IAS 23 and Leases

[kamranACA]

Dears

The question in hand has two aspects to be considered and replied. Let me have clarified the question first for readers so that the objective is clear beforehand.

QUESTION

The post first asked

“what is rationale of not capitalizing finance cost associated with lease as it is also unavoidable directly attributable cost incurred solely due to acquisition of that asset.

The poster again emphasized his query as under

“why the finance cost incurred on the acquisition of a qualifying asset is capitalized and why the finance cost incurred on the acquisition of a non qualifying asset is not capitalized.”

Another question was

“we will have to discuss whether the finance costs associated with finance lease are operational costs or the acquisition costs.”

ANSWER

I would like to enumerate following in response to the above queries

The matter here being discussed has more significant association with what can be capitalized and until what time such capitalization activity can be continued. So, issue is not merely of “borrowing costs’ or “leases”; rather is mainly of “capitalization” and encompasses the following

- when an asset is recognized;
- what is capitalization (elements of cost of any asset);
- when the capitalization activity has to be ceased;
- what is directly attributable acquisition cost;
- what is borrowing costs and whether or not finance cost associated with lease is its part;
- which borrowing cost is eligible for capitalization;
- why borrowing cost is eligible to be capitalized only in qualifying assets;
- when capitalization of borrowing cost has to be stopped even in a qualifying asset;
- what would be the nature of a borrowing cost that is not allowed to be capitalized;
- what would be the nature of borrowing cost (even on funds obtained for capitalization) after the date when qualifying asset has been completed.

There may arise some more issues connected with the query. However, the core issues will remain same.

Regarding the recognition of an asset and the nature of components of costs that are allowed to be capitalized as directly attributed to an asset, I hope there is no need to go at length since it is commonly known and if some body wishes to re-read can be seen at paragraphs 7, 11, 12, 15, 16, 17, 18 and 19 etc of IAS-16.

The basic rule for recognition is that “future economic benefits are probable to flow in and an estimate of related costs can be made”. This has to be kept in mind as an essence to decide what is to be capitalized and what is operational or periodic.

The most significant and primary thing is, however, to find that up to what time such costs could be capitalized. Paragraph 20 of IAS-16 states that,

“Recognition of costs in the carrying amount of an item of property, plant and equipment ceases when the item is in the location and condition necessary for it to be capable of “OPERATING” in the manner intended by the management. Therefore, the costs incurred in “USING or “Re-DEPLOYING” an item are not included in the cost carrying amount of that item”

IAS-16, for quite logical and obvious reasons states further in same paragraph that

“The following costs are not included in the carrying amount of an item of PPE

(a) costs incurred while an item capable of “OPERATING” in the manner intended by management has yet to brought into use or is operated at less than full capacity.
(b) Initial operating losses, such as those incurred while demand for the item’s output builds up; and
(c) Costs of relocating or reorganizing part or all of an entity’s operations”

Paragraph 22 of IAS-16 confirms that the cost of “self-constructed” assets is determined using the same principles as for an “acquired asset”.

…………………..{I would like the readers going back to Framework of IFRSs as well that establishes a foundation for all the pronouncements made or to be made and defines various elements of the financial statements.”}……………..

Now, having been mentioned the recognition criterion and the conditions on which capitalization should be stopped (crucial to the topic), I would like to straightly go on the issue of what exactly a qualifying asset is; and how it differs from non-qualifying asset. I hope again there is no need to narrate every thing and a brief discussion can serve the purpose.

As I earlier wrote finance cost on leasing arrangement is included in the ambit of borrowing costs by paragraph 6 of IAS-23. Its definition however includes all interest and other costs incurred in connection with borrowing of funds.

On one hand IAS-23 states that the borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset are those borrowing costs that WOULD HAVE BEEN AVOIDDED if the EXPENDITURE on qualifying asset HAD NOT BEEN MADE; (Please keep in mind it talks about expenditure i.e. borrowing cost and not about the funds obtained).

On the other hand this standard also puts cap on capitalizing such costs to a certain extent i.e. until such asset is not completed. In more clear words standard says;

“A qualifying asset is an asset that necessarily takes a substantial period of time to get READY for its INTENDED USE or SALE.”

The words “intended use” and “sale” are vital to understand the issue. Once an asset is available for “intended use” presumably its operations start. Like-wise when an asset is available for “SALE” it is again a finished product and ready for use.

