To prescribe the accounting treatment for borrowing cost incurred irrespective of its nature either capital or revenue and to interpret the said accounting standard in a fairly manner with the help of accounting standard interpretation as issued by ICAI.
With the advent of Industrialisation, Organisations need more resources so as to compete in the Industry which it pertains as well as to achieve its vision. Among those resources, Money is foremost and it is needed for various reasons which may include meeting its working capital requirement, construction of asset, etc. Most of the organisation opts for borrowings from banks, other financial institutions for the same.
Borrowings may include some outflow of cash even before such borrowings are made, which we may call as borrowing cost such as interest, loan processing charges by banks, other charges other than the principal amount while repaying.
Borrowing costs are interest and other costs incurred by an enterprise in connection with the borrowing of funds.
Interest charges on bank borrowings including short term and long term borrowingsBorrowing cost can be illustrated with many interpretations. But AS 16 provides an inclusive definition comprising of,
Amortisation of discounts, premiums
Ancillary costs in connection with arrangement of borrowings
Finance charges in respect of assets acquired on finance lease
Exchange difference arising in foreign currency borrowings to the extent they are regarded as an adjustment to interest costs.
A qualifying asset is an asset that necessarily takes a substantial period of time to get ready for its intended use or sale.
There are certain exceptions to qualifying asset. They are,
Investments other than investment properties
Inventories that are routinely manufactured over a short period of time
How to interpret?
In order to guide for a proper interpretation ICAI has issued ACCOUNTING STANDARD INTERPRETATION (ASI).
With reference to ASI-1, Substantial period of time dependents on the facts and circumstances of each case. However, ordinarily, a period of 12 months is considered, unless a shorter or longer period can be justified on the basis of circumstances of the case.
With reference to ASI-10, Adjustment to interest cost means the difference between the interest cost on foreign currency loan and interest that would have been paid on local currency loan had this loan been in local currency
Borrowing cost will be recognised only if such cost or expense is absolutely and directly attributable to acquisition, construction or production of qualifying asset and its is also important that the cost incurred only be capitalised when it is probable that they will result in future economic benefits to enterprise and can be measured reliably
Borrowing cost that are not recognised and as a result it is not eligible for capitalisation can be charged to the profit and loss account in the period which it occurs.
Interrelation of AS-16 with other accounting standards
Exchange differences arising from foreign currency borrowing are considered as borrowing cost for which the increase in liability towards principal amount should be capitalised to the extent of increase in the interest would be paid if loan was taken in Indian currency and the balance has to be treated as exchange difference as per AS-11, The effects of changes in foreign exchange rates.
ABC ltd Company has taken a loan of USD 10,000 on April 1, 20X3, for a specific project at an interest rate of 5% p.a. On April 1, 20X3, the exchange between the currencies was Rs.45 per USD. The exchange rate as at March 31,20X4 was Rs.48 per USD. The corresponding amount could have been borrowed by ABC ltd in local currency at an interest rate of 11% p.a.
(i) Interest = USD 10,000 X 5% X Rs.48 = Rs.24000
(ii) Increase in liability towards the principal amount = USD 10,000 X (48-45) = Rs.30,000.
(iii) Interest that would have resulted if the loan was taken in Indian currency =USD 10,000 X 45 X 11% = 49,500
(iv) Difference between (iii) and (i) = 49500 – 24000 = 25,500.
Therefore out of Rs.30,000 increase in liability towards principal amount, only Rs.25,500 will be considered as borrowing cost and the remaining Rs.4,500 will be considered as exchange difference and charged to Profit and Loss as per AS-11
Total Borrowing cost as per AS-16 = 24,000 25,500 = Rs.49,500
How will you answer change in the above case it the local interest rate is 13%
(i) Interest = USD 10,000 X 5% X Rs.48 = Rs.24,000
(ii) Increase in liability towards the principal amount = USD 10,000 X (48-45) = Rs.30,000.
(iii) Interest that would have resulted if the loan was taken in Indian currency =USD 10,000 X 45 X 13% = Rs.58,500
(iv) Difference between (iii) and (i) = 58,500 – 24,000 = Rs.34,500.
