example the construction of separate buildings within a new business park, the cessation of capitalising BC should be assessed on the substantial completion of each part. IAS 23 & 20

10. Class Practice Question The first payment on January 31 was funded from the entity’s pool of debt. However, the entity succeeded in raising a medium-term loan for an amount of $800,000 at March 31, 20X2, with simple interest of 9 percent per annum. These funds were specifically used for this construction. Excess funds were temporarily invested at 6 percent per annum monthly in arrears. The pool of debt was again used to an amount of $200,000 for the payment on November 30, which could not be funded from the medium-term loan. • The construction project was temporarily halted for 2 weeks in May when substantial technical and administrative work was carried out. Additionally, the company had to suspend work in entire July due to unexpected continuous rainfall. The following amounts of debt were outstanding at the balance sheet date, December 31, 20X2: Mork Inc. is constructing a warehouse that will take about 18 months to complete. It began construction on January 1, 20X2. The following payments were made during 20X2: IAS 23 & 20

11. IAS-20 Overview • Objectives, Scope and Definitions • Recognition and Measurement • Non-Monetary Government Grants • Presentation of GG • Grants Related to Assets • Grants Related to Income • Other Issues • Repayment of Government Grants • No Specific Relation to Operating Activities • Class Practice Questions

12. Objectives • Scope • Definitions Objectives, scope and Definitions Sets out the accounting requirements when an entity receives a form of Government Assistance(GA). The reference to ‘government’ includes, government agencies and similar local, national or international bodies. • Does not deal with: • the issues that arise in accounting for GG in FS reflecting the effect of changing prices; • the accounting treatment of tax-related GA; • government participation in the ownership of the enterprise; or • GG received in relation to an entity’s agricultural activities and accounted for in accordance with IAS 41 Agriculture. • GA is action by government designed to provide an EB specific to an entity or range of entities qualifying under certain criteria. GA for the purpose of this IAS does not include benefits provided only indirectly through action affecting general trading conditions, such as the provision of infrastructure in development areas or the imposition of trading constraints on competitors. • GG are assistance by government in the form of transfers of resources to an entity in return for past or future compliance with certain conditions relating to the operating activities of the entity. They exclude those forms of GA which cannot reasonably have a value placed upon them and transactions with government which cannot be distinguished from the normal trading transactions of the entity.(also called subsidies, subventions, or premiums) • Grants related to assetsare GG whose primary condition is that an entity qualifying for them should purchase, construct or otherwise acquire long-term assets. Subsidiary conditions may also be attached restricting the type or location of the assets or the periods during which they are to be acquired or held. • Grants related to incomeare GG other than those related to assets. • Forgivable loansare loans which the lender undertakes to waive repayment of under certain prescribed conditions. IAS 23 & 20

13. Recognition and Measurement • GG should only be recognised when there is reasonable assurance that any conditions attaching to the grant will be complied with and the grant will actually be received. • Actual receipt of the grant does not necessarily meet this requirement, since circumstances may exist where the grant will have to subsequently be repaid. • GG should not be recognised on a cash basis as this is not consistent with the general accounting concepts addressed in IAS 1 • The general principle is that a GG should be recognised as income in the periods in which the costs that it is intended to compensate are recognised. Where the grant has been received towards the cost of, say, a piece of machinery, the grant should be recognisedas income when depreciation is charged in respect of the asset. The purpose of this treatment is to provide a matching effect. A systematic basis should be used to recognisethe grant income. • If the receipt of a GG represents compensation for expenses already incurred by the entity, the grant should be recognised as income in the period in which it becomes receivable. • Immediate recognition will also be appropriate where the grant is given to provide immediate financial support and there are no future related expenses expected to be incurred. • These conditions equally apply to non-monetary (i.e. non-cash) grants that are measured at fair value. IAS 23 & 20

