A qualifying asset is one that necessarily requires more than one accounting period before being ready for use or sale.
IAS 23 establishes that interest on a loan acquired to construct a qualifying asset must be capitalized as a higher value of an asset.
For example, if a company requests a loan to finance the construction of a production plant, and it is estimated that the completion of the asset will extend beyond 2 years, the interest on the loan should be recognized as a higher value of the asset.
However, suppose the financing term is greater than the time of the construction of the asset.
In that case, the interest on the loan will be capitalized until the asset is ready for use to the management’s specifications.
After that, financial interest should be recognized as an expense in profit and loss.
Another essential aspect that the entity must consider is that an entity will capitalize the net effect between the interest on the funds it has borrowed, less the returns obtained from the temporary investment of such funds, under paragraphs 12 and 13 of IAS 23.
For example, a company dedicated to the production of airplanes requests a loan from a bank for 10 million over 12 years to finance its production.
The entity decides to keep the money received from the bank loan in medium-term investments.
After constructing the asset, the interest on the borrowed funds is 80,000, and the income from the returns on investments is 10,000.
In this case, the entity must only capitalize 70,000 as a higher value of the qualifying asset.
That is the equivalent of the net interest on the loan and the interest from the returns.
Beginning of capitalization of interest on a qualifying asset.
IAS 23 indicates three requirements that the entity must meet to start recognizing financing interests as a higher value of an asset.
These requirements include disbursements concerning the asset.
Recognition of borrowing costs.
And the activities necessary to prepare the asset for its intended use or sale.
The previously mentioned requirements must be met in full for an entity to be able to capitalize on the financing interests within the asset.
Some companies make the mistake of starting to capitalize the interest on a long-term loan without considering that there may be a high degree of uncertainty about the start of the activities necessary to put the asset in working order.
For example, in year 1, a company takes out a 15-year loan to build a warehouse.
The entity expects to acquire land and begin construction activities within six months with this money.
The company estimates that the entity will complete the project within 13 years.
As you can see in the example above, the three conditions are met to be able to capitalize on the interest.
Disbursements incurred concerning the asset, such as a land acquisition.
On the other hand, borrowing costs are incurred, and finally, the activities are carried out to put the asset in operating conditions.
However, if we were to use the same previous example, but on this occasion, the company starts the construction of the asset activities in 7 years instead of 6 months, there would be evidence to conclude that the last requirement of paragraph 27 of IAS 23 is not fulfilled.
Therefore, the interest could not be recognized as a higher asset value.
Suspension of the capitalization of a qualifying asset
On the other hand, paragraph 20 of IAS 23 determines that when there is a suspension in the development of the activities of a qualifying asset, interest cannot be capitalized.
However, if the conditions that led to the suspension of the necessary actions to put the asset into operating conditions resulted from events beyond the entity’s control, the company may continue to recognize the interest as a higher value of the asset.
For example, an entity dedicated to constructing luxury yachts requests a bank loan for 12 years to finance production.
The inventory is expected to be available for sale within 6 years.
In year 2, the company was forced to stop its activities because a hurricane damaged its production plant.
The entity’s management considers that it should continue to capitalize the interest on the loan as a higher value of production, regardless of whether the activities carried out at the plant are temporarily suspended.
Completion of the capitalization of a qualifying asset
Besides, an entity will cease to capitalize borrowing costs when all or substantially all activities necessary to prepare the asset for its intended use or sale have been completed.
Let’s see a practical example.
Qualifying asset practical example
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In year 1, an entity dedicated to constructing and selling vehicles requests a loan of 15 million over 5 years to finance its production.
The interest rate on loan is 10%.
The entity decides to invest the 15 million received from the bank in a profitable account that grants returns of 2% per year.
The company estimates that the completion of its production process will last 3 years and estimates that it will incur the following production costs over 3 years.
In year 1, 3,000,000
In year 2, 7,500,000
And finally, in year 3, 4,500,000 for a total of 15,000,000
The performance table of the invested funds is as follows:
As you can see, the withdrawals that the entity makes each year coincide with the estimated costs that the entity expects to incur in the period to complete its production.
During the first 3 years of the construction of the asset, the interest on the bank loan amounted to 3,738,342, while the returns on the invested funds amounted to 630,000.
This means that the net balance between these two values for 3,108,342 must be added to the 15,000,000 of the production cost of the asset for a grand total of 18,108,342.
The accounting recognition for each year is shown below.
As we can see, the first accounting record corresponds to the acquisition of the loan.
On the other hand, recognizing the money received in a profitable account is necessary.
Besides, the entity must recognize 1,500,000 of the interest associated with the loan during the first year.
And in addition, the recognition of the yields for the invested funds for 300,000.
Therefore, it will be necessary to repeat this process until year 3.
Since during years 4 and 5, financing will be recognized in profit and loss because the company already finished construction at the end of the third year.