 Hello, and welcome to this session. This is Professor Farhad. In this session, we're going to be looking at borrowing costs, IAS 38. This topic is covered in international accounting course, as well as the CPA exam when we talk about interest capitalization. As always, I would like to remind you, my viewers, to connect with me on a professional level only then. Please subscribe to my YouTube. I have over 1,400 accounting, auditing, and tax lectures. You want to make sure you subscribe to stay up-to-date. Like my lectures, share them, put them in the playlist, let the world know about them. If you're benefiting from my lectures, it means someone else might benefit as well. This is my Instagram account. Please follow me on Instagram. This is my Facebook, and you want to make sure you check out my website on a regular basis as I have CPA course offers. So let's talk about IAS 23, or borrowing cost. Now, what is the big idea? The borrowing cost, simply put, if you want to translate it into the language that we are more familiar with, it's interest expense. And what is interest expense? Interest expense is the cost of borrowing money. So this standard tells us, what do we need to do with interest expense? Well, obviously, if it's an expense, we need to expense it, right? That's the general rule. Well, that's the general rule, of course. When you borrow money and you incur interest expense, you have to incur it, you have to expense it. However, if you incur interest expense, and you are constructing an asset. Okay, what does that mean? So let's first, let's make it even simpler. You have two options. And by the way, this is a warehouse, okay? Just use your imagination. You can buy a warehouse for a million dollar, or you can construct it. So you can buy the warehouse, or you can construct the warehouse. Now the question becomes is this, if you bought the warehouse and you paid a million dollar, do you think the seller, do you think the seller included the interest expense in the price? Do you think the seller said, well, I'm gonna have to recover my interest expense. Therefore, the interest expense is included in the price. And I'm gonna assume that you said yes. Why? Because the seller wants to, let's assume the seller build it and sold it to you. They want to recover their expenses. They want to recover their cost. Therefore, what we say is, if you constructed this warehouse, and if you incurred interest, then you have the right to capitalize, that's the key word, capitalize the expense. Capitalize the interest expense. Specifically, interest, you have the right to capitalize the interest expense. What does that mean? It means you have the right to treat those expenses as an asset as part of the warehouse. And this is why we have to talk about borrowing costs. Okay? So this is the big idea. Maybe because generally speaking, you might say, hold on, borrowing costs is interest. Don't I expense interest? Yes, that's the general rule unless you are constructing an asset. You are required for borrowing costs to be capitalized to the extent that they're attributable to the acquisition, construction, or production of a qualified asset. Now we need to know what does it mean a qualifying asset? Okay, because that's important. What counts as a qualifying asset? We have two types of qualifying asset. Asset under construction for your own use. So you are constructing a building, like a warehouse for your own use, or you are constructing an asset with the intention of selling or leasing the asset, but as constructed or produced as a discrete project. So let's think about somebody asks you to build a boat for them. Then you're gonna sell that boat. So it's a discrete project. Simply put, you don't capitalize interest cost that's for mass production. So if you are producing inventory and that inventory is part of your regular business and you are incurring interest, you cannot capitalize, you cannot capitalize that interest. You cannot capitalize that interest. Okay. Other borrowing costs are expense in the period in which they are incurred. So simply put, if it's not a qualifying asset, any other cost incurred is part of your, part is an expense. Okay. So hopefully we got a good idea. So please remember producing regular inventory is expense, is expense. All right. Let's take a look. And let's see the picture of what it looks like. What does the big picture looks like? Okay. So for example, let's assume Petro-China incur borrowing cost equal to 23 million Chinese won. It directly expense 20 million, 20.8 million and capitalize the remainder. What does that mean? What does that mean? It means from a journal entry perspective they expense only 20 million, 20.8 and they add it to the asset 2.5. And this is in total their interest expense. This is in total their interest expense. How does IAS define borrowing costs? Well, it defined borrowing costs more broadly than USGAP. What do I mean by interest? Well, what do you mean by that? It defined it more broadly. For example, foreign exchange gains and losses are treated as borrowing costs to the extent they represent adjustment to interest costs. Let's assume you borrowed in one currency then you repaid the interest or the principle in another currency. And as a result, you had a gain or a loss on the exchange. Then guess what? Your borrowing cost might up. Your borrowing cost might go down. That's in the US. You're not allowed to make any foreign exchange adjustment. Also, when you borrow money you might take this money and invest it. For example, you borrowed $10 million for a project. Well, you're not gonna be spending the $10 million immediately. You're gonna put that money in the bank then spend it three, four million at a time. When you put that money in the bank it's gonna earn interest. Then what's gonna happen? Because it's gonna earn interest. The interest that you earned from your investment whatever that investment in is in the bank maybe it's just a money market account but nevertheless it's revenue. You can net that interest revenue against interest expense. Netting is not allowed under the US. If you earn any interest revenue from that money it's kept separately. So those are two differences of how interest borrowing cost is defined US gap versus IFRS. So the interest capitalization. So what do we need to know