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 that an entity incurs in relation to the borrowing of funds. The accounting standard that governs the treatment of borrowing costs is IAS 23, "Borrowing Costs."
According to IAS 23, borrowing costs that are directly attributable to the acquisition, construction, or production of a qualifying asset should be capitalized as part of the cost of that asset. A qualifying asset is one that takes a substantial period of time to get ready for its intended use or sale.
On the other hand, borrowing costs that do not meet the criteria for capitalization should be recognized as an expense 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 the borrowing costs incurred during the period. This is done by multiplying the average amount of the borrowing by the applicable borrowing rate. The borrowing costs that are directly attributable to the construction of the Power Plant should be capitalized.
In this case, the bank loan of R1,000,000 at a rate of 15% per annum is directly attributable to the construction of the Power Plant. Therefore, the borrowing costs associated with this loan should be capitalized.
The loan note of R1,500,000 at 18% and the debentures of R1,000,000 at 14% are not directly attributable to the construction of the Power Plant. Therefore, the borrowing costs associated with these loans should be expensed.
The expenditures on the project made on 31st March 2023, 30th June 2023, and 31st December 2023 should be capitalized as part of the cost of the Power Plant.
The investment of R400,000 of the bank loan for 2 months at an interest rate of 9% per annum is not directly attributable to the construction of the Power Plant. Therefore, the borrowing costs associated with this investment should be expensed.