Ricardo Limited is constructing a Power Plant which was completed on 31st December 2023. The company obtained a bank loan of R1,000,000 at a rate of 15% per annum to construct the Power Plant on 1st January 2023. As of 31st December 2023, Ricardo Limited also had the following loans outstanding:
18% 5-year loan Note of R1,500,000
14% Debentures of R1,000,000
Expenditures on the project were made as follows:
On the 31st March 2023, R600,000 was incurred;
R800,000 was incurred on 30th June 2023;
The final expenditure incurred was R300,000 on 31st December 2023.
During the year Ricardo Limited invested R400,000 of the bank loan for 2 months at an interest of 9% per annum.
Required:
· Define Borrowing costs and the accounting standard
· When do you capitalise costs and when are they expenses?
· Determine the amount of borrowing costs to be capitalized and expensed.
Borrowing costs are the interest and other costs incurred by a company in relation to the borrowing of funds. These costs include interest expense on loans, bank charges, and other direct or indirect costs of obtaining funds. The accounting standard that governs the treatment of borrowing costs is IAS 23 (International Accounting Standard).
According to IAS 23, borrowing costs can be either capitalized or expensed. Costs that are directly attributable to the acquisition, construction, or production of a qualifying asset (such as the Power Plant in this case) are capitalized. Capitalization begins when the company incurs borrowing costs, and it ceases when the qualifying asset is substantially ready for its intended use or sale.
On the other hand, borrowing costs that do not meet the criteria for capitalization are expensed in the period in which they are incurred.
To determine the amount of borrowing costs to be capitalized, we need to calculate the weighted average of Ricardo Limited's borrowings during the period of construction.
Weighted average of borrowings = (Principal x interest rate x time) / Total time
For the bank loan:
Principal = R1,000,000
Interest rate = 15%
Time = 1 year
Weighted average of bank loan = (1,000,000 x 15% x 1) / 1 = R150,000
For the 18% 5-year loan:
Principal = R1,500,000
Interest rate = 18%
Time = 1 year
Weighted average of 18% loan = (1,500,000 x 18% x 1) / 5 = R540,000
The total weighted average borrowing cost is R150,000 + R540,000 = R690,000.
Therefore, R690,000 is the amount of borrowing costs to be capitalized.
The remaining borrowing costs, which include the interest expense on the debentures and the bank loan not included in the capitalization, will be expensed. This amounts to:
Interest on debentures = 14% of R1,000,000 = R140,000
Interest on bank loan (excluding the portion capitalized) = 15% of (R1,000,000 - R150,000) = R127,500
Hence, the amount of borrowing costs to be expensed is R140,000 + R127,500 = R267,500.