Like inventories that are finished products, no further cost can be allocated, in case of qualifying fixed assets, once they are complete and available for “OPERATION” i.e. for intended use or sale, no further cost can be allocated in their carrying values. If we are arguing on it why we don’t argue in case of inventories?

Paragraph 20 of IAS-16 which I reproduced earlier is of vital most importance in understanding when adding up any further cost in carrying amount of an asset will not result in making up any probability of generating economic benefits from an asset and when “capitalization activity” should come at an end/ be ceased. It (para 20 of IAS-16) says that such point is reached “when the item is in the location and condition necessary for it to be capable of “OPERATING” in the manner intended by the management.”

Readers can see that IAS-23 is not saying any out of the world thing. Rather is addressing same issue that has been capped by IAS-16 for so clearer and well founded reason. What is that reason; certainly that if capitalization activity will not be stopped after completion of an asset, it will certainly lead to insensible increasing of the cost of the asset which will tantamount to overstatement of its carrying value that will not be causing any extra/additional inflow of economic benefits to the company. Anything that is not contributing in deriving economic benefits from an asset cannot be capitalized. Readers must also go through paragraph 12 of IAS-16 which also elaborates which “subsequent costs” can only be capitalized. No body will find out anything different than what IAS-23 says. It is the judgment about recoverability/inflow of economic benefits.

Every thing that does not contribute in enhancing the inflow of Economic Benefits cannot be added up / capitalized in carrying amount of an asset. This is further more clarified by IAS-23 in its paragraph 16 which states

“When the carrying amount or the expected ultimate cost of the qualifying asset exceeds its recoverable amount or net realizable value, the carrying amount is written down or written off in accordance with the requirements of other Standards. In certain circumstances, the amount of the write-down or write-off is written back in accordance with those other Standards.”

Here the term “recoverable amount” is taken from IAS-36 and ultimately carries same meaning i.e. anything that can ensure inflow of economic benefits through which such capital expense can be recovered. Any expenditure that does not enhance inflow cannot be capitalized and if has been capitalized for some reason has to be charged off to profit and loss account as an “operational or periodic item”.

A qualifying asset takes a tenure for completion during which, if any borrowings have been made, the related cost can be capitalized in the carrying value of such asset to the extent

- such assets remains under active constructions; and
- the over all capitalized value does not exceed “recoverable” value, and if it happens the excess is charged as impairment to periodic operational results (profits).

So even for a qualifying asset there is specified TIME for ceasing the CAPITALIZATION ACTIVITY and a specified limit over which the capitalized value cannot go.

All other expenses and borrowing costs are “periodic” or “performance” or “operational” costs.


In case of non-qualifying assets, the asset is already in finished form with a specified (having market based evidence) value/cost beyond which if capitalization will go, will be detrimental to “recoverability” of economic benefits attributed with the asset.

Even if some one will make a logic to capitalize borrowing costs in the carrying amount of the asset, he will immediately have to write down the carrying amount by charging impairment under IAS-36; since un-necessarily allocated costs, when asset was already available “FOR INTENDED USE OR SALE”, will not contribute in generating cash or economic benefits for the entity.

Nothing different applies in case of assets under finance lease arrangements, so similar concept is applied on that facet as well.

I can go in further detail on this topic but hope if some one is in confusion can get rid of it after reading this hastily drafted post. However, if some one wishes to develop an altogether different set of standards and framework, he is fully welcomed to share his ideas along with solutions as well. The above discussion establishes certain things such as

- IAS-23 does not say anything in isolation and we have to build our concept by looking at other pronouncements as well
- There is a limit to which costs can be capitalized and after which capitalization activity stops;
- The costs and expenditures (even on assets) that cannot be capitalized due to the reasons/limits prescribed, have to be taken to profit and loss account as current period expenditure;
- IAS-1 has eliminated the differentiation of “operating activities” and “non-operating activities” in relation to profit and loss account, so all costs charged to it are operational costs.

These are logics, parameters, limits, checks and balances created, developed and accepted worldwide. Even others who do not follow IFRSs have developed similar logics and parameters. We have to accept them since they are based on facts. Otherwise if some out of the world logic is to be questioned, there might not be found any logic of creation of this universe. Decision has to be made by us individually in each matter and satisfaction comes by understanding the things in more depth. If this is “beating about the bush”, I don’t mind it to be called as such.; and if this is not, then others should also not mind.

I wonder what is different in this post and earlier ones, except the length and some references. If some one is not agreeing to this, its his prerogative; but please let us know your view point instead of raising objections.

Regards,


KAMRAN.