The Exposure Draft (ED) of revised AS 16 Borrowing Costs, issued by the ICAI, retains the core principle that al borrowing costs incurred on borrowings undertaken to construct a ”qualifying asset” should be capitalized as part of the cost of constructing the asset. However, the ED proposes certain other changes vis-à-vis the existing AS 16. One change proposed is that the existing AS 16 explains the computation of exchange differences arising from foreign currency borrowings to the extent they are regarded as an adjustment to the borrowing costs. The said explanation is not proposed to be included in the ED, leaving the matter to the judgment of those, who prepare the financial statements.
Apparently, this is because no such guidance is available under IAS 23. In the context of IAS 23, when this matter was referred to the IFRIC, it concluded that ”how an entity applies IAS 23 to foreign currency borrowings is a matter of accounting policy requiring the exercise of judgment.”
The effect of foreign currency borrowings
In theory, foreign exchange rates and interest rates are related and, as such, it is fair to assume that any changes in foreign exchange rates reflect changes in interest rates. On this basis, all of the foreign exchange gain or loss on foreign currency borrowings would be considered as part of the borrowing costs on the borrowing. But recently, this argument has not been holding true, with many other factors impacting the relationship between foreign exchange rates and interest rates. Take the following two examples:
Entity A’s functional currency is INR, and it borrows GBP1,000 on 1 January 2009 for one year at a fixed interest rate of 5% to fund the construction of an asset. The spot exchange rate at this date is INR 90:GBP 1. At 31 December 2009, the exchange rate is INR 66:GBP 1. The entity has incurred a foreign currency gain of INR 24,000, while interest costs (assuming they were paid throughout the year at the then spot rate) say amounts to INR 3,750. How much of the foreign exchange gain included in the borrowing costs is eligible for capitalization?
Entity B’s functional currency is INR, and it borrows USD 1,000 on 1 January 2009 for one year at a fixed interest rate of 3% to fund the construction of an asset. The spot exchange rate at this date is INR40:USD1. At 31 December 2009, the exchange rate is INR55:USD1. The entity has incurred a foreign currency loss of INR15,000, while interest costs (assuming they were paid throughout the year at the then spot rate) amount to INR1,440. How much of the foreign exchange loss included in the borrowing costs is eligible for capitalization?
There are a number of possible approaches:
1. Determine, at the date of availing the loan, the equivalent interest rate on a local currency borrowing and use this as the borrowing cost to be capitalized. Let us assume that, for both the above examples, the interest rate on a INR90,000 borrowing at 1 January 2009 is 7% (entity A), and the interest rate on a INR40,000 borrowing at 1 January 2009 is 4% (entity B). The amount of borrowing costs eligible to be capitalized by entity A will be INR6,300, regardless of the movement in the foreign exchange rate. Entity B will be eligible to capitalize INR 1,600 as borrowing costs. However, this ignores the reason for entities borrowing in a foreign currency i.e., because they expect it to be less expensive. In this case, the movement in the exchange rates has effectively generated an additional gain for entity A, which is also counterintuitive.
2. Establish a”cap and floor” for the amount of foreign exchange gains or losses to be included in borrowing costs. The floor may be up to the amount that reduces the borrowing cost to nil. In the above example, entity A will include INR 3,750 of foreign currency gains as an element of borrowing costs, resulting in a net nil borrowing cost. The cap may be the interest on a local currency borrowing at inception, as this reflects the relationship between foreign currency and interest at that time. In the above example, entity B will therefore include INR160 of the foreign currency losses as borrowing costs, resulting in a net borrowing cost of INR1,600.
3. Determine a forward foreign exchange rate at the date of availing the borrowing and use this to determine the amount of foreign exchange gains or losses that are eligible for capitalization. Let us assume, in the above examples, the one year forward foreign exchange rates as at 1 January 2009 are INR84:GBP1 and INR44:FFC1. The amount of foreign currency gains on the borrowing that entity A includes as borrowing costs is INR 6,000 (Refer Note 1), regardless of the movement in the foreign exchange rate. Entity B includes INR 4,000 (Refer Note 2) of foreign currency losses on the borrowings as borrowing costs. While this approach provides a consistent assessment of the relationship between foreign exchange rates and interest rates, it is, by no means, a perfect approach. There are many factors affecting the relationship between foreign exchange rates and interest rates that cannot be adequately measured.
The effect of derivatives
It is also common for entities to enter derivative instruments that are designed to hedge against either foreign exchange gains or losses arising from foreign currency borrowing or changes in interest rates. The ED itself does not address the treatment of derivative instruments, and therefore the general principle to determine whether the derivative financial instrument is directly attributable to the acquisition or construction of a qualifying asset, applies. This is further complicated when considering the impact of AS 30 Financial instruments: Recognition and Measurement, which requires that derivative financial instruments are carried at fair value, with all changes being recognized in the income statement unless they are in a designated hedging relationship. Again, in the context of IFRS, the IFRIC discussed this matter and concluded that this was also “a matter of accounting policy requiring the exercise of judgment.” Management must consider the potential affect the accounting for the derivative has on the amount of borrowing costs eligible for capitalization. Let us take the following example: Entity C takes a loan of INR 5,000,000 on 1 January 2009 to construct a building. Interest is paid at LIBOR plus 1%. At the same date, the entity enters an interest rate swap with the same notional amount and the same interest payment dates, whereby it receives interest at LIBOR plus 1% and pays a fixed rate of 9%.
Two possible approaches exist:
1. The entity may determine that the inter-relationship between AS 30 and ED is such that the derivative instrument is directly attributable to the acquisition or construction of an asset only if it is designated as a hedge in accordance with AS 30. Therefore, in the above example to include the effects of the derivative in borrowing costs to be capitalized, the derivative instrument must have been designated as a hedge of the interest rate risk. In this case, the borrowing costs eligible will be the interest costs paid on the loan plus the net interest paid/received on the swap. If it is not designated as a hedge, the eligible borrowing costs will only comprise the interest costs paid on the loan.
2. Alternatively, the entity may determine that the inter-relationship between AS 30 and ED is irrelevant, and consider that the derivative instrument may be directly attributable to the acquisition or construction of an asset, even if it is not designated as a hedge under AS 30. This again will be based on the cash costs of the swap rather than the changes in fair value. Therefore, the borrowing costs eligible for capitalization will be the interest costs paid on the loan plus the net interest paid/ received on the swap. It will, however, be necessary for management to set up an approach to establish that it is directly attributable to the acquisition or construction of an asset. This is likely to be more difficult, the more the terms of the swap and loan differ.
Conclusion
Considering that no guidance is given in the ED, the management will need to carefully consider, which approach they apply to best reflect the relationship between foreign exchange rates and interest rates. This will require management to evaluate a number of alternative approaches to determine an appropriate policy. We recommend that the approach selected should be applied consistently and disclosed within the financial statements.
Note
1. Difference between spot at time of entry and forward rate is INR6 (INR90–INR84). Therefore giving FX gain of INR6,000.
2. Difference between spot rat time of entry and forward rate is INR4(INR40–INR44). Therefore giving FX loss of INR4,000.