about interest capitalization? Now by the way I covered this topic in depth in my intermediate accounting course in the US gap. So if you're interested in more detailed explanation with examples go there but I'm gonna work an example here. So the amount that we capitalize is the amount of interest that we could have avoided if the expenditure has not been made. So the first thing we have to understand is there's something called avoidable interest. The avoidable interest is the interest that we could have avoided that we did not incur. Okay, so we have to know that the so the interest that we capitalize it's that interest it's on the amount that we could have avoided if we did not undertake this project. And we'll work an example. So what we do is we have to compute something called the weighted average accumulated expenditure. What does it mean? The weighted average accumulated expenditure it means your interest expenditure don't start until you actually spend the money. So let's assume you spend the money for the last three month of the year. Interest is only counted for that last three month. Again, we're gonna work an example shortly because this will not make any sense until we work an example. The appropriate interest rate. So which interest rate do we use? It's a weighted average rate on borrowing on the borrowing outstanding is determined very similar between IAS 23 and US gap which we'll work an example show you which interest rate do we use? Now, if we borrowed specifically for the project if specific new borrowing can be associated with a qualifying asset then the actual interest rate is used to the extent of the weighted average accumulated expenditure. Okay, so let me give you let's work some numbers real quick. So this way it's I don't go out of I don't confuse you. Let's assume the weighted average accumulated expenditure happens to be 300,000. Just don't worry about this. I'm gonna show you how we compute this. Now let's assume we specifically borrowed for this project. Specifically, we borrowed $100,000 for this project. We borrowed $100,000. Then guess what? Of the $300,000, $100,000 we use the interest rate that we borrowed for this project specifically whatever that interest rate is. Let's assume that interest rate is 8%. Then what we're left with 200,000. The remaining balance what we use for the remaining balance is the weighted average interest rate. For this we use the weighted average interest rate. Whatever that weighted average interest rate is we will look at an example and we'll compute that weighted average interest rate. The weighted average interest rate could be 10%. I don't know, 6%. It doesn't matter, okay? But if we have specific borrowing we use the specific borrowing first against the weighted average accumulated expenditure then we would use the average rate of other debt. Interest income earned on temporary investment is offset against interest cost. Again, this has to do with only international standard not US gap. Obviously this is an international standard course. The capitalization of borrowing costs begin when the expenditure for the asset are incurred and ceases when substantially all activities necessary to prepare the asset for sale or use are completed. So simply put you will start the capitalization process from the time the project start until the time the project ends. All these steps will be illustrated in the next example. So let's take a look at this example. Assume a company borrowed 200,000 at 12% from state bank on January 1st for a specific purpose of constructing a special purpose equipment. So simply put we call this 200,000 or we call the specific borrowing. So we borrowed this money specifically for this project. Construction on the equipment begins January 1st. So this is when we start the capitalization period and the following expenditure were made. So we made the following expenditure. January, we spent 100,000. April, we spent 150. November, we spent 300,000. December, we spent 100,000. You might be saying, hold on, I borrowed 200,000. Where did this money came from? Well, we have money from other sources. Okay, here's the other sources of money. We have other debt. We have half a million dollar bond at a 14% rate and we have a note alone of 300,000. So we have money from other sources. Also, we have debt. So these are called other debt. This is called other debt. Well, first we have to find out if this asset is a qualifying asset. Well, special purpose equipment qualify because it required a period of time to get it ready and it's used in the company's operation. So this asset is a qualifying asset. When does the capitalization period begin? The capitalization period began January 1st and it's gonna end December 31st when the project is done. So we know when do we capitalize the interest and we know that the asset is a qualifying asset. The next thing we're gonna compute is the weighted average accumulated expenditure. Remember, we spent $100,000 January 1st and this information is coming from here. On January 1st, we spent $100,000. Well, think about it. If we used $100,000, that $100,000 would incur interest for 12 months. So 12 out of 12. April 30th, we spent 150,000 on the project. Well, this money that we spent, we took out of the bank and we paid, it's gonna incur interest eight, 12 of a month. It's incurring interest all year long, but for the project, it's eight, 12 of a month. November 30th, we spent $300,000. So this $300,000 would incur two 12 of a month interest. On December 31st, we spent $100,000 and it did not incur any interest for the year. Now, when we add all this up, this is called, this $250,000 is called the weighted average accumulated expenditure. So this is the expenditure that we could have avoided if we did not undertake this project on average. Okay, that we're gonna, it's gonna be subject to interest. And this is what I meant by this yellow highlighted number here, the weighted average accumulated expenditure. So simply put, in theory, we could have avoided $250,000, which is weighted throughout the year if we did not undertake this project. So notice, $250,000 is the weighted average accumulated expenditure. For this amount, we borrowed 200,000, for this project, we borrowed $200,000 from the bank. That was for specific borrowing. So this was the specific