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Interest Capitalization: One Small Step Toward Convergence

Convergence generally involves standard setters working together to achieve a standard that is superior to either of their existing standards. As a practical matter, in the short term, most changes have resulted in either the IASB or FASB modifying their standard to more closely conform to the standard of the other body. In the long term, where both boards’ standards on a given topic are perceived to need significant improvement, joint projects will result in entirely new standards.

Recently, the IASB has revised its guidance for interest capitalization in IAS 23, Borrowing Costs, to more closely conform to the U.S. standard, FASB Statement no. 34, Capitalization of Interest Cost. Previously, IAS 23 mirrored the U.S. GAAP standard in many ways but rejected mandatory capitalization, instead allowing both a “benchmark” and an “allowed alternative” method. The former immediately expensed all interest costs (called “borrowing costs” under IFRS), while the latter employed deferred expense recognition via capitalization.

IAS 23 as revised in 2007 (IAS 23R) requires capitalization of borrowing costs associated with qualifying assets (defined as those taking a substantial period of time to prepare for intended use or sale). Qualifying assets can be inventories, plant and equipment, intangibles and investment properties, unless the assets are accounted for at fair value (since adding borrowing costs would cause carrying amounts to exceed fair value, which is prohibited). Inventories that are routinely manufactured, or otherwise produced in large quantities on a repetitive basis, are outside the scope of IAS 23R.

Borrowing costs include interest as well as ancillary costs such as amortization of financing fees or charges and premium or discount on the borrowings. The basic principle is that avoidable borrowing costs incurred due to the acquisition, construction or production of qualifying assets are to be capitalized. When multiple, non-specific borrowings are incurred, the entity’s weighted average borrowing cost is the basis for capitalization. Also included in the definition of borrowing costs are exchange differences arising from foreign currency borrowings (to the extent they are regarded as an adjustment to interest costs), and finance charges associated with leases that are capitalized under IAS 17.

Borrowing cost capitalization under IAS 23R begins when the reporting entity first incurs expenditures for the asset; incurs borrowing costs; and undertakes activities that are necessary to prepare the asset for its intended use or sale. Expenditures are payments of cash or transfers of other assets, or incurrence of interest-bearing liabilities. Activities are broadly defined to include physical construction and also pre-construction technical and administrative work.

Borrowing cost capitalization does not take place, however, during periods when activities have ceased or have yet to begin, such as when land is held for future development. When substantially all necessary activities are completed, capitalization terminates.

The effective date of IAS 23R is Jan. 1, 2009, with earlier adoption encouraged. The amendments are to be applied prospectively; comparatives will not need to be restated, so if immediate expensing was previously employed and a long-lived asset is under construction at the adoption date, it will not be necessary to capitalize previously expensed borrowing costs.

While the latest revision to IAS 23 results from convergence efforts, differences with U.S. GAAP remain. These include the definition of borrowing costs, which is broader than interest cost under U.S. GAAP; the exclusion from qualifying assets under IAS 23R of investments accounted for by the equity method; and the treatment of exchange differences, which are included under IAS 23R but excluded under FASB Statement no. 34. These remaining differences are notable to U.S. CPAs, since if the United States ultimately adopts IFRS in place of U.S. GAAP, these will likely be the final differences.

By Barry Jay Epstein, CPA, Ph.D., a partner at Chicago-based Russell Novak & Co. LLP, and Eva Jermakowicz, CPA, Ph.D., a professor of accounting at Tennessee State University. Their e-mail addresses are bepstein@rnco.com and ejermakowicz@tnstate.edu, respectively.

Editor's Note
In 2002, FASB and the IASB published a joint memorandum of understanding that has come to be known as “The Norwalk Agreement.” This agreement outlined the commitment of the two standard-setting bodies to remove differences between U.S. GAAP and International Financial Reporting Standards (IFRS). This is the first column in a series that will examine the progress of joint projects between FASB and the IASB.