Therefore, whole 30,000 will be considered as borrowing cost.
Total Borrowing cost as per AS-16 = 24,000 30,000 = Rs.54,000
What will be the situation under Income-tax act?
Sec.43A Income-tax act explains how to deal with exchange rate differences arising from acquiring asset from a country outside India for the purposes of business or profession as a result increase or reduction in liability for making payment or for repayment of loan borrowed in foreign currency specially acquiring for asset. It clearly states that exchange difference has to be treated in Income tax only in relation to payment, and not on accrual basis as required under AS-16.
Therefore, only the exchange differences arising from the assets acquired or loan borrowed from outside India is to be capitalised. It never speaks about the concept of adjustment of interest costs. So, even if one has followed AS-16 for treating exchange difference as an adjustment to interest cost, it has to be nullify that effect while arriving at the block of assets as per Income tax act and instead, adjustment of assets only to the extent of exchange differences has to be made.
Expenditure on a qualifying asset comprises of only those that has resulted in payments of cash, transfers of other assets or the assumption of interest bearing liabilities. Such expenditure has to be decreased for any progress payment received and grants received in connection with asset .This is also similar in the case of Accounting standard-12, Government grants, as it prescribes that asset has to be accounted after deducting the amount of monetary grant received from the gross value of the asset.
In the inclusive definition of borrowing cost, it says that finance charge arising on account of assets acquired on financial lease is to be capitalised to the extent of such finance charges. Such finance charges will be computed as per the Accounting standard-19, Leases.
Measurement of borrowing costs includes such costs incurred in both specific and general borrowing. In case of specific borrowing, the money borrowed is used particularly for the purpose of acquiring a qualifying asset. Such cost has to be capitalised less any income on temporary investment made on such borrowings
On the other hand, it is general borrowing for which the money is borrowed generally for the purpose of various qualifying assets, the amount of borrowing cost to be capitalised to be determined by applying an appropriate capitalisation rate on the expenditure of the capitalisation rate. Capitalisation rate is the weighted average of the borrowing cost applicable to the borrowings of the enterprise outstanding during the period other than the borrowings made specifically for the purpose of obtaining qualifying asset.
Capitalisation Rate = Total Interest on borrowing
Therefore, the relationship is,
Specific borrowings – one loan with one asset or many assets
General borrowings – Many loans with many assets
Expenditure on qualifying asset
Payment of cash XX
Transfer of other assets XX
Interest bearing liabilities XX
Receipt of progress payment (XX)
Grant received in connection with asset (XX)
Another important note is that the amount of borrowing costs capitalised during the period should not exceed the amount of borrowing cost incurred during the period.
Capitalisation of borrowing coast will be commenced on the basis of three conditions. They include that the expenditure for acquisition, production of asset has been actually incurred and activities necessary to prepare the asset for which the asset has been originally assessed to be used and actual borrowing cost has been incurred for the same.
Borrowing costs in relation to qualifying assets are normally continuous for capitalisation. But in certain case they are suspended as prescribed when there is interruption in the active development of the asset. But there is exception to such suspension is not necessary in these cases,
When substantial technical and administrative work is being carried out.
When temporary delay is a necessary part of process of getting an asset ready for its intended use or sale. (E.g. Interest on loan taken to finance working capital requirement for a vineyard)
There is a point in which the capitalisation of borrowing cost should to be stopped. Such capitalisation should be ceased if construction of a certain portion of the asset is completed and such asset can be used independently for its intended use or sale. On the other hand, if the assets are completed in parts and cannot be used independently, then the capitalisation should continue till the asset is ready for its intended use.
The other kind of situation is that the capitalisation should be stopped if the asset is physically completed and only the routine administrative work is going on. Even if decoration work is remaining then the asset is deemed to be completed and the capitalisation of borrowing cost should be stopped for such asset.
Borrowing costs are disclosed in financial statements in terms of the particular accounting policy adopted and the amount of borrowing costs capitalised during the financial year.
