LKAS 23 - Borrowing Cost Capitalization - Adjusting for Exchange Differences

“LKAS 23 Borrowing costs” deals with the capitalization of directly attributable borrowing costs with related to qualifying assets. The standard specifies three types of borrowing costs that are eligible for capitalization;

• Interest expense calculated under the effective interest method
• Interest in respect of lease liabilities as per SLFRS 16
• Exchange differences to the extent that they are regarded as an adjustment to interest costs (LKAS 23.6)

The first two types can be familiar with you all as those costs are commonly incurred with regard to acquisition, construction or production of a qualifying asset. This article is expressly about the third category because unlike the first two, the criteria related to capitalization of exchange differences is a bit different and might not be widely known unless you practically applied those criteria.

And the standard is also silent after the definition. So our only lead is to break down the definition in a way that we can understand.

So let us begin with a breakdown of above definition:

What are exchange differences?

These are the exchange gains and losses related to the borrowings made for the acquisition, construction or production of our qualifying assets. This includes both transaction and translation gains/losses associated with the borrowings. I emphasize borrowings because you can`t go around capitalizing every exchange difference that arise from your construction.

A quick recap:What are transaction and translations gain/losses?

It`s time to refresh your knowledge on “LKAS 21 The Effects of Changes in Foreign Exchange Rates” which I do not cover in this article. But to sum it up as per this standard,

1) a transaction gain or loss arise when the exchange rates used to convert the foreign currency to functional currency at the point of initial recognition and settlement of a monetary item is different

2) a translation gain or loss arise when the exchange rate used to convert the foreign currency to functional currency at the point of initial recognition of a monetary asset or liability is different from that of the year end spot exchange rate.

Back to LKAS 23…..

Accordingly we can only capitalize exchange differences related to the borrowings such as,

• Translation gains and losses arising from converting borrowing balances at the yearend closing exchange rate
• Transaction gains and losses arising from settlements of borrowing

This means following items cannot be for capitalized under LKAS 23;

• Translation gains and losses from trade creditors, debtors, bank accounts held in foreign currencies.
• Transaction gains and losses from settlement of debtors and creditors and other expenses.

Adjustment to interest costs

Now comes the restrictions. As the first step we identified what are the exchange differences that we can capitalize. Step two deals with the amount that we can capitalize. Although the standard does not provide a specific guideline, it is stated that we can only capitalize exchange differences “to the extent that they are regarded as an adjustment to interest costs” (LKAS 23.6)

This means that there is a ceiling for the maximum amount that can be capitalized which is in between the range of;

• Interest incurred on the foreign currency borrowings translated to company`s functional currency and
• Interest that would have been incurred if we borrowed in the company`s functional currency

Which sounds really confusing. Therefore lets breakdown the above concept in an example:

Eg: Let`s assume that Company A is located in Sri Lanka and the functional currency is LKR. The Company borrowed USD 1,000 at an interest rate of 4% in order to construct a building on 1^st April 2019. The financial year end of the Company is 31^st March 2020.

The following exchange rates are available,

1st April 2019	1 USD = 175 LKR
31st March 2020	1 USD = 180 LKR
Average	1 USD = 177.5 LKR

Accordingly A calculates the interest payable as at 31^st March 2020 with regard for the borrowing as,

The exchange gain or loss at the translation to reporting currency as at 31^st March 2020 with regard to the borrowing and interest accrued is as follows: (Assuming that the bank has granted a grace period to the Company and the repayments will start from the beginning of the second year).

	USD	Rate change	Exchange loss/(gain) LKR
Principal amount	1,000	+5 (180-175)	5,000
Interest	40	+2.5 (180-177.5)	100
		Total exchange loss	5,100

Company A follows the above mentioned rule to capitalize total exchange loss up to the ceiling only. Therefore A calculates the ceiling as follows,

1) Interest incurred on the foreign currency borrowings translated to company`s functional currency

2) Interest that would have been incurred if we borrowed in the company`s functional currency

Assume that the Company can borrow a loan to construct the asset in local currency with similar terms at an interest rate of 6%. Then the interest would be,

· Principal amount (equivalent USD amount converted to LKR at 1^st April 2019)

                   = USD 1000*175 = LKR 175,000

·

 Interest payable at 6%

                   = LKR 175,000*6% = LKR 10,500

Then our limit to capitalize is the difference between the interest costs. i.e,

= LKR 10,500 – 7,100

= LKR 3,400 (This is the maximum amount of exchange loss that can be capitalized )

The main reason for this parity is the heavy fluctuation of functional currency against foreign currency. The reason for using the above policy is to avoid over capitalization of exchange gain or loss that might occur due to adverse economic conditions.

The same method will be applied when there is an exchange gain as well. The only difference is capitalization of exchange losses lead to increase the asset value, whereas an exchange gain will reduce the asset value.

I hope you all understood how to adjust the exchange differences under LKAS 23. Thank you for reading this article.

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References:

LKAS 23, Insight to IFRS Edition 16 issued by KPMG.

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Article Written By:

Kasuni Mayadunna ( Project Manager at KPMG , ACCA Member , BSc. Accounting (Special) , USJP ( First Class)