Question –

During the year ended 31 March 2011, XYZ Limited (the company) ordered two aircraft. The manufacturer will deliver the aircraft in March 2012. The company is required to make a down payment of 50% for each aircraft at the time of placing the order. The balance amount is payable on delivery. The company funded the entire down payment from bank borrowings.

The manufacturer has informed that the manufacture of each aircraft, including planning, production of parts and assembly, involves a typical time period of 24 to 30 months. The manufacturer will start the manufacturing process for the aircraft in September 2011.

Can the company capitalize the borrowing costs incurred on the funds borrowed for down payment? If yes, from which date?

Answer –

AS 16 Borrowing costs defines a “qualifying asset” as an “asset that necessarily takes a substantial period of time to get ready for its intended use or sale.” It also clarifies that ordinarily, a period of twelve months is considered as a substantial period of time unless a shorter or longer period can be justified on the basis of facts and circumstances of the case. In this case, the manufacture of each aircraft involves a normal time period of 24 to 30 months. Therefore, the aircraft is a qualifying asset under AS 16.

The AS 16 criteria for the capitalization of borrowing costs and our analysis are given below:

 

AS 16 criteria Analysis
Expenditure for the acquisition, construction or production of the qualifying asset is being incurred.

Borrowing costs are being incurred.

Activities that are necessary to prepare an asset for its intended use or sale are in progress.

The company has paid 50% down payment for the acquisition of asset. Thus, this criterion is met.

The company is incurring the borrowing cost on the amount borrowed from the bank.

AS 16 does not mandate that activities to prepare the asset for its intended use should always be carried by the company itself. In our view, it is acceptable to capitalize the borrowing cost even if these activities are being carried out by a third party. However, these activities should actually be in progress.

Keeping the above in view, we believe that the company can start capitalizing borrowing cost only from September 2011 when the actual manufacturing process started on the aircraft.

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0 responses to “Capitalization of borrowing cost on prepayments made to acquire an asset”

  1. CA.KUNJAR SHAH says:

    RIGHT…..

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