What are the significant differences between AS-16, IAS, and US GAAP?
There is a marked difference in the way US GAAP and IAS deal with capitalisation of borrowing costs. Under IAS-23, there are two treatments that are allowed,
The benchmark treatment which requires borrowing cost to be expensed when incurred
Alternative treatment which requires capitalisation of borrowing cost when certain rules and conditions are fulfilled.
But AS-16 does not allow dual treatment, i.e. borrowing costs are compulsorily capitalised when certain conditions are fulfilled and compulsorily not capitalised when certain conditions are not fulfilled. The same situation exists in the case of US GAAP-FAS-34 interest cost is capitalisable for all assets that require a period of time for their intended use, unless they are not material.
In spite of various accounting policies and financial reporting framework, AS-16, Borrowing costs are important to prepare those financial statements and so that the accounting information presented to the management is accurate and discloses material facts.
Accounting Conservatism and Risk Taking Decisions
Manager is in a position of Captain in Charge in ship of the Organization, so that to make organization more beautiful Manager has duty to make an important decision on Corporate Investment. These types of decisions create Agency Problems because of the time interest differences between manager and shareholder. This research is carried out to understand how conservatism accounting reduces agency problems, and examines the effect of conservatism on manager’s high risk investment decision. This research also examine that whether accounting conservatism solves the misalignment of interest between managers and organization through increasing hurdle rates used by managers during project selections, and sheds lights on literature attempting to identify the relation between accounting conservatism and manager’s investment decisions.
A study was conducted by Givoly and Hayn (2000), Beatty et al. (2008), and Khan and Watts in 2009, to measure accounting conservatism and firm’s characteristics such as size, leverage, and market-to-book ratio. They found evidences to support their hypothesis that accounting conservatism improves firms’ investment efficiency. According to Khan and Watts managers’ investment hurdle rates and induces conservative investment decisions are significantly increase under conservatism accounting, even when the agency problems are more severe this effect is more pronounced.
According to the positive accounting theory accounting conservatism plays very effective role in the roll contracting process. Corporate investment is an important decision, but this decision are not always made in the best interest of shareholders, so many time manager invest in a risky and even negative net present value projects just because of their personal interest in of investment. Accounting conservatism is a reporting mechanism which reflects accountant’s trend to require lower threshold to recognise bad news than good news. Accounting conservatism helps to improve corporate investment by preventing investment in high risk or unsuccessful investment projects by early terminations of such projects. This early terminations of projects reduces managers compensation and increases managers interest of job turnover. If manager is rational to predict the accelerated recognition of losses, and the timely termination of unsuccessful projects, they will be more cautious to make the investment decisions. (Francis and Martin (2010) and Bushman et al. (2007)) The increased cautiousness to invest will be reflected in the hurdle rate, which used to evaluate an investment project. In theory, hurdle rate is as equals as the cost of capital; managers should not take decision to invest in a project if the return is lower than the cost of financing. Indeed hurdle rate is observed to be either lowers than the cost of capital in practice, because of managerial discretion.
The result of the study state that Corporate governance role have established the roll of accounting conservatism in resolving information asymmetry, reducing agency costs, and improving debt contracting efficiency. (Ball (2001), Ball and Shivakumar (2005))
There are many research has been carried out in about the relation of the accounting conservatism and manager’s risk taking decision. Ahmed and Zhang, 2009 found that accounting conservatism reduces information imbalance between lenders and borrowers, and also reduces cost of capital for borrowers. They also found that if conservatism cause financially constrained firms to under investment than the relation between conservatism and firm’s future performance will negative. On the other hand reduce overinvestment problem for financially constrained firms, than the relation will be expected positive.
Another research carried out by Leuz (2001) and Guay and Vierrecchia (2006) and found that accounting conservatism force manager to avoid positive NPV projects, because Impaired incentives created for managers if gains not recognize timely untimely gain recognition, and manager force to avoid those types of positive projects. In particular, if gains are not recognize timely than manager will responsible for investment for those project, and may no longer be in the office by the time gains are realized. This is because always expect their future incentive rate higher in long term, than the firms required rate of return. If gains recognise by timely than even positive NPV for shareholder became negative for manager.