Adopting IFRS: One Nation’s Experience

Effective March 4, SEC rules allow foreign private issuers listing securities in the United States to report exclusively in International Financial Reporting Standards (IFRS) without reconciling their financial statements to U.S. GAAP. Israel is second only to Canada in the number of foreign private issuers that register with the SEC and has recently adopted IFRS. The JofA spoke with Itamar Levin, editor of The Accountant, a publication of the Institute of Certified Public Accountants in Israel, on how the transition to IFRS has gone.

JofA: What are the major issues and challenges facing the accounting profession in Israel?

Levin: Our top ranking professional challenge is the implementation of the IFRS from Jan. 1, 2008. This is pure IFRS, not a version of it as has been done in Europe, and this is a very serious challenge for everyone who is involved in financial reporting. The second challenge touches upon the expectations gap and our need to explain to the public what auditors can and are authorized to do and what they cannot and are not authorized to do.

JofA: Israel has nearly completed its transition to IFRS. How has the transition gone?

Levin: Up to now, the implementation of the IFRS has been moving forward satisfactorily, but you can certainly understand that the real challenge is still in front of us, from the year 2008 and thereafter. In the first stage, public companies have been required to report about their preparations for the transition and, after that, about the main financial implications that are expected.

Personally, I think that the first two to three years will not be easy ones, to say the least, since what one is talking about is the replacement of the language in which the companies, the auditors, the analysts, the banks and the interested parties are talking—in effect we are talking about the entire economy. At the same time, one must not ignore the fear that exists that there might be people who will try to exploit the transition and do things that should not be done, especially in the field of the remuneration of management. All of this places a serious challenge in front of the supervisory authorities and also the auditing bodies, including the members of the Institute.

JofA: The U.S. SEC recently voted to allow foreign companies that list securities in the United States to drop the requirement to reconcile their financial statements to U.S. GAAP if they report using IFRS as published by the IASB. Will this encourage more Israeli companies to list on U.S. exchanges?

Levin: Israeli companies have been carrying out public offerings in the USA for many years. Israel is second only to Canada in the number of foreign companies that are traded in the USA. At the same time, in recent years more than a few Israeli companies have turned to the European markets, among other reasons, because of the regulatory and legal climate in the USA. In my opinion, the Israeli companies will carry out their flotations in a place where they can do so more easily and at a higher value. The removal of the requirement to reconcile financial statements to the U.S. GAAP is certainly gratefully received, as is any step that makes raising capital easier.

Summary of IAS 23R Requirements

A qualifying asset is an asset that necessarily takes a substantial period of time to get ready for its intended use or sale.

Borrowing costs are interest and other costs that an entity incurs in connection with the borrowing of funds. These may include:

interest on borrowings;

amortization of discounts or premiums on borrowings;

amortization of ancillary costs;

finance charges in respect of finance leases; and

exchange differences arising from foreign currency borrowings to the extent that they are regarded as adjustment to interest costs.

An entity must determine which borrowings are to be allocated to the qualifying asset. In the case of specific borrowings, the borrowing costs of these specific borrowings less any investment income are capitalized as part of the cost of the qualifying asset.

In the case of general borrowings, an entity must calculate a capitalization rate based on the weighted average of the borrowing costs applicable other than the borrowings made specifically for the purpose of obtaining the qualifying asset.

Commencement of capitalization is the date when an entity incurs expenditures for the qualifying asset, incurs borrowing costs and undertakes activities that are necessary to prepare the assets for their intended use or sale. In case of suspension of activities during extended periods, an entity suspends capitalization. An entity stops capitalization of borrowing costs when substantially all the activities necessary are complete.

IAS 23R is applicable for periods beginning on or after Jan. 1, 2009. Early adoption is encouraged, but this should be disclosed. IAS 23R will not be available to EU reporters until it has been endorsed by the EU.

Source: PricewaterhouseCoopers