14. Non-Monetary Government Grants Where a grant is received in the form of a non-monetary asset (i.e. not in the form of cash) it is usual to recognise both the grant and the asset at FV (although nominal value is also permitted as an alternative). Illustration 1 • The government makes a grant to a start-up entity writing teaching software for children with learning difficulties. The purpose of the grant is to help with general financing on start up, and there are no further conditions attaching to the grant. The grant should be recognised in full immediately that it is receivable. This grant has been provided for the purpose of giving immediate financial support to the entity. • A manufacturing entity sets up a plant in an area of high unemployment. A grant of CU4 million is receivable if it continues to employ at least 100 people over a period of four years. It is highly probable it will do so. CU2 million of the grant is to be received immediately and a further CU2 million is receivable in four years’ time. Since there is reasonable assurance that the conditions attaching to the grant will be met, the grant is recognised as income evenly over the four year period in which the entity incurs the costs of employing the 100 people. • An agricultural research entity is given land that belonged to the government to set up a new laboratory and to investigate new farming methods. This is a grant related to a non-monetary asset and, as such, it should probably be recognisedwhen the costs of constructing the laboratory are incurred. Treatment will depend on the specific circumstances and whether there are conditions relating to the gift of land. • Free technical advice is provided by government employees to help an export entity to market its new technology in North America. Free technical advice is likely to be a grant that cannot reasonably have a value placed upon it and therefore should not be recognised. IAS 23 & 20

15. Presentation of GG- Related to Asset IAS 23 & 20

16. A GG related to income should be recognised in profit or loss when any conditions for their recognition have been met. Income related government grants may be presented as income and shown separately, or under ‘other income’ or deducted from the expenditure to which they relate. IAS 23 & 20

17. Other Issues-Repayment of GG • Treated as a change in accounting estimate • Related to income Repayment shall be applied first against any unamortised deferred credit set up in respect of the grant. To the extent that the repayment exceeds any such deferred credit, or where no deferred credit exists, the repayment shall be recognised immediately as an expense. • Related to an asset • Repayment shall be recorded by reducing the deferred income balance by the amount repayable with difference to P/L account, or • Repayment shall be recorded by increasing the carrying amount of the asset. The cumulative additional depreciation that would have been recognised to date as an expense in the absence of the grant shall be recognised immediately as an expense. IAS 23 & 20

18. Other Issues-No specific relation to operating activities SIC-10 considers the situation where government assistance is given but there are no conditions that relate specifically to the entity’s operating activities. Such government assistance is given, for example, to encourage an entity to operate in a particular industry or area. Although such government grants do not relate to specific activities of the entity, they meet the definition of a government grant and should therefore be recognised in accordance with the general requirements of IAS 20. IAS 23 & 20

19. Class Practice Questions On 1 January 20X8 The Ebro Company commenced trading to provide key skills education facilities in a region identified for technology development. Also on 1 January 20X8, the company received two grants from its government for setting up its operations in this location: Grant (a) – was paid to give financial assistance for start-up costs already incurred. Grant (b) – was paid to subsidise the costs of purchasing computer software over the five-year period. The company is almost certain to keep the facilities operational for the next five years. The company's accounting year end is 31 December. Are the following statements concerning recognition of the income from the two government grants true or false, according to IAS20 (1) Income from Grant (a) should be recognised in full on receipt in 20X8. (2) Income from Grant (b) should be recognised in full at the end of 5 years. For ElboCo.,WhichTWO of the following statements are correct according to IAS20? A Any adjustment needed when a government grant becomes repayable is accounted for as a change in accounting estimate BIn respect of loans from the government at an interest rate of 0%, an imputed interest charge should be made in profit or loss C Where conditions apply to a government grant, it should only be recognisedwhen there is reasonable assurance that the conditions will be met D A government grant should not be recognised until it is received in cash IAS 23 & 20

20. Class Practice Questions The Palila Company purchased a varnishing machine for CU150,000 on 1 January 20X7. The company received a government grant of CU13,500 in respect of this asset. Company policy was to depreciate the asset over 4 years on a straight-line basis and to treat the grant as deferred income. Under IAS20, what should be the carrying amounts of the machine and the deferred income ("DI") balance at 31 December 20X8? Carrying amount DI balance A CU75,000 CU6,750 B CU112,500 CU10,125 C CU81,750 CU6,750 D CU75,000 CU13,500 The Perth Company purchased a jewel polishing machine for CU360,000 on 1 January 20X7 and received a government grant of CU50,000 towards the capital cost. Company policy is to treat the grant as a reduction in the cost of the asset. The machine was to be depreciated on a straight-line basis over 8 years and was estimated to have a residual value of CU5,000 at the end of this period. Under IAS20, what should be the depreciation expense in respect of the machine for the year ended 31 December 20X7? A CU38,750 B CU76,250 C CU44,375 D CU38,125 IAS 23 & 20