borrowing. Remember, I talked about earlier. Then what's left is $50,000. So how are we gonna apply the interest rate on the $50,000? We're gonna see that in a moment, okay? So compute the actual and avoidable interest. Well, first you have to select the interest rate. For the portion of the weighted average expenditure that's less or equal to the amount borrowed specifically to finance the project, use the rate incurred on specific borrowing. So this is the $200,000, okay? Because $250,000 is the total. $200,000 is covered by the specific borrowing and we paid 12% on this project. Now, for the amount, for the portion of the weighted average accumulated expenditure, that's greater than the debt specifically incurred for the project. Remember, the additional money is $50,000 more than the specific borrowing that we're gonna have to compute. We're gonna multiply it by the weighted average interest rate. So this is gonna be multiplied by the weighted average rate of other debt. Other debt means other than the specific borrowing which we have two type of debt. We have a bond and we have a notes payable. Let's compute, let's start the computation. Let's compute the actual interest. The actual interest was specific borrowing times 12%, half a million times 14%, 300,000 times 10% equal to 30,000. So in total, the actual interest that this company will have to incur is 124,000. Now, the weighted average interest on other debt, on the general debt, on other debt, this is the other debt, those two. Well, it's $100,000 in interest which is 70 plus 30 plus 800,000 off loan. So simply put the average interest rate on other debt other than this debt other than the specific borrowing is 12.5. And the average should be in between 10 and 14 and it's more towards 14 because we have more money borrowed at 14%. So the average interest is 12%. Now we have to compute the avoidable interest. The avoidable interest, which is $200,000. The avoidable money is 250. So 200,000 will be subject to 12% and $50,000 will be subject to 12.5. So the avoidable interest is 30,250. The actual interest is 124, the avoidable interest is 32. What do we capitalize? We capitalize the lesser of these two. So we looked at the avoidable interest, which was 30,250, we had to compute this based on the weighted average accumulated expenditure. Then we look at the actual interest. The difference is another difference. The smaller is what we, this lesser of these two is what we capitalize. Therefore, when we computed the actual interest, here's what we did. We debited interest expense 124,000 and we credited cash or interest payable. Just do this here. We debited interest expense for the actual interest 124,000. We credited cash slash interest payable 124. Now at the end of the year, we find out that we have to capitalize 30,250. And what we do is we reduce interest expense by 30,250 and we increase the equipment. Therefore capitalizing, we capitalize, we made an adjusting entry to capitalize the amount of interest. This is basically a simple example without including any foreign currency translation, without including any foreign currency, foreign currency gains or losses without netting because this is basically a US gap example. But if there's no netting, no revenue, no foreign currency, this is how it works. Let's take a look at another example on the international level. On January 1st, P company borrowed 30 million euros at an annual interest rate of 8% to finance the construction of a new facility in Spain. The facility is expected to cost 30 million and take two years to build. So the company temporarily invested the euro borrowed until cash is needed and they earned 225,000, basically interest revenue. During year one, the expenditure of 20 million are incurred, the weighted average is 12 million. So they incurred 20 million but they computed the weighted average accumulated expenditure which happens to be only 12 million. The company made annual interest payment on the loan and would repay the loan in full December 31st, year two by converting US dollar into euros, okay? Now the US dollar, the US dollar euro exchange was 1.41 on January 1st, year one and 1.4 on December 31st, year one. So the end of the year was 1.4, at the beginning of the year it was 1.41, okay? Now, how much are we gonna capitalizing? Well, let's start with the interest. We incurred 12 million is the weighted average accumulated expenditure times 8%, that's 960 euros in interest. Now we have to pay it and you have to convert it into US dollar. We're gonna convert it at the rate on December 31st, year one, 1.4. So for US dollar, that's 1,344. If this was a US gap, well, we stopped, that's it. This is our interest, this is how much we're gonna capitalize. But, but because we have, we are using the international standard, okay? So we have to figure out what's our interest cost. Well, income earned on temporary investment is 225 euros times $1.4, 315. It means the interest net interest cost is 1 million and 29,000 because this revenue is going to offset the expense. Now, how much are we gonna capitalize? Well, there's an exchange rate gain because the weighted average accumulated expenditure would have cost us 1.42 January 1st, but by December 31st, it was 1.4. Therefore, from the foreign currency adjustment, exchange gain rate, we have an exchange gain rate of 240,000. Why? Because when we borrowed 12 million and we wanted to convert it in US dollar, it would have been 1.42. Now it's only 1.40 by the end of the year. Therefore, we have an exchange gain. Well, what does that mean? The net interest cost, if you were asked, it's 1 million and 29. After deducting the exchange rate gain, the total amount borrowed to be capitalized is only 789. Why? Because 1,344 minus the income earned minus the gain. Here we have to have it. We happen to have a gain. So we capitalized 789. So notice it's different than USGAP. Under USGAP, we would have only capitalized 1,344,000. I hope this session helped explain the borrowing cost under IAS 30, I believe 38. If you have any questions, any comments about this topic, please email me. If you happen to visit my website for additional lectures, please consider donating, IAS 23, not 38. That was intangibles. And please visit my website. I always have offers on CPA program. Good luck and study hard.