Accounting conservatism increases corporate investment efficiency in two ways. First is, by timelier incorporating bad news into earnings, accounting conservatism inform the board’s investigation of the unsuccessful investment project that may lead to its early abandonment, saving shareholders from unexpected future losses (Watts 2003). On the other hand, the expected personal costs related to project such as compensation, reputation and career concerns would increase managers’ cautiousness in choosing investment projects at the outset.
Extant studies by Ball and Shivakumar, 2005; Francis and Martin, 2010 believe that accounting conservatism can restrain managers to investing in negative NPV projects by accelerated loss recognition. In addition, if managers recognise ex ante about failure of particular project, they should record losses timely, because it will affect to their reputation and income as well, so manager should postpone investing in those project.
Furthermore, Roychowdhury (2010) found that risky projects are mostly become negative projects, therefor managers try to avoid risky projects due to timely loss recognition, because it creates also risk-averse, even if the projects have profitability to shareholders. If managers know that the project is have many risks of failure, manager have to write losses more timely before failure of project, because manager’s reputation income linked with compensation will be affected by it, so that manager avoid to involve to invest in those projects, even though projects are profitable.
Smith and Watts 1992; Kwon and Yin 2006 found that, firms with higher growth opportunities prefer to assets have higher contracting costs, because growth opportunities are often intangible in nature, so that information related to them are likely less verifiable. Therefore, managers have greater unrestricted power, and are more likely to manage earnings through accruals, so that agency costs are higher in high-growth firms. Furthermore high growth firms are more likely to have more volatile returns and higher probability of lawsuits, which creates a higher demand of accounting conservatism (Khan and Watts, 2009). Empirically, we use book-to-market ratio (an inverse measure of growth opportunity) to measure the growth opportunity of firms.
Driver and Temple (2010) found that, if the manager is aware of the embedded risk a hurdle rate that is higher than the cost of capital will be used by the irreversibility of the investment project. Corporate investment is efficient in the situation where internal funds flow gives the highest returns from investment project. However, managers deviate from the optimal level of investment, because of dysfunctional investment incentives (Stein et al. 2003). These dysfunctional incentives can be reflected in the hurdle rates used to select projects. Finance textbooks state that managers should benchmark the investment return to the cost of capital, so that with the project with lower returns than the cost of capital are rejected. In addition, managers use hurdle rates which sometimes higher or lower against the cost of capital, it depends on the managerial incentives invest.
Consistent with Hayn (2000),andWatts (2003), They found that both not only firm with goodwill purchased but also without goodwill have increasing trend in conservatism over time. Indeed He argue that lach of information will limit managers to random affect to recognize impairment losses agains their advantage timely.
The following hypotheses are proposed for this study:
H1 Accounting conservatism improves firms’ investment efficiency.
H2 Accounting conservatism helps manager to recognize bad news timely.
H3 Accounting consarvitism accelerates terminations of successful projects.
H4 Accounting conservatism can restrain managers to investing in negative NPV projects by accelerated loss recognition.
To testing hypothisese Basu’s (1997) used measure of conditional conservatism, because of theverification standerds of the hypotheses of recognizing bad newsand good news assumsions. (Richardson, 2006; Denis and Sibikov, 2010) they also examine relation between accounting conservatism with the component of investments by ussing total investments and changes in firm capital.
This study conclued that accounting conservatism is an important monitoring and contracting mechanism, and its helps manger to recognize bad news timely,so that manager could increase their managerial interest regarding project. Indeed accounting conservatism accelerates terminations of unsuccessful projects, also study found that conservative accounting increases hurdle rates, in addition conservatism changes hurdle rate because it reducing the future financial cost rather than by increasing the efficiency of contracting with the managers. We also find conservatism adds value to firms. This study also sheds lights on relation between accounting conservatism and managers’ investment decisions. The study also show that the accounting conservatism negatively correlate investment and firms future operating performance.